Duties And Liabilities Of Directors Under The Companies Act, 2013 – An Overview
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Category: Corporate & Insolvency
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DUTIES AND LIABILITIES OF DIRECTORS UNDER THE
COMPANIES ACT, 2013 – AN OVERVIEW R. Srivinithra, Assistant Professor, Vels Institute of Science, Technology and Advanced
Studies
ABSTRACT
The Companies Act, 2013 ("Act") is enacted to gradually replace the old Act of 1956, with the objective to bring more accountability and good corporate governance. The Ministry of Corporate Affairs has notified ninetyeight sections of the Act which have come into effect from September 12,
2013 and repealed the corresponding sections of the 1956 Act. The Act
appears to place a higher degree of responsibility on the Board members for good corporate compliance. A clear understanding of these obligations and responsibilities will be critical for current and prospective Board members. In the Act, the sections related to role, duties and removal of directors are yet to be implemented but it will happen soon and, therefore, merits attention. In the context of the Board of a company, the legislators have focused on the role of independent directors and have codified the duties of directors, which were missing in the old Act. The paper studies the provisions governing the rights and liabilities of directors under the companies Act, 2013.
BOARD OF DIRECTORS COMPOSITION:
The Listing Agreement mandates that the board of a listed company will have an optimum combination of executive and non-executive directors with not less than 50% of the board comprising non-executive directors. Where the chairman of the board is a non-executive director, at least one-third of the board should be independent directors. Where the chairman is an executive director, at least half of the board should be independent directors. In contrast, the new act requires that at least one-third of the total number of directors of every public listed company must be independent directors. In all other classes of public companies, the central government will have the power to prescribe the minimum number of independent directors. BOARD FORMATION: The 1956 Act prescribes minimum 2 directors for private and 3 directors for a public company.
This criterion is retained in the Act, but the maximum directors on the Board have been raised from 12 to 15 and the Act has also dispensed with the approval from Central Government for raising the number of directors above the prescribed limit. The Act requires the Board to devise mechanisms to ensure compliance with the applicable laws which should be effective and adequate. The Board may consist of several categories of directors including whole-time directors, managing directors, independent directors, nominee directors1 and women directors. Under the Act, there is a mandatory requirement that one-third of the Board should consist of independent directors for listed companies and public companies with a paid-up capital of INR 1,000 million (approx 6 million) or debt of INR 2,000 million (approx $32 million).
Independent directors are expected to be completely unrelated to the company or its shareholders. In order to implement this, the Act has prescribed certain disqualifications for appointment as an independent director which aim to ensure that a potential appointee or his relative (The definition of "relative" is narrowed down and includes spouse, parents, grandparents, children, siblings, son's spouse and children but excludes daughter's spouse and children, spouses of son's children and siblings' spouses) is not an employee or involved in any relationship or transaction with the company. The most important disqualification is that the director has a pecuniary relationship or is a partof any organization with which the company 1Explanation to Section 149 of the Act defines a nominee director as director nominated by any financial institution does business at the time of his appointment.
The Act mandates that not only him, but an independent director's relative should also not be an employee or be involved in any relationship or transaction with the company. These detailed criterions for eligibility of independent director were missing in the old Act and appear to have been introduced to bring objectivity to the functioning of the Board. Independent directors will not be able to hold shares and the Act even restricts their remuneration to payment of sitting fees and reimbursement for expenses, so as to ensure that they have no financial relationship with the company and can carry on their duties without any partiality. Independent directors may be selected from a data bank notified by the Central Government and after proper background check by the company to verify their independence.
2 Every listed company and unlisted companies with paid-up capital of INR 1,000 million will now be required to appoint one woman director within one year and three years of notification of Section 149(1), respectively. This requirement is introduced to facilitate the presence of women in the Board room. India is already making progress in gender issues and this is a welcome step which should help to put diverse views on the boards of companies. The section also stipulates that at least one director of the company should stay in India for 182 days or more in the previous calendar year. This will ensure that the Board shall continue to monitor directly the management of the company on a regular basis and shall be responsible for acts and deeds of the company.
Their continued presence will not delay statutory action steps and will be a step forward towards meeting the timely corporate compliance requirements. This requirement was missing in the old Act and foreign companies starting business in India typically appoint foreign directors as the directors of the Indian subsidiary. With the implementation of this prerequisite, foreign companies doing business in India will now have to appoint at least one resident director or Indian national to act as director to comply with this qualification. ROLE AND DUTIES OF THE DIRECTORS: AN OVERVIEW: Directors had negligible guidance under company law as regards their duties and liabilities. 2Sec 150 of the Act.
The pre-existing Companies Act, 1956 (the 1956 Act) did not explicitly stipulate directors’ duties, which made it necessary to fall back on common law principles (to be articulated by courts while delivering specific decisions). The statutory uncertainty was compounded by the absence of significant cases of director duties and liabilities before Indian courts. This somewhat unsatisfactory situation has been mended in the 2013 Act, which is rather explicit about directors’ duties (somewhat similar to the codification of directors’ duties under the UK Companies Act of 2006, section 172). The new provisions not only provide greater certainty to directors regarding their conduct, but also enable the beneficiaries as well as courts and regulators to judge the discharge of directors’ duties more objectively.
The duties and responsibilities of directors stipulated by the Indian Companies Act of 2013, can broadly be classified into the following two categories: --- i. The duties and liabilities which encourage and promote the sincerest investment of the best efforts of directors in the efficient and prudent corporate management, in providing elegant and swift resolutions of various business-related issues including those which are raised through "red flags", and in taking fully mature and wise decisions to avert unnecessary risks to the company. ii. Fiduciary duties which ensure and secure that the directors of companies always keep the interests of the company and its stakeholders, ahead and above their own personal interests.
The duty of care, skill and diligence requires directors to devote the requisite time and attention to affairs of the company, pursue issues that may arise through “red flags” and take decisions that do not expose the company to unnecessary risks. Fiduciary duties, on the other hand, require the directors to put the interests of the company ahead of their own personal interests. Rules that prevent conflict of interest and self-dealing on the part of directors are integral to this set of duties The following duties and liabilities have been imposed on the directors of companies, by the Indian Companies Act of 2013, under its Section 166: --- • A director of a company shall act in accordance with the Articles of Association (AOA) of the company.
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A director of the company shall act in good faith, in order to promote the objects of the company, for the benefits of the company as a whole, and in the best interests of the stakeholders of the company. • A director of a company shall exercise his duties with due and reasonable care, skill and diligence and shall exercise independent judgment. • A director of a company shall not involve in a situation in which he may have a direct or indirect interest that conflicts, or possibly may conflict, with the interest of the company. • A director of a company shall not achieve or attempt to achieve any undue gain or advantage either to himself or to his relatives, partners, or associates and if such director is found guilty of making any undue gain, he shall be liable to pay an amount equal to that gain to the company.
• A director of a company shall not assign his office and any assignment so made shall be void. • If a director of the company contravenes the provisions of this section such director shall be punishable with fine which shall not be less than one Lakh Rupees but which may extend to five Lac Rupees. BALANCING INTERESTS: Under the 1956 Act, a director’s primary duties were to the company and its shareholders. Although employees and creditors interests were recognized in matters pertaining to insolvency, but the law was settled that a director should primarily act in the best interests of all shareholders. With the 2013 Act, there is an attempt to shift the focus for directors from looking solely at shareholders’ interests to taking account interests of other stakeholders as well.
Though the idea may seem convincing from a corporate governance perspective, several practical difficulties could arise. For example, no guidelines for order of preference have been provided and accordingly, it is not clear whose interests should take precedence in case of conflicting interests. Thus, in such situations, would it be prudent for a director to act in the interest of employees ignoring the interests of the shareholders? Also, since the 2013 Act also requires the director to take into account environmental and community concerns, will an interpretation that a director who is on the board of a tobacco company or cigarette manufacturing company is in breach of the provisions of the 2013 Act right from day one, hold good? Further, this provision would also have a significant impact on nominee directors.
In exercising their fiduciary duties, nominee directors often seek instructions from the appointing shareholder in relation to decisions that need to be taken, for example, the manner in which to vote during a particular resolution. It would be difficult for a nominee director to act where the instructions of his nominating shareholder run inconsistent with the interests of a class of stakeholders. Such practical situations would make balancing act difficult for directors. To minimize risks, the board should consider seeking inputs from its different categories of stakeholders to identify what stakeholders believe may be an appropriate course of action.
INDEPENDENT DIRECTORS: The role of independent directors is chalked down in detail in the "Code for independent directors" appended to it,3which contains clear guidelines regarding professional conduct, roles and responsibilities of independent directors. Independent directors are bound by this Code to play a role in the appointments, determination of remuneration and removal of nonindependent directors and other managerial employees. Though the 1956 Act and Clause 49 of the listing agreement have the provision of an independent director for every listed company, they have not elaborated on the roles and duties of these directors as the Act does. Such enumeration now require an independent director to ensure that he does not abuse his position and devotes his time and attention to assist the company in implementing best corporate governance practices.
The legislators have also set certain generic duties for the independent directors to bring a perspective on matters related to strategy, performance and risk management and balance the conflicting interest of the stakeholders. The duties under the Code are exhaustive and needs the director to maintain confidentiality and attend the general meetings of the company. The independent directors have to hold at least one meeting every year,7 without the attendance of non-independent directors and with the members of management to review their respective performance, and determine whether the nonindependent directors are meeting the specified targets and reporting compliance. They also have to ensure that the financials are reflected accurately, controls system and risk management
3 Schedule IV OF the Act.
are in place, seek clarifications in case of ambiguity and take and follow the advice of experts at the company's expense. Independent directors are also expected by the Code to act as a moderator to resolve disputes, act in the interest of the company and with no partiality towards management or shareholders. In audit committee, the role of independent directors is expanded under the Act and they have to now examine the financials and approve the related party transactions compared to only a review function in both cases under the old Act. The independent directors have also been given the duty to determine the appointment, removal and remuneration of executive directors, key managerial personnel and senior management. However, the exact process will be clear once the rules are finalized.
The liability regime of the CA-2013 not only imposes the above-mentioned duties and responsibilities on the directors of Indian companies, but also advocates for independence and equitableness of the board of a company, especially a public limited company. Consequently, the roles, duties, and responsibilities of the Independent Directors have also been stipulated by the new Indian Companies Act of 2013. An Independent Director is that member of the board of a company, who does not possess any financial relationship with the company (except the sitting fees), nor can own shares in the company. The earlier Indian Companies Act of 1956 had no explicit provisions for the independent directors, and only the Old Clause 49 of the Listing Agreement of SEBI contained prescriptions for induction of independent directors to the listed companies.
The new Indian Companies Act of 2013 dictates that every listed company must contain at least one-third of the total magnitude of its directors, as the independent directors; and it also empowers the Government of India to include other categories of companies within the scope of this provision or requirement (Section 149 of the CA-2013). Public limited companies composited as per the former CA-1956, are granted a transition period of one year for making strict compliance with this mandatory provision. Again, the independent directors are not permitted to hold office for more than two consecutive terms of five-year periods. In the new regime, the roles and duties of the independent directors attained significant expansion, and many new other areas have been prudently covered.
Broadly, they are intelligently assigned the highly responsible role of the arbiters among various constituencies within the corporation. Hence, the new provisions for the independent directors of the limited companies are certainly very constructive for transparent and sound corporate governance, and are hugely beneficial to the company and its all shareholders.
Some of the most significant functions, duties, and liabilities of the independent directors, are the following (as per the Schedule IV of the CA-2013): --- • To assist in forwarding equitable and independent judgment to the board • To secure and promote the interests of all stakeholders of the concerned company, particularly of the minority shareholders • To conciliate and balance the conflicting interests of the stakeholders • To attend actively and constructively most of the board and committee meetings • To pay proper and adequate attention to Related Party Transactions (RPTs) • To report concerns honestly and impartially about any unethical behavior, violation of the code of conduct, or any suspected fraud in the company OTHER DIRECTORS: The non-independent directors are under an obligation to make disclosure for buying, selling or disposing of any property, leasing of any property, appointment of an agent and appointment in place of profit in the company or in associate/subsidiary.
4 In view of the fiduciary position held by directors, explicit provisions prescribing directors duties have been added to the new Act. These include keeping away from situations in which they have conflicting interest with that of the company, duty to make good in monetary terms any undue gain/advantage on the part of the directors etc. , similar to what was there in the old Act. There are also certain general duties, such as acting in good faith for the benefit of the company and to ensure that the company is filing its financials, annual return and payment of debentures in time. These amendments, though not substantial, have tried to shift the onus on the director for the loss/liability suffered by the company due to their lack of discipline by increasing the penalty and clearly codifying the role and duties.
The Act has focused on corporate compliance and a director will not be re-appointed if the company has failed to file its annual returns for three continuous years. Re-appointment in such 4Sec 184 of the Act. cases, in that company or any other company, can happen only after five years from the date of the failure to file accounts. However, if the company chooses to re-appoint a director even after its failure to file the accounts shall be penalized. Additionally, the practice of directors absenting themselves from meetings and sending proxy has been placed under check. Any director who was absent from the board meetings for the previous twelve months, whether he sought leave or not, will have to vacate his office.
If the director continues to function as a director even after he knows that he is disqualified to hold the office shall be imprisoned for up to one year or punishable with fine. The Act prohibits directors from buying, selling, leasing or disposing of any property, appointment of an agent and appointment in place of profit in the company or associate/subsidiary and, in all such cases, they are mandated to make a disclosure for these transactions. In case of non-disclosure by a director, he will indemnify the company against any loss incurred by it. The Act has codified and set high standards for a director's duty and liability towards the company. 5 The general penalty prescribed for all the contravention above is fine of INR 100,000 (approx ,615) to INR 500,000 (approx $8,076).
OFFICER IN DEFAULT: As provided under the 1956 Act, the definite on of the term “officer in default” includes directors. Various penal provisions in the 2013 Act, which seek to penalize a company’s officers would accordingly include company’s directors and charge them for offences committed under the Act.
The term “officer who is in default” has been defined under Section 2 (60) of the 2013 Act as: “officer who is in default for the purposes of any provision in this Act which enacts that an officer of the company who is in default shall be liable to any penalty or punishment by way of imprisonment, fine or otherwise, means any of the following officers of a company, namely– every director, in respect of a contravention of any of the provisions of this Act, who is aware of such contravention by virtue of the receipt by him of any proceedings of the board or participation in such proceedings without objecting to the same, or where such contravention has taken place with his consent or connivance. ” It is pertinent to note here that the term ‘officer in default’ now seeks to implicate every director 5Sec 166 of the Act.
(including nominee director) who is aware of the contravention. He need not even participate in any meetings of the board, but if the information as to a contravention is contained in any of the proceedings of the board received by him, he is deemed liable. Also, in view of the aforesaid provisions, a director needs to ensure that any objection raised by him at a board meeting is duly recorded in the minutes. LIABILITIES OF DIRECTORS: TYPES OF LIABILITIES: Being fiduciaries, directors are exposed to liabilities as a consequence of a breach of their duties. While liabilities may arise under various statutes, the focus here is on liabilities arising under company law. The first set of liabilities is statutory in nature, being specifically set forth in the Companies Act, 2013 (the 2013 Act).
These could be either civil liability requiring directors to make payments to victims or the state, or they could criminal liability resulting in fines or imprisonment. The approach in the new regime has been to impose stiffer penalties in case of a criminal offence so as to constitute a strong deterrent on director conduct that falls short of the desired standards. Examples of Statutory Liabilities of Directors • For misstatements in prospectus (sections 34 & 35); • For breach of solvency declaration (section 68); • For breach of directors’ duties (section 166); • For fraudulent trading (section 339); and • For offences where no specific punishment is prescribed (section 450). The second set of liabilities could arise from claims made against the directors either by the company or the shareholders for breaches of directors’ duties.
Since directors owe the duties to the company, at the outset it is the company that can bring a claim. Where the company is unable (or does not wish) to do so, it is open to the shareholders to bring a derivative claim on behalf of the company to recover monies for breach of directors’ duties. These claims are quite robust in theory, but are riddled with tremendous difficulties in practice. At a substantive level, there are obvious inadequacies regarding the types of remedies that can be exercised for breaches of directors’ duties, others relate to the speed and cost-effectiveness of bringing these actions. Given the jaw dropping rates of docket explosion before the Indian courts, the ability of shareholders or the company to bring a suit, and even more, to enforce a successful claim against directors, is highly doubtful.
It is not surprising that India displays a rather meager track record of civil claims against directors that have resulted in payouts by them. In order to obviate the difficulties (particularly on the procedural count) under the pre-existing law, the 2013 Act institutes mechanisms that are novel in the Indian context. The first is the establishment of a class action mechanism that allows a group of shareholders (constituting a minimum of 100 shareholders or those holding 10% shares in the company) to bring an action on behalf of all affected parties, which includes claims for compensation from directors for any fraudulent, unlawful or wrongful act or omission or conduct on their part.
More importantly, the 2013 Act devices a mechanism to sidestep the regular court system by enabling such actions to be brought before a yet-to-be-constituted National Company Law Tribunal (NCLT) that is expected to be speedier, more efficient and cost-effective. Once these remedial mechanisms are in place, it is likely that directors may be subject to greater scrutiny through the use of civil liability suits by companies and shareholders. Only time will tell whether the directors’ liabilities regime in India would transform itself from a scenario where directors face almost no lawsuits for company law duties to one where they might face too many lawsuits, and as to what impact that might have on their willingness to serve on corporate boards as well as on their conduct.
MITIGATING FACTORS: The severity of the liability provisions is softened through certain mitigating factors that operate in favor of directors. • Safe Harbour Provisions First, there are certain relief or safe harbour provisions. For instance, in any proceedings, a director could seek relief on the ground that he or she acted honestly and reasonably and that having regard to all the circumstances of the case, such director ought fairly to be excused.
This relief available under the Companies Act, 1956 (the 1956 Act) has been continued in the
2013 Act as well.
The newer legislation, however, creates a specific safe harbor provision for independent directors. In order to balance the extensive nature of the duties and liabilities imposed on independent directors, the 2013 Act seeks to limit their liability only to matters directly relatable to them. An independent director is liable “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. ” (section 149(12)). This is to insulate potential liability for independent directors for acts of the company for no fault of their own. While such a provision for limitation of liability is useful, much would depend upon the manner in which courts interpret it based on the specific facts and circumstances of individual cases.
In order to understand the scope of this provision, it would be useful to dissect the operative expressions: (i) “knowledge”, (ii) “attributable through board processes”, (iii) “consent or connivance”, and (iv) “not acted diligently”. (i) Knowledge When is a matter within the “knowledge” of an independent director? As is well known, independent directors, playing a non-executive role in the company, are involved in matters relating to the company only on a sporadic basis and not with any level of periodicity. The involvement may range from participation in board meetings to discussions with management to contributions made in case of specific issues of strategic nature that may arise from time to time. Moreover, questions may arise as to whether “knowledge” in this regard would refer to actual knowledge or constructive knowledge.
In response to this question, it might be eminently reasonable to include both actual and constructive knowledge within the provision. Actual knowledge would refer to something the director in fact knew. Constructive knowledge, on the other hand, would refer to something the director “ought to know”, which would impose an obligation on the director to conduct due enquiry. Mere reference to actual knowledge would lead to absurd results, as the director may be better off in a position of ignorance, which defeats the purpose. It would motivate directors to refrain from probing further in case any “red flags” have been raised. It goes without saying that such a broad interpretation would impose more onerous obligations on directors.
(ii) Attributable Through Board Processes While the question of “knowledge” (actual or constructive) is not altogether novel and arises in various areas of contract, corporate and commercial law, the extension of knowledge to that “attributable through board processes” makes the concept wider. This would mean that a director would be deemed to have knowledge of all matters that have been taken up at the board level. For example, if board papers are delivered to a director along with the agenda for a meeting, the director may be imputed with knowledge regarding the contents of those papers. Similarly, the director would be deemed to have knowledge of all matters discussed at a board meeting. In order to invoke the safe harbour provision, directors may be required to take additional practical steps.
For example, directors must ensure that any questions raised by them in a board meeting or any dissent expressed is properly recorded in the minutes of the meeting so as to provide prima facie evidence of proceedings before the board in case the role of the director were to be called into question in a liability suit. (iii) Consent or Connivance This is somewhat more straightforward as it requires higher level of mental state on the part of the directors, who are involved more positively in the act or omission. (iv) Not Acted Diligently This is linked to the duty of care, skill and diligence whereby directors must comply with certain minimum standard. Unlike several other jurisdictions, the standard is not clearly defined in the Indian context, given the lack of case law on this count.
It is, however, likely that all directors (whether executive, non-executive or independent) will be subject to a minimum standard that must be met. Hence, directors can no longer ignore developments within the company, fail to attend board meetings with a sense of regularity or omit to raise the right questions. All such matters would be subject to strict scrutiny which considering whether the directors have complied with the standard of diligence.
Indemnities from Company Second, it may be possible for directors to obtain indemnities from the company. Under the
1956 Act, companies were constrained from providing such indemnities, as they are not
permitted to indemnify directors for negligence, default, breach of duty and the like. The 2013 Act, however, does not contain such a restriction, which may confer greater flexibility on directors to seek indemnities from the company in case they have to meet any liabilities, particularly if no fault can be attached to the directors’ conduct. • D&O Insurance Third, and related to the previous, the practice of obtaining directors’ and officers’ (D&O) insurance has already become prevalent in Indian companies, especially among the larger ones, and is only likely to grow in view of the expansive liability regime under the new law. In fact, the 2013 Act implicitly recognizes the ability of the company to incur the premium expense in order to obtain D&O insurance policies.
While obtaining adequate level of D&O insurance policies would be prudent for all boards and directors, regard must be had to the fact that policies are usually accompanied by specific exceptions for fraud, wilful misconduct and other forms of intentional criminal conduct. EXEMPTION FOR INDEPENDENT DIRECTORS: Section 149(12) of the 2013 Act, inter-alia, states that notwithstanding anything contained in this Act an independent director shall be held liable, 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. This carve out has been provided to independent directors considering the limited degree or involvement of an independent director in the day to day affairs of the company.
The term ‘attributable through Board processes’ would normally be interpreted to mean that a director would be deemed to have knowledge of all matters that are taken at the board level. However, the term is not clearly defined and accordingly would be open to judicial interpretation and uncertainties. Further, the term ‘knowledge’ is also subjective and would be open to judicial interpretation. Since now the Act would hold independent directors for any action taken with their consent, it would be extremely important for independent directors to be extremely cautious when it comes to giving consent to any proposal. Else, they will have to be prepared to face the consequences of their actions.
Further, although, the law is attempting to limit the scope of offences in respect of independent directors, at the time of prosecution, all directors irrespective of their category are issued summons. Thereafter, the burden of proof lies on the independent director to prove that he was diligent in the discharge of his duties and that he had acted in a bona fide manner. However, till such a conclusion is drawn, the independent director suffers a lot of inconvenience and embarrassment. Considering the importance attached to their role, it is important that independent directors act in a more proactive manner, attend board meetings regularly and question all decisions which appear inappropriate.
CONCLUSION
While looking at all the details, the Act does not appear to have introduced too many significant changes in the provisions with respect to directors. The penalties for contravention under different sections have been increased from a minimum of INR 10,000 (approx 61) to a minimum of INR 50,000 (approx $807) to bring in more accountability. With the introduction of strict eligibility criteria for appointment of independent directors, their pecuniary interest is bypassed and this is to create a watchdog for public/listed companies. Penalty for any contravention by an independent director is also introduced, but they will be liable only for those fraudulent transactions for which they will give their consent or where it can be demonstrated that they have not acted diligently. This defense hardly provides any immunity as most Indian laws charge the directors for any offence.
The Act also permits an Indian company to indemnify its directors and officers, unlike the 1956 Act. Women too are encouraged to join the board room, thus bringing in diverse viewpoints and talent. In essence, the Act has endowed responsibility and introduced high standards for directors so that they are accountable to the shareholders for their action and personally liable for any damage caused by them. But, the effectiveness of these provisions will depend on how strictly they are enforced.
REFERENCES:
Companies Act, 1956; • Companies Act, 2013; • Derek Higgs, Review ofthe Role andEffectiveness of Non-Executive Directors(Jan. 2003); • HemantGoyal, Duties and Liability of Directors – An Indian Laws Perspective, Mondaq (Jan. 22, 2013); and Umakanth Varottil, • Companies Bill, 2011: Independent Directors, IndiaCorpLaw (Dec. 17, 2011). • India: Duties And Liability of Directors - An Indian Laws Perspective, Article by Hemant Goyal and Hemant Goyal