Recent news reports (here, here and here) have highlighted a shareholder proposal that has been initiated in preparation for the annual general meeting of Alembic Limited to be held on 28 July 2017. The shareholder in question is Unifi Capital Private Limited who is said (though not verified) to be holding 3% shares in Alembic. The proposal involves the election of a “small shareholder” director for which Unifi Capital put forward the name of Mr. Murali Rajagopalachari. Although the company has since withdrawn the item from the agenda for the shareholders meeting, the developments have raised the possibility that activist investors could potentially use the “small shareholder director” route in order to get their voice heard by resistant boards. Proxy advisory firm IiAS has a detailed memo on the impact this episode will have on shareholder activism. In this post, I outline some of the issues pertaining to the “small shareholder director” and conclude that its utility is likely to be limited, if at all, as a tool of shareholder activism.
Background and Purpose
The concept of a “constituency director” is not novel, either in India or elsewhere. Such a director’s election is attributable to a predefined constituency. A nominee director (proposed by a controlling shareholder or private equity investor) is a paradigmatic instance of a constituency director. Similarly, in the Indian context, directors nominated by banks through powers set forth in specific banking legislation are another example. However, the idea of small shareholders as a distinct constituency electing directors is not common around the world, and India appears to be an honourable exception in providing for a director to be elected by small shareholders.
To be sure, the concept of small shareholder director existed even under the Companies Act, 1956, although it was introduced into the legislation by way of an amendment in the year 2000. It is presently contained in section 151 of the Companies Act, 2013 (the “Act”). The idea seems to be premised on the need to provide representation and a voice to the small shareholders who are otherwise passive and apathetic. While it has been on the statute book for a decade and a half, it has hardly been used. Given that its potential use as a tool for shareholder activism has been highlighted, it is useful to consider some of the other features and issues surrounding the concept.
Election of a Small Shareholder Director
The bar for the election of a small shareholder director has been set quite high. Rule 7 of the Companies (Appointment and Qualification) of Directors Rules, 2014 (the “Rules”) provides that the lower of 1,000 shareholders or one-tenth of the total number of shareholders of a listed company may propose the election of a director. Alternatively, a listed company may, of its own accord, opt to have the small shareholders elect a director. The Companies Act, 2013 in section 151 defines “small shareholders” as those holding shares of nominal value of not more than Rs. 20,000.
It would certainly be a tall order for an activist investor to garner the support of such a high number of small shareholders. It not surprising at all, therefore, to find that small shareholdings could be “created”, as reported in the Alembic case. This can be done by orchestrating sales of shares to several small shareholders so as to generate the constituency required for the election of such a director. While it is not clear as to who has been behind the process of disaggregating the shareholding of the company, both an activist investor as well as incumbent management (or promoter) may indulge in the process, which will lead to an all-out proxy war. Whether the artificial creation of such constituencies in the run up to the election of a small shareholder director is legally permissible is an interesting question. On the one hand, it may be argued that there is nothing illegal about such disaggregation of shareholdings, as long as the sales and purchases of shares are otherwise legitimately carried out. But, on the other, the question arises as to whether this amounts to vote manipulation. A similar effort in Hong Kong in the context of a scheme of arrangement was clamped down by a court in the case of Re PCCW Limited ( HKCU 720). But, the exercise of powers under section 151 neither involve court approval nor are they through a scheme of arrangement, thereby creating a legal vacuum regarding the legitimacy of such an approach.
In any event, such directors are to be elected by way of a majority of small shareholders, with no other shareholders eligible to vote for the purpose. Moreover, such election ought to be conducted through a postal ballot.
Qualification of a Small Shareholder Director
The Rules provide that the person proposed as a small shareholder director must satisfy all the requirements for appointment as a director, and ought not to be disqualified under section 164 of the Act. Moreover, the small shareholder director may be considered an independent director if the requirements under section 149(6) and (7) are satisfied. This issue may come to the forefront in case of the appointment of a person who is put up by a significant shareholder such as an activist investor (as experienced in the Alembic case). Questions could arise whether the board could have the discretion to determine the suitability of the person for appointment as a director even if she otherwise satisfies the qualification criteria. At one level, if the election by the constituency of small shareholders is to act as an investor protection mechanism, the board must be left with a fait accompli once a person is elected to the board by the small shareholders. On the other hand, section 178 of the Act provides for a broader role for the Nomination and Remuneration Committee regarding the composition of the board as a whole, and as to the qualifications and competencies of individual directors. The topical question would be whether the Nomination and Remuneration Committee can exercise power under section 178 to determine the suitability of a person proposed to be a small shareholder director. Arguably, this will come within the ambit of the Committee’s roles and responsibilities, although how this will interact with the minority’s choice of director to represent their interests is unclear. Only a test case will determine how a conflict (or an apparent one) between the appointment of a small shareholder director (under section 151) can be reconciled with the terms of reference of the Nomination and Remuneration Committee to shape the composition of the board (under section 178).
These issues are not merely within the hypothetical realm. Take a case where a company has just the minimum number of independent directors as required by the Act. If a person proposed by the small shareholders for appointment under section 151 does not satisfy the “independence” requirements, her appointment to the board will bring the number of independent directors below the statutory minimum, thereby resulting in non-compliance. Can the board (or the Nomination and Remuneration Committee) in such circumstances refuse to facilitate the appointment of such a person as a small shareholder director? Alternatively, will it be under any form of compulsion to appointment the small shareholder director, and follow that up with the appointment of additional independent directors to bring about the requisite balance and to comply with the independence requirements? Companies that face activism through the small shareholder route will have to prepare for such scenarios.
Whose Interests to Serve?
Like the case of nominee directors, there could be considerable ambiguity if the small shareholder director is required to serve two masters, namely the company (as an entity) on the one hand and the small shareholders (collectively as the constituency) on the other. While the Act makes provision for the election of the small shareholder director, it does not explicitly lay out the roles, responsibilities, duties and liabilities of such director. In that sense, the small shareholder director is no different from other directors, and will be foisted with the array of duties under company law as applicable to all directors. While there is some level of segmentation among the director body when it comes to appointments, which creates a specific mode of appointment for the small shareholder director, no distinction exists in relation to the roles and responsibilities. The small shareholder directors’ duties are like that of other directors. Hence, such a director, once appointed by the small shareholders, cannot simply advance the interests of her constituents at the cost of the broader interests of the company and other shareholders. Directors’ duties under Indian law (albeit under common law and not expressly in statute) are owed to the company and not to individual shareholders. Hence, while the small shareholders are entitled to appoint a director, ostensibly protect and advance their interests, in the end the director so appointed cannot prefer the interests of the constituents over and above the broader interests of the company. Individuals being proposed for election as small shareholder directors must be fully cognizant of the unenviable position they are likely to be placed in. Discharge of such a role will require a great deal of sophistication and experience.
Impact on Shareholder Activism
What motivated this post was the enthusiasm displayed by the media and commentators regarding the use of the small shareholder director provision in the Act to stimulate greater shareholder activism. The excitement surrounding the Alembic case is emblematic of the euphoria, even though in that case the proposal itself may not be put to vote at the shareholders’ meeting. Given that the Indian company legislation is somewhat rare in providing for small shareholder directors, the possibility of its use as a tool of shareholder activism cannot be ruled out. At the same time, there are considerable limitations with its design and operation.
At the outset, as discussed earlier, the bar has been set too high for the proposal and election of small shareholder directors. Several aspects of the appointment and role of such director suffer from considerable ambiguity. Even assuming an appointment is successful in a given case, the small shareholder director is only one among several directors, and cannot affect the outcome of a board decision. Such director can be privy to information placed before the board, and can express views and opinions and seek to convince other directors on matters being discussed, but would not be in a position to veto any decision. To that extent, the utility of such a position is to make the voice of various stakeholders (including the electorate consisting of small shareholders) heard and to infuse a higher level of transparency in board decision-making.
More importantly, while the small shareholder director is an important tool for the protection of “small” shareholders, necessary care and caution must be exercised to ensure that the position is not used by one or more large institutional investors who have an axe to grind with the management or promoters. Without appropriate checks and balances, the small shareholders may end up acting as pawns in larger corporate battles amongst groups of influential shareholders (such as a large institutional investor and the promoters). This will end up compromising the interest of passive retail shareholders rather than protecting them, which was the reason for the small shareholder director in the first place.