[By Bhuwan Sarine]
The author is a student of National Law School of India University, Bengaluru.
Introduction
On 30 April 2024, the Securities and Exchange Board of India (“SEBI”) held the Independent Directors (“IDs”) of Manpasand Beverages Ltd. (“MBL”) liable for not performing their duties diligently. To provide a brief background, independent directors of a company are directors other than the managing or whole-time directors. They are not involved in the day-to-day operations of the company, and are there to ensure that the company is run in a way so as to protect the interests of the shareholders. Section 149(6) of the Companies Act, 2013 (“the Act”) defines them as having relevant expertise and not sharing any material relationship with the company. The order in Manpasand was pursuant to allegations of financial mismanagement in MBL wherein the IDs had to be diligent in assessing its financial statements. SEBI noted that while the IDs claimed lack of access to MBL’s documents, they did not furnish evidence to establish that they tried to obtain them. In summary, the SEBI applied the diligence test to impose liability on the IDs.
The standard for liability of IDs is provided under s. 149(12) of the Act . While Manpasand decided on the diligence test, the SEBI and SAT have used the knowledge test solely in the recent past. This paper uses those case laws to argue that the same is an incomplete interpretation of s. 149(12) and contradictory to the role IDs are supposed to play in the company. To that end, Part I sheds light on the two prongs of s. 149(12), Part II shows the incomplete reading of s. 149(12) of late, Part III explains why the same is erroneous, and the final part concludes.
I. The Two Prongs of Independent Directors’ Liability
Under the first part of s. 149(12) of the Act, an ID can be held liable if the acts of the company occurred with his knowledge and consent or connivance. The knowledge should be attributable to Board processes. The latter part of the sub-section imposes liability when the ID has not acted diligently. It is to be noted that the knowledge and diligence requirements are joined by ‘or,’ which means that both are separate standards[1] and IDs can be held liable if they fail to meet the threshold of any of them. While knowledge has to be in relation to the board process, diligence is over and above this requirement. To meet the latter, IDs need to be generally vigilant, apply their mind, and try to get the information from sources other than board meetings.
The standard of diligence required depends on the facts in question. In OSPL Infradeal Pvt. Ltd., the SEBI held the ID liable for approving loans to entities with negative net worth. It noted that the ID did not exercise caution while approving the loan, and hence due diligence was not met. Here, acting hastily was the reason diligence requirement was not met, and it could not be argued that since the ID was not part of the board meetings, he is not liable. Again, in Madhav Sapre and Ors., SEBI called the IDs to evaluate the records and documents before them independently, and not just to rely on the face value of the information provided in the meetings.[2] Since this was not done, they failed to discharge their role with the diligence required.[3]
From these instances, it is clear that diligence requirements are not dependent on board processes. Even if the IDs show that they had no knowledge of the mismanagement going on, they can still be held liable if the circumstances warranted taking proactive measures. In fact, the Bombay HC touched this aspect precisely in Sunny v. State of Maharashtra.[4] It was pointed out therein that the IDs can be held liable under two situations (first is having knowledge of the acts of omission/commission by the company, and second is failure to act diligently), and both are joined by ‘or,’ implying that liability is attracted if they fail to satisfy either of them.[5] However, recent interpretations have not been in consonance with the wording of the sub-section. They have been prompted by the assumption that knowledge requirement is a sine qua non, in the absence of which due diligence cannot even be assessed.
II. Incomplete Reading of S. 149(12) of Late
Having set out the components of s. 149(12), this section will examine the approach followed by the SEBI and SAT in the recent past. It is to be noted that even before the enactment of the Companies Act, 2013, the knowledge requirement was treated on a higher standing than the diligence requirement. In December 2004, an expert committee on company law (composed of experts drawn from trade and industry associations, professional bodies, institutes, chambers of commerce etc.) under the chairmanship of Dr. J. J. Irani was constituted to advise the government on the proposed revisions to the Companies Act, 1956. While the committee’s report elaborated on the modalities of the knowledge test, it did not mention anything related to due diligence.
The following cases will illustrate the erroneous interpretation of s. 149(12) of the Act. In MPS Infotechnics Ltd. v. SEBI, the SAT held that since the ID was not involved in the day-to-day affairs of the company’s management, he was not liable. It was premised on the view that the offence happened without the ID’s knowledge. Here, the SAT completely ignored the second standard, failing which IDs could be held liable. Going ahead, the SEBI, in the matter of M/s Global Infratech and Finance Ltd., applied the knowledge test solely. The case related to approval of allotment of preferential shares in a manipulative scheme. It absolved the IDs of liability because there was no evidence of them being involved in the board processes. While the SEBI required executive directors to be careful and diligent, there was no mention of the same expectation from the IDs. In this case, it appeared that the SEBI proceeded on the assumption that knowledge could arise from only one source, i.e., board meetings.
There were a string of judgements in 2022 where courts went ahead with the incomplete interpretation of s. 149(12).[6] In the matter of Karvy Stock Broking Ltd., the SEBI again held that the IDs were not liable since they were not informed or given details about any of the ongoing violations in PMS-Karvy in board meetings or otherwise. SEBI did not deal with the fact that the IDs had a duty to get the information from external sources, exercising due diligence.
The common thread running across all these cases is the examination of day-to-day involvement of the IDs. The next section will show why this approach is inconsistent with their overall role.
III. Inconsistency with the Role of Independent Directors
Schedule IV of the Act deals with the duties of the IDs towards the company and the shareholders. Their functions include scrutinising the performance of management and safeguarding the interests of all stakeholders, especially minority shareholders. Further, one of their duties is to seek clarification of information and if required, follow professional advice and opinion of outside experts. They are required to keep themselves well-informed about the company and the external environment in which it operates. It follows that IDs are expected to act against the interests of the company, if need arises. All of these align with the diligence test under s. 149(12).
Kraakman makes the point that the office of IDs is meant to protect the interests of minority shareholders, and is therefore a part of the ‘trusteeship strategy.’[7] Since they are not involved in making day-to-day decisions, their allegiance to the management is less as compared to executive directors.[8] As a corollary to this, Schedule IV of the Act is justified in requiring them to be critical of the company at times. Scholars such as Khanna and Mathew argue that literature views IDs to play dual roles, i.e., watchdogs of the management and strategic advisors. However, the results of their interviews with IDs showed that they perceived their roles to be closer to strategic advisors than as watchful monitors.
Even when we restrict their role to acting as strategic advisors, the expectation of being vigilant and exercising due diligence is not contradictory. Khanna and Mathew reason that the time commitment required to act as advisors may be far lesser than that required for a watchdog. Therefore, it is ironic to examine the day-to-day involvement of the IDs because unlike executive directors, they are not at the forefront of managing the affairs of the company. If liability is determined using this test, the threshold will not be met in a majority of the cases because the IDs are not involved on a day-to-day basis. This is where the SEBI and SAT have erred in the recent past.
But the Companies Act, 2013, is far from clear on the exact role of the IDs. Taking into account Schedule IV, their role as watchdogs cannot be ruled out. Viewed in this context, the diligence test under s. 149(12) becomes even more important to assess the liability of IDs. Thus, the exclusive reliance on knowledge gathered from board processes is giving an additional avenue for the IDs to escape liability.
Conclusion
As shown in Part I, satisfying the diligence test requires doing something over and above gathering knowledge from board processes. In Manpasand, this required keeping oversight of MBL’s financial reporting process and assessing its statements independently. But the SEBI and SAT have lowered the threshold substantially in the recent past by neglecting the second prong of s. 149(12) of the Act and relying only on the first prong, i.e., knowledge attributable through board processes. Further, examination of day-to-day involvement of the independent directors has diluted the essence of the role played by them in the company. This paper has highlighted this recent trend, and suggested assessing the independent directors on the touchstone of the two prongs of s. 149(12) while keeping in mind the connector ‘or’ linking them. While the Manpasand case appears like a comeback for the forgotten diligence test, it would be interesting to follow the trends going ahead.
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Endnotes:
[1] Sunny v State of Maharashtra, MANU/MH/2726/2022 [23].
[2] In Re: Madhav Sapre and Ors., MANU/SB/1961/22 [147].
[3] ibid.
[4] Sunny (n 1) [24].
[5] ibid [23].
[6] For instance, see the SAT order dated 13/10/2022 in Svam Software Ltd and Ors. v SEBI, Appeal No. 801/2021 at https://satweb.sat.gov.in/orders.
[7] Reinier Kraakman and others, The Anatomy of Corporate Law: A Comparative and Functional Approach (3rd edn, OUP 2017) 62.
[8] ibid.