A company is a separate legal entity from its shareholders, directors and management. However, being an artificial person, a company is run by its directors appointed by shareholders and they are responsible for the day to day business operations.
In recent times, businesses have seen funding from overseas entities which is strengthening the Indian corporate sector and our trade in the global market. On the other side, scams and frauds by siphoning of funds, accounting irregularities, non-compliances and corruption have also become a part of corporate functioning leading to a grey area needing immediate attention.
The issue of scam and fraud have been taken seriously by the Government as various actions of arrests have been taken against promoters and key persons in some cases. The Serious Fraud Investigation Office has also been established in the Companies Act, 2013 to keep a watch over white-collar crimes.
The high risk of internal fraud raises concerns about the liability of directors on the board of companies. In this article, we are explaining the key areas of liabilities for you as a director or a new person joining the board of a company as a director and what precautionary measures can be taken beforehand.
1. Types of liabilities
Once a company is registered, its distinct status, assets and liabilities continue till it is deregistered by the Registrar of companies. In the lifetime of a company, its directors are exposed to the following types of potential liabilities:
- Liabilities under Companies Act, 2013
- Liabilities under Income Tax Act, 1961
- Liabilities under Labour laws
- Liabilities under Negotiable Instrument Act,1881
- Liabilities under Insolvency and Bankruptcy Code, 2016
2. Liabilities under Companies Act, 2013
The Companies Act, 2013 (hereinafter referred to as ‘the Act) defines a director to mean ‘a director appointed to the Board of a company. The Act also contains the concept of an ‘officer who is in default’ for the purposes of imposing liability on such a person in respect of any contravention of the provisions of the Act by the company.
The ambit of ‘officer who is in default’ is wide and includes, inter alia, every whole-time director, director(s) who has given consent for becoming a key person in absence of any key managerial personnel, every director who is participating in proceedings relating to a contravention of provisions of the Act and is aware of such contravention. Hence, independent directors and non-executive directors also get covered within the meaning of officer in default.
There are several provisions in the Act where a director is held liable for penalties and imprisonment. Misleading statements in the prospectus, failure in repaying deposit money to depositors, indulging in any fraud in a company or with creditors, non-intimating stock exchanges about public offers, non-maintenance of proper books of accounts prior to winding up are few defaults inviting personal liability of directors.
It is important for independent directors and non-executive directors to know that their liability will arise only in cases where acts of omission or commission by a company had occurred with their knowledge attributable through board processes with their consent or where they did not act diligently and there is sufficient evidence to prove the same.
3. Liabilities under Income Tax Act, 1961
The Income Tax Act, 1961 imposes vicarious liability upon the directors in respect of the tax arrears of the companies. The liability is linked to the income of the previous year which has been assessed to tax. Section 179 of the Income Tax Act, 1961 affixes joint and several liabilities on every director of a private company for recovery of tax dues which could not be recovered from the company unless the director proves that the non-recovery cannot be attributed to any gross neglect, misfeasance breach of duty on his part in relation to the affairs of the company. This section applies to a person who is or has been a director in such a company for recovering tax dues.
4. Liabilities under Labour Laws
An offence committed by a company under labour laws viz. Factories Act, 1948, Employees Provident Fund, 1952, etc. makes the person who has control over affairs of the company liable for penal consequences. Therefore, directors automatically come into picture for potential liabilities and only those directors who are in charge of the overall affairs of the company are held liable for penalties and imprisonment.
5. Liabilities under Negotiable Instrument Act, 1881
An offence committed by a company relating to dishonouring of cheques is regulated by section 141 of the Negotiable Instrument Act, 1881. According to that section, vicarious liability is imposed on directors for dishonouring cheques drawn by a company. The liability is extended to the directors who are responsible for day to day affairs of the company and any director who is a signatory of the cheque is also held liable. However, a director will not be held liable for dishonour of cheque by the company if an offence occurred without his knowledge and he/she exercised due diligence in order to avoid the offence.
6. Liabilities under Insolvency and Bankruptcy Code, 2016
Once the insolvency resolution process under the Insolvency and Bankruptcy Code, 2016 (IBC 2016) starts, the powers of the board of directors are suspended, and an external professional is appointed to run the affairs of the company. IBC 2016 extends the liability on the directors of the corporate debtor (a company under IBC process) as and when a transaction involving them is brought under question.
The liability on directors is imposed to the extent of reversing the transaction or making a reasonable contribution to the assets of the company under IBC process to ensure the safeguarding of the creditor’s interest. However, a director is not liable if reasonable due diligence is undertaken and there was no fraudulent intention.
7. Precautions to be taken by directors
(i) Performance of duties
The directors of a company are integral to the everyday functioning of the company. Therefore, they are held liable for losses connected to culpable acts or negligence. To avoid personal liabilities, directors should perform their duties by acting diligently and prudently. Further, statutorily, directors should:
- Act in accordance with the articles of association of the company.
- Act in good faith to promote the objectives of the company.
- Perform duty of care, skill and diligence and exercise independent judgment.
- Act in the best interests of the company, its employees, the shareholders, and the community and for the protection of the environment.
Further, independent directors being external directors should possess more experience and knowledge to gather all ongoing functionalities of the company. Also, additional duties for independent directors are codified in Schedule IV of the Companies Act.
Directors’ and officers’ liability insurance is insurance that protects directors, officers and company itself for losses and other costs in case suits are filed against them for alleged wrongful acts. The growing number and intensity of risks for companies highlight the need for them to ensure that they have robust insurance coverage in place. And with directors’ and officers’ personal assets potentially at stake, ensuring sufficient coverage is especially important. Therefore, directors of companies can recommend taking directors and officers insurance to protect their interests.
In general, indemnification means covering expenses incurred by another person. Now, directors can ask for an indemnification policy against any liabilities he/she incur in case of alleged negligence, breach of duty, etc. It is important to note that a director cannot be indemnified against liability in civil or criminal proceedings for which he or she is found guilty.