Nominee directors have the same duties and obligations as ordinary directors, as per the Ministry of Corporate Affairs (MCA). The Registrar of Companies (ROC) has started initiating criminal prosecution of directors for violations of the Companies Act quite liberally. For the ROC, prosecuting in this manner reduces the cost of investigation and verification of detailed company filings. However, this may spell some serious risk for Angel Investors and VCs.
For angel investors and VCs, such prosecution raises the following issues:
1. Can directors nominated by angel investors or VCs be prosecuted for defaults in statutory compliance by a company?
2. Should angel investors, venture capitalist be careful not to assume certain responsibilities for directors nominated by them?
3. If investors do not take up compliance responsibilities, can they still have the desired level of control over the company?
Other than elaborate financial calculations of return and valuation of a potential company, these questions directly affect investors, and can seriously affect their ability to realize the targeted level of gain from an investee company.
Before we get into the liability of investor’s directors, a brief background to the rights investors prefer when they decide to invest in startups is necessary.
Angel Investors and Venture Capital Investors (VCs) usually have rights at shareholder meetings (general meetings) as well as board meetings of a company. Such rights are generally called corporate governance rights, and are mentioned in detail in the agreement they sign with the company and its promoters, known as the Shareholders Agreement or Investment Agreement.
Investors usually have the following rights over the board of directors:
1. They have the right to appoint a certain number of directors (such directors are usually called ‘nominee directors’ or ‘investor directors’)
2. Investors require that the presence of at least one (or more) nominee directors must be mandatory at a Board meeting, that is, an investor director is required for a valid quorum for a Board meeting.
3. The consent of an investor director is mandatory for certain matters, typically known as ‘Reserved matters’.
This essentially means that if the nominee doesn’t say a ‘Yes’, a resolution on that matter cannot be passed by the Board. These are known as affirmative voting rights.
4. Investors may nominate various observers at Board meetings. Observers do not have the powers of directors.
While investors are in control over the business decisions and policy of a company, they may not typically be interested in handling day to day compliance issues, and do not supervise everyday activities of the company. Therefore, they must ensure that their directors are not held liable for any statutory defaults of the company.
How investor directors can be liable under Companies Act
The Ministry of Corporate Affairs (MCA) has released a Master Circular on 29 July on prosecution of directors and has stated that nominee directors have the same duties and obligations as ordinary directors. Further, the penal provisions of the Companies Act state that an ‘officer in default’ is liable for non-compliance. A director is included in the meaning of an officer in default under the Companies Act. Nominee directors have not been excluded from this definition. Therefore, this provision is being used by the ROC to initiate prosecutions. The ROC is of the opinion that this is a perfectly valid practice to adopt because if a director is innocent, he will eventually be able to prove it before a court of law and be declared innocent. For the ROC, this reduces administrative costs of meticulously checking compliance by every company before prosecution of its directors.
Points of action for VCs / Angel Investors while structuring agreements
The MCA Master Circular states that prosecutions should be filed primarily against the managing director(s)/ whole time director(s)/manager(s) and the company secretary. Only in those cases where the above managerial personnel are not available, prosecution should be against ordinary directors. Non-executive directors who are not associated with annual filings should not be held prosecuted.
From this, there are 4 (four) points that VCs and angel investors should check at the time of investment:
1. VCs / Angel Investors should ensure that they appoint directors in non-executive capacity, that is, directors who are not in charge of day to day operations of the company and who do not get a salary for working for the company. They may, however, get sitting fees, which is usually nominal remuneration for assuming the office of a director.
2. Further, they must ensure that their investee companies have a Managing Director and a company secretary. The company must impose on some official, say for example, the Chief Financial Officer, the responsibility of maintaining compliance under the Companies Act, so that in no circumstance can such responsibility be imputed to angel or VC investors or their directors.
3. The role of nominee directors must be clearly spelled out in the articles of association of the company, as not including supervision of day to day activities or assumption of compliance-related functions. The articles must be amended after the Investment / Shareholders Agreement.
4. Merely writing in the shareholders or investment agreement that the nominee directors are not involved in the day-to-day management of the company will not suffice, if the nominees are later found by a court to have taken active interest in the company’s activities on a frequent basis. If nominees have voluntarily assumed such responsibilities, they will be required to undertake some level of diligence to ensure compliance, and it become difficult for them to show that they did not know about a particular violation by the company. Hence, nominee directors must take care not to get involved in day to day issues of the company.
Ministry of Corporate Affairs provides some relief
Luckily for investors, the Master Circular provides some relief. Before taking penal action, the ROC has now been advised to examine Board minutes and form filings (Annual Returns, Forms 32, Form 1AB, etc.). If the ROC conforms to this guidance, investors may breathe a sigh of relief and as chances of prosecution of nominees who have not been in charge of company functions in respect of a company which has defaulted are lower.
In the event of a prosecution…
Nevertheless, if the matter does lead to a prosecution in Court, the director need not lose hope. Most penal / criminal provisions of the Companies Act state that a director will not be liable for any breach or violation which occurred without his knowledge, without his consent or connivance, or where he has acted diligently in the Board process, such as meetings of the Board or committee meetings.
In the event of a prosecution, the director should:
1. Possess all documents and evidence showing that he was not in charge of day to day activities;
2. He should be able to demonstrate due care in performing functions assigned to him. This requirement can be shown by the director having been in constant touch with his nominating group, observing board and committee procedures and by his taking business decisions motivated by commercial (rather than personal) considerations; and
3. The director should be able to show that the violation in consideration occurred without his knowledge.
If a director is able to demonstrate the above 3 points to the satisfaction of a court, his chances of being declared innocent are very high.