Reviewing the Standard of Liability of Independent Directors

[By Raagini Ramachandran]

The author is a student at NALSAR University of Law.

Introduction

With several scams on the domestic as well as global front, the role of an Independent Director assumes significance so as to serve as a tool of corporate governance by exercising objectivity, impartiality and ensuring shareholder protection in their functioning. On March 2, 2020, the Ministry of Corporate Affairs (‘MCA’) released a circular (‘Circular’) clarifying the standard of liabilities of an Independent Director under the Act. This article reviews the existing standards of liabilities imposed on an Independent Director (‘ID’)  under the Companies Act, 2013 (‘The Act’) and the SEBI (Listing Obligations and Disclosure Requirements) Regulations,2015 (“LODR Regulations”) in the backdrop of this Circular.

Companies Act, 2013

The provisions of the Companies Act are applicable to companies incorporated under it. Section 2 (60) of the Act imposes a general liability on an “officer in default” who is liable to pay a penalty or be punished. An “officer in default” is defined as a director who participates in any of the board proceedings and has active knowledge of the default thereby providing his consent or connivance.

In SEBI vs. Gaurav Varshney it was held that “liability arises from being in charge of and responsible for the conduct of the company at the time when the offence was committed and not on the basis of merely holding a designation or office in a company.” Thus, liability depends on the role one plays in the affairs of a company and not merely on designation. This sort of a broad interpretation by Courts on the liability of the board of directors is traced to their functional undertaking as opposed to a titular immunity. In Pritha Bag v. SEBI the Hon’ble Securities Appellate Tribunal (“SAT”) differentiated the liability of directors on the basis of those directors who were identified as “officer in default” from the remaining directors of the board. The court interpreted that the former were responsible for those acts of company regarding which liability has been fastened on under S.2 (60) of the Act.

The scope of liability under S. 2 (60) is narrowed down by Section 149(12) of the Act which states that liability can be extended to an ID only to the extent 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.” It is imperative to break-down the language of this section to comprehend the underlying meaning of it.

“Board Processes”

The term “broad processes” assumes a centrality in this provision. Yet, there is no statutory definition of this term. The Oxford Handbook on Corporate Governance states that “board process” is understood as the decision-making activities of the board. The interpretation of this term in the Indian context by judgements and orders is “involvement in the decision-making process” as a criteria to hold an ID liable. In an order passed by the SAT, it was held that an ID will be held liable in case of active knowledge of the default attributable through the decision-making process of the board.

Section 149 (12) highlights that apart from board process, two crucial factors that ought to be assessed before imposing liability on an ID are:  “consent or connivance and due diligence”  

“Consent or Connivance”

This term has been interpreted in the SEBI order concerning Amazan Capital Ltd. wherein it was held that the liability of a director is “to be rooted on the conduct of the director in knowingly permitting an omission or commission to take place.”

“Diligence

The standard of diligence expected from an ID is to be aware of the actions of the board and take active measures to correct the same. In the SEBI Order concerning Finserve Ltd., it was held that irrespective of whether an ID is not a part of the day-to-day management of the company, the onus lies on them to remain diligent and take “concrete corrective measures with regards to the violation committed by the board.” This position can be traced back to Official Liquidator v. P.A. Tendolkar, wherein the Supreme Court held that “A Director cannot shut his eyes to what must be obvious to everyone who examines the affairs of the Company even superficially”. Thus this jurisprudence lays emphasis on the constructive knowledge of an ID on the affairs of the company, as well as the active efforts he makes to resolve potential defaults.

Expansionist Reading by Courts

The Courts in several judgements have premised the role of an ID on being an “officer in charge”. In Pooja Ravinder Devidasani v State of Maharashtra, the Supreme Court held that if it is proven that an ID “was at the helm of affairs of the company at the specific time when the decision was taken, he may be made liable.” Such an expansionist reading of the liability of board of director highlights the primacy on the conduct and function of an ID. An order passed by the SEBI states that where “active steps” towards prevention of the default has been made, and board process is used as a “platform to conduct function in a diligent manner”, an ID will not be held liable.

In certain cases, the courts impute vicarious liability on a director for the wrongs of the corporation. In Sunil Bharti Mittal v. CBI, the Supreme Court held that the “criminal intention of directors can be attributed to the company on the principle of ‘alter ego’”. Several special legislation such as the Negotiable Instruments Act, 1881 and Prevention of Money Laundering Act, 2002 provides for vicarious liability by stating that “persons in charge of the company” are liable for offences by the company.

LODR Regulations as a “narrowing framework”

The LODR Regulation is a framework for listed entities. Under regulation 25(5) “An  ID  is  liable,  for omission  or commission  by listed  entities  which  had  occurred  with  his  knowledge,  attributable through processes of board of directors,  and with his consent or connivance or where he had not acted diligently in accordance with these regulations.”

Here, the term “processes of board of directors” are the behavioural and legal norms of the board such as deliberative decision-making and performance of duties owed to the company and shareholders. These norms are governed by soft laws as no written set of rules can contemplate every situation that a director or the board collectively may find itself in. However, Regulation 26 specifies that the code of conduct to be carried out by an ID should be in accordance with the Act. Schedule IV of the Act contains an elaborate code of conduct for an ID. The Regulations specifically holds an ID liable only in case of acts and omission on their part per the provisions under these regulations, which confine the liability of ID only to the extent of their duties in the light of Schedule-IV of the Act. Thus, under LODR Regulations, the obligations of an ID in a listed companies are narrowed down to this extent.

However, a corporate governance regime with emphasis on shareholder protection is envisioned in the case of listed companies. Thus, by reading the LODR Regulations and Companies Act together, the standard of liability of an ID is more extensive in case of listed entities. Unlisted companies on the other hand are subject to merely the corporate governance norms contained in Schedule IV of the Act, which “applies to all public listed companies and certain classes of public companies.”

MCA Circular

Clause 2 of the Circular suggests that active knowledge of ID and “express consent” to a default are to be taken into consideration while imposing liability. This enhances the standard of vigilance that an ID must undertake.  However, with respect to liability of an ID clause 4 of the Circular states that “in certain cases the director or officer specifically mentioned in the penal provisions of the Act must only be held liable.” Further, it states that the ID will “not be held liable for any instance of filing or compliance of orders of statutory authorities.” This seems to be an attempt on the part of MCA to narrow down the scope of liability of an ID. This Circular is categorically differentiating the scope of roles of an ID to ensure they are not held liable for anything pertaining to the day-to-day functioning of the company. Additionally, this Circular states that Section 149 (12) of the Act is a non-obstante clause and that due care must be taken so as to ensure that no unnecessary proceedings are initiated against an ID. Moreover, it is mandated that relevant documents be served along with a notice to ascertain the involvement of the concerned officer in the affairs of the company. The requirement of strong evidence suggesting complacence of an ID in frauds committed by companies is mandated under clause 5 of the Circular. Thus, this Circular provides elaborate protection to ID and limits the extent to which they can be held liable while conducting their roles.

Conclusion

This Circular is a welcomed step towards the strengthening of corporate governance in India. It enunciates the standard of vigilance expected from an ID, and at the same time creates a check in place to ensure that an ID is not unreasonably facing proceedings. The Circular preserves the sanctity of the role of an independent director and ensures that she/he is not held liable for day-to-day functions of the company. The Judicial interpretation of liability under the Act extends to the functional role of the ID, such as her/him being in charge of the company, and it will be interesting to observe the impact of this Circular in future course. Further, The LODR Regulation mainly serves as a framework for corporate governance which supplements the Act and based on a harmonious reading of the both, it is clear that both strive to consolidate the provisions to enable better enforceability in furtherance of corporate governance.

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