Standard For Independence Of Independent Directors; A Lesson From Delaware

Aryaman Kapoor & Joseph George

26 May 2024 2:58 PM GMT

  • Standard For Independence Of Independent Directors; A Lesson From Delaware

    Tesla and Elon Musk found themselves in a legal battle with their shareholders in 2018 with regards to Elon Musk's pay package worth USD 56 Billion, which according to some of the shareholders was unfair. Finally, the decision was rendered in January 2024 where the Court of Chancery of the State of Delaware, a court which holds a reputation for fairness, experience, and expertise in...

    Tesla and Elon Musk found themselves in a legal battle with their shareholders in 2018 with regards to Elon Musk's pay package worth USD 56 Billion, which according to some of the shareholders was unfair. Finally, the decision was rendered in January 2024 where the Court of Chancery of the State of Delaware, a court which holds a reputation for fairness, experience, and expertise in presiding over corporate disputes, held that the process leading to the approval of Musk's compensation plan was deeply flawed. It was also noted that Elon Musk had a conflict of interest as he had a long standing relationship with members of the compensation committee. This case is a very straight forward example of poor corporate governance and the first agency problem, where there is a conflict between firm's owners and its hired managers.

    In the judgement that was delivered by the Delaware court, one of the major issues that was discussed related to the independence of the independent directors. The Court noted that Elon Musk wore several influential hats inside Tesla and had thick ties with the directors who were tasked with the duty of negotiating the compensation plan on behalf of the Tesla, against Musk. The Court noted that Tesla's statement for the compensation plan stated that the compensation committee consisted of all independent directors. However, the Court assessed the ties of each director with Musk and noted that there was lack of independence on metrics other than financial deals. The Court took into consideration certain unconventional factors such as personal ties of the directors which have no financial involvement. These included friendships, vacations of families together, attendance in marriages, requests of both to invest in a third company where neither of them held a stake, etc.

    The Court noted that Delaware law imposes fiduciary duties on those who control a corporation to minimize agency costs caused by the divide between economic ownership and legal control. This fiduciary duty requires the directors to owe a duty of loyalty to the corporation and its stakeholders where the directors are not permitted to use their position of trust and confidence to further their private interests. On this point, the Court stated that despite this fiduciary duty to represent the interests of Tesla as members of the Compensation Committee, Gracias and Ehrenpreis negotiated the compensation plan in tandem with Musk and represented his interests due to their personal relationship with him, instead of keeping in mind the best interests of the shareholders of Tesla.

    When assessing independence in this aspect, Delaware courts usually consider not only the directors' relationships with the party to whom they are allegedly beholden, but also how they acted with respect to that party. To this effect, the Court stated that “A director lacks independence if he or she is so beholden to an interested director that his or her discretion would be sterilized”.

    It was also noted by the Court that it is possible for directors with strong ties to a controller to demonstrate their independence and directors without strong individual ties to a controller to can fall victim to a “controlled mindset”. A controlled mindset can be evidenced by the directors approaching negotiations with “less intent on negotiating with the controller and more interested in achieving the result that the Controller wanted”. Such was also the case here as the Court noted that no meaningful or positional negotiations took place over the size of the compensation that Musk received.

    Before looking at how India can incorporate the standards that were set by the court of Delaware, it is important to look at the standards for independence of independent directors in India which are provided in the Companies Act of 2013 ['Act'] and various SEBI Regulations. Section 149(6) of the Act and Regulation 16(1)(b) of the SEBI (Listing Obligations and Disclosure Requirements) Regulations ['LODR'] broadly state that an independent director and their relatives must not be a promoter of the company or its related companies, should not have any pecuniary relationship (with certain financial limits), and should not be related to the company's promoter, among other restrictions. In terms of pecuniary relationship, the MCA has clarified that transactions taken place at arm's length price from the purview will not be said to be a part of pecuniary relationship under Section 149(6)(c).

    In 1957, the Madras High Court had also noted that a director is precluded from dealing on behalf of the company with himself entering into engagements in which he has a personal interest conflicting or which possibly makes conflicts with the interests of those whom he is bound by fiduciary duties to protect and this rule is as applicable to the case of one of several directors as to a managing or a sole director. However, in 1981 the Supreme Court in the landmark case of Needle Industries (India) Ltd. v. Needle Industries Newey (India) Holding Ltd. has held that the friendliness of a person will not disqualify their appointment as an independent director.

    These cases dealt with the previous Companies Act and not the 2013 Act. Under the present Act and SEBI Regulations, only persons who possess a pecuniary relationships with the promoters or the company and its associates companies as well as holdings, are barred from being appointed as an independent director under Section 149(6)(c). This means that personal relationships such as friendships are not considered a conflict of interest and are not a part of the standard of independence for independence directors in India. The same has also been confirmed in a FAQ of the ICSI Guidance Note on Independent Directors.

    Moreover, the specific duties of independent directors are listed out in Section 149(8) of the Act which are listed in Schedule IV. This lists down the guidelines for professional conduct, role, functions, and duties of independent directors. These guidelines and duties include acting objectively, exercising responsibilities in a bona fide manner in the interest of the company, not allowing any extraneous considerations that will vitiate the exercise of objective independent judgement in the paramount interest of the company as a whole, while concurring or dissenting from the collective judgement of the Board in its decision making, informing the Board in case of loss of independence, refraining from actions which would lead to loss of independence and not abusing the position in a way that will be detrimental to the company or the shareholders.

    Now coming to how the decision of the Chancery of the State of Delaware in the Elon Musk case can be helpful for Indian jurisprudence. There are two factors of the judgement that are applicable. The first relates to actions of an independent director which may be detrimental to the company. In the Elon Musk case, as stated above, it was held that some directors having strong ties to the 'controller' can be independent in their decision-making, while some directors may fall prey to the “controlled mindset”. The independence or the lack thereof, can be evidenced by the extent of exercise of their powers, such as the power to hold positional negotiations, or to question the resolutions put before them.

    Schedule IV, Part 5 of the guidelines of professional conduct for independent directors states that it is upon to the independent director to ensure that any extraneous considerations do not vitiate their exercise of objective and independent judgement. Therefore, if one makes a liberal interpretation of the concept of Part 5. One can say that this standard for independence (“controlled mindset” plaguing the judgement of an independent director) has already been covered under the Indian statutes. However, it is imperative that Indian courts do utilize the Musk case and provide this provision a liberal interpretation when a relevant case comes along.

    At the same time, the Delaware court has given the benefit of doubt to those independent directors who may not be independent to make decisions independently and in the interest of the company and its shareholders. This concept deviates from the Indian approach as once it is established that an independent director has a pecuniary relationship with the company or the promoters, there is an assumption of lack of independence without looking into the facts or circumstances of the decision made. This approach can also be adopted into the Indian jurisprudence where if there is a case where the director suffers a loss of independence, instead of vitiating the decisions made by such director, the court can look into the specific decisions made by the independent director to conclude whether the decisions were made with independent judgement.

    Now coming to the second factor that relates to inclusion of relationships other than pecuniary relationships as a reason for loss of independence. As stated in the previous section, the only relationship that bars a person from being appointed as an independent director is a pecuniary relationship. There is no law barring a personal relationship with the promoters of the company or related companies. However, there is a need to expand this restrictive standard. While it is understandable that codification of such a provision is not possible as defining what a personal relationship is difficult due to the informal and transient nature of such relationships. This is where courts need to step in and investigate cases where loss of independence has been alleged while accounting for a conflict of interest which stems from personal relationships as was done by the Delaware court.

    To conclude, the Delaware Court's ruling on Elon Musk's compensation package serves as a critical example of the importance of a robust corporate governance and the need for truly independent directors. The court's emphasis on the deep personal ties between Musk and the directors serves as a cue for the evolution and expansion of standards for the independence of independent directors. For India, the lessons from this case are clear. The current standards for independent directors, as outlined in the Companies Act of 2013 and SEBI regulations, focus predominantly on pecuniary relationships. However, this case demonstrates the need to broaden the definition of independence to include personal relationships that could impair a director's ability to make unbiased decisions. Indian courts should consider a more liberal interpretation of independence, similar to the Delaware court's approach, where the focus is on the director's actions and decision-making process rather than solely on formal relationships. By incorporating these broader standards, Indian jurisprudence can strengthen the framework for corporate governance, ensuring that independent directors act in the best interests of the company and its shareholders. This approach will enhance the integrity of board decisions and foster greater trust in corporate governance practices in India.

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