The Tata-Mistry Dispute: Quo Vadis
– Prof J Ramachandran, Savithran Ramesh, Prof K S Manikandan
If the reported efforts of the two groups to settle their dispute before the next hearing were to succeed, it would mean a lost opportunity to not have the Supreme Court of India weigh in on the foundational principles of corporate governance—that of voice and exit for shareholders—that this dispute is about.
Last week, the Shapoorji Pallonji Group (SP Group) announced its intention to exit the Tata Group after the Supreme Court restrained it from further pledging its shares in Tata Sons until the next hearing. The SP Group’s decision signals a rather bitter end to the seven-decades-long relationship that turned publicly sour in 2016 with the abrupt dismissal of Cyrus Mistry as Chairman of Tata Sons. If the reported efforts of the two groups to settle their dispute before the next hearing were to succeed, it would mean a lost opportunity to not have the Supreme Court of India weigh in on the foundational principles of corporate governance—that of voice and exit for shareholders—that this dispute is about.
The division between ownership and control lies at the heart of corporate governance. The primary objective of most individuals who invest their money in a company (investors) is to receive economic benefits — a proportionate share in the profits of the company, for instance — though they cede effective control over how their money is deployed, which rests with those in control of the corporation. Apart from the protection granted by the legal framework in limiting their exposure to the money invested, investors protect themselves further by reserving the right to sell their stake (right to exit) and by seeking a say (right to voice) in the management of the company. The judicial decisions in the Tata-Mistry dispute to date have implications for both these rights.
Let us begin by considering the right to voice. The right to an effective voice is preserved through two mechanisms. First, by requiring those in control to seek shareholder approval for certain critical matters such as changes to share capital, transfer of business, etc. Second, by having the right to elect the members of the board of directors. The board, empowered by the articles of association of the company, monitors decision making by managers. The efficacy of these two mechanisms in giving voice to the shareholders is determined by the shareholding structure. In situations where there is a controlling shareholder, who has a large or dominant stake — the case with much of corporate India, including Tata Sons — the voice of this controlling shareholder carries significant weight. This means that the voice of the other (minority) shareholders inevitably gets muted. The minority shareholders’ hopes of being heard, especially when their interests vary from that of the controlling shareholder, will primarily depend on the board of directors — specifically, on what principles govern the board’s existence and functioning. Does the board have an existence independent of those who elected the directors so that it might do what it considers to be right/appropriate? Or is it expected to privilege the interests of the controlling shareholders, who effectively have the power to elect and remove the directors? These questions lie at the heart of the differing judgements of the National Company Law Tribunal (NCLT) and the National Company Law Appellate Tribunal (NCLAT) in the Tata-Mistry dispute.
The articles of association of Tata Sons allow Tata Trusts, the controlling shareholder with 67% of Tata Sons’ shares, to nominate up to a third of the directors on the board of Tata Sons so long as the Trusts held at least 40% of the shares. The articles also require the affirmative vote of a majority of the nominee directors to decide any matter requiring the board’s approval and specified a list of matters that required the board’s approval. The SP Group argued that the affirmative vote compromised the independent functioning of the directors and made the board of Tata Sons redundant at best. The NCLT viewed the board of directors as an extension of the shareholders electing them. Invoking the principle of “corporate democracy”, NCLT held that the article requiring affirmative vote of nominated directors is justified since the Tata Trusts could have elected all the directors on the board by virtue of their majority and controlled the company through such a mechanism.
The NCLAT disagreed. It concluded that the affirmative vote had an overriding effect that renders the majority decision of the board subservient to it. This implies that the board of a company has an independent existence and its authority to take decisions is delinked from that of the controlling shareholder. Effectively, the board is not bound by the dictates of the controlling shareholders who may have the power to elect and remove them. This means that the fiduciary duty of the directors is not to any particular shareholder but to the corporation itself.
The matter is now pending before the Supreme Court. A ruling in the case will help determine the effectiveness of voice as a lever of governance available to shareholders. The Supreme Court’s interpretation is also likely to critically inform the scope of the right to exit for shareholders, as demonstrated by recent developments in the Tata-Mistry dispute.
The exercise of the right to exit is relatively straightforward in public companies whose shares are traded in the stock markets. The prevailing share price acts as a signal of value and thus the shareholders can exit at any time, especially if the shares are traded actively. However, in the case of private companies (or even deemed public companies) which are permitted to restrict transferability of shares, the terms of exit (when, to whom and at what price) are specified in the articles of association and/or shareholder contracts. For instance, in Tata Sons’ case, when an existing shareholder seeks to exit, the board of directors has the power to find potential buyers, determine the fair value for the shares, and even block potential investors suggested by the exiting shareholder on certain grounds. In such cases where the articles bestow the responsibility of determining the terms of exit to the board of directors, the question of whom they are responsible to becomes even more critical.
Let us consider the implication of this in the present dispute between SP Group and Tata Sons. In determining fair value, should the board of Tata Sons privilege the interests of Tata Trusts, the dominant shareholder (as the NCLT interpretation implies)? Or should the board do what it independently thinks is right/appropriate for Tata Sons (as the NCLAT interpretation implies)? The counsel for Tata Sons reportedly termed the SP Group’s decision to pledge its shareholdings in Tata Sons ‘mischievous’ since it allowed the possibility of an outside investor such as Warren Buffet coming forward to offer a 30% premium price which forces Tata Sons to match that higher offer. What if the board of directors believes that the ‘premium’ price offered by Warren Buffet is the fair value even if lower valuations could be arrived at which were more favourable to the controlling shareholder? Or what if the board of directors were to have an independent standing and believe that having someone like Warren Buffet as an investor is good for the corporation, though it may not align with the interests of the controlling shareholder? The Supreme Court’s guidance on the role of the board will help address these questions which have far-reaching implications for the evolution of corporate governance in India.
J Ramachandran is Professor of Strategy at IIM Bangalore; Savithran Ramesh is Research Associate at IIM Bangalore; and K S Manikandan is Associate Professor of Strategy at IIM Trichy.
Source: The Economic Times