Director’s violation of duty cause for derivative action

By Shreya Ramesh, Bharucha & Partners
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Prior to the enactment of the Companies Act, 2013, issues relating to directors’ obligations and fiduciary duties were uncodified. Delhi High Court in Rajeev Saumitra v Neetu Singh & Ors considered directors’ duties under section 166 of the 2013 act, particularly the duty to act in the best interest of the company. The court also considered whether shareholders may take derivative action, on behalf of the company, against an errant director, and answered in the affirmative.

Given that derivative actions in India are rare, this ruling offers shareholders remedial measures against directors acting in breach of their fiduciary obligations, which now are crystallized in section 166.

Dispute

The case involved Rajeev Saumitra and his wife, Neetu Singh, the directors of Paramount Coaching Centre, each holding 50% of the company’s shares. During her tenure as a director of Paramount, Singh established a one-person company, called KD Campus (KDC), with primarily the same object and purpose as Paramount. Inevitably, the interest of Paramount and KDC were in direct conflict. Disputes arose when Singh profiteered at the cost of and to the detriment of Paramount, by luring its clients to KDC. There was also a conflict regarding the use of the mark Paramount by KDC.

Shreya Ramesh
Shreya Ramesh

Saumitra filed a derivative suit, in his capacity as a 50% shareholder of Paramount, to restrain Singh and KDC from using the goodwill or the mark of Paramount and seek repayment of the undue gains and benefits enjoyed by Singh through KDC. It was urged on behalf of Saumitra that Singh had enjoyed secret profits, in violation of section 166 of the 2013 act and section 88 of the Indian Trusts Act, 1882, which, the Supreme Court, Saumitra argued, has held must be construed to encompass the fiduciary relationship between directors and companies. It was contended that Singh had also fallen foul of common law principles governing directors’ duties. Given that section 166 enumerates the duties of directors, an interesting question arose as to whether common law principles would continue to apply.

Singh challenged the maintainability of the suit by arguing that the claim was in the nature of a personal claim rather than one moved on Paramount’s behalf, and remedies would be more appropriately sought before the Company Law Board under sections 397 and 298 of the Companies Act, 1956, for oppression and mismanagement.

Ruling

Delhi High Court, placing reliance on its ruling in Norma (India) Ltd v Sameer Khandelwal and Ors and Calcutta High Court’s recent ruling in Starlite Real Estate (Ascot) Mauritius Ltd & Anr v Jagrati Trade Services Pvt Ltd, observed that the reliefs afforded under sections 397 and 398 are personal in nature, while a remedy obtained in a derivative action before civil courts would flow to the company.

Illustratively, when the directors in management are in dereliction of their duties, it is left to the shareholders, whether the minority or otherwise, to move an action on behalf of the company since the company itself will be unable to sue the directors. Proceedings under sections 397 and 398 hold force in a wholly different sphere and reliefs granted under these sections would accrue to the suing shareholders rather than the company.

Given the inherent difference in the remedies, sections 397 and 398 ought not to be construed as vacating a civil court’s jurisdiction in a derivative action. On the contrary, there must be a presumption as to the existence of concurrent jurisdiction. These principles are well enunciated in a catena of judgments considered at length by Delhi High Court.

The court also found that Singh had, by establishing KDC in the vicinity of Paramount, acted in violation of her duties under section 166 by enjoying secret profits gained by acting in a manner detrimental to Paramount’s interests. When the personal interests of a director are in direct conflict with the duties owed to the company, the court observed that the errant director would be liable to repay to the company all the gains obtained by disloyalty.

Albeit the court did not have to rule specifically on the issue, given that Singh fell squarely within the ambit of section 166, it appears, arguably, that common law principles governing duties of directors will continue to apply along with section 166.

The court granted an injunction restraining Singh and KDC from opening any offices in conflict with Paramount’s business and within a 300-metre radius of Paramount’s premises or using the goodwill or mark of Paramount. In addition, KDC was required to maintain proper accounts, under the aegis of a court receiver, so as to enable the adjustment of accounts after judgment is passed in the suit.

The ruling, one of the first to deal extensively with the issue of duties of directors, has brought to the fore significant issues. Courts will eventually have to consider whether directors ought to be liable to companies for duties arising out of common law, in addition to those enumerated in section 166 of the 2013 act.

Shreya Ramesh is an associate in the litigation team at Bharucha & Partners.

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