Authors: Bhavin Gada (Partner), Manendra Singh (Senior Associate), and Tanvi Goyal (Associate Manager)
These unprecedented times require the flag bearers to take decisions, which (under the law) are in the ‘best’ interest of all stakeholders. Interestingly, the directors are the flag bearers of a corporate entity, and first port of call on review if something were to go south. While the directors, being the decision makers, have their conspicuous issues (such as, moral, legal, ethical, discretionary) whilst approving any matter; it is quintessential to delve into the risks and uncertainties associated with such decision making. Before we take this discussion further, we believe that it would be apt to distinguish the words ‘risk’ and ‘uncertainty’, which many often erroneously blend. A person is said to have taken a ‘risk’ where he can guess the outcome of a decision. An ‘uncertainty’ lies in the proposition that the decision maker cannot guess the outcome of a decision.
The recent outbreak of COVID-19 and consequent actions by the governments, has casted a heavy burden on the directors to find solutions to keep the companies afloat. At the peril of personal liability, the directors are required to take decisions which have either inherent risks (business or regulatory) or are followed by uncertain outcomes. These decisions may range from cost cutting, restructuring, availing financial facilities, helping group companies by providing guarantee, acting as surety, and other similar actions.
In this article, we have analysed the balancing act that a director needs to play while protecting not just the interest of the stakeholders of the company, but also ensuring that personal liability of the director may be kept at bay.
Company’s interest is primary?
It has been long established that a company is a juristic person and acts through its board of directors. A board is a collective body of directors and is the mind behind various decisions taken by a company. When it comes to decision making by a company, the factors which drive the actions of a director, thus becomes imperative. The moot question thus is, do they only need to keep the interest of the company in mind or are there other stakeholders as well whose interest they should consider. It is in this context, speaking of the fiduciary duties of the directors, the Apex Court has held that the fiduciary capacity within which the directors have to act enjoins upon them a duty to act on behalf of a company with utmost good faith, utmost care and skill and due diligence and in the interest of the company they represent.[1] In different cases before the High Court of Delhi[2] and High Court of Gujarat[3], the courts observed that the director of a company though he owes a fiduciary duty to the company, he owes no fiduciary or contractual duty or duty of care to third parties who deal with the company, except in certain circumstances.
While the earlier Companies Act, 1956, did not codify the statutory duties of a director, the Companies Act, 2013 (“CA 2013”), in Section 166, has codified the duties of a director. Section 166 inter alia requires a director of a company to act in good faith in order to promote the objects of the company for the benefit of its members as a whole, and in the best interests of the company, its employees, the shareholders, the community and for the protection of environment. It is pertinent to note that, in the same breath, Section 166 has casted director’s duties towards various parties mentioned therein, that is, towards, company, employees, shareholders, community and environment, without their being any guiding factors on the checks and balances of such conspicuous conflicts.
The Hon’ble Delhi High Court has made a very interesting observation in one case[4] with respect to Section 166 of CA 2013. The Court observes that: (a) Section 166 stipulates ‘Duties of a Director to a Company’ and not ‘Rights of Shareholders’; (b) in case a Director violates the duties prescribed in Section 166, the cause of action accrues in favour of the company; (c) the said section is akin to the common law right; (d) it is merely repository to the Director’s fiduciary duties; (e) it does not apply to the shareholder.
It is in the aforementioned context, the risks associated with the decision-making responsibilities of the directors have been aggravated during this pandemic of COVID-19. Due to the uncertainty of various factors involved in the decision making the directors may find it challenging to draw balance, while pursuing various decisions for and on behalf of the company.
Business decisions in the times of COVID-19 leading towards twilight zone? Do directors become personally liable?
There are certain statutes which amplify the dichotomy to the concept that, the directors are responsible to act not just in interests of the company, but in the interest of other parties. The aforementioned dichotomy is especially a cause of concern when invoking the provisions of Insolvency and Bankruptcy Code, 2016 (“IBC”) has become a cult for creditors.
IBC highlights that director’s duties towards the company is not exclusive and that there are duties owed by the director towards the creditors of the company. In particular, Section 66(2) of IBC provides that a director is liable to make contribution to the assets of the company if the adjudicating authority (being, National Company Law Tribunal) is of the view that, before the insolvency commencement date, such director “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 the company and the director did not exercise “due diligence” in minimizing the potential loss to the creditors of the company. Section 66(2) does not distinguish between a non-executive director, or an independent director or an executive director.
This section highlights two main principles, viz. director’s obligation to exercise due diligence and protect the interest of creditors and failure to exercise due diligence will attract personal liability on the director to contribute to the assets of the company in insolvency. Similar provisions can be found in various other statutes that cast obligations on directors as a body – and does not distinguish between executive and non-executive positions.
The first question that arises is when does this obligation of a director arise? Determining the exact point when the obligation of the director arises is important for directors to take appropriate steps towards discharge of due diligence expected of him. The first part of the provision suggests that such period is the time when the director “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 the company. In other words, the period just before the commencement of insolvency. However, we are yet to witness a jurisprudence which adjudicates the factors that establish the basis on which a director can be said to have or ought to have knowledge.
The second question that arises is what kind of “due diligence” is expected of a director in this period when the company is in the vicinity of an insolvency. Explanation to Section 66(2) provides that a director shall be deemed to have exercised due diligence if such diligence was reasonably expected of a person carrying out the same functions as are carried out by such director in relation to the company. This standard to determine whether the director has exercised “due diligence” is again subjective is nature and much depends upon the perception of the courts based on the facts of each case.
Since Section 66(2) imposes a personal liability upon directors, it is imperative that directors keep the interest of creditors in mind while taking business decisions especially in the present times when most companies are facing a financial crisis.
Balancing company’s or employees’ or creditors’ interest in the backdrop of COVID-19?
The recent order of the Ministry of Home Affairs dated March 29, 2020 (MHA Order) passed in relation to the steps required to be undertaken during lockdown, highlighted companies’ obligation to protect the interest of its employees. The order required all employers, be it in the industry or in the shops and commercial establishments, to make payment of wages of their workers, at their workplaces, on the due date, without any deduction, for the period their establishments are under closure during the lockdown. Non-compliance with MHA Order is amenable to penalties in terms thereof.
Subsequently, on April 10, 2020 the Ministry of Corporate Affairs issued a list of frequently asked questions in relation to corporate social responsibility, whereunder it was stated that payment of salary/wages to employees and workers during the lockdown period is a “moral obligation” of the employers, as the employee has no alternative source of employment or livelihood during this period. Section 166 of CA 2013, in addition to director’s duty to act in the best interest of the company, a director also has to act in the interest of the employee.
The MHA Order has been impugned before the Hon’ble Supreme Court of India, and in the meantime, fourth lockdown has been imposed by the Ministry of Home Affairs vide its order dated May 17, 2020, which seems to suggest that the MHA Order has been withdrawn, without providing any clarity as to the consequences that may have arisen for the acts done before such withdrawal and whether it ipso facto absolves the employers from the liabilities that they may have incurred. While it may be debated that MHA Order may not be valid, the legislation (i.e. Section 72 Disaster Management Act, 2005) under which the MHA Order has been passed, has empowered the legislature to promulgate laws that supersede other laws. While directors may find themselves in precarious position for taking decisions in furtherance of statutory orders resulting in monetary outflow, the companies may be pushed into insolvency.
Conclusion
During the COVID-19 times and the times to follow, the companies will be facing financial difficulties and there will be a constant struggle to balance company’s interest as against interest of other stakeholders. In the struggle to survive, companies may be looking for refinancing, reorganization or restructuring of group companies or planning to enter into any arrangements which are or are likely to increase the financial liability of the company. These will require the directors to assess such arrangements and employ such due diligence to mitigate their personal liability. It is critical that their decisions and deliberations are documented and recorded in the minutes properly, and in cases of interpretational difficulties, assistance is sought from professionals. The only certainty about COVID-19 is its uncertain impact on businesses, and it cannot be denied that the directors (including independent directors) have got to play the crucial role in steering the company out of financial troubles, therefore, directors need to constantly review their position and identify issues at the early stages such that they do not become personally liability.
[1] Dale and Carrington Intv. (P) Ltd. and Ors. v. P.K. Prathapan and Ors., (2004) 122 CompCas 161
[2] In Tristar Consultants v. Vcustomer Services India Pvt. Ltd. and Ors., ILR (2007) I Delhi 1053
[3] In Paschim Gujarat Vij Company Limited v. Manibhadra Ispat Ltd., Special Civil Application No. 13889 of 2019
[4] Rajeev Saumitra v. Neetu Singh and Ors., Delhi HC, [2016] 198 CompCas 359 (Delhi)