• May
  • 03
  • 2013

Director’s Liability under the Companies Act, 1956

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CS Kiran Mukadam, ACS, M.Com, SET

Hercules Hoists Limited, Mumbai

Since the emergence of various corporate scandals in India over the past few years, there has been much attention and debate on the role of Company’s Directors. There has been a lot of focus on independent Directors. A Director must be acted honestly and with due diligence. A Director is liable for fraud in the conduct of the business of a company even though no specific act of dishonesty is proved against him personally. Director may be personally liable to any party that has an interest in the affairs of the Company like shareholders, government, regulators, creditors, liquidators, etc. With liability well established and with increasing statutory duties and an increasing litigious environment, the number of actions against Director is increasing.

Meaning of Director

As per section 2(13) of the Companies Act 1956, Directors includes any person occupying the position of Directors by whatever name called. The definition of Director is inclusive definition. It includes any person who occupies the position of a Director is known as Director whether or not designated as Director. It is not the name by which a person is called but position he occupies and the functions and duties which he discharge that determine whether in fact he is a Director or not. He is in charge of an activity, department, or organization or a member of the board of people that manages or oversees the affairs of a business and a person who supervises the actors and other staff in a film, play, or similar production. Simply, Director means a person who control or supervise the affairs of business. Therefore, the Director is liable for every act which he control.

He is duly appointed by the Company through Articles of Association or in general meeting, to control the business of the Company and authorised by Articles of Association to contract on behalf of the Company. A  Director is a person charged with the conduct and management of the company’s activities. Under Companies Act, Directors are the primary agent of the Company to transact its business. He has to exercise strategic oversight over business operations while directly measuring and rewarding management’s performance. Simultaneously he has to ensure compliance with the legal framework, integrity of financial accounting and reporting systems and credibility in the eyes of the stakeholders through proper and timely disclosures.

Legal position of Director:

It is difficult to define the exact legal position of the Directors of a Company. The companies act does not defines the actual position of Directors. The Director shall act as a agent or trustee or managing partner in the Company. In agency term, the Director acts on behalf of the Company. So the Company is liable for contracts in which Director enter into. Director also acts as a trustee. He stands in a fiduciary position towards the company in respect of his powers and capital under his control. There exists a relationship of a trustee and trust between the directors and the shareholders of the Company. The directors have been held trustees of the assets of the Company and in many cases the courts have directed them to reimburse the loss to the Company, where it was found that directors have applied the Company’s money for personal purpose or undue advantage. He shall exercise his powers in the interest of the Company. The Directors enjoys the vast power of management and acts as a decision making body. The Director shall be personally liable in following cases-

1)    If he contracts in his own name

2)    If he use the companies name incorrectly

3)    If he exceeds his authority

4)    If he sign the contract in such way that it is not clear whether it is company or agent who is signing.

But, Director has no power to act on behalf of the company in any matter, except to the extent to which any power or powers of the Board have been delegated to him by the Board, within the limits prescribed under the Companies Act or any other law or memorandum and articles of association of the Company. He must display care in performance of work assigned to him.  The following words expressed in respect of legal duty of Director by judge in case Lggunas Nitrute Co. Vs. Langunas Nitrate Syndicate (1899) 2 Ch.392

“ If Director act within powers, if they act with such care as is to be reasonably expected of them having regard to their knowledge & expenses and if they act honestly for the benefit of the company , they discharge both their equitable as well as legal duty to the company.”

Duties and Responsibilities:

Director’s duties are to use their fair and reasonable diligence while discharging their duties and they shall act honestly, and with such care as may be reasonably expected from, having regard to their knowledge and experience. Each Director has a fiduciary duty towards the company. Most of the powers of Directors are power in trust and therefore should be executed in the interest of the Company and not in the interest of Director or any section of members. All the powers entrusted to the Directors are only exercisable by them in this fiduciary capacity. It is duty of director to follow the applicable provisions under various acts to the Company. If not, then he is liable for breach of fiduciary duties. Also, the Directors can be made liable for acts of misconduct or willful misuse of powers. Directors should be exercised their powers and their duties with reasonable care and skill. If they fail to exercise reasonable care, skill and diligence, they shall be liable for any loss or damage resulting there from. He is liable for act of negligence, breach of statutory duties, breach of warranty, liability for act of co-directors etc.

Case Study:

The liability of the Director to the company may arise from breach of fiduciary duties, liability towards third party, negligence, ultra vires act, mala fide acts. The court has in deciding the liability of Directors, taken into consideration Director Position as a whole. Some of these liabilities are in contract, some are in tort, some are under the criminal law and other are statutory that is under Companies Act 1956 and other laws. The Court has, in deciding the liability of Directors, taken into considerations a directors position as a whole. In order to decide Director liability, consider following hypothetical example-

Mr. A, B, C and D are the four Directors of one of the Company. The shares of the company were listed on different stock exchanges in the country. The role of each Director in the Company are-

Mr. A- Promoter and Whole time Director

Mr. B- Independent and chairman of Audit Committee

Mr. C- Independent and member of Audit Committee

Mr. D- Independent and member of Audit Committee

The Board of Director and audit committee approved the financial result of the Company. In investigation, it is found that the financial result contained inflated figures. The manipulation in the financial result of the Company resulted in rise in share price of the Company In the show cause notice, it was alleged that the company and its directors caused to publish false and misleading financial result of the Company. The director’s files detailed replies to the show cause notice denying all the allegations. In replies, Mr. A contended that he was expert in only HR management, leadership and team building in the Company. All Business, financial operation and verification of accounts were handled by Managing Director. The remaining three Independent Director argued that they relied on the concurrence and approved of accounts by the finance division and managing director in good faith. Then-

a)    What is the liability of Whole Time Director and Independent Directors liable in that case?

b)    Will the Directors rely on the professional experts who prepare the financial statement?

c)    Is it necessary that the Director must be expert in all fields?

Analysis:

Misrepresentation is an offence under Indian Contract Act. . Misrepresentation cases can be prosecuted criminally or civilly under a variety of statutes or they might be the basis for common law claims. The gist of the offence is the deliberate making of false statements to induce the intended victim to part with money or property. The specific elements of proof of misrepresentation vary whether the case is prosecuted as a criminal or civil action. Considering Above example, to provide inflated figures than actual is one of the types of misrepresentation. In that, all directors were not personally involved in day to day matters of the company. The financial results had certified and verified by Chief executive officer and statutory Auditor of the Company, which they had approved. They had no role on in the verification and authentication of the financial results since they had been already varied by competent professional.

Liability of Mr. A:

Mr. A was contended in his argument that he was only expertise in Human Resource Management. According to him, all business operations and financials were handled by Managing Director of the Company. He relied in the concurrence and approval of accounts by the finance division and Managing Director in good faith. But, as per companies act 1956, a Director is statutorily expected to show the diligence and care of a prudent man while documents placed for approval in Board meeting. It is responsibility of Director to identify deficiencies wherever possible by employing verification and scrutiny. A Director cannot take stand that the documents have approved totally depending on the expertise of the managing director or professional. But, a Director who did not participate in the board action or did not know about it , cannot be liable for act of Co-Director. If he has knowledge or he is party to confirm that action, then he is liable for act of co-directors. In that case, Mr. A was unaware about inflated figures and he relied on managing director in good faith. But, he was participated in the meeting in which the accounts were approved.  Considering his position and his action in relation to approval of accounts, Mr. A found to be guilty in this case, because-

a)    Whole time Director Role is very significant in day to day matters of the Company. His role and responsibility  are equivalent to that Managing Director

b)    The Director cannot take shelter that he was not expert in the particular field. The Directors are severally and jointly liable for all contracts in which they enter into contract on behalf of the Company except specifically mentioned.

c)    According to section 5 of the Companies Act 1956, the whole time director who is in default, shall be liable to any punishment or penalty. Therefore, Mr. A shall be “officer in default” under section 5 of the Companies Act 1956.

Liability Mr. B, C and D:

Mr. B. C and D were independent Directors and also they not participated in day to day affairs of the Company. The Audit committee was constituted under section 292A of the Companies Act 1956 and listing agreement with stock exchange. Being a committee of Board, the duties of audit committee were determined by the Board at the time of its constitution. As per this and also reference to applicable provision of companies  act 1956 and listing agreement with stock exchange, the role of audit committee are-

1)    Oversight of the Company’s financial reporting process and disclosure of its financial information to ensure that the financial statement is correct, sufficient and credible.

2)    Reviewing with the management the annual financial statement before submission to the board for approval

3)    Checking of Major accounting entries

4)    Disclosure of any related party transactions

5)    To check significant adjustment made in financial statement arising out of audit findings.

The above mentioned three directors had attended board meeting where verified and vetted documents were produced for approval the same in good faith.  In documents, no irregularity could be pointed out since the professionals working in the Company who have been delegated with the task of preparing, consolidating and verifying the account. The Board has entrusted the audit committee with onerous duty to see that the financial results are correct and complete in every respect.. The role of above mentioned director under listing agreement is to check the financial statement correctness, its credibility and reliability. As per SMS Pharmaceuticals Vs. Neeta bhalla case (2005), the liability of Director depend on his role which he play in the Company. Therefore, above three Directors has found to be guilty, because they cannot take shelter under verification of accounts made by professional experts and auditor and also they had fail to exercise their actual role as per listing agreement.

There is no distinction between executive and non-executive Director or independent director. If a breach of duty is to be attributed to a Board on basis that board member were present at a meeting which had approved a wrongful act, then the liability of each Director is joint and several. In above example, the action took place. All four Directors are liable in providing the inflated figures in Annual Accounts of the Company. They had approved the inflated annual accounts in Board Meeting. Therefore, they cannot take shelter that they were not expert in the finance or prepared the same by professionals.

The ministry of Company Affairs has issued one circular no. 08/2011 relating to “Prosecution of Director” on 25th March 2011. Independent Director, Director appoint under section 408 by central government, nominee director on PSU appoint by government shall be held liable for any act of omission or commission by the company or by any officers of the company which constitute a breach or violation of any provision of the Companies Act, 1956, and which occurred with his knowledge attributable through Board process and with his consent or connivance or where he has acted diligently in the Board process. Also, this circular stated that the director shall be liable, if they are in default to comply the specific responsibility which assign under section 209(5), 209(6), 211 and 212 of the Companies Act 1956. As per section 5 of the Companies Act1956, if the Director who is in default to comply with specific responsibility , shall be  treated as “officer in default”. In given case, all directors were aware about the fact and also they approved the annual statement without considering their reliability. They unable to comply with provision of the Companies act 1956. Therefore they found to be guilty as a  “ officer in default”

Conclusion:

Directors have both collectively and individually, a continuing duty to acquire and maintain a sufficient knowledge and understanding of company business to enable them properly to discharge of their duties as director. The Director cannot confine himself to tending his name to the Company, but taking responsibility for its day to day management even if the functions delegates to some other persons. . The duty, care, diligence, verification of critical points cannot be abdicated by directors. The role of Director in affairs of the Company is important. Director have the fiduciary relation with the Company, But in case of Non Executive Director, there are uncertainty in determining his duties. The Non-Executive or Independent Director is not involved in day to day affairs of the Company. But the court is in opinion that the non executive director could not simply rely on the information provided by the management or executive director. While as Board member, independent and non executive directors have the same legal duties and obligations as executive directors. Simply, the Directors should be followed all provision, rules and regulations diligently as a part of their fiduciary duties towards stakeholders without relying on another or experts. In case of default, the liability shall arise on basis of his position and also specific responsibility.

Ref: 1)  Narayanan Vs. SEBI (2012)

       2) Company Law and Practice- Taxman


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