CORPORATE LAW I PROJECT [VASU AGGARWAL, 2514, SUBMISSION DATE – 4 JANUARY]

TITLE – INTRODUCTION OF LIABILITY RULE PROTECTION FOR STAKEHOLDERS’ RIGHT TO

PROTECTION OF THEIR ENTITLEMENT BY THE INDEPENDENT DIRECTORS

This paper argues for liability rule protection inter alia for the stakeholders’ (especially,
minority-shareholders) entitlement to protection of their interests by the independent directors.

[Section 1] LACK OF PROTECTION FOR THE ENTITLEMENT OF MINORITY

SHAREHOLDERS

A director of a company is expected to exercise independent judgment in advancing the

interest of the company. The director is also expected to take into account interests of different
stakeholders such as its employees, shareholders, and even the environment. Upon failure to
exercise these duties, the director may be punished with a fine ranging from one-lakh to five-
lakh rupees. In India, it is more important to protect the interests of the minority shareholders
because there are controlled shareholdings which lead to agency problems between the
controlling-shareholders and non-controlling-shareholders. These problems include squeezing
out, and tunnelling. These problems are more likely to arise if the directors are dependent upon
the controlling-shareholders/majority-shareholders. Therefore, the institution of Independent
Director is important to maintain the distance between the board and the shareholders.

Independent Directors shall inter alia safeguard “the interests of all stakeholders,
particularly the minority shareholders”. This means that these stakeholders, particularly the
minority shareholders have the entitlement to protection of their interests by the independent
directors. However, there has been a constant distrust in the “independence” of the independent
directors. In a recent survey, it was observed that 65% shareholders lack trust in the
independent directors. They are believed to be under constant dependence upon the majority-
shareholders, or the board that is controlled by these majority shareholders. Such dependence
upon majority-shareholders/board clouds the judgment, and causes distrust as to whether they
are protecting the interests of all stakeholders. This dependence has been caused primarily
because the remuneration and commission of the independent directors are determined by the
members. Higher remunerations and perquisites create an incentive for the independent
directors to act in favour of the members. Other reasons [appointment, removal] have also been
attributed to this lack of independence. However, the most important reason complementing
all these reasons is the absence of any liability for violation of these duties [destruction of the
entitlement], especially violation of the duty to safeguard minority shareholders’ interests.

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 It is important to clarify that there are some scattered regulations [Environment Protection,
Foreign Exchange Management, Essential Commodities, S.149(12) of CA2013] that may
potentially impose liability on the independent directors; however, there is no provision either
deterring the independent directors from deviating from exercising their independent judgment,
or there is any provision deterring interest-groups from attempting to interfere with the
independent judgment of the directors.

[Section 2] INTRODUCING PROTECTION FOR THE ENTITLEMENTS OF THE

SHAREHOLDERS: A VIEW FROM THE CATHEDRAL

Calabresi and Melamed, in their seminal paper, argue that simply setting the entitlement
does not solve the problem of "might makes right" —as in this case, setting entitlement in favor
of the minority shareholders does not solve the problem of majority-shareholders/controllers
leveraging their bargaining position in exploiting the minority shareholders. Therefore, to
avoid majority shareholders from leveraging their bargaining positions, the entitlement in favor
of minority shareholders must be protected. These protection rules [second order rules], in form
of property/liability/inalienability rule, may be employed. This article argues that the liability
rule model forms the most appropriate protection for the entitlement of minority shareholders.

Liability Rules are preferable when destruction of entitlement may be allowed at a pre-
determined value of the entitlement. This may be due to efficiency reasons, especially where
there are great transaction costs to setting initial entitlement through negotiation. In case of the
entitlements of the minority shareholders to have their interests protected through the
independent directors, there would be great transaction costs. Different minority shareholders
may value the price of their entitlement differently, or they may overestimate/underestimate
the price and simply break the negotiations.

For example, a majority-shareholder may value the entitlement at Y, but one minority-
shareholder-A may value it at Y-10, and another minority-shareholder-B might value it at Y+5.
If minority-shareholder-B and similar shareholders hold out on Y+5, either believing that
minority-shareholder-A and similar shareholders may agree to a lower value or that the buyer
may agree to a lower price, it is likely that the negotiations fail. [See parallel-example here pg-
1107-1108] In other words, the diversity of the minority shareholders, who all hold
entitlements to protection of their interests, renders negotiations implausible. However, this
problem does not arise if society can collectively decide the value of this entitlement.

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Therefore, the majority-shareholders/controllers must be able to destroy the entitlement for a
pre-determined value of the entitlement [non-consensual taking].

From the preceding discussion, draft/suggested provision—“Any person, who interferes

with or affects, in any manner, the compliance with Schedule IV by the independent directors,
shall be liable to monetary penalty or compensation to be decided by the Tribunal”. “If any
independent director acts in contravention to the Schedule IV, they shall be liable to a fine”.

Consider this example taken in a different context by Khanna and Varottil. A corporate
firm which might benefit from a decision at 100-million, which costs the firm 75-million and
the controller (in time and effort) 18-million. For the firm, such a deal is worth perusing, given
7-million profit. However, there is no incentive for the controller [owning 51% stake] to peruse
it because it causes personal loss of 5.5-million for the controller. There could be incentive for
the controller to squeeze out the minority shareholders, in which case, the controller makes a
profit of 7-million. In such a situation, the minority shareholders have the entitlement to
protection of their interests by the independent directors. Since this entitlement is deterring the
controller from squeezing out the minorities and taking advantage of the profit situation, the
controller may want to buy the entitlement but such negotiations might be implausible as
argued before. The liability rule model, as suggested, allows the controller to non-consensually
destroy the entitlement by subjecting themselves to compensation. Therefore, here, if the
controller does in fact make the transaction after destroying the entitlement, she may make a
profit even after compensating the minority shareholders. As a result of this transaction, the
controller, (now) together with the minority-shareholders is able to make a profit of 7-million.
[such a situation may also allow for Kaldor-hicks efficiency]

[Section 3] COUNTERING CRITICISM

There may be three prima facie criticisms to the suggestion of introducing liabilities—
already existing protection in form of relief in case of oppression (first), violation of separate
legal patrimony (second), and enforcement concerns (third).

First, it must be noted that the protection in form of relief against oppression is an ex-post-
facto remedies i.e. they activate only after the event has occurred. However, the independent
directors are expected to act ex-ante i.e. before the event, and the suggested liability rule
protection bolsters the ex-ante remedy.

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 Second, in certain situations, it may be the case that the decision is being made by the
company, which is a separate legal entity. However, in India, there are broad exceptions to
separate legal patrimony principle where the corporate veil may be lifted. Even if the limited
grounds, as in UK, are considered, suggested liability provisions fairly fall in the evasion
principle.

Third, even if there are legitimate concerns of enforcement of such entitlement such as
identification of perpetrators, weak enforcement, as in the suggested model, would better
protect the entitlement than no enforcement, as in status quo.