Committee Of Independent Directors In M&A: Virtue Or Charade?
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Committee Of Independent Directors In M&A: Virtue Or Charade?


The idea of independence in corporate boards has taken strong root in corporate governance despite the misgivings and controversies surrounding the concept. Less explored is the use of special committees comprised entirely of independent directors for examining material or conflicted transactions that companies may enter into. The need for special committees has taken centre stage in Indian corporate governance lately, arising largely from two developments emanating in November 2020 from the Securities and Exchange Board of India.

Committee Of Independent Directors In M&A: Virtue Or Charade?

Evolution Of Special Committees

First, SEBI mandated that before pursuing a scheme of arrangement, a listed company must file with the stock exchange a report from the committee of independent directors recommending that the draft scheme takes into consideration the fact that it is not detrimental to shareholders.

Second, in a consultation paper relating to delisting, SEBI has proposed that such a special committee must provide its reasoned recommendations in favour of a delisting before such a transaction can be put through.

These emerge in the context of an already assigned role for a special committee of independent directors under SEBI’s takeover regulations to make recommendations to the target’s shareholders.

With this, the role of special committees has attained ubiquity in India. While this development is welcome in enhancing the interests of minority shareholders in listed companies, the prevalent regime runs the risk by which special committees turn out to be an artifice behind which corporate insiders can take cover.

Interestingly, special committees are a judicial invention. They can be attributed to a 1983 American decision in Weinberger v UOP, Inc. where the Delaware Supreme Court, while denying the effectiveness of a squeeze-out transaction by a controlling shareholder, observed in a footnote that the outcome may have been different if the target had appointed a special committee to negotiate on its behalf. Placing emphasis on this observation, the legal and corporate fraternities in the United States began including special committees as part of the deal process to withstand judicial scrutiny.

Although the special committee developed as a shield to defend the corporate sector against legal challenge, they took on the form of a sword that regulators such as SEBI now wield in the interests of affected minority shareholders in mergers and acquisitions.

Special committees are beneficial, as they seek to simulate an arm’s length transaction where insiders such as the management or controlling shareholders may suffer from conflicts of interest. Independent directors on the special committee, it is said, carry incentives to perform their monitoring role effectively to enhance their reputational capital. This will enable them to cater to the interests of minority shareholders that could be adversely affected in an M&A. While this holds well in theory, translating it into practice is another matter altogether. As William Allen, former chancellor of the Delaware Court of Chancery astutely observed: “I remain open to the possibility that such committees can be employed effectively to protect corporate and shareholder interests. But I must confess a painful awareness of the ways in which the device may be subverted and rendered less than useful.”

Issues And Concerns

The challenges surrounding the special committee are manifold.

First, it is hard to ensure the independence of committee members not merely in law but also in spirit. For example, in India where concentrated shareholding is the norm and directors are elected by shareholders, independent directors tend to serve at the pleasure of the promoters. Even if the directors are nominally independent, they would be subject to an inherent bias. While SEBI’s regime governing special committees accounts for nominal independence, it fails to consider “disinterestedness” by which independent directors on the committee must not bear any form of interest, either directly or indirectly, in the transaction under review.

Second, questions may arise regarding the availability of skills and expertise on the part of special committee members to put a complex M&A transaction to the litmus test of whether it is detrimental to shareholders. It is true that special committees may seek expert advice from investment bankers, accountants, and lawyers, ultimately the committee must be responsible for its own decision.

Third, independent directors may suffer from operational constraints in effectively discharging their duties on special committees. As expected, independent directors contribute to the company on a part-time basis, but the demands of a special committee role may require them to contribute more extensively during the period that an M&A transaction is under consideration. If there is a mismatch between the expectations and the reality, the utility of the special committee could be significantly undermined.

Fourth, much depends upon the extent to which special committees are empowered. What are their terms of reference? Are they substantive enough, or merely process-oriented? Does a special committee have the ability to say “no” to a transaction proposed by management and promoter? What if there are no instances at all, or even only a few instances, where special committees have declined to sign off on a transaction on the ground that it is detrimental to shareholder interests? Would that not be a sure indication of committees functioning in form rather than in substance? Only time will tell if special committees serve their purpose across these parameters.

Finally, independent directors may suffer from disincentives to participate in special committee due to fear of excessive liability. Complex M&A transactions, and schemes of arrangement in particular, are subject to strict scrutiny by investors and regulators alike. Given that SEBI’s new requirements thrust independent directors to the forefront of M&A deals, it would be hard for them to seek shelter under the safe harbour provision under company law that protects independent directors against liability for unknowing acts or where they were not part of the decision-making process.

Ironing Out The Creases

Apart from the broader issues arising from special committees, SEBI’s November 2020 pronouncement mandating them for schemes of arrangement gives rise to more specific questions. At the outset, SEBI mandates a special committee report for all schemes of arrangement, not merely those that involve conflicts of interest. It is true that schemes of arrangement are utilised in India for a wide array of M&A transactions, including mergers, demergers, and other forms of corporate and capital restructuring.

It would have been more prudent for SEBI to train the special committees’ focus on conflicted transactions where they could play a more meaningful role rather than to force their intervention in all transactions, thereby diffusing their attention and resources.

SEBI has itself recognised this distinction in a related context: its March 2017 circular governing schemes of arrangement imposes special voting requirements among public shareholders in specific types of schemes where conflicts are likely to be involved.

SEBI’s mandate for special committees in the context of schemes is somewhat unconventional. It requires them to produce a report taking into consideration that the “scheme is not detrimental to the shareholders of the listed entity”. The audience for the report is unclear. Is it merely for regulatory purposes, to be considered by stock exchanges and SEBI, or is it for the consumption of the shareholders? Contrast this with the requirement under the takeover regulations where the special committee must “provide its written reasoned recommendations on the open offer to the shareholders of the target company”. In the takeover scenario, the special committee bears responsibility to the shareholders who could assuage grievances for any misrepresentation caused directly to them. In the case of a scheme, though, it is unclear what recourse shareholders may have for any wrongful actions taken by the special committee.

Another comparison is warranted with duties of board members generally under the Companies Act, which requires directors to act “in the best interests” of the company and shareholders, among other constituencies. From a legal perspective, that is arguably a more onerous test than ensuring merely that the scheme is not “detrimental to” shareholders. The SEBI regime focuses only on shareholders, while company law requires directors to act in the interest of other stakeholders whose interests are bound to be affected by a scheme. In case of a conflict among the various interests, the special committee members bear the daunting task of navigating through the differing considerations.

These challenges can be overcome in two ways.

The first involves regulatory finessing which would require SEBI to harmonise the various special committee mandates depending upon the type of M&A transaction involved, and also with directors’ duties under company law more generally. The second requires companies to step up their game by setting out policies that determine the composition, mandate, responsibilities, and processes for the functioning of their special committees. The proliferation of special committee requirements suggests that the instrument is here to stay as a means to protect minority shareholder interests. However, much lies in the ability of various corporate and regulatory actors in harnessing its full potential rather than relegating it to a box-ticking ritual.

Umakanth Varottil is an Associate Professor of Law at the National University of Singapore. He specialises in company law, corporate governance and mergers and acquisitions.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.

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