Unveiling the Shadows: Legal Implications of “Accustomed to Act” with relation to Shadow Directors

[By Divyansh Bhatnagar & K Prashant Agrawal]

The authors are students of Damodaram Sanjivayya National Law University.

 

Introduction

The concepts of Related Party and Shadow Director and the implications of the phraseology “any person in whose advice, directions, or instruction the Board of Directors of a Company is accustomed to act” involves jurisprudence of utmost relevance to corporate law in India and foreign jurisdictions. The jurisprudence of the phrase has abundantly been utilized in corporate law legislations in India, namely the Companies Acts of 1956 and 2013 as well as the IBC, 2016. It is also evident in foreign jurisdictions, such as the UK Companies Act of 1948, the Australian Corporate Act, 2001, and the Singapore Companies Act, 2006.

Sec. 5 of the Companies Act, 1956 establishes the meaning of “officer who is in default”. The section mentions that any person under whose directions or instructions the Board of Directors of the company is accustomed to act may be designated an officer who is in default and shall be liable to any punishment or penalty where a company undertakes such illegal or noncompliant acts. Similarly, Sec. 2(69) of the Companies Act, 2013, defines who a “promoter” is, states “in accordance with whose advice, directions or instructions the Board of Directors of the company is accustomed to act. Similar usage of the phrase is found in definitions of “officer”, “officer in default”, and “Related Party” under Sec. 2(59), (60), & (76) respectively of the Companies Act, 2013. The concept of a related party is of utmost importance to understanding the intention behind these provisions.

Related Party

The definition of “related party” is broad, both concerning an individual and with regard to a business, therefore identifying the parties included would need careful consideration. A company’s KMPs as well as some relatives are considered related parties. Companies must make sure that a procedure for updating the related parties list is set up with consideration for any potential external modifications. For instance, in order to guarantee that all subsidiaries comply and adhere, any modifications to a holding company’s KMPs must be informed to all of them.

Although the majority of the definition of a related party is fairly clear-cut, one must exercise discretion when interpreting the term person to refer to someone whose advice, directions, or instructions a director or manager is “accustomed to act” upon. The 2013 Act does not introduce the idea of being “accustomed to act.” A person who imparts the advice, instructions, or orders that a director, manager, or the board is used to acting upon is commonly referred to as a “shadow director.” A similar idea was present in the 1956 Act.

Shadow Directors

The primary purpose of the law’s reference to “shadow directors” is to designate individuals whose instructions the board of a firm is customarily following. Shadow directors are individuals who are not technically appointed to the board but who still have the ability to exert absentee control over the board due to their ownership of shares or advantageous control over the business. Such a person is a “deemed director” even though they do not officially possess the title of director.

Accordingly, related parties would include a ‘shadow director’ i.e., any person under whose advice, directions, or instructions the company’s director or manager or board of directors is accustomed to act. It is necessary to demonstrate that the company’s directors followed the ‘alleged’ shadow director’s instructions rather than using their discretion or judgment in order to establish shadow directorship. The phrase “accustomed to act” calls for general behavior from the directors, demonstrating that they routinely follow the guidelines or orders of the relevant third party (the “shadow director”). The concept appears to be to hold accountable (as “related parties”) those individuals who actually control the company and are able to direct its affairs by designating as directors their own delegates or individuals who are subservient to them. The term is intended to identify those, other than professional advisers, with real influence over corporate affairs.

Judicial Interpretation & Application

Judicial pronouncements by the Indian courts and tribunals, although relatively few, have been able to effectively interpret and help further demonstrate the application of the phrase and interpretation of related concepts in the Indian context.

In the case of Raj Chawla v. SEBI,[i] the Delhi High Court quashed a criminal complaint against the petitioner. He was not found to be in a position where he could control corporate affairs as a director or as an executive of the company, and he was not found to be a person under whose advice, directions, or instructions the company was accustomed to act at the time the company conducted the incriminating act.

In Re: Issuance of Optionally Fully Convertible Debentures by Sahara India Real Estate Corporation Limited and Ors.,[ii] a Sahara India Group company had issued a red herring prospectus following which Mr. Subrata Roy Sahara was served a Show Cause Notice for the same. He contested the notice by stating that since he was neither in a directorial nor a managerial position in the company in question. However, SEBI held that Mr. Sahara, apart from being the founder of the Sahara Group, was a major Shareholder in the company. Hence, he was adjudged to be a person in whose directions or instructions the Board of Directors of the Company was accustomed to act and, therefore, he falls within the ambit of “Officer in default.”

In the case of Cyrus Investments v. Tata Sons & Ors.,[iii] the NCLT while determining whether Mr. Tata could be referred to as the “Shadow Director” interpreted the term and mentioned how it was slightly differing from “Officer in Default”. The NCLT stated that the term “shadow director” itself suggests that the individual in question is one who subtly induces another person to act in a way that is against the law or otherwise prohibited. Consequently, the idea of a “shadow director” cannot be compared to the recommendations and counsel offered by Mr. Tata. Moreover, the word “shadow” itself suggests that something is being done in secret; this phrase is typically only applied when someone’s guidance has resulted in wrongdoing. When considering the shadow director concept, the one receiving the counsel ought to have done something that would have harmed someone else.

In the case of Arcelor Mittal v. Satish Kumar Gupta,[iv] the Supreme Court interpreted the subclauses (b) and (c) of the definition of “Promoter” under the Companies Act, 2013. The court stated that in subclauses (b) and (c), a de facto position is discussed. According to subclause (b), a person may be considered a promoter of a company if they have “control” over its affairs, either directly or indirectly, through whatever means. Such a person may, under subclause (c), be someone who actually advises, directs, or instructs the Board to act; they do not need to be a member of the company’s board of directors.

Lastly, in the case of In re: Swastik Textile Mills Ltd.,[v] the Bombay High Court while trying to determine when a certain person is accustomed to act in a manner stated that “Whether certain persons are accustomed to act in a particular manner or not is something which can be shown by instances of past behavior or other material facts and not by mere presumptions.”

Conclusion

The analysis of the legal ramifications of the expression “accustomed to act” illuminates the complex terrain of corporate law. The term “shadow director” extends beyond formal titles, encapsulating individuals whose advice, directions, or instructions the board is accustomed to following. The use of this concept is further clarified by judicial interpretations, which offer complex perspectives. Within the dynamic sphere of corporate governance, the term “accustomed to act” assumes significant importance as a pivotal criterion, necessitating a consistent display of conduct by directors who adhere to the advice of influential figures. The phrase serves the purpose of not only designating individuals as shadow directors but also aims to uphold accountability and transparency in the realm of corporate affairs.

The legal ramifications associated with related parties and shadow directors highlight the necessity for a thorough understanding of past conduct and material facts, in order to ensure that those who have substantial influence over a company’s activities are subject to appropriate levels of accountability.

 

[i] Raj Chawla v. SEBI, 2010 SCC OnLine Del 90.

[ii] In Re: Issuance of Optionally Fully Convertible Debentures by Sahara India Real Estate Corporation Limited and Ors., (2011) 5 CompLJ 470 (SAT).

[iii] Cyrus Investments v. Tata Sons & Ors., (2020) 2 CompLJ 94

[iv] Arcelor Mittal v. Satish Kumar Gupta, (2019) 2 SCC 1.

[v] In Re: Swastik Textile Mills Ltd., 1983 SCC OnLine Bom 367.

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