Role of an independent Director in a takeover transaction

In this article, Arunava Chakraborty pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, discusses Role of an independent Director in a takeover transaction.

A takeover occurs when an acquiring company makes a bid in an effort to assume control of a target company, often by purchasing a majority stake. If the takeover goes through, the acquiring company becomes responsible for all of the target company’s operations, holdings and debt. When the target is a publicly traded company, the acquiring company makes an offer for all of the target’s outstanding shares.

A takeover is virtually the same as an acquisition, except the term “takeover” has a negative connotation, indicating the target does not wish to be purchased. A company may act as a bidder by seeking to increase its market share or achieve economies of scale that help it reduce its costs and thereby increase its profits. Companies that make attractive takeover targets include those that have a unique niche in a particular product or service; small companies with viable products or services but insufficient financing; a similar company in close geographic proximity where combining forces could improve efficiency; and otherwise viable companies that are paying too much for debt that could be refinanced at a lower cost if a larger company with better credit took over.

What are general duties as a director?

The Companies Act 2013 sets out the seven general statutory duties of a director. These are listed below with some additional commentary.

1. To act within powers (regulation 16). This requires a director to comply with the company’s constitution and decisions made under the constitution and to exercise the powers only for the reasons for which they were given.
2. To act in a way the director considers (in good faith) is most likely to promote the success of the company for the benefit of its members as a whole (or, if relevant, other purposes specified in the constitution). (Regulation 20-24). In performing this duty, a director must have regard to all relevant matters, but the following are specifically identified in legislation:
   1. the likely consequences of any decision in the long term;
   2. the interests of the company’s employees;
   3. the need to foster the company’s business relationships with suppliers, customers and others; the impact of the company’s operations on the community and the environment;
   4. the desirability of the company maintaining a reputation for high standard business conduct; and the need to act fairly as between members of the company.
3. To exercise independent judgment, that is, not to subordinate the director’s power to the will of others. This does not prevent directors from relying on advice, so long as they exercise their own judgement on whether or not to follow it.
4. To exercise reasonable care, skill and diligence (regulation 25). This requires a director to be diligent, careful and well informed about the company’s affairs. If a director has particular knowledge, skill or experience relevant to his function (for instance, is a qualified accountant and acting as a finance director), expectations regarding what is ‘reasonable’ will be judged accordingly (regulation 25).
5. To avoid conflicts (or possible conflicts) between the interests of the director and those of the company (regulation 30-36). The prohibition will not apply if the company consents (and consent meets the necessary formal requirements).
6. Not to accept benefits from third parties (i.e. a person other than the company) by reason of being a director or doing anything as director (regulation 31). The company may authorise acceptance (subject to its constitution), for instance to enable a director to benefit from reasonable corporate hospitality; and
7. To declare any interest in a proposed transaction or arrangement (regulation 32-36). The declaration must be made before the transaction is entered into and the prohibition applies to indirect interests as well as direct interests.

In addition to these duties, a director has duties:

• to consider or act in the interests of creditors (particularly in times of threatened insolvency) (regulation 26)
• to maintain confidentiality of the company’s affairs (a duty which to a large extent follows from the general duties outlined above)

INDEPENDENT DIRECTOR

An Independent director (also sometimes known as an outside director) is a director (member) of a board of directors who does not have a material or pecuniary relationship with company or related persons, except sitting fees. In the US, independent outsiders make up 66% of all boards and 72% of S&P 500 company boards, according to The Wall Street Journal.

In India as of 2017, a majority of the minimum two directors of public companies having share capital in excess of Rs. 100 million (Rs 100,000,000) should be independent. Clause 49 of the listing agreements defines independent directors as follows:

“For the purpose of this clause the expression ‘independent directors’ means directors who apart from receiving director’s remuneration, do not have any other material pecuniary relationship or transactions with the company, its promoters, its management or its subsidiaries, which in judgment of the board may affect independence of judgment of the directors.”

The Companies Act, 2013, most sections of which got implemented from 1 April 2014, has mandated all listed public companies to have at least one-third of the total Directors to be independent. Whereas in the case of unlisted public companies, the following class of companies shall have at least two directors as independent directors:

• Public Companies having paid up share capital of Ten Crore rupees or more; or
• Public Companies having turnover of One Hundred Crore rupees or more; or
• Public Companies which have, in aggregate, outstanding loans, debentures and deposits exceeding 50 Crore rupees or more.

The Companies Act, 2013 is drafted taking into consideration the noteworthy inputs and contribution that an Independent Director can bring in to the business. Section 149(6) of the act stipulates the criteria for a candidate that ensures highest standards of integrity, while also preventing any conflict of interest. The provisions seek to ensure the autonomy of the appointee to facilitate effective discharge of duties such as upholding shareholders’ interest, upholding corporate governance standards, among others.^[6] The compensation offered to such Independent Directors in the form of “sitting fee” has also been increased from Rs. 20,000 (prescribed by Companies Act, 1956) to a maximum of Rs. 1, 00,000/- per meeting.

In India, the gravity of Independent Directors (referred as “ID’s”) was recognized with the introduction of corporate governance. The Companies Act, 1956 (referred as “the Act, 1956”) do not directly talks about ID’s, as no such provision exists regarding the compulsory appointment of ID’s on the Board. However, Clause 49of the listing agreement which is applicable on all listed companies mandates the appointment of ID’s on the Board. A need has been felt to update the Act and make it globally compliant and more meaningful in the context of investor protection and customer interest.

The Companies Act, 2013 (referred as “the Act, 2013”) came into force as Act no. 18 of 2013 after obtaining the assent of the President on August 29, 2013. The Ministry of Company Affairs (referred as “MCA”) enforced the 98 sections of the Act through the notification dated September 12, 2013.

INDEPENDENT DIRECTORS – AN OVERVIEW

The need for the ID’s aroused due to the need of a strong framework of corporate governance in the functioning of the company. There is a “growing importance” of their role and responsibility. The Act, 2013 makes the role of ID’s very different from that of executive directors. An ID is vested with a variety of roles, duties and liabilities for good corporate governance. He helps a company to protect the interest of minority shareholders and ensure that the board does not favour any particular set of shareholders or stakeholders.

The role they play in a company broadly includes improving corporate credibility, governance standards, and the risk management of the company. The whole and sole purpose behind.

ROLE OF INDEPENDENT DIRECTOR

State corporate law generally provides that the business and affairs of a corporation shall be managed under the direction of its board of directors which encompasses the independent directors.  The independent directors have a fiduciary relationship to the corporation, which requires that they act in the best interest of the corporation, as opposed to their own.  Generally a court will not second-guess directors’ decisions as long as the board has conducted an appropriate process in reaching its decisions. This is referred to as the “business judgment rule.” The business judgment rule creates a rebuttable presumption that “in making a business decision the independent directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company” (as quoted in multiple Delaware cases including Smith vs. Van Gorkom, 488 A.2d 858 (Del. 1985)).

However, in certain instances, such as in a merger and acquisition transaction, where a board may have a conflict of interest (i.e., get the most money for the corporation and its shareholders vs. getting the most for themselves via either cash or job security), the independent directors’ actions face a higher level of scrutiny. This is referred to as the “enhanced scrutiny business judgment rule” and stems from the Unocal and Revlon cases discussed below, both of which involved hostile takeovers.

A third standard, referred to as the “entire fairness standard,” is only triggered where there is a conflict of interest involving directors and/or shareholders such as where directors are on both sides of the transaction. Under the entire fairness standard, the directors must establish that the entire transaction is fair to the shareholders, including both the process and dealings and price and terms.

In all matters, directors’ fiduciary duties to a corporation include honesty and good faith as well as the duty of care, duty of loyalty and a duty of disclosure.  In short, the duty of care requires the director to perform their duty with the same care a reasonable person would use, to further the best interest of the corporation and to exercise good faith, under the facts and circumstances of that particular corporation. The duty of loyalty requires that there be no conflict between duty and self-interest.  The duty of disclosure requires the director to provide complete and materially accurate information to a corporation.

As with many aspects of securities law, and the law in general, a director’s responsibilities and obligations in the face of a merger or acquisition transaction depend on the facts and circumstances. From a high level, if a transaction is not material or only marginally material to the company, the level of involvement and scrutiny facing the board of directors is reduced and only the basic business judgment rule will apply.  For instance, in instances where a company’s growth strategy is acquisition-based, the independent directors may set out the strategy and parameters for potential target acquisitions but leave the completion of the acquisitions largely with the c-suite executives and officers.

Moreover, the director’s responsibilities must take into account whether they are on the buy or sell side of a transaction.  When on the buy side, the considerations include getting the best price deal for the company and integration of products, services, staff, and processes.  On the other hand, when on the sell side, the primary objective of maximizing the return to shareholders through social interests and considerations (such as the loss of jobs) may also be considered in the process.

The law focuses on the process, steps and considerations made by the independent directors, as opposed to the actual final decision.  The greater the diligence and effort put into the process, the better, both for the company and its shareholders, and the protection of the directors in the face of scrutiny.  Courts will consider facts such as attendance at meetings; the number and frequency of meetings; knowledge of the subject matter; time spent deliberating; advice and counsel sought by third-party experts; requests for information from management; and requests for and review of documents and contracts.

In the performance of their obligations and fiduciary responsibilities, an independent director may, and should, seek the advice and counsel of third parties, such as attorneys, investment bankers, and valuation experts.  Moreover, it is generally good practice to obtain a third-party fairness opinion on a transaction.  Most investment banking houses that do M&A work also provide fairness opinions on transactions.  Furthermore, most firms will prepare a fairness opinion even if they are not otherwise engaged or involved in the transaction.  In addition to adding a layer of protection to the independent directors, the fairness opinion is utilized by the accountant and auditor in determining or supporting valuations in a transaction, especially where a related party is involved.  This firm has relationships with many firms that provide such opinions and encourage our clients to utilize these services.

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