Startups may not be different from any other business entity. However, it is for good reason that they have been accorded a special status with respect to, among other things, raising finances and regulatory compliances. Expert advice from corporate lawyers handling advisory to startups would be helpful to make the most of the benefits and exemptions offered under the regulatory regime, ensure compliance with law, and structure transactions and documents from a futuristic perspective while protecting its legitimate business interest.
Introduction
Over the past two decades, the Environmental, Social, and Governance ('ESG') framework has transformed the business landscape. The legal framework has evolved from voluntary guidelines such as National Voluntary Guidelines on Social, Environmental, and Economic Responsibilities of Business to mandatory disclosures under the Business Responsibility and Sustainability Report ('BRSR') for top 1000 listed companies.
One may argue that mandatory ESG disclosures are directed towards top companies due to the resource constraints that smaller companies may face; however, provisions regarding ESG measures and reporting are embedded in corporate governance under the Companies Act, 2013 ('Companies Act'), which applies to all companies.
It is important to understand the extent to which such ESG measures and reporting apply to startups and examine whether there is merit in exploring exceptions, if not a separate regime, for startups in this regard.
This article examines the ESG measures and reporting under the Companies Act and its impact on startups.
Meaning of startup
'Startup' as a concept was introduced under the 'Startup India' initiative launched in 2016 by the Government of India to create a conducive environment for young companies seeking to innovate and/ or improve products, processes or services in India. The various Ministries of the Government of India have initiated several activities for the purpose. To bring uniformity in the identified enterprises, the Department of Promotion of Industry and Internal Trade (DPIIT), Ministry of Commerce, Government of India, vide notification dated February 17, 2016 (as amended on February 19, 2019), published the eligibility criteria for an entity to be recognized as a 'Startup':
"An entity shall be considered as a Startup:
i. Upto a period of ten years from the date of incorporation/ registration, if it is incorporated as a private limited company (as defined in the Companies Act, 2013) or registered as a partnership firm (registered under section 59 of the Partnership Act, 1932) or a limited liability partnership (under the Limited Liability Partnership Act, 2008) in India.
ii. Turnover of the entity for any of the financial years since incorporation/ registration has not exceeded one hundred crore rupees.
iii. Entity is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation.
Provided that an entity formed by splitting up or reconstructing an existing business shall not be considered a 'Startup'."
It is helpful to note that the expression 'startup' has not been used under the Companies Act.
The startup ecosystem
IT tools are often instrumental in achieving innovation, scalability, and democratizing access to startups' products and services. Startups are typically heavily reliant on IT (particularly AI) to harness the potential that big data and data analytics hold in relation to innovation, scalability, and democratizing access to products and services.
Several benefits have been extended to startups to create a conducive environment, such as:
- Tax exemptions under Section 80-IAC (Special provision in respect of specified business) and Section 56(2)(viib) (Income from other sources) of the Income Tax Act, 1961.
- Foreign direct investment norms have been eased for startups. Under the Foreign Exchange Management (Non-debt Instruments) Rules, 2019, 'startups' as defined by the DPIIT are permitted to issue convertible notes, i.e.,
- "an instrument issued by a startup company acknowledging receipt of money initially as debt, repayable at the option of the holder, or which is convertible into such number of equity shares of that company, within a period not exceeding five years from the date of issue of the convertible note, upon occurrence of specified events as per other terms and conditions agreed and indicated in the instrument;."
- Rebates on trademark and patent filing fees.
- Easement of Public Procurement for startups to participate in Government e-marketplaces and tenders.
- Self-certification by startups concerning compliance under certain labour laws (namely, the Building and Other Construction Workers (Regulation of Employment and Conditions of Service) Act,1996; The Inter-State Migrant Workmen (Regulation of Employment & Conditions of Service) Act, 1979; The Payment of Gratuity Act, 1972; The Contract Labour (Regulation and Abolition) Act, 1970; The Employees' Provident Funds and Miscellaneous Provisions Act, 1952; The Employees' State Insurance Act, 1948; The Industrial Disputes Act,1947; The Trade Unions Act,1926; The Industrial Employment (Standing Orders),1946) and certain environmental laws (namely, The Water (Prevention & Control of Pollution) Act, 1974; The Water (Prevention & Control of Pollution) Cess (Amendment) Act, 2003; The Air (Prevention & Control of Pollution) Act, 1981). The exemptions under environmental laws are available only to startups in the 'White category'. The Ministry of Environment, Forest & Climate Change introduced a list of 'White category' industries, which includes sectors such as air coolers/conditioners, electrical and electronic items, organic manure, etc.
- Faster exit mechanisms for winding up under the Insolvency and Bankruptcy Code, 2016.
ESG and the Companies Act
The BRSR framework under the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 mandates ESG disclosures only by the top 1000 listed companies. However, elements of ESG do find a place in the Companies Act, which applies to all companies registered under the Companies Act.
- A director has a duty to act in the best interests of the Company, its employees, the shareholders, and the community and to protect the environment. For reasons elaborated later, it will be helpful to note here that CSR obligations only apply to a company having a net worth of rupees five hundred crores or more, or a turnover of rupees one thousand crores or more, or a net profit of rupees five crores or more during any financial year.
- The Board of Directors, in their Report (attached to statements laid before a company in its general meeting), are required to include statements relating to energy conversation and technology absorption and details about the policy developed and implemented by the Company on corporate social responsibility initiatives taken during the year.
Director's duties towards Community and the Environment
Section 166 of the Companies Act casts a positive obligation on the directors.
Section 166 of the Companies Act states that "a director of a company shall act in good faith in order to promote the objects of the company for the benefit of its members as a whole, and in the best interests of the company, its employees, the shareholders, the community and for the protection of environment."
A breakdown of the above provision reads as follows:
A director of a company shall act;
- in good faith in order to promote the objects of the Company for the benefit of its members as a whole and
- in the best interests of:
a. the Company,
b. its employees,
c. the shareholders,
d. the community and
e. for the protection of the environment.
The following decisions of the Hon'ble Supreme Court support the preceding understanding of said Section 166 (2):
In the case of Tata Consultancy Services Limited v. Cyrus Investments Pvt. Ltd. and Ors (MANU/SC/0227/2021), the Hon'ble Supreme Court held that
"The history of evolution of the corporate world shows that it has moved from the (i) familial to (ii) contractual and managerial to (iii) a regime of social accountability and responsibility. This is why Section 166(2) also talks about the duty of a Director to protect environment, in addition to his duties to (i) promote the objects of the Company for the benefit of its members as a whole; and (ii) act in the best interests of the Company, its employees, the shareholders and the community."
The Hon'ble Supreme Court also looked into the situation where the promotion of the objects of a company may be a transgression from the duty of a director towards the community and the environment, "Coming to the argument revolving around the duty of a Director, it is necessary that we balance the duty of a Director, Under Section 166(2) to act in the best interests of the company, its employees, the shareholders, the community and the protection of environment, with the duties of a Director nominated by an Institution including a public charitable trust."
In the matter of M.K. Ranjitsinh and Ors. v. Union of India and Ors., (MANU/SC/0288/2021) the Hon'ble Supreme Court observed that "Section 166(2) of the Companies Act, 2013 ordains the Director of a Company to act in good faith, not only in the best interest of the Company, its employees, the shareholders and the community, but also for the protection of environment."
The Hon'ble Court further noted that "The term 'environment' is not defined in the Companies Act, 2013, however, it has to be given the meaning assigned to it under the Environment (Protection) Act, 1986, which defines the word 'environment' to include the "interrelationship which exists among and between water, air and land, and human being, other living creatures, plants, microorganisms and property."
(The judgement mentioned above was modified by the Hon'ble Supreme Court on March 21, 2024. However, the modification does not affect the observations mentioned above.)
It can be understood that duty towards 'community' and 'environment' captures the essence of the 'environment' and 'social' elements of ESG, while duty towards the 'company', 'employees', and 'shareholders' capture, in most part, the essence of the 'governance' element of ESG.
Evidently, Section 166 extends the duty of directors not just towards the Company, shareholders, and its employees but also towards other stakeholders by imposing a duty to act in the best interests of the community and the environment.
It will be helpful to examine the genesis of said Section 166 (2) to understand the Committee recommendations, further to which this Section was introduced in the Companies Act, 2013.
Legislative History: Tracing the Intent
Section 166 (2) of the Companies Act can be traced to the 21st Report of the Standing Committee on Finance (2009-2010) on the Companies Bill, 2009. This Report records the suggestion of the Institute of Company Secretaries of India (ICSI) to incorporate Section 166(2) in the Companies Act as follows:
"(2) A director of a company shall act in good faith in order to promote the objects of the company for the benefit of its members as a whole, and in the best interest of the company, its employees, the community and the environment."
The Committee accepted the suggestion of ICSI and stated as under:
"The Committee welcomes the proposed changes with regard to the duties of a director to promote the objects of the company in the best interests of its employees, the community and the environment as well, particularly in the backdrop of Corporate Social Responsibility, which is proposed to be included in this statute."
The above-suggested provision was adopted in the Companies Act, 2013 with the inclusion of the terms 'shareholders' and 'protection of environment'.
Said Section 166(2), as originally proposed by the Standing Committee, required a director to act in good faith to promote the Company's objects for the benefit of its members as a whole and in the best interests of the Company, its employees, community, and environment.
The foregoing language does not cast an independent duty on the directors to act in the interest of the community or the environment.
It is noteworthy that the Committee was very accepting of the ICSI's suggestion, particularly in light of the Corporate Social Responsibility that was then proposed to be introduced under Section 135 of the Companies Act, 2013.
It would seem that the director's extended duty to the community and environment was viewed in the context of the role that corporations were expected to play in society at large under their 'Corporate Social Responsibility'.
Arguably, the legislative intent with respect to casting an independent duty to the community and environment was to enable the discharge of Corporate Social Responsibility under Section 135 of the Companies Act. However, Section 166(2), as introduced in the Companies Act 2013, is independent of the 'Corporate Social Responsibility' obligations.
Directors' Report
Section 134 of the Companies Act requires a report by the Board of Directors to be attached to statements laid before a company in general meeting, which shall include, among other things,
"(m) the conservation of energy, technology absorption, foreign exchange earnings and outgo, in such manner as may be prescribed.
...
(o) the details about the policy developed and implemented by the Company on corporate social responsibility initiatives taken during the year; "
Rule 8 of the Companies (Accounts) Rules, 2014 lists down the manner in which reporting under paragraph (m) is required to be done.
(A) Conservation of energy-
(i) the steps taken or impact on conservation of energy;
(ii) the steps taken by the Company for utilizing alternate sources of energy;
(iii) the capital investment on energy conservation equipments;
(B) Technology absorption-
(i) the efforts made towards technology absorption;
(ii) the benefits derived like product improvement, cost reduction, product development or import substitution;
(iii) in case of imported technology (imported during the last three years reckoned from the beginning of the financial year)-
(a) the details of technology imported;
(b) the year of import;
(c) whether the technology been fully absorbed;
(d) if not fully absorbed, areas where absorption has not taken place, and the reasons thereof; and
(iv) the expenditure incurred on Research and Development.
(C) Foreign exchange earnings and Outgo- The Foreign Exchange earned in terms of actual inflows during the year and the Foreign Exchange outgo during the year in terms of actual outflows.
The qualitative reporting under the above paragraphs (m) and (o) of Section 134 of the Companies Act may be an area of concern. The reporting made by certain companies, as mentioned below, illustrates the point.
Case 1
The board report of a top 1000 listed non-banking finance company covers the reporting under paragraphs (m) and (o) in the manner listed below:
"Conservation of Energy
The operations of the Company are not energy intensive. The Company implements various energy conservation measures across all its functions and value chain, which are highlighted in the Business Responsibility and Sustainability Report.
Technology Absorption
The details pertaining to technology absorption have been explained in the Management Discussion and Analysis. Considering the nature of services and businesses, no specific amount of expenditure is earmarked for Research and Development. However, the Company on an ongoing basis strives for various improvements in the products, platforms, and processes.
...
Corporate Social Responsibility
Detailed information on CSR Policy, its salient features, details pertaining to spent and unspent amount forms part of Annual Report on CSR activities."
The above reporting, for obvious reasons, is not ideal.
Case 2
The board report of a private limited company which does not meet the threshold for CSR obligations reads as follows:
"The Company has neither any activity relation to conservation of energy nor Technology absorption during the year under review.
...
The Company has not developed and implemented any Corporate Social Responsibility initiatives as the said provisions are not applicable."
The above reporting regarding the Conservation of Energy is far from ideal.
Case 3
A Company engaged in the IT training and certification sector, in its board report, has made the following disclosure in respect of paragraph (m)
The particulars, as prescribed under Sub-Section (3) (m) of Section 134 of the Companies Act, 2013, read with the Companies (Accounts) Rules, 2014, are enclosed below:
Conservation of Energy: Adequate measures are taken to conserve energy, although the Company's operations are low-energy intensive.
Technology Absorption: Your Company continues to use the latest technologies for improving the productivity and quality of its services.
The above reporting regarding the Conservation of Energy is far from ideal.
It is relevant to examine the statutory obligation of a director towards the community and the environment, particularly in light of the board report requirement illustrated above under the Companies Act. It would appear that the requirements under the board's Report and the duties of a director do not correlate.
Startups: ESG Considerations and Issues
Environment, sustainability, and governance are all important, but examining the issues in context is also essential. The predominant assets of any startup in the technology space are the computing hardware and associated equipment and accessories required for their operations, which cause significant carbon emissions. Determining the true share of the environmental impact of startup operations as part of the entire value chain in the IT industry is a herculean task, even for large corporations, let alone startups.
Most early-stage startups do not possess the required tools or do not have the 'luxury' of evaluating the environmental impact of their activities. They are pushed to create monetary value for their investors while also ensuring that innovation is not compromised in the process.
The broad language of said Section 166(2), which casts a duty on the directors towards the community and environment, maybe too onerous for a startup for reasons including:
- The terms 'environment' and 'community' have very broad connotations, making it difficult to ascertain the scope of duties in relation to the environment and community.
- There is no accurate method for ascertaining the carbon footprint of IT use, especially given that so many players are involved across the value chain.
- The duty needs to address the issue of competing interests, where the short-term commercial goals may be required to be prioritized over the duties towards the community and the environment.
The International Energy Agency ('IEA') projects that data centres' electricity consumption in 2026 will be double that of 2022 — 1,000 terawatts, roughly equivalent to Japan's current total consumption. As per the IEA, AI also uses more energy than other forms of computing. Training a single model uses more electricity than 100 US homes consume annually. The concern remains whether this growth of AI would appropriately lead to proportionate energy efficiency, as well as the bare minimum expectations from AI.
The development in the AI sector and opportunities for innovation also bring with it a responsibility to address environmental impacts. Integration of ESG into the operations of startups and deployment of AI can, more than a practical necessity, become a strategic choice. AI can be leveraged by startups to contribute towards sustainable practices such as resource management, optimizing energy usage and mitigating factors for climate change. In the long run, start ups would be required to align the use of AI with ESG principles to create synergy between technology and sustainability.
Viewpoint
In the case of startups, a legislative mandate in respect of ESG compliances and reporting is likely to find more acceptance if the compliance is standard and simple to understand, if there are measurable and clear guidelines concerning its compliance and if it is economically viable and or advantageous.
The imposition of stringent environmental compliances on startups, especially tech-based startups with high energy consumption levels, might stifle growth and innovation. These startups have immense potential to tackle the growing environmental concerns. The ESG framework in the Indian context should strike a balance between innovation, the well-being of the community, and the protection of the environment.
A catch-all duty of a director to protect the interests of the 'community' and 'environment', as sought to be cast under Section 166(2) of the Companies Act, is relevant but arguably half-hearted. The said provision specifically obligates the directors to act in the best interests of the community and protect the environment. This duty would require the directors to consider the impacts of the Company's actions on all these aspects.
The Section casts a wide net—good to have but difficult to implement. Further, board report requirements under Section 134(m) and Section 134(o) of the Companies Act 2013 do not correlate with the directors' duties. Arguably, a cohesive and practical mandate is needed to bridge the gap between the legislative intent and application of the Section.
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