Director liability during financial distress- An interplay of the IBC, 2016 and the Companies Act, 2013
Dimpal Khotele
4th Year BBA LL.B(H), Amity Law School, Amity University, Chhattisgarh
Directors have fiduciary duties towards the company, including the duty to act in the best interests of the company and its stakeholders.[1]
As an artificial legal entity, a company relies on the wisdom and actions of its board of directors to function.[2] The life of a company is determined by the delicate balance between its management, led by the Board of Directors and shareholders, and non-shareholder constituencies acting as risk bearers. At every stage of the company’s financial life, the Board of Directors is bound by fiduciary duties to these constituencies.[3]
The roles and responsibilities of company directors, as well as their interactions with external stakeholders, are crucial both when the company is solvent and when it faces insolvency. Consequently, the expectations and nature of the duties incumbent upon the board of directors shift depending on the company’s financial health. [4] Under common law, directors have a legal obligation to fulfill their duties to the company, acting in its best interests. In practice, for a solvent company, this requires considering the interests of all members collectively, rather than focusing on the interests of individual members.[5]
The previous Companies Act, 1956 was vague about the specific duties and liabilities of company directors. In response, the 2013 Act introduced a defined set of responsibilities and liabilities for directors to improve corporate governance laws.[6] This marked a significant shift in legal philosophy from a focus on shareholders to a broader stakeholder orientation. Under shareholder theory, shareholders are seen as the primary owners of the company, necessitating management practices that maximize shareholder value. In contrast, stakeholder theory demands a more inclusive and sustainable management approach, considering the needs and interests of a wider group including employees, creditors, consumers, the environment, and the broader community.[7]
It is undisputed that in times of solvency, director’s responsibilities are mainly directed towards shareholders, under the guidance of the Companies Act. Conversely, in periods of insolvency, their obligations pivot primarily towards creditors, as stipulated by the Insolvency and Bankruptcy Code.[8] The Insolvency and Bankruptcy Code envisages a default-based ‘cash flow test’ as opposed to the ‘asset or balance sheet test’ as enshrined in Section 4 of the Code. And, it works on the process of the ‘creditor in control’ where the Insolvency Professional acts as an agent of the creditor as opposed to the practice of ‘debtor in possession’ seen in the USA.
In a solvent company, directors typically face limited liabilities, unless there is involvement in fraud or misrepresentation. However, when a company nears insolvency, directors may incur personal liabilities for any losses suffered by creditors. This period is often referred to as the Twilight Zone. There is no single, definitive point marking the commencement of the zone. Instead, it can be assessed through various indicators including severe financial decline, legal actions, or the director’s recognition of inevitable insolvency based on their diligent and reasonable judgment of the company’s financial status. Directors need to continuously evaluate the financial health of the company to determine the potential onset of this critical phase. This period extends until the formal initiation of insolvency proceedings.[9]
Framework of director liability:
The Companies Act (Act)
As a corporation approaches insolvency, the responsibilities and potential liabilities of directors intensify significantly. It is incumbent upon directors to prioritize the best interests of the company and its creditors, exercising meticulous judgment to prevent further deterioration of the company’s financial condition[10]. The fundamental duties of directors, as stipulated in Section 166 of the Act are primarily oriented toward the shareholders. These duties encompass acting in good faith and promoting the best interests of the company. Failure to comply with these responsibilities not only constitutes a breach of fiduciary duties but also subjects directors to liabilities and penalties as specified in Section 166(7) of the Act. This underscores the crucial nature of their roles, especially during times of financial instability.[11]
Section 337 of the Act imposes penal liabilities on directors and other officers for certain fraudulent activities as the company nears insolvency, serving as a mechanism for retribution for actions detrimental to creditors and other stakeholders. This section ensures that directors are criminally accountable for their conduct, prescribing penalties including imprisonment, fines, or both, thereby deterring fraudulent activities during financially unstable periods.
Moreover, Section 339 heightens the deterrence by establishing personal liability for directors during the Twilight Zone when director’s decisions can severely impact creditor’s ability to recover dues during insolvency proceedings. This section allows for a Tribunal to declare that any directors knowingly participating in business conducted with intent to defraud creditors, or for any fraudulent purpose, are personally responsible for all or any of the company’s liabilities. Such directors also face liabilities under Section 447 for any proven fraud, with penalties including both imprisonment and fines.
Section 340 further empowers the Tribunal to hold directors personally accountable to repay or restore the company’s assets or compensate for any misfeasance or misapplication observed as the company approaches insolvency and is undergoing winding up.
Additionally, Section 338 addresses the maintenance of proper company books of account before insolvency. Directors failing to maintain proper records can be held liable, especially if they cannot prove that such failure was excusable under the circumstances. Penalties for this infringement include imprisonment of one to three years and fines ranging from one to three lakh rupees.
Lastly, Section 286 targets former directors and managers who exited the company within one year before its insolvency, on the premise that their actions might have contributed to the company’s financial decline. These individuals are treated as if they were members of an unlimited liability company, meaning they could be called upon to contribute to the company’s assets to cover its debts as if the company had begun winding up the day they left their positions. This provision caps their liability to prevent unfair excess but ensures accountability for their actions during their tenure.
Insolvency and Bankruptcy Code (IBC/Code)
Under Section 17(1)(b) of the Code, the appointment of the interim resolution professional marks a significant shift in control from the board of directors to the IRP. From the date of this appointment, the powers of the board are suspended, and the IRP assumes those responsibilities. Consequently, directors are stripped of their power to make managerial or operational decisions for the company, which effectively shields them from liability for any actions taken beyond this point. [12]
However, the IBC also delineates specific obligations for directors during the Twilight Zone the period leading up to insolvency proceedings. Directors must adhere to these duties, as failure to do so could lead to liabilities.[13] These include ensuring complete and accurate disclosure of the company’s financial status to the IRP[14] and extending all assistance in managing the affairs and avoiding any actions that could further jeopardize the company’s financial position[15]. If directors neglect these obligations or engage in any fraudulent activity intended to defraud creditors or other stakeholders during this period, they could still be held accountable.[16]
This framework is designed to protect the interests of creditors and maintain orderly insolvency proceedings while holding directors accountable for their conduct leading up to the IRP’s appointment. Thus, while the director’s formal powers are curtailed post-appointment of the IRP, their actions before this can still expose them to liability if they fail to act under the prescribed duties during the twilight period.
As section 19 mandates the personnel of the corporate debtor, including its directors, to extend all assistance and cooperation to the interim resolution professional as required by them a failure to cooperate can lead to penalties and could be seen as obstructing the process in case of an application to direct cooperation by the IRP to the Adjudicating Authority. Furthermore, Section 65 penalizes any person, including directors, for initiating or causing to initiate any insolvency resolution process or liquidation proceedings fraudulently or with malicious intent, or for any purpose other than for the resolution of insolvency, or liquidation. If the person is found guilty, they may be criminally penalized.
Moreover, Section 66 of the Code necessitates that directors exercise reasonable due diligence in their functions to minimize potential losses to the creditors of the corporate debtor. It stipulates that a director should have known or ought to have known about the unavoidable commencement of a corporate insolvency resolution process for the corporate debtor and failed to minimize losses to creditors. In cases where directors knew or should have known the inevitable approach of insolvency, they are required to conduct due diligence to reduce potential losses to creditors. Violating these requirements subjects the director to personal liability, requiring them to contribute to the assets of the distressed company. Derived from English law, this section imposes both objective and subjective standards in evaluating a director’s conduct: objectively assessing the expected knowledge, skill, and experience of a reasonable person in a similar position, and subjectively considering the specific director’s actual capabilities when making legal determinations.[17]
The PUFE (Preferential, Undervalued, Fraudulent, or Extortionate) transactions are the vulnerable transactions that are discussed in Sections 43 to 50 of the Code.[18] The liability of directors in cases of PUFE transactions is primarily derived from their roles in the governance and decision-making processes of a company. Although the Code does not specifically name directors, the roles typically played by them in managing the affairs of the company mean that they are often directly or indirectly involved in the transactions scrutinized under these sections of the IBC.
The decisions made by a company, especially those related to management, are typically ascribed to its directors. This principle enables regulators and courts to hold directors responsible for corporate wrongdoing, including PUFE transactions. The Code also provides a detailed and comprehensive list defining who qualifies as related parties. This list includes, among others, directors or KMPs of the corporate debtor, a corporation holding a subsidiary, or an associate company of the corporate debtor.[19]
A transaction may be reversed or annulled under section 43 of the IBC if it is determined to be preferential. While involvement in preferential transactions does not directly result in criminal penalties under the Code, directors may be subject to civil liabilities. These liabilities include the possibility of recovering the benefit of the transactions and holding directors liable for any breaches of fiduciary duty or violations of IBC provisions meant to maintain creditor parity. In this case, the liability is civil in nature and aims to put the company and its creditors back in the comparable predicament as before the transaction.
In Anuj Jain v. Axis Bank case[20], the Court ruled that the following elements must be met for a transaction to be considered preferential: it must be a transfer of property or interest in a CD for the benefit of a creditor, surety, or guarantor due to an antecedent financial or operational debt or liability[21]; it must place the recipient in a beneficial position as opposed to the status quo in the event of assets under section 53 of the Code[22]; and it must have occurred during the lookback period of one year for transactions involving unrelated parties and two years for transactions involving related parties[23]. Moreover, it must not fall under the exceptions provided by Section 43(3).[24]
IBBI (Insolvency Resolution Process for Corporate Persons) Regulations, 2016 specifies the process for identifying Preferential and other relevant transactions. It requires the resolution professional to form an opinion and decide on these transactions within specified timelines and report them to the Adjudicating Authority[25].
Transactions under which the company makes gifts or enters into transactions that involve selling goods or services at significantly undervalued prices without a commensurate consideration are covered under section 45 of the Code. Similar to preferential transactions, undervalued transactions can be reversed. Directors who knowingly participate in or facilitate such transactions, especially if done with the intent to defraud, can be held liable for any losses or disadvantages caused to the company or its creditors. The liability may include reversing the transaction and possibly compensating the estate of the corporate debtor for the loss in value, thus ensuring that creditors are not adversely affected by such transfers. Again, the code emphasizes the restitution and rectification of the imbalance created by the transaction.
If a transaction is made with the intent to defraud creditors, or for any fraudulent purpose, directors involved can be held personally liable. Section 49 deals with such transactions made with the intent to defraud creditors. The involvement of directors in fraudulent transactions can lead to significant civil liabilities, including compensatory damages to the estate or the creditors affected by the fraud. Although Section 49 focuses on civil remedies, fraudulent activities can also attract criminal liability under other laws like the Indian Penal Code, depending on the nature and severity of the fraud. Such transactions can be declared null and void, and directors can be made to compensate for the damages caused to the corporate debtor or its creditors. This section is different from other sections involving these vulnerable transactions as fraud vitiates everything, and therefore, there is no timeline prescribed[26].
Credit transactions that are deemed to be made on terms that are extortionate to the debtor, such as unreasonably high interest rates or terms that are not in line with market practices, make a part of the vulnerable transactions under section 50 of the Code. The role of directors in procuring such credit on onerous terms can lead to the transaction being set aside. This ensures that the corporate debtor is not saddled with unfair debt that can impede its ability to service other creditors or continue its operations efficiently.
Comparative analysis
The liabilities of directors under the Act and the Code while sharing some similarities, are specifically tailored to different stages of a company’s lifecycle, addressing distinct aspects of directorial responsibility.
The Act offers a comprehensive framework governing director’s duty not only in times of distress but throughout the operational life of the company. It mandates broad responsibilities such as acting in the best interests of the company and its shareholders and upholding high standards of governance and fiduciary duty. In contrast, the IBC is specifically crafted for scenarios of financial distress and insolvency. It focuses on the protection of creditors and the equitable resolution of the company’s financial obligations. This code activates during crucial times when a company faces financial instability, focusing specifically on insolvency proceedings and related concerns.
While the Act addresses creditor interests, especially in provisions against fraudulent activities, its broader mandate is to balance the interests of all stakeholders, including shareholders. On the other hand, the IBC is explicitly designed to protect creditors, instituting stringent rules to ensure that directors avoid any actions that could compromise creditor’s rights, such as engaging in preferential, undervalued, or fraudulent transactions.
The Act uses a combination of civil and criminal penalties to enforce compliance, with deterrents such as imprisonment and fines for severe breaches of duty. Conversely, the IBC emphasizes financial restitution, aiming to compensate creditors and restore equity, with less focus on imprisonment unless fraud is involved. This represents a shift from punitive to corrective measures, prioritizing financial recovery and fairness for creditors over directly penalizing directors.
Under the Act, directors face penalties for non-compliance that may include fines and imprisonment, with personal liability extending to cases of fraud or mismanagement as the company approaches insolvency. This includes holding directors accountable for their past decisions that contributed to the company’s financial downfall. The IBC further sharpens this focus by suspending the powers of directors once an insolvency professional is appointed, thereby limiting their influence during the resolution process. It also imposes strict responsibilities on directors to cooperate with the resolution process and penalizes fraudulent behaviors during the insolvency proceedings.
Personal liability under the Act may arise from specific wrongful acts, including fraud or failure to maintain proper records. The IBC extends personal liability further, especially focusing on the twilight period during which director’s decisions can greatly affect creditor’s ability to recover debts. This serves as a robust deterrent against irresponsible or unethical management decisions in times of financial crisis.
Conclusion
The transition of a company into insolvency signifies a profound shift in the director’s fiduciary responsibilities, transitioning from a shareholder-centric approach to one predominantly concerned with creditor rights. Directors are necessitated to delicately balance conflicting stakeholder interests, ensuring equitable treatment of creditors and forestalling fraudulent transactions. The Twilight Zone emerges as a critical period in this transition, marked by intense scrutiny of the director’s decisions that may significantly affect the financial and operational viability of the distressed company. It is during this time that directors are most susceptible to allegations of misconduct, particularly if they fail to act in the collective best interests of creditors.
The Insolvency and Bankruptcy Code and the Companies Act 2013 establish a comprehensive framework for assessing director’s conduct. Their provisions meticulously define the boundaries of acceptable actions by directors during insolvency. These statutes not only prescribe the responsibilities but also delineate the consequences of deviations that lead to fraudulent or preferential transactions. Directors may face significant risks, including civil and criminal liabilities, which can result in personal financial consequences and criminal penalties.
A critical takeaway is the level of diligence required from directors during insolvency. The legal framework expects directors to operate with a heightened sense of ethical responsibility and foresight. This focus is integral to the primary objective of insolvency proceedings, which aim to resolve the entity’s financial obligations fairly while minimizing losses to creditors. The stringent legal frameworks function as both a directive and a deterrent for directors, stressing the necessity for meticulous due diligence and strict adherence to statutory duties. Directors are compelled to remain vigilant and proactive in monitoring the company’s fiscal health and acting in the best interest of all stakeholders, particularly creditors during insolvency episodes. Non-compliance can result in severe consequences including personal liabilities and criminal indictments, thereby reinforcing the essential role of directorial conduct in upholding corporate solvency and ethical integrity.
References:
[1] Elizabeth Warren, Emerging Jurisprudence on Corporate Insolvency Director Duties in the Twilight Zone, https://ibbi.gov.in/uploads/engagement/WinnerUtsavMitraNLIUBhopal.pdf (last visited on April 16, 2024)
[2] Insolvency and Bankruptcy Board of India, https://ibbi.gov.in/uploads/meetings/e8e306852963ae62b5fe59c298edb97d.pdf (Last visited on April 16, 2024)
[3] M. P. Ram Mohan and Urmil Shah, Tracing Director Liability Framework during Borderline Insolvency & Corporate Failure in India, IIMA, August 2021, Page 1, https://www.iima.ac.in/sites/default/files/rnpfiles/812680252021-08-02.pdf
[4] Supra note 2
[5] Company Law Review Steering Group, Modern Company Law for a Competitive Economy: Developing the Framework (Department of Trade & Industry, 2000), para 3.51.
[6] Deva Prasad, M., Ansari, S., & Narayan, S. (2020). Legislative Design of Director’s Responsibility in India: In Search of Clarity. Statute Law Review. doi:10.1093/slr/hmaa021
[7] Mihir Naniwadekar Umakanth Varottil, The Stakeholder Approach Towards Directors’ Duties Under Indian Company Law: A Comparative Analysis, NUS Centre for Law & Business Working Paper 16/03, August 2016
[8] Supra note 2
[9] Gaurav Joshi, Paper on Position of Directors in Twilight Zone, May 2020, IBC Laws, https://ibclaw.in/paper-on-position-of-directors-in-twilight-zone-by-gaurav-joshi/ (last visited on April 19, 2024)
[10] Abhisshek Singla, Understanding Director’s Liability Under The Companies Act 2013, https://burgeon.co.in/blog/understanding-directors-liability-under-the-companies-act-2013/ (last visited April 19, 2024)
[11] Supra note 1
[12] Supra note 1
[13] Insolvency Code and Its impact on Role of Directors, https://www.independentdirectorsdatabank.in/img/newsletter/2021/61c462d0b51ff.pdf (last visited 20 April, 2024)
[14]Section 18 (a)(ii), IBC 2016
[15] Section 19 (1), IBC 2016
[16] Section 66, IBC 2016
[17] Supra note 1
[18] Aditi Bhawsar, PUFE Transactions Under IBC: A Guide to Buying Distressed Assets in 2020, https://signalx.ai/blog/pufe-transactions-under-ibc/ (last visited 20 April 2024)
[19] Jasleen Bedi, Explainer: What Are PUFE Transactions Under The IBC, 2016?, LiveLaw.in, https://www.livelaw.in/columns/insolvency-and-bankruptcy-code-resolution-professional-rp-nclt-corporate-debtor-preferential-transactions-206832
[20] [2020] ibclaw.in 06 SC, Para 19.5
[21] Section 43(2) IBC, 2016
[22] ibid
[23] Section 43(4) IBC, 2016
[24] Supra note 20
[25] Regulation 35A, IBBI (Insolvency Resolution Process for Corporate Persons) Regulations, 2016
[26] Supra note 19
