Vicarious Liability of Non-Executive Directors:

Vicarious Liability of Non-Executive Directors: A Case for Reform of Law
By Bharat Vasani & CAM Corporate Team on November 11, 2020
POSTED IN COMPANIES ACT, CORPORATE LAW
Vicarious Liability of Non-Executive Directors - A Case for Reform of Law

Context:
The vicarious liability provisions have been evolving ever since the evolution of law of torts. Offence by companies is a standard vicarious liability provision in most statutes, which is often used to fasten the liability on directors for the acts and omissions of the company. These vicarious liability provisions are borrowed from colonial-era laws and incorporated in our domestic legislations. As a rule, there is no concept of vicarious liability in criminal law. Such provisions imposing liability on directors for acts/ omissions of the company are present in most statutes.

The vicarious liability provisions have a standard language providing that the person-in-charge of and responsible for the conduct of the business of the company at the time of the commission of the offence, as well as other officers are liable for that offence. However, those provisions do not make a distinction between Managing Directors (MDs)/ Executive Directors (EDs) and Non-Executive Directors (NEDs)/ Independent Directors (IDs).

In this context, one needs to examine the scheme of Section 179 of the Companies Act, 2013 (the Act). The said section provides that the Board of Directors of a company shall be entitled to exercise all such powers, and to do all such acts and things, as the company is authorised to exercise and do. The said Section also does not distinguish between the powers of MD/ EDs and NEDs/ IDs. However, in practice, the Boards always delegate their powers to MD/ EDs/ CEOs. As a result of this broad-brush approach, Section 179 of the Act has been often mis-construed by law enforcement agencies/ trial courts to fasten the liability on the entire Board for any legal infractions of the company.

An example of the vicarious liability provision can be seen under Section 141 of the Negotiable Instruments Act, 1881, which provides that every person who, at the time the offence was committed, was in charge of, and was responsible to the company for the conduct of the business of the company, as well as the company, shall be deemed to be guilty of the offence and shall be liable to be proceeded against and punished accordingly. Similarly, Section 42 of Foreign Exchange Management Act, 1999, provides that where a person committing a contravention of any of the provisions of this Act or of any rule, direction or order made thereunder is a company, every person who, at the time the contravention was committed, was in charge of, and was responsible to, the company for the conduct of the business of the company as well as the company, shall be deemed to be guilty of the contravention and shall be liable to be proceeded against and punished accordingly. In both the instances, there is no distinction between EDs and NEDs in imposing the liability.

The Supreme Court (SC) in KK Ahuja v. V.K Arora[1] analysed the two terms often used in vicarious liability provisions, i.e., in charge of and responsible to. It acknowledged that there was little guidance on what made an officer in charge and responsible to so that they can be held liable under the vicarious liability provisions. It was held that the in-charge principle presents a factual test and the responsible to principle presents a legal test. A person would be in-charge of the business of the company if the person is in overall control of the day-to-day business of the company. There might be a director, for example, an independent director or a non-executive director, who might not be in charge of the business of the company. A case of vicarious criminal liability cannot succeed unless the prosecution satisfies both the principles of vicarious liability.

In the case of S.M.S. Pharmaceuticals Ltd. v. Neeta Bhalla[2], the SC held that 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. Conversely, a person not holding any office or designation in a company may be liable if he satisfies the main requirement of being in-charge of and responsible for the conduct of business of a company at the relevant time. Liability depends on the role one plays in the affairs of a company and not on designation or status[3].

Cardinal Rule
The SC in the case of Sunil Bharti Mittal v. Central Bureau of Investigation[4] had clarified that the principle of alter ego can only be applied to make a company liable for acts of a person or a group of persons who exercise significant and pervasive control over the affairs of the company and could not be applied in the reverse. It was further noted that directors of the company can be held responsible for the wrong done by the company only where there is sufficient evidence to prove that such persons played an active role and they had a criminal intent or otherwise, the relevant statute has specifically imposed liability on them, such as labour and environmental law statutes. Vicarious liability cannot be imposed on any director in the absence of legislative mandate.

Furthermore, the SC in the case of Shiv Kumar Jatia v. State of NCT of Delhi[5], reaffirmed its views set forth in the Sunil Mittal case, and held that an individual either as a director or a managing director or chairman of the company can be made an accused, along with the company, only if there is sufficient material to prove his active role, coupled with criminal intent. It is essential that the criminal intent alleged must have direct nexus with the accused.

However, recently, in a few instances, the SC has departed from this normal rule on the legal liability of NEDs/ IDs in certain interim orders[6]. It needs to be emphasised that mitigating factors such as knowledge, exercise of due diligence, consent or connivance are also a part of such clause. The director of a company is liable to be convicted for an offence committed by the company if he/ she was in charge of and was responsible to the company for the conduct of its business or if it is proved that the offence was committed with the consent or connivance of, or was attributable to any negligence on the part of the director concerned[7].

Issuing summons to NEDs and IDs without their involvement in the offence
In practice, despite the clear law laid down by the SC on vicarious liability of NEDs in a number of cases, the law enforcement agencies and Judicial Magistrates keep issuing summons to all the directors in spite of their lack of knowledge or involvement in legal infractions by the company. Going by past experiences, frivolous criminal prosecutions are initiated for mere technical violations of the Shops & Establishments Act, Standards of Weights & Measures Act, Drugs & Cosmetics Act, Insecticides Act etc. Non-application of mind at the stage of summoning exposes NEDs/ IDs to reputational damage and inconvenience caused by protracted legal proceedings. In many instances, such cases are initiated years after such director has stepped down from the Board. For determining the culpability of any person, a trial court is bound to apply its mind and also to form and record its opinion[8] that there is sufficient ground for proceeding and initiating criminal proceedings against any person based on the material available on record and clear active involvement of such NED in the legal violation.

In the case of Sunil Bharti Mittal v. Central Bureau of Investigation[9], the SC allowed an appeal against the order passed by a Magistrate in summoning the Appellants. It was observed by the SC that even though the Magistrate had not found any incriminating material against the Appellants, still they were summoned and proceedings were initiated on the basis of their designations, on the assumption that they represented the directing mind and will of the company. It was held that a wide discretion has been given to the Magistrate under Section 204 of the Code of Criminal Procedure (CrPC) and such discretion must be judicially exercised. Moreover, the court has the powers, in the course of inquiry into or trial of an offence, to proceed against any person as an accused even if he is not named in the charge sheet filed, if the court believes that there is sufficient evidence to proceed against such person. The words sufficient grounds for proceeding in Section 204 of the CrPC are of immense importance. It is these words which suggest that an opinion is to be formed only after due application of mind that there is sufficient basis for proceeding against the said accused and formation of such an opinion is to be stated in the order itself.

Further, certain statues like the Prevention of Money-Laundering Act, 2002, have the provisions for the reversal of burden of proof[10] and the stringent conditions prescribed for the grant of bail[11].

Safe harbour under Section 149(12) of the Act
Section 149(12) of the Act has a limited safe harbour for NEDs and IDs. However, this limited immunity is only for the offences under the Act and not under any other laws and it comes with a rider that such NED/ID  needs to satisfy the court that he had acted diligently.

Recently, the Ministry of Corporate Affairs (MCA) has vide its March 2020[12] circular issued directions to the Registrar of Companies, directing them not to initiate any civil or criminal proceedings against IDs or NEDs (non-promoters and non-KMP) unless sufficient evidence exists against them. Monitoring the day-to-day compliances of the company is not the responsibility of the ID/ NED. Hence an ID/ NED cannot be held liable for acts, which are beyond their control, like failure on the part of the company to maintain and update statutory registers, minutes of meetings, filing of returns, etc. A whole-time director or a KMP is involved in the day-to-day affairs of the company and therefore should be liable for the violation of any law of the company. Additionally, it was also clarified that the Registrars are required to follow a standard operating procedure, as prescribed by MCA, while initiating proceedings against officer who is in default.

Indian version of the Business Judgment Rule
Section 463 of the Act provides that in any proceeding for negligence, default, breach of duty, misfeasance or breach of trust, if it appears to the courts that the officer has acted honestly and reasonably, and that having regard to all the circumstances of the case, including those connected with his appointment, he ought fairly to be excused, the court may relieve him either wholly or partly, from liability. This is an Indian version of the Business Judgement Rule, which comes to the rescue of the directors.

Concluding Thoughts
The current framework of liability of directors exposes IDs and NEDs to investigations and penal proceedings for the acts and omissions of a company without their knowledge or involvement in the said default. Reputational loss, mental stress and hardships caused by protracted legal proceedings have discouraged and de-incentivised several professionals from accepting board positions.

Such initiation of criminal process against NEDs and IDs without any evidence of their involvement have led to such NEDs/IDs rushing to various HCs for quashing of criminal charges against them by invoking the inherent powers of the HC under Section 482 of CRPC. This leads to further clogging of our already over-burdened judicial system and protracted litigation.

Even the Standing Committee on Finances Report on the Companies Bill, 2011, had noted that while the Companies Bill, 2011, makes an attempt to mitigate the liability of independent directors, the fact remains that it still treats them equivalent to other directors by holding them responsible for board processes. This kind of risk has led to resignations of directors and discouragement amongst many potentially well-qualified candidates from joining boards of companies. As per the data run by Prime Database[13], a record of 1,393 ID posts were vacated in 2019, compared with 767 in 2018 and 717 in 2017.

Therefore, there is an urgent need to amend the vicarious liability provisions in every statute to make a clear distinction in the liability of executive and non-executive directors. Alternatively, an overarching provision with a non-obstante clause can be introduced in the Act to give an overriding effect for liability arising under any law. This will not only alleviate the concerns of IDs and NEDs, but also reduce unwarranted litigations arising out of frivolous proceedings initiated against IDs and NEDs. Corresponding amendment on similar lines in Section 204 of CRPC will go a long way in addressing this problem.

[1] 2009 10 SCC 48.

[2] 2005 8 SCC 89. Also see: SEBI v. Gaurav Varshney, 2016 14 SCC 430.

[3] Shailendra Swarup v. Enforcement Directorate, 2020 221 CompCas 758 (SC).

[4] 2015 4 SCC 609. Also see: Iridium India Telecom Ltd. v. Motorola Inc. 2011 1 SCC 74.

[5] AIR 2019 SC 4463.

[6] Usha Ananthasubramanian v. Union of India, 2020 4 SCC 122; Chitra Sharma v. Union of India, W.P (Civil) No. 744 of 2017; Bikram Chatterji v. Union of India, W.P (Civil) No. 940 of 2017.

[7] State of Karnataka v. Pratap Chand, 1981 2 SCC 335.

[8] Section 204 of Code of Criminal Procedure.

[9] 2015 4 SCC 609.

[10] Section 24, Prevention of Money-laundering Act, 2002.

[11] Section 45, Prevention of Money-laundering Act, 2002.

[12] Circular No. 1/2020 dated March 02, 2020.

 Reference https://corporate.cyrilamarchandblogs.com/2020/11/vicarious-liability-of-non-executive-directors-a-case-for-reform-of-law/