This blog is an addendum of the study report on “Responsibilities of Board of Directors and Promoters towards Investors and Stakeholders” submitted to IIM Kozhikode by Nilotpal, Raghu, Ritam, Sanjay, Shailesh, Shubam, Subin, Tushar, and Yash as part of the “Leadership and Corporate accountability” course included in the EPGP program.

  • A startup raised 5 crores in their first funding round from a VC firm. The founders were serving as the directors. While raising the investment, it was stated that the money will be used for product development and marketing. However, the founders diverted a significant portion of the funds towards personal expenses and even buying a car for the company, which the founders used for personal purposes.

  • A promising AI startup was built on the skills of their founding CTO. The CTO was not happy with the way things were going and decided to leave the company and informed the other founders who were in discussion with potential investors to raise funds for the next round. However, they did not disclose the CTO’s departure plan to the investors. After the investment was made, the CTO left, and the investors felt misled as they believed the CTO’s presence was crucial for the company’s success.

  • A large family owned construction company was operating with significant leverage. The board of directors (who were family members) decided to split the company into two entities, one holding the profitable assets and the other holding the debt. The directors did not inform the creditors about this restructuring plan. After the split, the creditors found it challenging to recover their dues from the new entity holding the debt, leading to significant haircut for them.

  • A firm was not paying salaries to its employees for several months due to cash flow issues. The board of directors decided to prioritize payments to suppliers and other operational expenses over employee salaries. When employees raised concerns, the board assured them that their dues would be cleared soon, but no concrete plan was shared.

What is common in all these scenarios? Does these feel wrong to you? Yes, they do. In all these scenarios, the board of directors and promoters have failed in their fiduciary duties towards investors, stakeholders, and employees.

What is Fiduciary Duty?

Fiduciary relation arises when a party is entrusted with property, information, or power to make decisions that involve discretionary judgement for the benefit of someone other than themselves. A trustee and beneficiary, doctor and patient, lawyer and client – all these are fiduciary relationships. In a corporate environment where investors and shareholders entrust their money with a company to do business expecting wealth maximization, they are entering a fiduciary relationship. The responsibilities (duties) of the promoters, directors, and executives towards the investors and other stakeholders can be called as their Fiduciary responsibilities which are as follows:

  • Candor and disclosure
  • Diligence and care
  • Loyalty and self-restraint

So who has the fiduciary duties in a company and to whom?

The board of directors and promoters have fiduciary duties towards the company, its shareholders, and stakeholders (creditors, customers, employees, etc.). The executives and employees also have fiduciary duties towards the company.

Person Role
Promoters Establish the company and may have additional responsibilities during formation. Founders in a startup company.
Board of Directors Manage company affairs and ensure compliance with laws and regulations. They are appointed by shareholders. Promoters can be board members too.
Investors / shareholders Invests their capital (money) to purchase shares, expecting wealth maximization.
Creditors A bank or a financial institution providing loans or credit to the company. Could be debenture holders too

What should they do?

The fiduciary duties of the board of directors and promoters can be broadly classified into three categories:

1. Duty of Candor and Disclosure

  • Provide accurate and complete information about the company’s financial status, operations, and risks to investors and stakeholders.
  • Disclose any conflicts of interest that may affect decision-making.
  • Inform investors about significant changes in management, strategy, or financial health.

2. Duty of Diligence and Care

  • Make informed decisions based on thorough research and analysis.
  • Regularly monitor the company’s performance and address any issues promptly.
  • Ensure compliance with legal and regulatory requirements.

3. Duty of Loyalty and Self-Restraint

  • Prioritize the interests of the company and its shareholders over personal gains.
  • Avoid engaging in activities that could create conflicts of interest.
  • Refrain from using company resources for personal benefit.

Why do conflicts arise?

Different parties in the relationship may have different interests, leading to conflicts. The conflicts are of 3 types:

Type 1 agency problem → Owner vs managers

A director – who is appointed by the shareholders to operate the company – acting not in the interest of the shareholders. This could for their own personal gains. For Example – a director who is about to resign signing a non-favorable contract.

Type 2 agency problem → Majority vs minority shareholders

Where majority investors take decisions which could be hurtful to minority shareholders. A special can be passed by the vote of 75% of shareholders, effectively bypassing the minority shareholders up to 25%. For example, a share buyback decision.

Type 3 agency problem → Shareholders vs creditors

Involvement, risk appetite and expected returns for shareholders and creditors (banks, financial institutions, debenture holders etc.) are different. Shareholders might take higher risks to maximize returns at the expense of creditors.

All these conflicts happen due to information asymmetry. Information asymmetry is the situation in which parties on one side has additional information which they can use to their advantage.

The decision-making process

Every organisation takes strategic, tactical, and operational decisions on a regular basis. Some of them are taken at the board level (budget, hiring, policy etc) while some decisions are taken by the collective wisdom of the shareholders (changes in AoA or MoA of the company, change of business location, share buy back etc). In a board level decision, the decision is taken with a simple majority while each director gets one vote. In a shareholder meeting, the decision is taken based on the type of resolution – ordinary or special. An ordinary resolution requires a simple majority (more than 50%) while a special resolution requires a 75% majority to pass where people vote based on the number of shares they hold.

For the shareholders to vote in an informed manner, it is the duty of the board of directors and promoters to provide all relevant information related to the decision to be taken.

What protections are available to investors and stakeholders?

To protect the interests of investors and stakeholders, various legal and regulatory frameworks are in place. Some of these include:

  • The Companies Act, 2013
  • SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018
  • SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015
  • SEBI (Prohibition of Insider Trading) Regulations
  • Insolvency and Bankruptcy Code, 2016

The companies act, 2013 has specific provisions related to the duties of directors (Section 166) and penalties for breach of fiduciary duties. SEBI regulations also mandate disclosure requirements and corporate governance norms to protect investors. To list a few, whistleblower policies, independent directors, audit committees, etc. are some of the measures to ensure accountability.

For example, a promoter cannot exit the company right after raising funds from investors without fulfilling certain lock-in periods as per SEBI regulations - otherwise known as ‘skin in the game’.

Conclusion

Fiduciary duties are crucial for maintaining trust and integrity in the corporate world. Board of directors and promoters must uphold these duties to ensure the long-term success of the company and protect the interests of investors and stakeholders. Investors and stakeholders should also be aware of their rights and the protections available to them to hold the board accountable. Failing to do so can lead to legal consequences and damage to reputation.