U. K. Sinha, Saparya Sood and Saumya Sahai*
Multiple examples have come to light in the last two decades where mis-governance in corporations has led to significant market wide impact across jurisdictions. The remedial measures have resulted in enactment of strong corporate governance laws. There has been a global consensus on these reforms. UN agencies and institutions like the International Organization of Securities Commissions, have come out with governance standards, which most of the member countries have agreed to adopt.
In India, a series of expert committees examined this issue and recommended corporate governance measures which have been adopted by Securities and Exchange Board of India (SEBI). The minimum public shareholding has been mandated in order to reduce the hold of dominant shareholders and also to have reasonable amount of public float for fair price discovery. The Companies Act, 1956 was amended from time to time and finally a new Companies Act has been put in place in 2013 (Companies Act, 2013). SEBI came out with the SEBI (Listing Obligations and Disclosure Requirements) Regulations in 2015 (LODR Regulations), which introduced the idea of principles of corporate governance. SEBI mandated that the principles of governance would prevail over regulations in case of any incongruity or ambiguity. The principles have expanded from shareholder protection to safeguarding the interest of all the stakeholders of the company, such as employees, environment and the community at large. The idea of shareholder democracy has been strengthened through the requirement of uniform, timely and adequate disclosures as well as through measures to facilitate effective participation of the shareholders in the affairs of the company, such as electronic voting.
It is also important to note that the typical principal-agent conflict (shareholder-manager) assumes a different dimension in India, primarily because a higher percentage of companies are promoter driven. Not only do promoters have high shareholding but also in almost all cases they work as directors and managers in their companies, which creates the incentive for principal-agent collusion rather than conflict. The minority shareholders and other stake holders are more vulnerable in these companies. The laws and regulations have been conscious of this risk and have incorporated remedial and preventive measures. However, this agency problem aggravates when the company witnesses financial troubles or approaches insolvency. Promoters and managers are at the helm of affairs of the company and are the first ones to know and recognise the signs of stress. At this stage, they may use their position to attain undue advantage for themselves thereby compromising the rights of shareholders and creditors. It is often seen that the creditors and other stakeholders of financially troubled corporations allege that the board and management did not discharge their fiduciary duties and engaged in questionable corporate governance practices.
HETEROGENEITY OF BOARDS
Earlier boards used to be homogenous, often hand-picked by the promoters or the dominant shareholders. Rules now provide for compulsory heterogeneity in the board so that different points of view emerge and independent perspectives also come into play while taking a decision. Besides whole time director, there have to be independent directors, woman directors and even non-executive non-independent directors. The ratio of independent directors in the board has been increased. Detailed duties and liabilities of the directors and the board as such have been prescribed.
Duties of the Board
Directors are the officers in charge of a company and owe fiduciary duties to the company and its stakeholders1. The duties of directors of a company are primarily governed by section 166 of the Companies Act, 2013. A director must exercise good faith in order to promote the objects of the company, for the benefit of the members, the company, employees, shareholders, communities and for the protection of environment; he must exercise independent judgement and discharge his duties with due care, skill and diligence; a director must not be involved in any situation which has a direct or indirect conflict of interest or attempt to achieve any undue gain or advantage for himself or his relatives, partners, or associate.
In addition to the above, under the LODR Regulations, the board is required to provide strategic guidance to the management of the company. It has to ensure that the financial reporting is correct and fair and that appropriate systems of control are in place, in particular, systems for risk management, financial and operational control, and compliance with the law and relevant standards. The board has to review and guide the corporate strategy, major plans of action, risk policy, annual budgets and business plans, set performance objectives, monitor implementation and corporate performance. It is also required to monitor the effectiveness of the listed entity’s governance practices and make changes as needed.
Certain committees of the board like the audit committee or the nomination and remuneration committee have to be led by an independent director and are required to have majority of independent directors. The audit committee has been given a critical role in matters like approving the accounts or appointment of boards or in examining the internal audit finding. They are responsible for all internal financial control and have to ensure that the accounts are drawn as per the prescribed accounting standards. They are also responsible for following the regulations to prevent any insider trading and for dealing with environment, health and safety issues.
Disenfranchisement is another innovation designed to isolate the promoter – director or his relatives and associates when any related party transaction is to be approved. If any asset is to be sold or acquired or any new business has to be entered into where the other contracting parties are a related one, or even normal business operations of the company require dealing with goods and services of a related party, the audit committee has to approve it. The same applies in cases of inter-corporate loans or sharing of common services. The tests of transaction being at arm’s length and at fair value have to be applied. Not only that, where the related party transactions are material in nature, shareholder’s approval is required. In such cases the promoter shareholder and its related parties are debarred from voting to approve. The resolution has to be carried out with a majority of minority shareholding approval.
SHAREHOLDERS AND CREDITORS
This paper argues how good governance practices can help a company in dealing with stress and help in minimising the impact or even avoiding the insolvency situation. Often, the conflict of interest is not between the shareholders and the creditors. In many cases, it is between shareholders and creditors on one side and the promoters and managers of the company on the other side. Most large public companies have concentrated promoter shareholding, thereby disturbing the balance of power between the minority shareholders and managers. While the board of directors is supposed to act in the best interest of all the stakeholders, in many scenarios, directors are accustomed to act as per the directions of the promoter. When the directors and promoters see incipient signs of stress in a company, often they are seen to be indulging in fraudulent practices like diverting funds to related parties, selling off the assets of the company, taking loans recklessly, taking decisions that involve high risks and so on. Hence, agents indulge in self-serving practices and make unjust enrichments for themselves and if the company undergoes insolvency, shareholders and creditors are the ones to bear the consequences.
Corporate governance tries to impose checks and balances in the power dynamics of the principals and agents. The Insolvency and Bankruptcy Code (Code) has put in place strong deterrence measures to prevent directors and promoters from indulging in self-serving practices.
Under the framework of the Code, directors have a duty to act in the best interest of the creditors when the initial signs of distress are felt and when they have reasonable cause to believe that the company may face an insolvency situation. This is the look back period or the twilight period which is the time-period preceding the insolvency commencement date for which directors can be held liable for past actions. In April 2018, the head of Insolvency and Bankruptcy Board of India sent a cautionary notice to the directors saying that they have an additional responsibility to protect the interest of the creditors especially during the twilight period.2
Section 66(2) of the Code lays down the duties of the director during the twilight zone. It states that on an application made by the resolution professional during the corporate insolvency resolution process, the Adjudicating Authority (AA), which is the National Company Law Tribunal (NCLT) may by an order direct that a director of the corporate debtor (CD) shall be liable to make such contribution to the assets of the CD as it may deem fit if:
`before the insolvency commencement date, such director or partner knew or ought to have known that there was no reasonable prospect of avoiding the commencement of a corporate insolvency resolution process in respect of such corporate debtor; and such director did not exercise due diligence in minimising the potential loss to the creditors of the corporate debtor.’
Further, under sections 45, 49 and 69, the resolution professional or liquidator has been empowered to approach the NCLT for taking corrective actions if he is of the opinion that a transaction has been undervalued or for defrauding creditors.‘ A transaction shall be considered undervalued where the CD:
‘(a) makes a gift to a person; (b) enters into a transaction with a person which involves the transfer of one or more assets by the corporate debtor for a consideration the value of which is significantly less than the value of the consideration provided by the corporate debtor; and such transactions have not taken place in the ordinary course of business of the corporate debtor.’ 4
Where the NCLT is satisfied that an undervalued transaction has been entered into by the CD:
‘(a) for keeping assets of the corporate debtor beyond the reach of any person who is entitled to make a claim against the corporate debtor; (b) in order to adversely affect the interests of such a person in relation to the claim’, it may make orders as provided under the Code.‘5
The look back period for such transactions is two years preceding the date of commencement of insolvency if it was entered with a related party and one year, otherwise. 6 Section 69 lays down the punishment for an officer of the corporate debtor for defrauding creditors. The section also lays down defences that a director may take in such a situation. A person shall not be punished if he is able to prove that, at the time of the commission of the act, he had no intention to defraud the creditors of the CD.
Moreover, the Code also imposes civil and criminal liability for the erring directors of the company. Civil liability extends to disgorgement of personal assets of directors, whereas in cases of actual fraud, falsification of books of account and siphoning off of funds, the Code imposes fines and imprisonment.
A CHECK ON THE PROMOTERS
Another strong deterrence imposed by the Code is the fear of loss of company by the promoters. From the date of appointment of the interim resolution professional, the management of the affairs of the CD vest in the insolvency resolution professional and the powers of the board or the partners of the CD are suspended and exercised by the interim resolution professional. 7 Once, the insolvency resolution professional takes charge of the affairs of the company, the officers and managers of the corporate debtor have to report to the interim professional. Further, the personnel, promoters or any other person associated with the management of the corporate debtor are required to extend all assistance and cooperation to the interim resolution professional as may be required by him in managing the affairs of the company.‘ Therefore, as soon as the company enters into insolvency, promoters lose the management of the company. In this regard, the observations of the Bankruptcy Law Review Committee (BLRC) are quite pertinent and apt:
‘ The limited liability company is a contract between equity and debt. As long as debt obligations are met, equity owners have complete control, and creditors have no say in how the business is run. When default takes place, control is supposed to transfer to the creditors; equity owners have no say.’ 9
Under the scheme of the Code, promoters are practically barred from bidding for their own company10. This is one of the biggest structural changes introduced by the Code whereby, the promoter loses his company for not complying with the corporate governance norms.
The insolvency framework in the United Kingdom and Italy also emphasises a similar need for protection of the creditors before a company goes into insolvency and the duties of directors that become more onerous once the signs of stress are clear that a situation of insolvency cannot be avoided. The frameworks in the two jurisdictions are briefly discussed below.
The insolvency resolution framework in the United Kingdom (UK)comprises the Insolvency Act of 1986, which was modified by the Insolvency Act of 2000, and the Enterprise Act of 2002. The Insolvency Act, 1986 was supplemented by the Insolvency Rules, 1986 which have been replaced by the Insolvency Rules, 2016. These rules came into effect on April 6, 2017. The Companies Act, 2006 of the UK (hereinafter ‘the UK Act’)is also an important legislation that is pari materia to the Indian Companies Act.
The UK Act lays down the duties of directors. The duties laid down are broad ranging and include the duty to promote the success of the company for the benefit of its members as a whole and in doing so have regard (amongst other matters) to:
As in India, the UK Act does not in the first place, recognise the duty of the directors explicitly towards the creditors of the company. However, under the UK law, the duty to promote the success of the company has been made subject to any enactment or rule of law requiring directors, in certain circumstances, to consider or act in the interests of creditors of the company. The explanatory notes to section 172 of the UK Act clarify that:
‘the duty to promote the success of the company is displaced when the company is insolvent. Section 214 of the Insolvency Act, 1986 provides a mechanism under which the liquidator can require the directors to contribute towards the funds available to creditors in an insolvent winding up, where they ought to have recognized that the company had no reasonable prospect of avoiding insolvent liquidation and then failed to take all reasonable steps to minimise the loss to creditors.’
Thus, as a company’s financial position worsens and there are incipient signs of stress, the duties and responsibilities of the directors become more important and undergo a shift in focus from the interests of the stakeholders mentioned under the sections to that of the creditors. The Insolvency Act, 1986 defines ‘wrongful trading’ which applies (i) once the company has gone into insolvent liquidation, (ii) at some point before the commencement of the winding up, when the directors know, or ought to have concluded that there was no reasonable prospect that the company would avoid going into insolvent liquidation. 12 At this point, unless the directors place the company into an insolvency process, they should have taken every step that is available to them in order to minimise the potential loss to the company’s creditors. This could include consulting professional advisers, consulting the bankers, taking steps to make financial forecasts etc. The section lays down an objective test which must be applied to come to a finding that the inevitability of the company going into insolvency process was evident. Under the section:
‘the facts which a director ought to know or ascertain, the conclusion which he ought to reach and the steps which he ought to take are those which would be known or ascertained, or reached or taken, by a reasonably diligent person having both, (a) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by that director in relation to the company, and(b) the general knowledge, skill and experience that director has.’ 13
There is no look back period provided under the section for wrongful trading or fraudulent trading14 (when in the course of the winding up of a company it appears that any business of the company has been carried on with intent to defraud creditors of the company or creditors of any other person, or for any fraudulent purpose) within which a director’s actions may be assessed. These provisions under the UK insolvency law finds a place under section 66 of the Code which is titled ‘fraudulent trading and wrongful trading’ and also has no look back period as is the case with the UK law. A director’s failure to comply with the wrongful trading test or with his or her duties (under the UK Act or under common law) may lead to personal liability or disqualification as a director. Consequently, directors are often eager to file for insolvency without too much delay, although a premature filing which causes losses to creditors also presents a risk to directors.
Further, the courts in UK have held15 that the standard to be applied to assess a director’s conduct and for the discharge of his duty to exercise reasonable case, skill and diligence under section 174 of the Companies Act, 2006 has to satisfy this test under section 214 of the Insolvency Act, 1986. This makes the directors’ pre-emptive duties more stringent and thus, requires them to be alert to the company’s financial situation.
Evidently, the insolvency framework in India is closely modelled to that under the UK law.
The Bankruptcy Law Reform Committee referred to several provisions from the Insolvency Act, 1986 in the UK in its report. The provision of ‘wrongful trading’ in the UK law incorporates the importance of corporate governance under the insolvency framework. It places on directors the obligation to identify signs of stress and to respond proactively in order to protect the creditor’s interests. This combined with the fact that there is no definite look back period for wrongful trading in the UK law and the assessment of whether a director took all possible measures to protect a creditor’s interest once it was clear that the company could not have avoided going into insolvency could happen up to an indefinite period preceding the commencement of insolvency, makes the UK and the Indian insolvency frame work stringent from an corporate governance perspective. The UK law places on directors the need to shift their focus from the shareholders to the creditors on identification of signs of financial stress and places on them the obligation to identify these signs and take adequate measures to protect the creditors’ interest once it becomes evident that a situation of insolvency cannot be avoided.
While the direct nexus between corporate governance and insolvency, has definitely taken a cogent legal form under section 66 with the enactment of the Code, the section aims to shift the focus of directors in the pre-insolvency stage from the shareholders to the creditors and other stakeholders (under section 166 of the Indian Companies Act) of the company. As under the UK law, if the duty of a director to exercise skill, care and diligence under section 166 of the Indian Companies Act is read with the ‘wrongful trading’ provision of the Code, it is not far-fetched to conclude, that creditors are now envisioned as a stakeholder under the Code towards whom the directors owe fiduciary duties which was not the case under the Companies Act in India. It is important to note that the UK law, like the Indian law, does not place on the directors the obligation to identify signs of financial stress and avoid a situation of insolvency altogether. While this duty may exist on a general interpretation of the duties of directors as codified under the UK Act there is no liability that can be incurred for failure to prevent a company from going into insolvency. In this sense, the Italian law has made some progress recently and is discussed below.
The insolvency framework in Italy with respect to liability of directors is more expansive than in the UK and India. The Italian law places extensive responsibility on the directors to identify incipient signs of stress in the company’s financial position. On January 10, 2019, the Italian Government enacted a new bankruptcy code through the Legislative Decree No. 14/2019 named the ‘Code of Crisis and Insolvency’ (the Italian Insolvency Code) which replaces large parts of Italy’s insolvency legislation dating back to 1942. The Italian Insolvency Code will enter into force only in August, 2020 and will majorly overhaul Italy’s bankruptcy and restructuring framework. The main purpose of the overhaul is to reform the bankruptcy proceedings with a view to preserve the continuity of the company but more importantly, it aims to put in place measures to prevent such a situation of bankruptcy in the first place. This has been done by enacting many corporate governance measures that aim to identify and then, prevent the aggravation of the incipient signs of distress in a company. Certain amendments under the Italian Insolvency Code has also amended certain sections of the Italian Civil Code (ICC) which have come into force since March 16, 2019.
Under the ICC, the definition of ‘distress’ has been introduced and equated to probable future insolvency, in turn defined as the determination that prospective cash-flows will be insufficient to meet the debtor’s expected obligations over the next six months. Several reforms have been introduced including a system of crisis alert measures to identify and address distress situations at a stage when insolvency can still be avoided. Distress as defined under the Italian Insolvency Code will be requisite to trigger the alert measures. This system of alert measures will not apply to listed companies, ‘large enterprises’ (as defined under the laws of the EU) and financial institutions.
As per the provisions of the ICC, in association with local Chambers of Commerce, a Crisis Composition Committee will be set up to help debtors in working out arrangements with creditors.16 Further, if statutory or outside auditors are of the opinion that the debtor is in distress, the board of directors must be informed. Further, certain external agencies such as the Tax Authority, the National Social Insurance Agency, and the collection agency, must also immediately notify the debtor, in the event the company fails to pay taxes or social security contributions for an amount exceeding the thresholds provided for by the ICC. These indicators of crisis may be supplemented by additional crisis indicators that a company may adopt if it believes that the ones laid out under the Italian Insolvency Code are insufficient for the circumstances and the financial situation of the company.
A noteworthy change to the ICC is that the directors of all types of businesses that act as corporations or in collective form, i.e. sole proprietorships, joint-stock and limited liability companies will have to take the necessary steps to adopt an organisational, administrative and accounting structure that is appropriate for the nature and size of the company, in order to facilitate the early detection of an emerging sign of distress. After the detection of distress, the directors have a duty to implement those instruments provided by the regulations to overcome the state of crisis and restore the continuity of the business.“
Another article of relevance that must be noted is Article 2476 (6) of the ICC which has a new paragraph that has been added. It extends the liability of the directors of a joint-stock corporation as provided under Article 2394 of the ICC to the directors of the limited liability company specifically and states that:
‘the directors are liable towards the company’s creditors for failure to comply with the obligations inherent to the preservation of the integrity of the company’s assets. The cause of action can be proposed by the creditors when the corporation’s assets are insufficient to satisfy their claims. The waiver of the action by the company does not prevent the exercise of the cause of action by its creditors. The transaction can be challenged by the company’s creditors with a revocatory action when the required grounds are present.’
Thus, the Italian law not only places a responsibility on directors to identify signs of stress when they first appear so as to avert a situation of insolvency, it also seeks to hold them responsible for actions that they took in applying their business judgment to save the crisis but which actually aggravated the situation and drove the company to insolvency. In this regard, the insolvency framework under Italy now seeks to make directors responsible for detecting early stage symptoms of financial distress in a company, and managing the crisis once the incipient signs are identified or limiting the crisis.
Evidently, the amendments made to the Italian Insolvency Code are in line with the evolving corporate jurisprudence that looks at directors as having the ability to steer the company in the direction away from a crisis or insolvency situation. The nexus between corporate governance and companies coming into insolvency is clear. Italy has taken steps to give this nexus a shape and form by expanding the role of the board of a company.
The Italian model makes corporate governance the backbone of the insolvency framework and expands the realm of mandated governance expected from the board of a company to include the responsibility to identify signs of distress and take steps towards aversion of risk of insolvency. Admittedly, there may be external factors that play a role in driving the company to insolvency and it may not always be the case that it is the actions of the directors that are the necessary reason for a crisis. It can be said that in absence of any adverse external factors, the directors may take decisions where even though they were trying to dispel a crisis, they may aggravate a situation. However, these decisions are not questioned by the court if taken within the bounds of economic rationality and prudent business judgment.
The principles of corporate governance inform a duty on the directors to act with care, skill and reasonableness and in the best interests of the company. They have to ensure that provisions of all applicable laws are followed and rights of all stakeholders are respected. The board has a responsibility to monitor conflicts of interest and be alert on misuse of related party transactions. They have to monitor the management effectively, set the culture of the organisation with high ethical standard and take into account the interests of all stakeholders. Non-adherence of these governance principles is often the cause of destruction of value – not only for shareholders but also for all stakeholders. A good governance principle is the first and fundamental line of defence for all stakeholders. If the board and its committees are alert and follow the governance norms in letter and in spirit, the impact of financial distress in the company or its stakeholders could be reduced or averted.
The corporate governance norms under the Companies Act, 2013 and the LODR Regulations have evolved constantly in the last few years. The Code supplements these governance requirements by seeking to refocus the responsibilities of the company and the board towards protecting the interest of the creditors. But often the conflict is not between the interests of the creditors and other stakeholders, such as shareholders, employees, customers and the community but between the stakeholders on one side and the board and management vested with the responsibilities to steer the company away from a crisis situation, on the other. A harmonious working of governance provisions and the insolvency resolution process can be mutually reinforcing and also be beneficial to the larger economy.
1 Section 166 of the Companies Act, 2013.
2 K. R. Srivats, (April 4, 2018). Insolvency law: IBBI chief puts India Inc’s directors on notice. The Hindu
3 Section 45 (1) of the Code
4 Section 45 (2) of the Code
5 Section 49(1) of the Code.
6 Section 46(1) of the Code
7 Section 17 of the Code
8 Section 19 of the Code
9 The Report of the Bankruptcy Law Reform Committee Volume I: Rationale and Design. pp. 10.
10 Section 29A of the Code
11 Section 172 of the UK Act.
12 Section 214 of the Insolvency Act, 1986 (UK).
13 Section 214 of the Insolvency Act, 1986 (UK).
14 Section 213 of the Insolvency Act, 1986 (UK).
15 Re D’ Jan of London Ltd, Copp v D’ Jan1 BCLC 561; Cohen v Selby  1 BCLC 176 at 
16 Piscicelli, Carlo de Vito. & Francesco, Iodice. (July 16, 2019) Italy’s New Insolvency Code, Oxford Business Law Blog,
17 Article 2086 (2), Italian Civil Code, 1942.
*(Mr. U. K. Sinha is a former Chairman of the Securities and Exchange Board of India. Ms. Saparya Sood is an Associate at Cyril Amarchand Mangaldas Advocates & Solicitors. Ms. Saumya Sahai is an Associate at Cyril Amarchand Mangaldas Advocates & Solicitors.)