Mitigating Liability of Directors and Officers

Mitigating Liability of Directors and Officers.

[Mincy Mathew]

The author is a third-year student at National Law Institute University, Bhopal.

The board of directors is the primary management body of any company, and as such, it owes a fiduciary duty to the company and is expected to act in good faith and to promote the best interests of all the stakeholders. The directors are personally liable to pay losses suffered by the company following an act which is wrong, negligent, outside the company’s authority, beyond their power, or which evidences insufficient skill and care in managing the company’s affairs. The liability of the directors, in such cases, is joint and several.

Along with the Companies Act, the directors must comply with income tax law, labor laws, and environmental laws, among others. With an increasing role of the directors in ensuring compliance with corporate governance norms, the directors may ask for protection against any future liability. The liability of an “officer in default” is unlimited and the directors would, therefore, seek to protect their personal assets.

For mitigating the liability of a director, the Companies Act, 2013 provides certain safe harbor provisions. According to section 463 of the Act, if in any proceeding for negligence, default, breach of duty, misfeasance or breach of trust against an officer of a company, it appears to the court hearing the case that the officer has acted honestly and reasonably, and that having regard to all the circumstances of the case, he ought fairly to be excused, the court may relieve him, either wholly or in part, from his liability on such terms as it may think fit. In addition, for independent directors, the liability will be “only in respect of such acts of omission or commission by a company which had occurred with his knowledge, attributable through board processes, and with his consent or connivance or where he had not acted diligently.”[1]

However, it is important to ensure that there is an additional protection given to the directors, because in certain cases, statutory protection may be inadequate. It may sometimes be difficult to ascertain whether an act was “within the knowledge” of a director or whether a director acted “diligently” and, therefore, such liabilities are difficult to foresee. Accordingly, a company may also provide certain indemnities to its directors for any liability arising out of any act done in his professional capacity, excluding intentional criminal conduct. The Companies Act, 1956 prohibited any indemnity to the director, but there is no corresponding provision in the 2013 Act. The 2013 Act, therefore, may allow greater flexibility to directors to ask for such indemnities from the company especially where no fault could be attributed to them. Such protection may be provided to them by incorporating an indemnity provision in the constituent documents, or by issuing a letter of indemnity to individual directors, as is the case with several companies in India.

An indemnification agreement is entered into by a director with the company, which makes good any losses caused by the director to the company, during the performance of his duties. Even though indemnification may be provided in the charter documents, it is advisable that a separate indemnification agreement is entered into between the director and the company. A separate agreement provides the surety that the new management cannot amend the articles to the detriment of the directors and that its scope extends even after his resignation. In addition, a separate agreement, being a bilateral agreement, ensures a more detailed and a better negotiated deal. While negotiating the indemnities, care must be taken to draft it wide enough to cover any complicated corporate transaction, while still excluding dishonest or fraudulent conduct. The indemnification agreement should ideally also include a D&O insurance to provide security in case the company is financially unable to pay for the indemnification.

The Companies Act, 2013 recognizes the right of the companies to purchase D&O insurance in section 197. The section provides that:

Where any insurance is taken by a company on behalf of its managing director, whole-time director, manager, Chief Executive Officer, Chief Financial Officer or Company Secretary for indemnifying any of them against any liability in respect of any negligence, default, misfeasance, breach of duty or breach of trust for which they may be guilty in relation to the company, the premium paid on such insurance shall not be treated as part of the remuneration payable to any such personnel. Provided that if such person is proved to be guilty, the premium paid on such insurance shall be treated as part of the remuneration.

D&O insurance provides indemnity to the directors and the officers of the concerned company against costs incurred in defending proceedings instituted against and in respect of any damages awarded to the claimants against them, such as an out-of-court settlement. A typical D&O insurance policy may include three types of coverage:

  • A-side coverage. This part covers directors, officers, and sometimes employees for defense costs, settlement fees, or judgments in situations when they are not indemnified by the company.
  • B-side coverage. This covers the company for the losses incurred by its directors, officers, and employees when the company does indemnify them.
  • C-side coverage. This financially protects the entire corporation, against any loss and is also known as ‘entity coverage’.

The company has to have the consent of the board of directors in order to avail itself of a D&O policy. Further, while procuring such policies, it must be ensured that the sameprovide for certain exceptions especially as regards fraud or wilful misconduct. D&O insurance is essential to mitigate the liability of the director, as it ensures indemnification of any loss even if the company is unable to pay.

A mitigation strategy adopted by the company cannot decrease the liability of a director acting in complete disregard of his duties and cannot act as a replacement for corporate governance mechanisms. However, it will ensure that the directors feel safeguarded against any unknown liability. Thus, quality personnel stay in the company and are best able to fulfill their professional duties.

[1]Section 149(12).

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