Monday, June 16, 2014

Director Liability Under the New Regime

Types of Liability

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.

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, as Mihir has previously elaborated. 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 meagre 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 favour 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.

Conclusion

Given the lack of case law in India on these matters, the above discussion comprises only a set of predictions as to how things might pan out in the near future on independent director exoneration. Nevertheless, directors may take adequate precautions at a practical level to discharge their roles effectively so as to avoid any potential liability under the new regime.

The discussion in this post is confined to matters of civil liability. Directors may continue to be bound by criminal liability provisions both under the Companies Act as well as other legislation applicable to companies. In those situations, the usual principles of corporate criminal liability would apply, some of which we have had a chance to previously discuss here.

[This post is adaptation and an expanded version of a section in “Directors’ Duties and Liabilities in the New Era”, NSE Quarterly Briefing No. 5 (April 2014)]

3 comments:

vswami said...

"....While such a provision for limitation of liability is useful, much would depend upon the manner in which courts interpret...."

It ought not to be forgotten,or sidelined that, before reaching the stage of court litigation, there are preceding stages to be gone through. To be precise, "much would upon' how the empowered administering /executive authorities,- entrusted with the duties and responsibilities to implement and enforce the referred provisions-would be inclined to look at, into, or through, 'fairly' or otherwise. Those are anterior stages to be necessarily gone through, which are vulnerable and have unpredictable potentials, truly desirable or not.
As such, ideally, impartial views and independent opinion of eminent experts,- other than law experts,-that is,of sociologists and humanists, could be of greater relevance, hence need to be given due weight-age.

Arjun Menon said...

Well my question relates to "Indemnification of Directors"

Can any express agreement or a special resolution be filed with the registrar which indemnifies a director of the Board, say for a bank granting a loan to the company, where one of the directors have given a personal guarantee, can one of the directors be indemnified against any foreseeable action(s) the bank may take in the event on non-repayment, if the whole transaction wasn't fraudulent and done in good faith.

Arjun Menon

Umakanth Varottil said...

@Arjun Menon. The viability of such an indemnity under the Companies Act, 2013 is not only untested but is somewhat open. However, given that the express restriction against indemnities that existed in the 1956 Act is not present in the new legislation, one could argue in favour of such an indemnity.