Independent Directors: Demystifying Annotated Notions of Liability and Ethics

By: Dhruva Sareen

An independent director (hereinafter ‘ID’) is that member of the company’s Board of Directors (Board) who is independent from the management in the context of any pecuniary or managerial control. As was put by the Naresh Chandra Committee Report (NCC Report) – a board packed by executive directors, or friends of the promoter or CEO, can hardly be expected to exercise independent oversight judgement. Therefore, bereft of any undue incentivization by the Board, the independent directors ensure impartiality in the functioning of a company’s Board and safeguard the interests of shareholders.

The Companies Act, 2013 has revamped the existing regime of corporate governance in India. One crucial feature of this facelift has been the introduction of statutory requirements with respect to introducing IDs on a company’s Board of Directors. In light of several corporate governance failures like Satya and Sahara, a legislative mandate for board independence and fixation of accountability was a pre-requisite.

Arguing the Liability of IDs

The Companies Act, 2013 contains a general immunity for IDs and non-executive directors, stating that they shall be held liable only in respect of such acts of omission or commission by a company that had occurred within their knowledge, attributable through Board processes, and with their consent or connivance or where they had not acted diligently.

The language of this provision has been taken from the Ministry of Corporate Affairs (MCA) Circular dated July 29, 2011. The aforementioned circular specifically stipulated that in the ascertainment of the liability of directors for the violations committed by a company under the Companies Act, 1956, extra caution must be exercised in making certain classes of directors, including IDs, liable for such acts – just because a person occupies the office of a director does not mean that he or she will become liable for all acts of the company. Such directors who had nothing to do with the wrongful acts need not be roped in.

The Reserve Bank of India, in its Master Circular on Wilful Defaulters, states that once a unit is classified as a wilful defaulter, one of the penalties that the unit, along with its entrepreneurs or promoters, will be subjected to, is their debarment from access to sources of institutional finance that they may require for floating a new venture, for the next five years. Additionally, the Master Circular also stipulates that a provision must be present in loan agreements where a bank or financial institution has a significant stake, stating that the borrowing company must ensure that a person whose name appears in the list of wilful defaulters is not present on the company’s Board of Directors. Also, directors can be subjected to criminal action by the banks for carrying out wilful default under section 403 (dishonest misappropriation of property) and section 415 (cheating) of the Indian Penal Code, 1860.

However, these provisions for ascertaining the liability of directors did not make any distinction between the various classes of directors, though the Master Circular did require the defaulter companies to separately highlight nominee and IDs from other directors.

In Ionic Metalliks v. Union of India, a division bench of the Gujarat High Court struck down the penalty provision of the RBI Master Circular as unconstitutional, since it found the part to be arbitrary. The court stated that not all directors can be held liable for each and every act of the company – the role of every director in the management of the day-to-day affairs of the company varies, and this role will determine his liability. The following extract from the judgement is relevant in this regard –

“In our opinion, a director of a company, other than the promoter or a direct borrower of the loan from the bank, could also be a director who has a limited role to play and not directly or indirectly responsible for the company going in a debt cannot be restrained, if he himself on his own, wants to start a business or a new venture, from approaching a bank for financial assistance.

In accordance with the above judgement, the Reserve Bank of India modified its Master Circular which now contains a clause titled, ‘Mechanism for Identification of Wilful Defaulters’. This clause specifically stipulates that a ‘non-whole time director’, which includes independent directors, should not be classified as a ‘wilful defaulter’ unless either of the following facts are conclusively established: (i) the director was aware of the fact of wilful default by the borrower by virtue of any proceedings recorded in the Minutes of the Board or a Committee of the Board and has not recorded his objection to the same in the Minutes, or (ii) the wilful default had taken place with his consent or connivance.

Thus, the RBI Master Circular is an example of a situation wherein a special exception has been carved out for IDs in order to determine their liability. However, this exception is in line with the legal position on determining the liability of any director, whether independent or not, under the Indian law.

The general principle with respect to the liability of directors has been that where the director acts honestly, reasonably and with due diligence, he will not be held liable for conniving at fraud. However, where the fraudulent conduct of the company is such that it would be visible to anyone even on a superficial examination of the company’s affairs, then any director, whether independent or not, can be held liable for his dereliction and negligence, even though he may not be guilty of participating in the fraudulent act.

Thus, even IDs can be held liable in such a situation, where the fraudulent acts may not be directly attributed to them, but where they were under an obligation to be aware of the occurrence of such acts by virtue of being an ID. However, it is interesting to note here that the NCC Report laid special emphasis on distinguishing between the criminal liabilities of executive directors and non-executive directors. It contained a specific recommendation which stated that provisions must be inserted in various statutes such as the Companies Act, Negotiable Instruments Act etc. to exempt independent directors from criminal and civil liabilities provided in the same. It also stated that independent directors must be indemnified from the costs of litigation.

Analysing the Code for IDs

Schedule IV of the Companies Act, 2013 lays down a Code for Independent Directors (hereinafter ‘the Code’) which contains the duties and functions of IDs and how they can fulfill the same in an independent and faithful manner. However, it also imposes certain additional obligations on the company, which go beyond those provided in the Act. Thus, the question regarding the legal status and enforceability of a schedule arises. A Schedule is as much an Act of the Legislature as the Act itself, and it must be read together with the Act for all purposes of construction. Even where the words of the Schedule go beyond the purpose that has been defined for it in a particular section, or beyond the scope conveyed by its heading prima facie, such words, where stated clearly, have to be given effect to. Also, the Act clearly states that the company and independent directors shall abide by the provisions specified in Schedule IV. As a general rule, the use of the word, “shall” denotes that a provision is mandatory, unless a contrary intention of the legislature can be shown.

Thus, this shows that the additional obligations that are contained in Schedule IV are binding on the company as well as the ID, and must be complied with. The Code lays down the role and functions of the ID, including points such as upholding ethical standards, acting objectively, not abusing his position etc. Moreover, it provides that all IDs should strive to attend all meetings of the Board and keep themselves well-informed about the company’s affairs while not obstructing the functioning of the Board. It has been provided in the Code that on account of resignation or removal of IDs, a replacement within a period of 180 days from the date of the resignation or removal is mandatory. However, such replacement is not necessary, where the minimum requirement of the number of independent directors on the Board is already satisfied. One of the most significant aspects of the Code is the requirement of a separate meeting, which is to be held at least once every year to review the performance of the Board, the Company Chairman and the managerial communication, both individually and collectively.

Thus, the Act details out the duties and responsibilities of the IDs and curtails the ambit of its liabilities. While the endeavours of the Act deserve appreciation, the contention remains that the Act has been prescriptive while outlining the role of such directors; the question arising thereof whether too much leeway has been given to such directors.

Is there Something called ‘Too Much Cushion’?

It should be stated at the outset that the Act has been fruitful in bringing assurance to independent directors that unwarranted prosecution will not hinder bold decisions. The Act has been instrumental in increasing the severity of the liability for all directors; however, several safeguards have been put into place to tilt the balance in the favour of directors.

In the context of IDs, the Act creates a safe harbour provision in the form of Section 149(12) by restraining their liability to matters directly attributable to them. The said safeguard would depend on the interpretation of the court on the basis of the board process, notes and agenda to establish knowledge under Section 149(12). Moreover, the Act demarcating a shift from the 1956 legislation allows the indemnification of directors to meet any liabilities if misconduct cannot be substantially denoted to the acts of a director. The Director and Officers’ Insurance Policy is now on a fast growth spiral in the big conglomerates.

It could be argued that by not making IDs severally liable with the other directors, a free leeway has been provided to the IDs to simply dissociate themselves from the companies in troubled times. The rationale for the creation of such a position was to ensure board transparency and ethical conduct. However, by virtue of the safe harbour provision, the IDs have the option to plead ignorance and simply walk away with no accountability whatsoever. The question which arises is regarding the motivation for the IDs to perform their duties adequately. It was held by the Supreme Court in S.M.S. Pharmaceuticals v Neeta Bhalla and & Anr that the liability arises from being in charge of and responsible for the conduct of the business of the company at the relevant time when the offence was committed and not on the basis of merely holding a designation or office in a company. Even though the judgement was given prior to the enactment of the Act, it still brings forth the principle that the liability should arise on part of all directors who are in charge of the conduct of business. An ID is no exception to the above set gamut of individuals.

A lot of faith has been put in the repository of independent directors and their selfless conduct and efforts thereof. However, without a stick to balance the carrots, how far this expectation from IDs to act to the fullest potential on their own accord is reasonable, remains doubtful.

(Dhruva is a student at National Law University, Jodhpur.)