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Director Disqualification : The Evil Of Proviso

This article pertaining to the recent developments in area of directors disqualifications and subsequent vacancy arises therein. At the very outset, it is important to note that India is having concept of mixed economy whereby which the executive strikes an optimum balance of socialistic and capitalistic features as domination of either of them would negate the contribution of other.

In addition to said fact, it is also an undisputed fact that the corporate sector is boon to the national income of the country and at the same time is a reason of millions of job creation in the economy. Hence, by that logic, the corporate sector is an classic illustration of having presence of both capitalistic and socialistic features of Indian economy at the same time. Corporate democracy is an essential & substantial element for the corporate sector as in absence of it, the corporate sector would become play hand of majority and consequently the very idea of mixed economy would fail and capitalist would take over socialistic characters.

Hence, to control this entire lacuna and to strike optimum balance of both, the companies act has from very beginning brought an idea of removing the Individuals from very post of representation when such so called directors by virtue of their omission or commission while exercising their official duties allow themselves to be in a position and to make themselves enrich with undue gain or cause loss either actual or constructive to the stakeholders.

With evolution of company law jurisprudence, the major challenges and threats always arises in form of frauds, force and ill-gotten gains. It is also important to note that crime is accompanied to every society irrespective of its size, history, culture and economic conditions.

There may be a case where some acts are recognized as crime in one country but not in another country or some acts are universally recognized as crime in all of civilized nations such as crime against homicide.

However, there is new class of crime which is evolving in modern era and that very class of crime is known as white collar crime or socio economic offences. The corporate frauds come within purview of this class only and hence in order to prevent the overall economy and social, the corporate sector need to be refined with amendments and alterations to do the overall justice to the very idea of India and its structure of economy.

Thus, in this context our line of observation would be focus to recent amendments in area of directors disqualifications and some recent pertinent observations by judicial organs.

Section 164 & Section 167 Of Companies Act, 2013

Section 164: Disqualifications for Appointment of Director

164. (1) A person shall not be eligible for appointment as a director of a company, if -
(a) he is of unsound mind and stands so declared by a competent court;
(b) he is an undischarged insolvent;
(c) he has applied to be adjudicated as an insolvent and his application is pending;
(d) he has been convicted by a court of any offence, whether involving moral turpitude or otherwise, and sentenced in respect thereof to imprisonment for not less than six months and a period of five years has not elapsed from the date of expiry of the sentence:
Provided that if a person has been convicted of any offence and sentenced in respect thereof to imprisonment for a period of seven years or more, he shall not be eligible to be appointed as a director in any company;
(e) an order disqualifying him for appointment as a director has been passed by a court or Tribunal and the order is in force;
(f) he has not paid any calls in respect of any shares of the company held by him, whether alone or jointly with others, and six months have elapsed from the last day fixed for the payment of the call;
(g) he has been convicted of the offence dealing with related party transactions under section 188 at any time during the last preceding five years; or
(h) he has not complied with sub-section (3) of section 152.
(i) he has not complied with the provisions of sub-section (1) of section 165

(2) No person who is or has been a director of a company which—
(a) has not filed financial statements or annual returns for any continuous period of three financial years; or

(b) has failed to repay the deposits accepted by it or pay interest thereon or to redeem any debentures on the due date or pay interest due thereon or pay any dividend declared and such failure to pay or redeem continues for one year or more, shall be eligible to be re-appointed as a director of that company or appointed in other company for a period of five years from the date on which the said company fails to do so.

Provided that where a person is appointed as a director of a company which is in default of clause (a) or clause (b), he shall not incur the disqualification for a period of six months from the date of his appointment.

(3) A private company may by its articles provide for any disqualifications for appointment as a director in addition to those specified in sub-sections (1) and (2):
Provided that the disqualifications referred to in clauses (d), (e) and (g) of sub-section (1) shall continue to apply even if the appeal or petition has been filed against the order of conviction or disqualification.

Section 167:Vacation of Office of Director

167. (1) The office of a director shall become vacant in case—
(a) he incurs any of the disqualifications specified in section 164;

Provided that where he incurs disqualification under sub-section (2) of section 164, the office of the director shall become vacant in all the companies, other than the company which is in default under that sub-section.

(b) he absents himself from all the meetings of the Board of Directors held during a period of twelve months with or without seeking leave of absence of the Board;
(c) he acts in contravention of the provisions of section 184 relating to entering into contracts or arrangements in which he is directly or indirectly interested;
(d) he fails to disclose his interest in any contract or arrangement in which he is directly or indirectly interested, in contravention of the provisions of section 184;
(e) he becomes disqualified by an order of a court or the Tribunal;
(f) he is convicted by a court of any offence, whether involving moral turpitude or otherwise and sentenced in respect thereof to imprisonment for not less than six months:

Provided that the office shall not be vacated by the director in case of orders referred to in clauses (e) and (f)-
(i) for thirty days from the date of conviction or order of disqualification;
(ii) where an appeal or petition is preferred within thirty days as aforesaid against the conviction resulting in sentence or order, until expiry of seven days from the date on which such appeal or petition is disposed of; or
(iii) where any further appeal or petition is preferred against order or sentence within seven days, until such further appeal or petition is disposed of.

(g) he is removed in pursuance of the provisions of this Act;
(h) he, having been appointed a director by virtue of his holding any office or other employment in the holding, subsidiary or associate company, ceases to hold such office or other employment in that company.

(2) If a person, functions as a director even when he knows that the office of director held by him has become vacant on account of any of the disqualifications specified in subsection (1), he shall be punishable with imprisonment for a term which may extend to one year or with fine which shall not be less than one lakh rupees but which may extend to five lakh rupees, or with both.

(3) Where all the directors of a company vacate their offices under any of the disqualifications specified in sub-section (1), the promoter or, in his absence, the Central Government shall appoint the required number of directors who shall hold office till the directors are appointed by the company in the general meeting.

(4) A private company may, by its articles, provide any other ground for the vacation of the office of a director in addition to those specified in sub-section (1).

Analysis of Section 164 And Section 167:

Section 164 provides for disqualification to the directors.

Section 164(1) provides for disqualification owe due to personal reasons
Whereas Section 164(2) provides for disqualification owe due to non-compliance on part of company.

Section 167(1)(a) provides for vacant of office by director on attracting section 164 disqualifications.

Question has been raised whether Section 167(1)(a) applies only to Section 164(1) or Section 164(2) as well ?
One argument is that if it apply to Section 164(2) as well then it would mean that on attraction of Section 164(2), all the directors have to vacant the office. Not only that, any person who became the director in such company would get attracted section 167(1)(a) as he would automatically be disqualified and have to vacated.

Two suggestion were suggested by 2016 report:
  1. Section 167(1)(a) to be apply only to Section 164(1) and not Section 164(2), or
  2. Section 167(1)(a) to apply to both Section 164(1) and Section 164(2) but to clear the chaos , such director would vacant the office in all companies except the defaulting company. This is for reason being to make such defaults good in defaulting company.
Proviso to Section 167(1)(a) has been added to implement second option of suggestion that Section 167(1)(a) apply to both Section 164(1) and Section 164(2) but create an exception by proviso with respect to situation of Section 164(2).

Also, Proviso added to Section 164(2) is a good governance provision which gives a new comer director in defaulting company a cooling period of 6 months to clear the defaults by filling the returns, deposits, etc. The automatic vacation to such new comer would not arise for 6 months.

Thus, Board of defaulting company would comprise : existing directors who have to vacant in other companies and new comers who would remain immune for 6 months from application of section 167(1)(a) by virtue of proviso added to Section 164(2).

Case Law:
G. Vasudevan (A Company secretary) v. Union of India & Anr. (High Court of judicature at Madras, W.P 32763 of 2019)

Issue: Constitution validity of Proviso added to section 167(1)(a) via 2017 amendment act challenged?

Petitioner contentions:
  1. Proviso to Section 167(1)(a) of the Companies Act, leads to unequal treatment being met out to Directors of a company defaulting company based on whether they are Directors in other companies or not.
     
  2. The petitioner claims that since this proviso states that such Directors of a defaulting company would only have to vacate Directorship in other companies while retaining the same in the defaulting company, this leads to unfair treatment to those Directors who hold such posts in multiple companies.
     
  3. The petitioner further claims that this differential classification is not based on an intelligible differentia and that there is no justification provided for mandating the vacation of Directorship in other companies, thus leading to this provision being arbitrary and violative of Article 14 of the Constitution of India.
     
  4. It is also contended that the impugned provision irrationally has a detrimental effect on other, non-defaulting companies and punishes individual Directors for the defaults of a company even when fault cannot be directly attributed to them.
     
  5. The petitioner also claims that the impugned proviso also violates the principles of natural justice.

Court observations:
  1. Though the corresponding provisions in the Companies Act 1956 and the Companies Act 2013 deal with similar subject matter, there are important distinctions between the same. As per Section 167(1)(a) of the 2013 Act, the office of the Director is to become vacant if a Director incurs any disqualification as provided for under Section 164.

    However, no such all-encompassing provision existed in the 1956 Act with each of the grounds for vacation being listed individually. It is important to note that liability under Section 274(1)(g) was not a ground for a Director to vacate his post in any company.
     
  2. Before the impugned proviso was inserted in the Companies Act 2013, Directors of a company who had defaulted under Section 164(2) would have to vacate their post as Director of the defaulting company only. This was leading to a situation where any person who became a Director of a company which had defaulted under Section 164(2) automatically attracted Section 167(1).

    Thus, no person could be appointed as a Director in those companies which had defaulted under Section 164(2). This was noted in the judgment dated 14.11.2019, passed by the Hon'ble Delhi High Court in Mukut Pathak & Ors Vs. Union of India, WP.No.9088 of 2018 which while placing reliance on the decision dated 09.07.2019 of the Hon'ble Bombay High Court in Kaynet Finance Ltd. Vs. Verona Capital Ltd., Appeal Lodging No.318 of 2019 I Arbitration Petition No.716 of 2019.
     
  3. It was in order to rectify such situations the proviso to Section 167(1)(a) was inserted by the 2017 Amendment Act. It is worthwhile to mention that the Company Law Committee had also made its recommendations to this effect.

    The relevant portion of the 2016 Company Law Committee report reads as under:-

    11.13 Section 167(1)(a) dealing with vacation of office by a director triggers an automatic vacation of office of the director if he incurs any of the disqualifications stipulated under Section 164. Section 164(1) provides for disqualifications which are incurred by a director in his personal capacity such as being an undischarged bankrupt, of unsound mind, convicted of an offence etc., and Section 164(2) lists out disqualifications related to the company such as non-compliance of annual filing requirements, etc. The Committee acknowledged that this Section created a paradoxical situation, as the office of all the directors in a Board would become vacant where they are disqualified under Section 164(2), and a new person could not be appointed as a director as they would also attract such a disqualification. In this regard, the Committee recommended that the vacancy of an office should be triggered only where a disqualification is incurred in a personal capacity and therefore, the scope of Section 167(1)(a) should be limited to only disqualifications under Section 164(1). 11.14 The Committee also recommended that a disqualification under Section 164(2) be only applicable to a person who was a director at the time of the noncompliance, and in case of a continuing non-compliance, there should be a period of six months’ time allowed for a new Director to make the company compliant. 11.15 The Committee felt that the proviso to Section 164 (appearing under sub-section (3) of the section) creates an inconsistent situation when read with the proviso to Section 167(1)(f), as these provide for a person to be appointed as a Director if he has been convicted/disqualified by a Court but has an appeal preferred in a Court whereas for a sitting Director, it does not allow such consideration and he has to vacate office on conviction, even if an appeal had been preferred against such conviction and sentence. The Committee, therefore, recommended that such inconsistency be corrected and in case of requirement for vacation of office of a Director, it should not take effect until the appeals are disposed off, while in case of disqualification, it is not required to provide for period of pendency of appeal."
     
  4. A perusal of the above extract makes it clear that Section 274(1)(g) of the Companies Act 1956 was made to protect investors rights and to ensure that Directors of companies act vigilantly in preventing any misfeasance or discrepancy which may affect investors and the public. It is thus held that the underlying object of Section 274(1)(g) is facilitating good corporate governance and it cannot be declared unconstitutional without considering the purpose that the provision serves.
     
  5. In our opinion, the legislative intent behind the inclusion of the proviso to Section 167(1)(a) is also to ensure good governance and inculcate a sense of security in investors through transparent disclosures and control over erring Directors. The Hon'ble Supreme Court inN.Narayanan Vs. Adjudicating Officer, Security and Exchange Board of India, (2013) 12 SCC 152, in paragraphs 35 and 36 state as under:-

    35.Gower and Davies in Principles of Modern Company Law, 9th Edn. (2012) at p. 751, reiterated their views on the scope and rationale of annual reporting required under the Companies Acts, as follows: “On the basis that ‘forewarned is forearmed’ the fundamental principle underlying the Companies Act has been that of disclosure. If the public and the members were enabled to find out all relevant information about the company, this, thought the founding fathers of our company law, would be a sure shield. The shield may not have proved quite so strong as they had expected and in more recent times, it has been supported by offensive weapons."

    36.The Companies Act casts an obligation on the company registered under the Companies Act to keep the books of accounts to achieve transparency. Previously, it was thought that the production of the annual accounts and their preparation is that of the accounting professional engaged by the company where two groups who were vitally interested were the shareholders and the creditors. But the scenario has drastically changed, especially with regard to the company whose securities are traded in public market. Disclosure of information about the company is, therefore, crucial for the accurate pricing of the company's securities and for market integrity.

    Records maintained by the company should show and explain the company's transactions, it should disclose with reasonable accuracy the financial position, at any time, and to enable the Directors to ensure that the balance sheet and profit and loss accounts will comply with the statutory expectations that accounts give a true and fair view. The Companies (Amendment) Act, 2000 has added clause (iii) to Section 209-A(1) of the Companies Act, 1956 under which SEBI has also been given the power of inspection of listed companies or
    companies intending to get listed through such officers, as may be authorized by it. "
     
  6. An analysis of the above mentioned extract reveals that filing of returns and disclosures regarding the finances of the company are vital to ensure greater transparency and accountability to the public which is the need of the hour in today's corporate set up. These measures are extremely necessary in the interest of fair trade and ensuring justice. Additionally, a great deal of responsibility is borne by the Directors of a company to ensure that the company acts in accordance with laws and upholds the principles of transparency and probity.

    It would be apt to rely on the judgment of the Hon'ble Supreme Court in Official Liquidator,Supreme Bank Ltd., Vs. P.A.Tendolkar,(1973) 1 SCC 602, that holds that the Directors of a company must be responsible for actions and affairs of the company which are visible to the public even superficially. A Director must not derelict his duties as a Director and must exercise all due diligence necessarily to ensure that the company abides by laws and regulations. The relevant paragraphs are extracted hereunder:-

    "45.It is certainly a question of fact, to be determined upon the evidence in each case, whether a Director, alleged to be liable for misfeasance, had acted reasonably as well as honestly and with due diligence, so that he could not be held liable for conniving at fraud and misappropriation which takes place. A Director may be shown to be so placed and to have been so closely and so long associated personally with the management of the Company that he will be deemed to be not merely cognizant of but liable for fraud in the conduct of the business of a Company even though no specific act of dishonesty is proved against him personally.

    He cannot shut his eyes to what must be obvious to everyone who examines the affairs of the Company even superficially. If he does so he could be held liable for dereliction of duties undertaken by him and compelled to make good the losses incurred by the Company due to his neglect even if he is not shown to be guilty of participating in the commission of fraud. It is enough if his negligence is of such a character as to enable frauds to be committed and losses thereby incurred by the Company."
     
  7. It has also been noted by the Hon'ble Supreme Court inDale & Carrington Invt. Pvt. Ltd. v. P.K. Prathapan,(2005) 1 SCC 212 that the directors of a company owe an obligation to the shareholders of the company to make all disclosures and to act in the best interest of the company, exercising due diligence and good faith. The Hon'ble Supreme Court also stated that irrespective of whether directors are described as trustees, agents or representatives, they have a duty to act for the benefit of the company and must not derelict their duty towards the shareholders and investors in the company.
     
  8. A Director, irrespective of the nature of Directorship, by virtue of the fact that he holds the position of Directorship cannot claim immunity for the defaults of the company in the filing of returns or the business of the company, and therefore cannot be made to vacate his post in other companies. This Court can take judicial notice of the fact that people invest their hard earned money in companies in which there are persons of repute holding the position of a Director.

    The Director therefore cannot absolve himself of the misdeeds of the company after holding a position in the company. Section 166 of the Companies Act 2013, which enumerates the duties of a Director mandates that the Director of a company shall act in good faith in order to promote the objects of the company for the benefit of the other members as a whole and in the best interest of the company, its employees, shareholders, the community and the protection of the environment.

    The object of inserting the proviso is to ensure that a person who is a Director in a Company that does not file its returns for a period of three years or does not return the money back to its investors or creditors does not continue as Director in other companies. This proviso will also act as a deterrent from incorporating shell companies to park illegally obtained money. There is thus a rational nexus between the amendment and the object for which the amendment was brought about in the Companies Act 2013. The contention of the petitioner that the proviso to Section 167(1)(a) is irrational, manifestlyarbitrary and unreasonable, and thus must be declared as ultra viresArticle 14 of the Constitution of India cannot be accepted.
     
Decision:
The proviso to Section 167(1)(a) must be interpreted in ordinary terms and would apply to the entirety of Section 164 including sub-section 2. The Court has further held that this proviso can be justified on two grounds.
  1. Firstly, it has been reiterated that the exclusion of Directors from vacating their posts in the defaulting company while doing so in all other companies where they hold Directorship has been done in order to prevent the anomalous situation wherein the post of Director in a company remains vacant in perpetuity owing to automatic application of Section 167(1)(a) to all newly appointed Directors.
     
  2. Secondly, the underlying object behind the proviso to Section 167(1)(a) is seen to be the same as that of Section 164(2) both of which exist in the interest of transparency and probity in governance. Owing to these justifications, the Court thus holds that the proviso to Section 167(1)(a) is neither manifestly arbitrary nor does it offend any of the fundamental rights guaranteed under Part III of the Constitution of India.
Disclaimer:
The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of any agency of the Indian government. Examples of analysis performed within this article are only examples. They should not be utilized in real-world analytic products as they are based only on very limited and dated open source information. Assumptions made within the analysis are not reflective of the position of any Indian government State.

The author is a Practicing company secretary and has completed its CS management trainee with a reputed corporate law firm. Further, he is a Second Year Law student at faculty of law, University of Delhi. He is enrolled as Para Legal volunteer with Delhi State Legal Service authority and is an active Participant in Moot Court.
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