Ratification of Breach of Duty by Shareholders – Case Analysis

[By Harshit Joshi]

The author is a student at the Vivekananda Institute of Professional Studies.

Introduction

According to common law principles, a breach of duty by a director can be ratified if the shareholders pass a resolution exonerating the director from the liability arising from such breach. It is an expansion of the common law concept that states people who owe duties may be relieved from the legal obligations resulting from those duties by those to whom the duties are owed. Therefore, shareholders have the authority and power to ratify any irregularities in the company’s operations, relieving directors of personal obligations to the company.

This article examines the case of Terrascope Ventures Limited v. Securities and Exchange Board of India, in which the Securities Appellate Tribunal, Mumbai (“SAT”) recently upheld the validity of shareholders’ ratification of breach of fiduciary duties by directors on June 2, 2022. Through this study, the article aims to investigate the validity and relevance of the ratification principle in regard to Indian law by tracking its prevalence in common law jurisdictions.

Brief Facts

According to section 166 of the Companies Act 2013, directors of companies owe a fiduciary and statutory duty to the company, its personnel, and its shareholders. The validity of any ratification by shareholders subsequent to the adoption of a special resolution is conditional on the nature of the director’s breach of duty. In order for the shareholders to make an informed choice, this ratification procedure is subject to full and open disclosure of all relevant information. Directors who are also shareholders cannot ratify their own breach of duty. Shareholders cannot approve a breach of duty resulting from an act ultra vires of the company.

A special resolution enacted on October 1, 2012, in accordance with section 81(1A) of the Companies Act, 1956, authorized Terrascope Ventures Limited, formerly known as Moryo Industries Limited, to issue 63,50,000 shares as a preference. The shareholders and general public were informed at an extraordinary general meeting held the same day that the funds raised through the preferential issue would be used for the following: (1) capital expenditures, including the purchase of businesses or companies; (2) opening of offices abroad; (3) funding long-term working capital requirements; (4) marketing; and, (5) for other authorized corporate purposes.

The company’s trading operations were the subject of a Securities Exchange Board of India (“SEBI”) inquiry from 15 January 2013 to 31 August 2014. According to the adjudicating authority’s order, the proceeds from the preferential issue were used to buy shares in other companies and to extend loans and advances to other businesses and entities, which was against regulations 3 and 4 of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003. This was done in contrast to the objectives stated in the notice given at the Extraordinary General Meeting.

The adjudicating officer further observed that the company had broken the terms of Section 21 of the Securities Contracts (Regulation) Act, 1956, read with Clause 43 of the Listing Agreement by failing to disclose the variation in how the proceeds were utilized to the Stock Exchange (which requires listed companies to furnish a statement to stock exchanges indicating the variations between projected and actual utilization of funds). Furthermore, the directors’ report in Moryo’s annual report for the fiscal years 2012–13 and 2013–14 did not offer an explanation for the discrepancy between intended and actual utilization.

The firm’s shareholders approved a special resolution on September 29, 2017, approving all the acts, deeds, and things the company had done regarding the use of the money from the preferential issue. The adjudicating officer stated that such post-facto approval of the company’s misconduct was unlawful. The Hon’ble Tribunal has observed that penal liability is neither dependent upon the intention of parties nor gains accrued from such delay in its judgment of Akriti Global Traders Ltd. v. Securities and Exchange Board of India.

The adjudicating officer noted that even though the utilization of revenues did not produce any excessive advantages, a penal liability nevertheless exists because regulations’ provisions were breached. In accordance with section 15 HA of the SEBI Act of 1992 and section 23E of the Securities Contracts (Regulation) Act of 1956, the order imposed a fine of Rs. 1 crore on the company and Rs. 25 lakhs on each of the directors.

Order of the Securities Appellate Tribunal, Mumbai

The SAT effectively overturned the SEBI ruling by holding that although the use of the proceeds from the preferential offer was carried out in deviation from the objects issued, the shareholders later approved the deviation. This post-facto ratification of a duty breach was recognized as legal by the tribunal. The tribunal, in its order, relied on the ruling of the Supreme Court in the case of National Institute of Technology vs Pannalal Choudhury. The Supreme Court has observed that the expression “ratification” means “the making valid of an act already done”. This principle is derived from the Latin maxim “ratihabitio mandato aequiparatur” meaning thereby “a subsequent ratification of an act is equivalent to a prior authority to perform such act.”

The tribunal further ruled that because the variation in the use of the funds was ratified by the shareholders, it was no longer a “variance” that needed to be notified to the stock exchange and so did not breach clause 43 of the Listing Agreement.

Provision of Ratification in Common Law

Most common law countries statutorily recognize the competence of shareholders to ratify directors’ breaches of duty, absolving them of corresponding liabilities. However, Indian laws do not provide any such power to shareholders and only acknowledge the competence of the courts to acquit directors of their violation of duty after full consideration of the circumstances of the case. There is no enabling mechanism that creates the conditions under which ratification would be declared legally effective because there is no statutory mention of shareholders’ power to ratify directors’ breach of duty.

Section 239 of the UK Companies Act 2006 applies where a company ratifies the action of a director that constitutes negligence, default, a violation of duty, or a breach of trust with regard to the company. The decision of the company to ratify such conduct must be made by resolution of the members of the company where neither the director nor any member connected with him is an eligible member. Section 239(2) of the Australian Corporations Act 2001 states that when a court decides whether to ratify or approve conduct, it may consider how well informed the members were about the conduct when making their decision and whether the members who ratified or approved the conduct were acting for legitimate purposes.

In Regal (Hastings) Limited v. Gulliver, the House of Lords established the principle that directors have a fiduciary duty to the company and must avoid conflicts between the company’s and their personal interests. Due to their position as a director of the firm, they may be held accountable for their decisions and earnings made outside of the company if those decisions have any connection to the company. The principle has found a conspicuous place under section 166(4) of the Companies Act, 2013. In India, the application of the principle of ratification is still uncertain. The sole reference to directors being released from responsibilities deriving from breaches of duty may be found in Section 463 of the Companies Act 2013, which gives courts the authority to award relief in specific situations after considering the facts.

Conclusion

In this instance, in addition to their obligations to their shareholders, Terrascope Ventures Limited’s directors were also required by section 21 of the Securities Contracts (Regulation) Act of 1956, read in conjunction with clause 43 of the Listing Agreement to report the variation in the utilization of proceeds to the Stock Exchange. The adjudicating officer appointed by SEBI had properly determined that the shareholders’ post facto ratification of the directors’ duty breach was illegal.

A problematic precedent has been set by the Securities Appellate Tribunal’s recent decision, which recognized the validity of such ratification in law. The Companies Act, 2013 does not have a provision allowing shareholders to ratify a director’s breach of duty. Other common law jurisdictions have consistently interpreted the regulations throughout time and developed the requisite legal precedent in relation to the need for shareholders to ratify directors’ breaches of duty. Due to the lack of requisite clarity in Indian legislation, this loophole in law can be exploited by errant directors, who would be encouraged to seek shareholder approval in order to avoid potential consequences deriving from a violation of duty of care.

Owing to the same, the directors who violate the law should be held accountable without giving shareholders the option to ratify the punishment, and the fiduciary duties of directors must remain an absolute and sacrosanct obligation to them. It is suggested through this article that strict adherence to the principles of corporate governance should be there which requires directors to act in the best interest of the company. It is only prudent to not adopt the common law principle of ratification under the Indian company laws. Application of the same will give the negligent directors a chance to escape the liability.

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