Thursday, September 12, 2013

Remedies against Directors' Undue Gains: Personal or Proprietary?

What is the appropriate remedy against a director who makes secret profits? Should the remedy be merely a personal one, or should it be a proprietary one? This issue is one of great importance and several jurisdictions have been debating the issue for years now. The rules against conflict and profit are at the core of a director’s duties; and it is essential for a legal system to provide a coherent set of remedies to maintain the strength of this rule. Whether the remedy against the director is personal or proprietary in nature is important, and not only for theoretical neatness. A recent decision of the English Court of Appeal explained the importance of the distinction between personal and proprietary remedies thus:

In some cases it matters because the fiduciary is insolvent; and the establishment of a proprietary remedy may mean that the profit is unavailable for distribution among his creditors… In some cases it is said to matter because the secret profit has been invested in an asset that has itself increased in value... Sometimes it matters because the defaulting fiduciary no longer has the profit and the principal wishes to recover it from a third party into whose hands it has come

The question of whether secret profits derived by a fiduciary are held in constructive trust or not has long been a matter of debate. In England, cases such as Lister v. Stubbs indicated that the remedy against the defaulting fiduciary is purely personal in nature. The Privy Council in an appeal from Hong Kong however favoured a proprietary remedy – AGHK v. Reid. Since Reid, the debate has intensified in England: see Sinclair v. Versailles and FHR European Ventures v. Mankarious. Other common law jurisdictions have tended to favour a proprietary remedy. The leading Australian case, Grimaldi v. Chameleon Mining (No. 2), saw an extensive analysis of the position across several countries. Finn J. ultimately concluded that the law must – and does – recognize a proprietary remedy. (Part of – but not the entire – reasoning depends on the different nature in which the law of constructive trusts is approached in Australia.) 

In FHR, the English Court of Appeal recognized that the English insistence on a personal remedy runs counter to the law in Australia, Canada, Hong Kong, Singapore, New Zealand and the US. English Courts have shown a tendency to recognize a proprietary remedy by reading down Lister, though perhaps, a complete departure has not yet been made. 

In India, section 88 of the Trusts Act seemed to be fairly clear that a proprietary remedy is available. However, section 166(5) of the Companies Act, 2013 appears to provide only a personal remedy against directors. If this is correct, India would perhaps be a unique jurisdiction – one which has moved from a proprietary to a personal remedy. This does not seem desirable; indeed, it is hard to believe that a conscious draftsperson intended this result. The language of s. 166(5) does however seem to indicate an exclusive personal remedy. The section says:

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

Thus, the company is given the right to an amount equal to the gain: not the gain itself. The section does not provide that the gain shall be held in trust or for the benefit of the company. All it says is that the director shall be liable to pay an amount to the company; and the measure of that amount shall be the gain which he received. (This also highlights some difficult but interesting questions on how the ‘gain’ is to be measured etc.) 

It is noteworthy that none of the other sub-sections (1) to (6) prescribe any measure of liability against the directors. Sub-section (5) is peculiar in this regard. Sub-section (7) imposes a statutory penal fine: it can be inferred that sub-section (7) would not bar the other remedies of the wronged company. What is hard to understand is why a specific remedy is provided in sub-section (5) alone. It could be argued that including this specific remedy (coupled with the absence of a provision saving other legal remedies) would mean that section 166(5) provides the sole remedy for “making an undue gain”. 

It is not easy to harmonise s. 166(5) with the remedies found elsewhere in the law – say in s. 88 of the Trusts Act. Textually, one may attempt to ‘harmoniously’ read the two sections: s. 166(5) speaks of “any undue gain”, while s. 88 speaks of “pecuniary advantage from adverse dealings”. On a reading of the language, s. 166(5) covers a broader scope. One could perhaps try to say that s. 88 deals only with a no-conflicts rule, for which a proprietary remedy remain; while s. 166(5) deals only with the no-profit rule, for which only a personal remedy is available. The principled basis for such a distinction is hard to find; and it is also hard to say why a breach of the no-profit rule should have less harsh consequences than the breach of a no-conflict rule. Further, distinguishing between the rules against conflicts and the rules against profits is no easy matter: conflicts naturally lead to profits – what does one apply in such cases? Finally, the language of the two sections in any event does not fit easily with the proposed categorization. 

It could be said, perhaps, that s. 166(5) gives an additional option – it allows a personal as well as a proprietary remedy, and clarifies that the personal remedy can be compensatory as well as restitutionary (subject to a double recovery bar). First, the language does not really support this conclusion. Secondly, non-statutory common law and equitable rules would in any case have allowed an option to the claimant for following a personal remedy if he so chooses; and can demand an account for profits. So, even on this reading, a major portion of s. 166(5) would be rendered unnecessary. What, then, does one make of this? 

Once harmonization of the two is not possible, one would have to say that s. 166(5) – being both the later and the specific rule – would have to prevail. The only realistic conclusion seems to be that the proper interpretation of the statute would make a personal remedy as the only available remedy; and s. 166(5) would prevail over s. 88. As a matter of policy, this raises serious concerns: the company will be left less well-protected than it would have been at common law. The Standing Committee Report appears not to have considered these issues; and how Courts will interpret the phrase “an amount equal to that gain” cannot easily be predicted. The section appears to codify the law relating to the remedy of an account for profits, but fails to consider the availability of other remedies. It would have been ideal if the legislature had adopted the statutory solutions found in Singapore or England. In Singapore, for example, s. 157 deals with available remedies, and sub-section (4) provides “This section is in addition to and not in derogation of any other written law or rule of law relating to the duty or liability of directors or officers of a company.” Section 178 of the UK Companies Act dealing with the civil consequences of breaches by directors of ss. 172-177 states that the consequences would be the same as if the “corresponding common law rule or equitable principle applied.” Indian Courts will either have to apply the statute as it stands to conclude that only personal remedies are available; or will somehow have to reason towards effectively implying the Singapore or English solution. How the latter can be legitimately achieved is hard to understand. 

(I would like to thank Prof. Umakanth and Mr. V Niranjan for their inputs: the responsibility for all errors remains mine, however)


vswami said...

Sporadic Thought:

The 'one-man company',a concept that has been in vogue and widely accepted / prevalent elsewhere before, has, in India, been recently given a legal recognition.So also, what are known as LLPs.
The facets/implications sought to be touched upon herein would, therefore, require a study and deliberation in legal circles,separately/specially wprt those types of legal entities falling within the purview of 'company'.

vswami said...

As brought out/implied, no conclusive much less a satisfactory answer could be arrived at to the question as to who has made, and is accountable, for 'undue gains'; is it the person or the firm of which he is a director or officer. Further, anyone venturing to voluntarily or obligated to embark on a detailed study/analysis, ought to bear in mind and extend it also to the inevitable consequences under the other laws in force; primarily, on varied types of 'taxation'. Possibly available Case Law might provide helpful clues/guidance for that purpose.