This article is written by Ridhi Suri, pursuing a Certificate Course in National Company Law Tribunal (NCLT) Litigation from Lawsikho.com.

Introduction

As a central principle of company law in India and across various other jurisdictions, a company is considered as a separate legal entity, distinct and independent of the persons that constitute it. This conception is largely understood as the veil of incorporation^[i], a principle that separates the legal personality of a company from its members, thus affording them protection against personal liability towards the debts and obligations of the company. This brings us to a question: “Can Directors of a Company be made personally liable for the debts that the latter owes to its creditors?” As per the general notion and the aforesaid principle, the answer is negative. However, since a company is merely a legal person and not a natural one, it is operated and managed through its directors who are responsible for its daily affairs and act as agents or trustees of the company, and the fact that an artificial person does not possess the capability to act in an illegal or fraudulent manner cannot be overlooked. Therefore, due to the burgeoning abuse of the principle of the veil of incorporation, courts do not hesitate in lifting or piercing the corporate veil and make such directors personally liable for any misfeasance or fraudulent activities done by them under the name of the corporate personality. Such perception of the courts can be dated back to the 18^th century, where the Hon’ble High Court of Judicature at Bombay opined that “A man, of course, is not forced to place himself in a fiduciary position, but if he does undertake the affairs of others he must exercise ordinary prudence and vigilance.”^[ii] It further went on to state that “It is an established rule that trustees cannot delegate their office, and, if they do thus divest themselves of their trust, they are held liable for any breach of trust committed by the person to whom the office has been entrusted.”^[iii]

Reason behind making Directors liable for certain acts of the company: they act as the agents, trustees, and the brain of the company

Directors are persons selected to manage the affairs of the Company for the benefit of the shareholders. It is an office of trust, which if they undertake, it is their duty to perform fully and entirely.^[iv] This two-fold character of the directors has been well expressed by Lord Selbourne in Great Eastern Railway Company v. Turner,^[v] wherein it was observed that “the Directors are the mere trustees or agents of the company–trustees of the company’s money and property; agents in the transactions which they enter into on behalf of the company.” Directors are not employees of the company, but persons responsible for the conduct of its affairs, and act in a fiduciary capacity vis-à-vis the company. The position of Directors as trustees of the company was made clear in the case of Albert Judah Judah vs. Rampada Gupta and Ors.^[vi], wherein it was observed that Directors do not hold the position of trustee incomplete sense and it cannot be said that the entire law relating to trustees is applicable upon them, however, a Director may be made liable “for breach of trust when he misapplies the fund and misappropriated any assets.” Hence, any fraudulent actions in relation to the company’s financial transactions with third parties can be attributed to the Directors who act as the brain of the company. In the case of Bath v. Standard Land Co. Ltd.^[vii], it was rightly observed by Hon’ble J. Neville that the Board of Directors is the brain of the company, and the latter can act only through its Directors.

Can directors or members of a company be held vicariously liable for acts of the company where such legal fiction is not expressly created by the statute?

The clarity on this point has been brought by the Hon’ble Supreme Court in the case of HDFC Securities Ltd. and Ors. vs. State of Maharashtra and Ors.^[viii], wherein it was held that the Indian Penal Code, 1860 does not envisage vicarious liability of the director or other members of the company for an offence committed by the latter. It is necessary that such offence must be specifically stated in the statute and legal fiction is created therein, for eg. Negotiable Instruments Act, 1881. Further, the court placed reliance upon the observation of the court in the case of S.K. Alagh v. State of Uttar Pradesh and Ors.^[ix], wherein it was laid down that “Indian Penal Code, save and except some provisions specifically providing therefor, does not contemplate any vicarious liability on the part of a party who is not charged directly for the commission of an offence.” Further in Maksud Saiyed v. State of Gujarat and Ors.,^[x] Hon’ble Supreme Court observed that the Indian Penal Code does not contemplate the vicarious liability of Managing or other directors of the accused company.

Statutes must expressly and indisputably contain provisions attaching such vicarious liability.^[xi] Further, it is obligatory on part of the complainant to make specific allegations against the Directors in order to make them vicariously liable. In the case of Sunil Bharti Mittal v. Central Bureau of Investigation^[xii], Hon’ble Supreme Court held that “the concept of ‘vicarious liability’ is unknown to criminal law.” The Court went on to state that there is no specific allegation made against such persons which is mandatory to attach such liability.

Circumstances warranting personal liability of directors on account of non-payment of debt

• Dishonour of cheque under Negotiable Instruments Act, 1881

A director of a company can be made personally liable in case of dishonour of a cheque drawn under the name of a company. Explanation (b) to Section 141 of the Act defines a director in relation to a firm as the “partner of the firm”, and in the case of a company, it is defined as a person appointed to the Board of the company.^[xiii] Such liability is attached to a director of the company by virtue of Section 141 of the Negotiable Instruments Act, which states that:

“If the person committing offence under Section 138 is a company, every person who, at the time the offence was committed, was in charge of, and was responsible to, the company for the conduct of the business of the company, as well as the company, shall be deemed to be guilty of the offence and shall be liable to be proceeded against and punished accordingly”.

Principles laid down by Courts to make Directors of a company liable in case of dishonor of cheque:

• The Director of a company does not become automatically liable for offence committed on behalf of the company, and it is necessary to make specific averments in this respect.^[xiv] The rules for such averments have been laid down by Hon’ble Supreme Court in the case of K. Ahuja v. V.K. Vora^[xv]:
• If the person accused of the offence of dishonour of cheque is a Managing Director or Joint Managing Director, it is sufficient to state that the accused holds such position in the company, and it is not necessary to specifically aver that he is responsible for the conduct of the business of the company, as it is implied that a Managing Director is in charge of the affairs of the company.
• Where such Director accused is the signatory of the cheque in question, there is no need to make a specific averment that such Director is responsible for the conduct of affairs of the company.
• The Director must be responsible for conduct of business and affairs of the company, at the time when the cheque was drawn.^[xvi] Hon’ble Supreme Court in the case of Girdhari Lal Gupta vs. D.H. Mehta^[xvii] observed that such a person in charge of business must be in overall control of the day-to-day affairs of the company. Therefore, a Non-Executive Director, who does not involve himself in the day-to-day management of the affairs of the company^[xviii] and is not responsible for the conduct of the business of the company^[xix] can only be held vicariously liable for such act, omission or commission by the company where it:
• Occurred with the knowledge of such Non-Executive Director, or
• Is attributable through the Board processes. or
• Occurred with the consent or connivance of such Director, or
• Where such Directors did not act diligently.^[xx]
• Where such Non-Executive Director does not initiate any action upon his knowledge of such wrong being committed in the name of the company. The knowledge must flow from processes of the Board, and where any follow up action is taken by the Non-Executive Director, it must be recorded in the minutes of the Board^[xxi]
• The statutory provision adumbrated in Section 141(1) is required to be strictly construed for the reason that it is a penal statute.^[xxii] Penal statutes providing constructive vicarious liability should be construed much more strictly- When conditions are prescribed for extending such constructive criminal liability to others, the courts will insist upon strict literal compliance. There is no question of inferential or implied compliance.^[xxiii]

• Defenses available to directors

• Proviso to Section 141(1) of Negotiable Instruments Act, 1881 provides for a valid defense in favour of the Directors if they prove that they did not have the knowledge of such offence being committed, or they exercised due diligence in order to avoid such dishonour of cheque.
• Other valid defense is that the Director was not responsible for the day-to-day affairs of the company. As stated above, a Non-Executive Director shall not be liable for an offence committed by the company if he had no knowledge of it. Another defense on similar lines is that the Director did not hold such a position in the company at the time when such cheque was drawn. It is rightly observed by Hon’ble High Court of Chhattisgarh that “the mere fact that at some point of time, an officer of a company had played some role in the financial affairs of the company, will not be sufficient to attract the constructive liability under Section 141 of the Act”.^[xxiv] In the case of Gunmala Sales Pvt Ltd v. Navkar Infra Projects Pvt Ltd.^[xxv]Hon’ble Supreme Court held that the Directors can escape liability if there is incontrovertible proof that they were not involved in the commission of the offence due to resignation, prolonged illness etc.  
• Another objection that can be raised by the accused Director is that the complaint for dishonour of cheque is not made in accordance with Section 138 r.w. Section 141 of the Negotiable Instruments Act, or the averments are not made according to the aforesaid rules laid down by the Supreme Court in this respect.

• Liability for fraudulent conduct of business under Companies Act, 2013 and Insolvency & Bankruptcy Code, 2016

To illustrate, suppose a person “A” makes a business transfer to a company incorporated for this purpose, and in which A is the Managing Director and his wife as the Director. “A” conducts business in a manner leading to serious financial losses to the company. He takes shares and debentures for the price, creating a charge upon the company’s assets, and still continues to pay the Directors dividends. In spite of this, “A” orders goods worth £6,000 on credit.^[xxvi] Now the Company becomes insolvent and is being wound up, then who will be liable to repay such debts? This is where the liability of Directors is pitched in and they are held vicariously liable for exploiting their position as the trustee of the Company and operating the business of the Company with an intent to defraud its creditors. In the present case, it was held that “if a company continues to carry on business and to incur debts at a time when there is to the knowledge of the directors no reasonable prospects of the creditors ever receiving payments of those debts, it is, in general, a proper inference that the company is carrying on business with the intent to defraud.”^[xxvii] Winding up of the company does not absolve the directors from their criminal liability.^[xxviii]

• Requirements for affixing liability to the Directors of the Company for fraudulent conduct of business during winding up proceedings under the Companies Act, 2013

1. There must be a prima facie case that the business of the company is being carried with intent to defraud creditors of the company.^[xxix]
2. An application is required to be made to the Tribunal by the Official Liquidator or creditor or contributory to the company.^[xxx]
3. That the fraudulent trading is with the knowledge of the Director and such intent to defraud is attributable to him. Such a person who knowingly does such fraudulent activity is liable for action under Section 447 of Companies Act, 2013 which prescribes punishment for persons guilty of fraud.
4. Such fraudulent trading took place at the time when the concerned Director was responsible for managing the affairs of the company.

• Powers of the tribunal under Companies Act, 2013

1. Declaration of liability: As per Section 339 of Companies Act, 2013, on fulfillment of the abovementioned requirements, the Tribunal may declare that the Director, Manager or any other people so involved will be liable and personally responsible, without any limitation of liability, for all such debts and liabilities as directed by the Tribunal.^[xxxi]
2. Make provisions to give effect to the declaration: The Tribunal may further pass directions to effectuate such declaration, and for this purpose make provision for creating charge or interest in any debt, obligation, mortgage or charge on the assets of the company with him.^[xxxii]
3. Criminal Liability for breach of trust or misfeasance: Section 340 of the Companies Act, 2013 empowers the Tribunal to initiate inquiry and order for repayment or contribution towards the assets by the concerned Director, Manager, Liquidator or Officer of the company for his act of misfeasance, misappropriation of funds or breach of trust. Section confers criminal liability in such cases of breach of trust or misfeasance. As per Section 341 of the Act, the Tribunal is empowered to pass an order under Section 339 and Section 340 of the Act against the partner of the firm or director of the company.

• Requirements for making Directors liable for fraudulent trading under Insolvency & Bankruptcy Code, 2016

1. There must be a prima facie case that the business of the corporate debtor is being operated with the intent to defraud its creditors or for any fraudulent purpose. If there is a strong prima facie which turns out to be correct, then directors have deliberately indulged in sharp practice to defraud creditors.^[xxxiii]
2. The Director knew or was reasonably expected to know, that the commencement of the Corporate Insolvency Resolution Process (“CIRP”) cannot be avoided.^[xxxiv] This period when the Directors know that there is no reasonable prospect to avoid the initiation of CIRP is known as the ‘twilight period’. The phrase ‘twilight period’ is not laid down in any statute, but is a common business connotation. In such a period, directors must act diligently to avoid any loss to the assets of the corporate debtor as it would have a major impact on the outcome of the insolvency proceedings.
3. Such Directors did not exercise due diligence in order to minimize the potential loss to the creditors from such wrongful trading.^[xxxv] The rationale behind this is to put an obligation on directors of the company to take necessary action at the beginning when the financial crunch starts to cripple by conducting sufficient due diligence. This provision warrants vigilance from the directors at the very onset of financial distress, or they shall be held liable even if no dishonest intention is attributable to them.
4. There must be a dishonest intention or knowledge on part of the Director of the company,^[xxxvi] with respect to the fact that the company will not be able to meet its liabilities as and when they fall due, and continues to run the business recklessly.
5. Where a company continues to incur debts when in the opinion of a reasonable businessman, holding the position of a director, there is no reasonable prospect that the creditors receive the payment when it falls due, there is a sufficient inference that the business is being carried recklessly.^[xxxvii] To precisely state it in the words of Buckley J.: “In my judgment, there is nothing wrong in the fact that directors incur credit at a time when, to their knowledge, the company is not able to meet all its liabilities as they fall due. What is manifestly wrong is if directors allow a company to incur credit at a time when the business is being carried on in such circumstances that it is clear that the company will never be able to satisfy its creditors. However, there is nothing to say that directors who genuinely believe that the clouds will roll away and the sunshine of prosperity will shine upon them again and disperse the fog of their depression are not entitled to incur credit to help them to get over the bad time.”^[xxxviii]
6. The transactions in question were not made in the ordinary course of business of the company and must be proved to be of fraudulent nature by the Resolution Professional. In Anuj Jain vs. Axis Bank Limited and Ors.^[xxxix] it was held by Hon’ble Supreme Court that “where a transaction is made in the ordinary course of business and in absence of any contrary evidence to show that they were made to defraud the creditors of the ‘Corporate Debtor’ or for any fraudulent purpose, on the mere allegation made by the ‘Resolution Professional’, it was not open to the Adjudicating Authority to hold that the transactions come within the meaning of ‘fraudulent trading’ or ‘wrongful trading’ under Section 66.”

• Power of the adjudicating authority in case of violation of Section 66 of the Code

Section 67 of the Code empowers the Adjudicating Authority to:

1. Provide for liability of the person responsible, to be a charge on any debt or other obligation, due from the corporate debtor to the person liable, or on or mortgage or interest in a mortgage on assets of the corporate debtor held or vested in him.^[xl] Such order is limited to the debt with respect to creditors who have been defrauded.^[xli]
2. Pass such directions necessary to give effect to the above-mentioned order.^[xlii] Such direction may also require that the debt owed to the defrauded creditor shall be placed at a prior rank in the waterfall mechanism provided under Section 53 of the Code.^[xliii]

Conclusion

Traits of diligence, honesty, and transparency in managing the affairs of the company constitute essential conditions for holding the position of a director. In pursuance of the above, it is important that directors of the company should take immediate action in case of the abovementioned offences committed by the company that attracts liability of directors. Furthermore, it is important that such action and the objection to the fraudulent trade must be duly recorded in the minutes of the board meeting in order to escape liability posed by the statute.

References

^[i] The legal fiction of corporate veil was laid down by House of Lords in Solomon vs Solomon [1897] AC 22 Case

^[ii] The New Fleming Spinning And Weaving Company Ltd. vs Kessowji Naik And Ors. (1885) ILR 9 Bom 373

^[iii] Ibid- para 15

^[iv] York and North Midland Ry. Co. v. Hudson (1845) 16 Beav 485 Roumilly

^[v] (1872); 8 Ch. A. 149

^[vi]  MANU/WB/0200/1959

^[vii] (1910) 2 Ch. 408 at p. 416

^[viii] (09.12.2016 – SC) : MANU/SC/1573/2016

^[ix] MANU/SC/7162/2008 : (2008) 5 SCC 662

^[x] MANU/SC/7923/2007 : (2008) 5 SCC 668,

^[xi] Ibid

^[xii] MANU/SC/0016/2015 : (2015) 4 SCC 609

^[xiii] Section 2(34) of Companies Act, 2013

^[xiv] S.M.S. Pharmaceuticals Ltd. vs. Neeta Bhalla and Ors. (20.02.2007 – SC) : MANU/SC/7125/2007

^[xv] MANU/SC/1111/2009

^[xvi] SMS Pharmaceuticals v. Neeta Bhalla and Anr.(MANU/SC/7125/2007)

^[xvii] MANU/SC/0487/1971

^[xviii] Pooja Ravinder Devidasani v. State (MANU/SC/1177/2014)

^[xix] C.S. Raju v. SEBI (MANU/SC/0598/2018)

^[xx] Section 149(12)(ii) of Companies Act, 2013.

^[xxi] http://www.mca.gov.in/MinistryV2/management+and+board+governance.html

^[xxii] K. Srikanth Singh v. North East Securities Ltd. OR Anil Rice Mills and Ors. vs. State of Chhattisgarh and Ors. (16.12.2011 – CGHC) : MANU/CG/0370/2011

^[xxiii] K.K. Ahuja v. V.K. Vora (MANU/SC/1111/2009)

^[xxiv] K. Srikanth Singh v. North East Securities Ltd. OR Anil Rice Mills and Ors. vs. State of Chhattisgarh and Ors. (16.12.2011 – CGHC) : MANU/CG/0370/2011

^[xxv] Criminal Appeal Nos.2261-2265 OF 2014

^[xxvi] Facts of English case of Re William C. Leitch Bros Ltd. Re 1932 (2) Ch.71

^[xxvii] Maugham J. in the case of Re William C. Leitch Bros Ltd. Re 1932 (2) Ch.71

^[xxviii] Satellite Television Asian Region Ltd. and Ors. vs. Kunvar Ajay Designer Saree P. Ltd. (14.11.2008 – GUJHC) : MANU/GJ/0884/2008

^[xxix] Ibid

^[xxx] Section 339(1) of Companies Act, 2013

^[xxxi] Section 339(3) of Companies Act, 2013

^[xxxii] Section 339(2)(a) of Companies Act, 2013

^[xxxiii] Re: IN THE MATTER OF AN APPLICATION FOR JUDICIAL REVIEW BY C, A, W, M and McE (30.11.2007 – UKNI): MANU/UKNI/0001/2007

^[xxxiv] Section 66(2)(a) of IBC

^[xxxv] Section 66(2)(b) of IBC

^[xxxvi] Section 66(1) of IBC.

^[xxxvii] Philotex (Pty) Ltd and Others v. Snyman and Others; Braitex (Pty) Ltd. and Others v. Snyman and Others (13.11.1997 – SASC): MANU/SASC/0072/1997

^[xxxviii] Re Carbon Developments (Pty) Ltd (In Liquidation) 1993 (1) SA 493 (A) at 504 A – C

^[xxxix] 26.02.2020 – SC: MANU/SC/0228/2020

^[xl] Section 67(1)(a) of Insolvency & Bankruptcy Code, 2016.

^[xli] Nagendra Prabhu v. Popular Bank ((1969) ILR Ker 340.

^[xlii] Section 67(1)(b) of Insolvency & Bankruptcy Code, 2016.

^[xliii] Section 67(2) of Insolvency & Bankruptcy Code, 2016.

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