Thursday, December 5, 2013

Guest Post: Corporate Governance Disputes & Liability of Professionals and Non-Executive Directors

[The following is a guest post from Vinod Kothari of Vinod Kothari & Co. He can be contacted at vinod@vinodkothari.com]

The trail of litigation in Newcastle International Airport Limited vs. Eversheds LLP [2013] EWCA Civ 1514 , decided by the Court of Appeal on 28 November 2013, may be interesting for more than reason. One is quite obvious – a litigation that might have cost the plaintiff close to a million dollars in legal costs ended up in just 2 pounds of damages against the professional firm Eversheds LLP. However, more importantly, the litigation highlights the new world of professionals’ liabilities – that companies in time to come will not hesitate to sue non-executive directors, professionals, or whoever else, for failing to ensure the balance of duties and self-interest required to ensure proper system of corporate governance.

At the same time, the trail of litigation points to the ever-difficult regime of legal liabilities of non-executive directors.

Facts of the case

The litigation has so far been directed against Eversheds, a solicitor firm that advised Newcastle International Airport (NIAL). The NIAL board consisted of 2 executive directors, and 5 non-executive directors. Advised by Eversheds, the Remuneration Committee, consisting of non-executive directors, approved of new agreements, drafted by Eversheds, which not only bestowed the executive directors with a fat GBP 8 million bonus on completion of refinancing of the debt of NIAL, but also effectively released them from restraints in joining competing airports at Bristol/Leeds.

In earlier decision by Chancery Division, in [2012] EWHC 2648 (Ch), the Judges dismissed, with costs, claim for damages against the law firm. The claims were mainly founded on the ground that the law firm had taken their brief from one of the executive directors. Additionally, the advice of the law firm was non-speaking, and the law firm did not brief the client on the consequences of following their advice. The claim was dismissed in the following words:  Eversheds “acted in good faith on the basis of instructions which it was entitled to accept. I accept that this was not a case where Eversheds treated Mr Parkin in his personal capacity as the client. It followed his instructions because he was clothed with apparent authority and Eversheds had no reason to believe that any of his instructions were unauthorised.”



Despite holding the law firm liable for breach of their retainer to the client, the Court imposed GBP 2 as token damages.

Role of remuneration committee

This litigation may be particularly significant in advancing the law on the duty of a solicitor to a client – not only ending up with drafting what one is expected to draft, but also of explaining, in “user-friendly language” the implications of the advice.

However, equally significantly, the litigation throws serious charges of inaction, not reading of documents, etc. on non-executive directors in general, and the remuneration committee in particular. The Chancery Court had, in no unclear language, held that it was the non-executive directors who were to be blamed for the losses suffered by NIAL. It noted regarding the role of the Remuneration Committee (RC) chairperson: “A major factor resulting in NIAL's signing of the contracts was the incompetence displayed in relation to the consideration of their terms by the chairman of the RC, Rosemary Radcliffe CBE, although it must also be said that she appears otherwise to enjoy universal plaudits for her general ability. In this case, however, she deployed little of it and things went badly wrong.”

The litigation has so far chased the law firm for damages: they spent a fortune to get GBP 2. However, it is anyone’s guess as to what would have been the success had the company chased the non-executive directors. The ruling makes it clear that in the new world of corporate governance, independent directors are not mere embellishments on the company’s boards. Not only would the law seek to punish them where there are lapses or negligent omissions, even the companies/shareholders will not hesitate to pursue them for damages.

 

Other rulings on liability of independent directors

There have been several instances in the past where claim for negligent conduct have been made against independent directors. One of the most important of such cases is Equitable Life v Bowry [2003] EWHC 2263 where the company claimed compensation against the auditors, also filed a civil case against its non-executive directors. Subsequently, litigation was dropped against the directors, but continued against auditors. The case, estimated to have cost some GBP 30 million in legal fees, dragged for years.

Before the Equitable Life ruling, in Dorchester Finance Company Limited v Stebbing (1989) BCLC 498, stated the general proposition of law that there is no distinction in law between executive and non-executive directors in terms of their liability.  A detailed analysis of the case law in respect of liability of non-executive directors can be found here.

Liabilities of independent directors: Higgs Committee

The Jan 2003 report on The Review of Role and Effectiveness of Non-executive Directors, popularly known as the Higgs Report, has gone at length on the issue of liabilities of independent directors. The ruling in the case of Equitable Life was particularly cited as being of concern. Arguments for exempting independent directors were put forth; at the same time, the argument against any special treatment, given the unitary board structures under the UK law were also advanced. Higgs did not make any specific recommendation for generic exemption of independent directors, and only recommended good use of the equitable right to seek exemption under sec.  727 of the UK Act of 1985, and generally a more expeditious disposal of cases by courts.

Liability of independent directors: Indian Companies Act 2013

The Indian Companies Act 2013 [sec 149 (12)] contains what may seem like a general immunity for independent directors and non-executive directors. The section states:

(12) Notwithstanding anything contained in this Act,—

(i)        an independent director;

(ii)       a non-executive director not being promoter or key managerial personnel, 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 provision is not new – there was a circular from the MCA to a similar intent in 2011. However, now that this intent is coded in the law, it is important to understand a few points regarding the provision:

1. The provision is applicable not just to independent directors, but other non-executive, non-promoter directors as well. Nominees of strategic investors, who are not independent directors under the new law, will also be covered by this immunity.

2. One may casually call this section a general immunity provision, but it is not immunity, truly speaking. All this provision says is – a director shall be liable only such acts of omission or commission by a company (a) which occurred (i) with his knowledge being a part of the board; and (ii) with his consent or connivance; or (b) where he did not act diligently. Where the act/omission had occurred with his consent or connivance, it is not necessary to prove knowledge – so the essential element in (a) is, in fact, consent or connivance. As there is an “or” between (a) and (b), it may be argued whether diligence will be a defence even where an act occurred with the consent or connivance of the director? Of course, if the director in question was present and voting at a board resolution, his consent is explicit. If he disclaims, or votes against a matter, he surely has a defence. But with diligence, where he could not detect that there was an offence taking place, can he argue that mere knowledge or consent cannot have an element of criminality where, with due diligence, the director could not detect the offence? Of course, he does not have operational level data or details. He knows only so much as comes out during the board process. In the case of Newcastle above, the maxim that absent dishonesty or exceptional circumstances one is entitled to believe in what one is told. The immunity provisions of sec. 463, which have been there in the statute over decades, also talk about the director acting honestly and reasonably. Thus, the presumption must be that if the director has acted honestly, diligently, and reasonably, he cannot sleep-walk into legal liabilities merely because he puts the cap of a director in a company.

3. Sub-section (12) of sec 149 clearly shifts the onus on the prosecution to make a case that the director had not acted diligently, or that he had consent or connivance. If the prosecution continues to implicate independent directors, and they burden of proving that the defence of sub-section (12) applies in their case, the very purpose of sub-section (12) will be frustrated.

There is also a provision in sec 463 for exoneration by a court if the director in question acted honestly and reasonably. This provision is not new and corresponds to sec. 633 of the 1956 Act and sec. 727 of the UK Companies Act 1985.

If the Companies Act is the only statute that made a director liable for the offences of the company, perhaps something like the general immunity contained in sec. 149 (12) of the Companies Act would have helped. However, there are hundreds of other laws that charge directors. In fact, the general legal principle is – wherever a company is liable for a criminal proceeding, the directors, being the “controlling brain” of the company, are liable. A UK publication says there are over 250 statutes under which directors may be held liable[1]. The India, the number may be running in near a thousand laws.

Conclusion


Clearly, the sole purpose of modern corporate governance codes requiring the presence of independent directors on corporate boards is to impart balance to decision-making. Independent directors cannot plead that they were looking elsewhere while executive directors pursue self interest. At the same time, the unitary board structure cannot be a reason to paint all directors with the same brush. One needs to realise that independent directors are outsiders to the companies they serve – the precise reason why they are regarded as independent. One cannot, thus, be independent while at the same time carry the luggage of operational liabilities pertaining to a company. Particularly so when the regulations now require mandatory retirement of independent directors.

- Vinod Kothari

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