It has, for a long time, been a common practice for investors to appoint nominee directors on the boards of their investee companies. Nominee directors were an investor’s preferred method of participating in the governance of investee companies. Nominee directors were also often empowered to exercise certain veto rights whereby investee companies could not undertake certain critical actions without their consent. Investment agreements and articles of association relating to many investments made before the enactment of the Companies Act, 2013, contain such provisions with continuing effect.
Under the Companies Act, 1956, directors had a fiduciary duty to act in the best interests of the company. This principle was imported from common law through judicial precedent, but was not codified, permitting some flexibility in interpretation, especially in relation to non-executive directors.
Non-executive directors were seen to be primarily responsible for oversight and governance and were generally liable only where a company did not have executive directors. Given the uncertainty regarding the liability of non-executive directors, the Ministry of Corporate Affairs (MCA), in a circular dated 25 March 2011, clarified that for non-executive directors to be subject to criminal prosecution, the burden of proof was on the registrar of companies (ROC).
In contrast, the potential liability of non-executive directors has increased exponentially under the 2013 act. The duties of directors are now codified in section 166, in terms of which all directors, including non-executive nominee directors, have the following duties: (a) to act in accordance with the articles of the company; (b) to act in good faith 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; (c) to exercise duties with due and reasonable care, skill and diligence and with independent judgment; (d) to not be involved in a situation of direct, indirect or potential conflict with the interests of the company; (e) to not obtain or attempt to obtain any undue gain or advantage either to themselves or to their relatives, partners or associates; (f) and to not assign their office.
Further, although the term “officer in default” applies only to executive directors, non-executive directors are also subject to liability, under section 149(12), if acts or omissions by the company (i) occur with their knowledge, “attributable through board processes”, and with their consent or connivance; or (ii) where they have “not acted diligently”. Legally, acting diligently usually means more than merely not acting in a negligent manner.
Two potential issues arise in respect of section 149(12). Firstly, non-executive directors not involved in everyday operations of the company now face a potential risk, if knowledge can be attributed through board processes. For example, a non-diligent approach to reading notices and agendas by a nominee director or cursorily signing off past meeting minutes may be sufficient to prove knowledge of an act or omission.
While the MCA’s clarification put the burden of proof on the ROC, under the 2013 act, if a non-executive director did not participate in a discussion at the board meeting, but did not raise an overt objection to a potential default, it seems that the director may also be held liable. For the moment, both the attribution of knowledge through board processes and the requirement for overt objection seem to be onerous responsibilities on nominee directors. Furthermore, attribution of knowledge through board processes could potentially interfere with the exercise of veto rights, even where no default or liability occurs.
What can be done?
In light of these changes, it may become imperative to revisit provisions in investment agreements and articles of associations of companies which have private equity investment. This is especially important because affirmative voting rights exercised at the board level may lead to a potential conflict between the duties of nominee directors under section 166 and their interests as a representative of the investor. An affirmative voting right given to a nominee director may be construed as a direct or indirect conflict with the interests of the company or as a failure to act in the interests of the members of the company (including those other than the investor).
Several solutions may be suggested to reduce both the obligations and the liabilities of nominee directors, including appointing non-voting board observers with veto rights exercised at a shareholder level. To reduce all possibility of conflict, the veto may be provided at the stage of preparing the agenda, such that the relevant reserved matter simply doesn’t come before the board or the shareholders unless approved by the investor. However, these methods remain untested and the real consequences of the 2013 act’s changes remain to be seen.
Joyjyoti Misra is an associate partner and Arjun Rajgopal is a senior associate at Khaitan & Co. Views of the authors are personal and should not be considered as those of the firm.
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