India – Liability Of Investor Nominee Directors In Indian Start-Ups.

20 January 2022

 

Introduction
 

India has seen an unprecedented number of private equity and venture capital investments in the year 2021 – Indian companies raised over US$ 62 billion, across nearly 1200 deals. While such high and continuously increasing numbers are indicative of the growing faith of investors in Indian technology companies, a worrying trend has also been noted with respect to investors not exercising their contractual rights to nominate a director on the board of an investee company, which is typically a non-executive director (i.e., a director who is not actively involved in conducting the affairs of the company). The right to nominate a director, if exercised by the investor, enhances corporate governance, and provides a formal platform for the investor and the founders to exchange key information on the business of the company in a secure environment established under the principles of fiduciary duties of directors. However, it has been observed that investors are vehemently reluctant to nominate such non-executive directors to the board of an investee company, because of the liability that may be imposed upon such non-executive directors, despite the lack of their active participation in the operations of the investee company.
 

Liability of Non-Executive Directors Under Companies Act, 2013
 

A company being a juristic person functions through its board of directors. Accordingly, unless otherwise recorded in any other enforceable corporate documents, the board of directors of the company is ultimately responsible for all acts of commission or omission of the company. However, the extent of responsibility and liability for such acts or omissions varies for executive directors and the non-executive directors of the company, depending on the varying degree of involvement of such directors in the day-to-day management and administration of the company.
 

As a logical consequence to the non-executive directors not being actively involved in the management of the company, and pursuant to the safeguards provided to non-executive directors under Section 149 (12) of the Companies Act, 2013 (“Act”), the liability of non-executive directors, who are not promoters or occupy key managerial positions in the company, has been limited. Accordingly, the liability of such non-executive directors is limited to only those acts which have occurred with their knowledge, where the knowledge is attributable to processes of the board of the company, or those acts which occurred with their consent, connivance or where they had not acted diligently.
 

The legislature has taken note of the difference in the role played by the executive and the non-executive directors. Accordingly, the legislators have incorporated protections into the law to make sure that non-executive directors are not held liable for something which they had no control over, despite their due diligence. Further, the Ministry of Corporate Affairs (“MCA”) through its circular dated 2 March 2020 has clarified the following in relation to proceedings initiated by the Registrar of Companies (“Registrar”) against non- executive directors who are not promoters or key managerial personnel in a company:
 

• Civil or criminal proceedings should not unnecessarily be initiated against such non-executive directors unless the criteria under Section 149 (12) of the Act are met and there exists sufficient evidence to establish the same; and
• Registrars must follow a standard operating procedure, as prescribed by MCA, while initiating proceedings against the officers of a company, to ensure that non-executive directors are not unnecessarily proceeded against, in the event of a default by the company.

 

However, it must be noted that to avail the safeguards under the Act, non-executive directors are required to discharge the burden of proof and establish that they had acted diligently in the discharge of their duties, and as such were not involved in the day-to-day management and administration of the company. Further, the limited liability of non-executive directors pursuant to Section 149 (12) of the Act and the above circular, does not reduce the level and magnitude of the fiduciary duty and care owed by them to the company and all its stakeholders.
 

Vicarious Liability Provisions Under Other Statutes
 

Most statutes under Indian laws lay down a standard vicarious liability provision on the directors and officers of a company for the acts and omissions of the company. The standard vicarious liability provisions impose liability on any person who is responsible for the conduct of the business of the company. As can be seen, these provisions are extremely widely worded, do not create any distinction between executive directors and non-executive directors of the company, and may be used to impose liability, or at the very least initiate proceedings against the entire board of directors of the company.
 

In relation to imposition of such vicarious liability, the Supreme Court of India has in a number of judicial pronouncements, including in the matters of Sunil Bharti Mittal vs CBI, and S.M.S. Pharmaceuticals Ltd. Vs. Neeta Bhalla, held that an individual can be held liable for the acts of a company only if there is sufficient evidence of the individual’s active role coupled with criminal intent in the acts of the company. Further, Indian courts have held that liability shall be imposed on the person 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 a person merely holding a designation or office in the company.
 

However, in practice it is seen that the general protection and safeguards under the Act, as well as the protection offered to non-executive directors through the judicial pronouncements may be useful only at a much later stage, i.e., at the time of imposition of the actual penalty, but for all purposes prior to such stage the relevant authorities treat all directors of the board at par with each other. This, in turn results in such authorities or law enforcement agencies issuing summons or notices to the non-executive directors, in spite of their non-involvement in the affairs of the company. This often causes inconveniences to the non-executive director in terms of the loss of time and money in dealing with lengthy legal proceedings, as well as in dealing with the reputational harm associated with such legal proceedings.
 

Issues Faced by Non-Executive Directors
 

While the law in relation to imposition of liability on non-executive directors has been rightly interpreted by Indian courts, in reality the non-executive directors end up dealing with multiple hardships associated with the legal proceedings that may be initiated by the law enforcement agencies, as well as having to establish that they had acted diligently in order to be eligible for the protection under Section 149 (12) of the Act. These issues get further emphasized when one takes into consideration the vast number of laws (including all labour laws, industry specific laws, environmental laws, etc.), and the regulatory requirements thereunder that a company must comply with. Under such circumstances, private equity and venture capital investors have generally been reluctant to nominate a non-executive director on the board of an investee company resulting in alternative governance structures being created to ensure that their investments are protected.

 

Steps taken by PE / VC Investors to Mitigate Liability
 

While investors have resorted to innovative ways to continue to monitor their investment, the same at times become ineffective to address the key concerns of the investors as the enforcement of contractual rights takes time. We have discussed a few of these mechanisms hereinafter.
 

• Appointment of board observers instead of non-executive directors on the board: Even though board observers may be appointed to attend and observe the meetings of the company, under Indian corporate law, an observer cannot contribute or participate in a discussion in the board meeting. Accordingly, the same results in a dilution of the level of control that may be exercised by the investors and makes the entire existence of any representation on the board of directors irrelevant.
• Obtaining directors’ and officers’ liability insurance: A directors’ and officers’ liability insurance may be obtained by the company to protect the interest of its directors and officers, however, while taking such a policy the company should ensure that the non-executive directors are covered by the policy and such directors will be able to get the benefit of such policy from the time the proceedings are initiated and not at the end of the proceedings.
• Clearly delineating the duties and responsibilities of the non-executive directors in the contractual documents: An investor may ensure that the investee company has identified specific individuals to act as officers of the company and be in charge of various aspects of operations of the company. This may assist the non-executive directors in establishing that they do not fall within the category of an ‘officer who is in default’ under the Act. Although this is not sufficient to ensure that no proceedings or investigations are initiated against the non-executive directors, it builds in an additional level of protection for non-executive directors to prove non-involvement with managing the affairs of the company.
• Indemnity from the company and/ or founders, for liability incurred by the non-executive directors: While an investor may obtain such indemnity rights from the company and / or the founders, the enforcement of these indemnity rights is complicated and time consuming process and may not give the desired result if the company or the founders are not financially sound. Further, such indemnity rights are only available once the investor is able to establish that he has suffered a loss due to the actions of the investigating or law enforcement agencies or any other officers or directors of the investee company.

 

Conclusion
 

All stakeholders in the start-up ecosystem should realize that directors, whether executive or non-executive, have an important role in furthering the cause of Indian start-ups. Directors may have diverse knowledge, experience or connects which may help entrepreneurs, young and old, in expediting their learning process and scaling up their start-ups. The ‘board of directors’ structure is already a recognized structure to conduct the business of the company. Rules and regulations relating to the duties and the conduct of the directors are already codified. Further, the creation and enforcement of alternative contractual governance structures is time consuming. Accordingly, in the best interest of governing a company under established rules, our justice delivery system should build adequate safeguards which should protect all directors (other than persons responsible for the act) and especially non-executive directors unless there is enough evidence on record to show that such directors were involved in the alleged wrongful acts. This change in approach may help India to attract even better talent to further its growing global heft in the start-up industry.