DIRECTORS’ CARE AND DUTY IN CASE OF BREACH

 

By V. Karthyaeni,

Gujarat National Law University

 

1. INTRODUCTION

 

Nature of Responsibility for Liability of Corporations

Responsibility is an elusive term. It has many equally plausible definitions and the values it expresses differ from time to time, place to place. Indeed, it has been described so integral a part of human relationships that it, in its various meanings and shadings, serves as a synonym for every important political word.[1]

In the context of corporate liability, an oft-cited opinion is the 18th century expression of Baron Edward Thurlow L.C. that corporations have no soul to be damned and no body to be kicked.[2]

While the corporation is legally separate and distinct from its members, it is ultimately an artificial creation and it acts through its servants or agents. The decisions of a majority of its members in general meetings are regarded as the acts of the corporation. The Board of Directors, as a whole, is generally delegated all powers of the management and it may sub-delegate any of these powers to individuals directors or other servants and managers. There is a relationship akin to agency between the corporation and its board as well as the servants or agents that are delegated with specific responsibilities.

 

Traditional Approach to Corporate Liability- Directing Mind Theory

Traditionally, the approaches through which corporations may be said to incur liability for the acts of its directors or other employees are vicarious liability, agency and directing mind theory.

There were decisions like that of Lennard’s[3] and Tesco Supermarkets[4] which held that personal liability may be established against corporations where the reprehensible conduct or state of knowledge of an alleged infringement or wrongdoing was found in an individual or individuals who were identified as its ‘directing mind and will’ or alter ego. The essence of the traditional directing mind theory is that it is necessary for those individuals, whose position or function in the corporation are such that they are deemed to be its directing mind, to have committed the acts or possessed the requisite knowledge in order for it to incur personal liability.

 

Development of the Directing Mind Theory and the Principles of Attribution

The expression ‘principles of attribution’ has come to be associated with the decision of the Privy Council in Meridian Global Funds Management Asia Ltd v. Securities Commission[5]. The notion of attribution is not a completely new concept. It is essentially a derivation of the traditional directing mind theory that was established in the cases of Lennard’s and Tesco Supermarkets. The idea is to identify the individual or individuals in a corporation whose conduct or state of knowledge is attributable to it where they are deemed to be the corporation whose conduct itself- its alter ego. It seeks to address the same principles as that of the directing mind theory i.e to enable to finding of the liability against the corporations, especially where the proof of which requires corporations to have acted reprehensively or entertained a particular state of mind.

The question of attribution is fundamental to company law, as a corporation can neither act nor think on its own. The damages and losses that result from the infringements or wrongdoings associated with corporations also reinforce the need to determine whether a corporation can undertake a prohibited action or entertain a culpable state of mind. At the same it is necessary to avoid the injustice of attributing to the corporation every act or omission of its servants or agents. Under the traditional directing mind theory and principles of attribution, it is through identifying the relevant individuals in the corporation whose conduct or knowledge are attributed to it in order for corporate liability to be established. Nevertheless, it is here that the similarity ends.

The difference with the principles of attribution, as expounded by Lord Hoffman in the Meridian case, is that they seek to provide a more systematic and coherent approach to determining liability of corporations. The Meridian case should be read with the cases of Lennard’s, Tesco Supermarkets, El Ajou and Ready Mixed Concrete cases where the principles of attribution were laid down.

 

Firstly, they recognize corporations as legal abstractions involving references to rules that determine its existence, powers and obligations.

Secondly, it is governed by its organs (the board of directors and shareholders in general meetings).

Thirdly, the fact that the corporation acts through its servants or agents does not mean that the conduct or state of knowledge of those individuals should be attributed to it in every circumstance. The nature of criminal and regulatory offences as well as civil infringements or wrongdoings also advances the need for rules to ascertain the instances where the corporation may be charged with personal responsibility. This is especially so since the claimant to satisfy the court that the corporation had caused a certain event or responsibility should be attributed to it for the existence of a certain state of affairs, and it had a defined state of mind in relation to the causing of the event or the existence of the state of affairs.

 

Therefore the directing mind theory and the attributive principles focus directors and officers running an enterprise making them liable for their acts. Hence the concept of directors liability is of ongoing interest in corporate circles.

 

 

2. Director of a Company

The expression "director" includes any person occupying the position of director, by whatever name called.[S.2(13)][6].
The Articles of a company may, therefore, designate its Directors as governors, members of the governing council or, the board of management, or give them any other title. However, so far as the law is concerned, they are simple Directors.
Corporate executives today are possessed of “immense power which must be regulated not only for public good but also for the protection of those whose investments are involved.”[7] Directorships will always be susceptible to abuse. The law therefore, imposes upon them certain duties, which when, properly enforced, will, without driving away from the field competent men, materially reduce the chances of abuse.

 

2.1 BONA FIDES DOCTRINE

The English and Australian Courts long considered the bona fides doctrine and were geared more or less to arrest dishonesty or mala fides , but well entrenched of a reluctance to interfere with the internal management of companies acting within their powers[8]. That the courts should develop such a reluctance to interfere in the exercise of director’s powers is not surprising for this was an area in which it was felt that the shareholders were seized of control, and that such matters were really for them. And so provided that directors of British and Australian companies acted bona fide in the interests of the company as a whole, it was felt that the shareholders had little cause for complaint.[9]

 

2.2 PROPER PURPOSES DOCTRINE

The proper purpose test or as it is also referred as, the collateral purposes test[10] allows directors acts to be reviewed by the courts upon a more objective basis than that which has been traditionally applied in relation to bona fides. Notwithstanding that the directors may have acted honestly in what they believe to be in the company’s interests, they may nevertheless be liable to the company if they have exercised their powers for purposes different from that for which the powers were conferred upon them.[11] Strict adherence of the bona fides doctrine can permit too much of subjectivity in the directors’ decision-making process.[12] The attractiveness of the proper purposes doctrine is that it introduces an objective element into the equation absent statutory interference. It is significant that the proper purposes doctrine has application where directors’ good faith is not challenged. [13]

It is however necessary to distinguish between an excess of authority and an act which pima facie is within the powers delegated to directors of British companies, but which they have abused by exercising for an improper purpose.[14] Ascertainment of that purpose is a question of fact and the relevant question is whether the challenged power, ‘would have been exercised but for the presence of the impermissible purpose.[15]

 

2.3 DEVELOPMENT OF THE PROPER PURPOSES DOCTRINE: AN ENGLISH PERSPECTIVE

The proper purposes doctrine, it must now be recognized as having evolved into a separate test to be applied in circumstances where prima facie the power complained of is within the scope of the directors’ authority, but which they have abused by exercising for an improper purpose; often, so as to manipulate control.[16]

The following cases highlight how the proper purposes doctrine has evolved under the general law. The first is Fraser v. Whalley[17]. The essential facts appear within the following extract from Page Wood VC’s Judgment:

“The directors are informed that at the next general meeting they are likely to be removed and therefore, on the very verge of a general meeting, they, without giving notice to anyone, with this indecent haste and scramble which is shown by the times at which the meetings were held, resolve that shares are, on the faith of this obsolete power entrusted to them for a different purpose, to be issued for the very purpose of controlling the ensuing general meeting.”[18]

However, the case which probably more than any other gave recognition to a separate test over and above the traditional bona fides test was, Hogg v Cramphorn Ltd [19]. In the case, the directors had issued shares with special voting rights to the trustees of a scheme set up for the benefit of the company employees in an attempt to forestall a takeover bid. While Buckley J, had accepted that the directors had acted in good faith, and they honestly believed that what they had done would benefit the company, his Lordship observed nonetheless that, ‘an essential element of the scheme, and indeed its primary purpose was to ensure control of the company by the directors and those whom they could confidently regard as their supporters. Buckley J, formed the view that the power to issue shares was fiduciary and if it was, ‘exercised for an improper motive, the issue of these shares is liable to be set aside.’ The issue of shares was accordingly declared invalid. However, since the directors’ breach of duty rendered their action voidable rather than void, it was capable of ratification by the shareholders in general meeting. The action was stood over and the allotment was later ratified. This decision had excited a measure of controversy in English and Australian Law.[20]

It is well established that the onus of showing that a director has not acted honestly in the exercise of his or her powers and the discharge of his or her office is upon the aggrieved party. The point is well established in Hindle v. John Cotton Ltd[21] where the House of Lords were asked to declare a resolution of the board void. Although the articles gave literal power to do what had been done, the House of Lords nonetheless granted the order sought. In doing so, Viscount Finlay outlined the nature of the task that the court must undertake as the following passage from his celebrated speech to the House of Lords demonstrates:

“Where the question is one of abuse of powers, the state of mind of those who acted, and the motive on which they acted , are all important and you may go into the question of what their intention was, collecting from the surrounding circumstances all the material which genuinely throw light upon that question of the state of mind of directors so as to show whether they were honestly acting in discharge of their powers in the interests of the company or were acting from some bye-motive, possibly of personal advantage, or for any other reason.”[22]

Although isolated cases can be found where the bona fides test has been applied, the latter day English Courts have tended to promote, in preference, the proper purposes doctrine which found very clear favor with the Privy Council in Howard Smith Ltd v. Ampol Petroleum Ltd[23]. In delivering its opinion in Howard Smith, the Privy Council reaffirmed the judiciary’s reluctance to interfere with, or even supervise, the merits of decisions within the powers of management honestly arrived at. But the Privy Council nonetheless considered that a court ‘is entitled to look at the situation objectively in order to estimate how critical or pressing or substantial or per contra, insubstantial an alleged requirement may have been.

The application of the proper purposes test in this manner therefore enables the directors’ decision-making to be challenged without necessarily condemning their motives for so deciding. That in turn, permits judges, of a more robust interventionist disposition, to consider the decision itself rather than simply the decision-making process; thus giving rise to the review of business judgments of business men, long considered anathema to the English and the Australian judiciary.

 

3. Liability to the Company

3.1 Duties of Skill and Care
Unless the Articles of the Company provide otherwise, the directors are responsible for the management of the company. They should exercise skill and care in carrying out their managerial functions. However, a mere error of judgment will not amount to a breach of the duty of care which a director owes to a company. A professionally qualified or expert person who is a director must however exercise his expert skill and knowledge for the company.

3.1.1 A Brief History of Duty of Care

In an oft-cited article, Professor Bishop wrote that “the search for cases in which directors of industrial corporations have been held liable in derivative suits for negligence uncomplicated by self-dealing is a search for a very small number of needles in a very large haystack." Up to that point (May 1968), he had found only four such cases. A more recent count (December 1983) brought the total to seven. By any reckoning, reported cases holding directors liable for purely "hon­est mistakes" are rare indeed.

One reason for the duty of care doctrine's twilight existence is that its greatest strength is also its greatest weakness: the enormous coverage of its negligence standard and then the application of “gross negligence” rule. Another manifestation of this judicial avoidance is the liberal ap­plication of the business judgment rule. It is well-noted that judges are very reluctant to interfere with the business judgments of direc­tors. The business judgment rule has virtually en-gulfed the duty of care doctrine.

 

3.1.2 Liability for negligence

Fidelity alone is not enough. A director has to perform his functions with reasonable care. He has to attend with due diligence and caution the work assigned to him.[24]

An early example is Overend Gurney & Co v Gibb[25] where a company was formed to take over a private bank. Without investigating the value of the bank’s assets and the extent of its liabilities and with knowledge that the bank was in a state of insolvency, the directors paid ₤50,000 for goodwill. Still holding them not liable, the House of Lords laid down that there should be violation of either the Act or the memorandum or the transaction was such that no man of ordinary prudence would have entered into.

Directors may not know the nature of the company’s trade, because all that the law expects from them is that if they know they must use the knowledge for the benefit of the company.[26] Accordingly the directors were held guilty of negligence when they participated in a transaction without trying to know whether the transaction was really for the purposes of the company or they were authorized by the Board in that respect, and it was no defence for any director to show that he believed that he was bound to sign because the other directors wanted it or that he joined under protest or that even without his joining, the other directors were determined to carry out the transaction.[27]

Directors were also held liable where they released the company’s funds for paying the debt without trying to know whether anything  was really due and for purchasing the assets  without knowing whether there was any real transfer of those assets.[28]

Liability for negligence also followed where without any board resolution being properly passed a single member was allowed to manage a part of the company’s business and he misconducted himself.[29]

 

3.1.3 Exclusion of liability now not allowed [S.201] –

ROMER J’s formulation of directors’ duties in City Equitable Fire Insurance Company, Re[30]

“His duties will depend upon the nature of the company’s business and the manner in which the work of the company is distributed between the directors and other officials of the company. In discharging these duties a director must exercise some degree of skill and diligence. But he does not owe to his company the duty to take all possible care to act with best care. Indeed, he need not exhibit in the performance of his duties a greater degree of skill than may reasonably be expected from a person of his knowledge and experience, or in other words, directors are not liable for mere errors of judgment.[31]

In the above case one B was the director of City Equitable fire Insurance Co. the company was ordered to be wound up. A searching investigation of the affairs of the company was then made and this investigation showed a shortage of funds which the company should have been possessed of over ₤12,00,000. The collapse of the company was due to bad investments, bad debts and misappropriation. All the losses were due to B’s instrumentality. He was accordingly convicted for his funds.

But the question of whether during the period covered by B’s nefarious activities the other directors were properly discharging their duties to the company. But there was exemption clause in the articles to which the directors were liable only for gross negligence. The facts of the case did not disclose that the degree of negligence and, therefore, the case of the official receiver against B’s co-director failed.

S.201 renders void any provision in the company’s articles or in any agreement which excludes liability for negligence, default, misfeasance, breach of duty or breach of trust.

 

3.1.4 Standard and degree of care and skill-

The above ROMER J formulation is largely subjective, as a director has to use only such “skill as may reasonably be expected from a person of his knowledge and experience.” Traditionally, only gross negligence the directors used to be made liable. But the current trend is towards objectivity.[32]

In the words of Justice CARDOZO”

“The diligent director is the one who exhibits in the performance of his trust the same degree of care and prudence that men prompted by self interest generally exercise on their own affairs.”[33]

This standard demands reasonable business prudence form the managers.

Payment of ₤4000 without legal advice, as compensation to a director for retirement when, in fact, he was entitled to no compensation was, an act which could not be regarded as reasonable.[34]

The directors of a company manufacturing car components were held liable because they failed to ensure that their company had established an efficient production system before commencing production and caused loss by paying wages, salaries and general overheads which were not matched by output.[35]

Directors would decidedly be liable for omitting to do what they could have done in the circumstances. Where the president of an investment company improvidently invested in companies in which he was interested and caused loss, his fellow directors were held liable because they had left the investment of the company’s funds to the president’s unfettered discretion and exercised no supervision over him.[36]

What seems to be now the leading case on director’s duty of care is the New York South Wales Court of Appeal decision in Daniels v Anderson[37] wherein it was observed that the old cases, with their notions of subjective tests and gross negligence have become outdated. “The idea that the shareholders were ultimately responsible for the unwise appointment of directors led to the duty of care, skill and diligence, which a director owed to a company being characterized as remarkably low.”[38]

One must look to see whether there are reasons of policy for saying that a director does not owe a duty of care to the company. The concept of negligence which depends ultimately upon a general public sentiment of moral wrongdoing for which the offender must pay can be adopted to measure appropriately in the given case whether the acts or omission of an entrepreneur are negligent.

The New Zealand Companies Act, imposes a new duty on the directors, not to engage in reckless trading. This expression is defined in the act as agreeing to cause or allowing conduct likely to create a substantial risk of serious loss to the company’s creditors.[39]

The director is not liable for the misapplication of a cheque properly drawn, but before a director signs a cheque he should satisfy himself that a resolution of the director or of a committee of the directors has authorized such a payment. A director is not liable for omitting to claim a debt to the company, or to enforce a liability incurred before he joined the Board.

 

3.1.5 Special Statutory Protection against Liability [S.633]-

S.633 extends special protection against a liability that may have been incurred in good faith. Where it appears to the court that the director sued, “has acted honestly and reasonably, and that having regard to all the circumstances of the case….he ought to fairly to be excused, the court may relieve him either wholly or partly from his liability on such terms as it may think fit. Three circumstances must be shown to exist. The position must be such that the person to be excused is shown to have acted honestly, secondly, reasonably, and thirdly, having regard to all the circumstances he ought fairly to be excused. In Claridge’s Patent Ashphalt Co, Re, [40] a company was formed for the production of certain compositions of cement for making roads. Owing to great increase in motor traffic there was a profitable future in making roads and it was proposed that the company should embark upon this new business. After consulting the company’s solicitors, who advised that the scheme was not ultra vires, the directors applied the company’s capital, but the new business proved a failure.

They were sued for misapplication of funds but the court granted relief.

Similarly, in a case before the Orissa High Court[41], where the annual general meeting of a company could not be held in time on account of the dissolution at the material time of the Company’s Board of Directors by a court order, the court granted relief against liability for default.

Where a statement in the prospectus was that the company had 25 years of experience in its line of business, whereas the experience was that of the partnership which was taken over by the company and the business was commenced a bit late than what was stated in the prospectus, the directors were held not guilty of misrepresentation. Relief against prosecution was granted.[42]

Relief was allowed where the directors could not hold AGMs and file annual returns, the failure being due to the takeover of the company by the Government and the matter being beyond their control.[43]

The totality of the circumstances have to be examined for considering whether relief is to be allowed or not.

 

3.1.6 Duty to attend Board Meetings

Negligence by non-attendance-

If some persons are guilty of gross non-attendance, and leave the management entirely to others, they may be guilty by this means if breaches of trust are committed by others.[44]

The defendants were directors of a trust company whose by-laws required monthly directors' meetings. A meeting was omitted because of the absence of several directors upon vacations. Losses resulted to the trust company which would have been prevented had the directors met and exercised proper supervision over certain loans. Held, that the directors are accountable to the trust company for such losses.[45]



3.2 Fiduciary Duties

The common law, the Quebec Civil Code and corporate statutes impose duties on corporate directors. One of these is a fiduciary duty for directors not to place themselves in a position where their duty to act in the best interests of the corporation conflicts with their personal interests. This principle has been adopted by the Indian Courts wherein the directors are required to act in the best interests of the company. They should not act in a way which could result in a conflict between their own interests and those of the company. Should such a conflict arise the director should make full disclosure to and, in certain circumstances, obtain the approval of the shareholders in general meeting. If this is not done, any profits made by the director in breach of his fiduciary duty will be held on trust for the company, and are recoverable by it.[46]

By virtue of his position a company director will have control over the company's assets, so a director could also be in breach of his fiduciary duty if:

(a) he uses for his own benefit information which he acquires in his capacity as director;
(b) if he disposes of corporate assets at an undervalue for purposes other than for the benefit of the company;
(c) if he diverts contracts to himself which had been offered to the company. Again there will usually be a liability to account to the company for any gain or, as the case may be, to indemnify it against any loss.

3.2.1 Liability for Breach of Trust-

Traditionally, the duties of directors fashioned out of common law as developed through the cases.[47]

Good faith requires that all their endeavors must be directed to the benefit of the company. Thus where a director of a company, being also the member of another company, earned business from the other company by providing some business facility  of his company, he was held liable to account for such profits, although the company had itself not lost anything and also could not have earned the bonus.[48] Where a director was aware of the fact that the company’s property was being sold for ₤350,000 when its real value stood at ₤650,000, this was a breach of the fiduciary duty.

 

3.2.2 Business Opportunities-

A Director should not exploit his own use the corporate opportunities. In Cook v. Deeks[49] the directors of a company diverted a contract opportunity of the company to themselves and by their votes as holders of three-fourth majority resolved that the company had no interest in the contract. It was held that the benefits of the contract belonged in equity to the company and the directors could not validly use their voting power to vest it in themselves.

On the same principle, where a director is instructed to purchase some property for the company, and he purchases the same for himself and then sell it to the company at a profit, he is clearly liable to account for the profit so made. As he was under an obligation to acquire the property for the company, the belonged in equity to the company from the moment he purchased it and could not have made a profit on its resale.

Supposing now he is not under any direction to purchase the property for the company, but purchases the property on his own account which is subsequently sold to the company at a profit. The Judicial Committee in Burland v. Earle[50] answered that the company is entitled to claim for the profit.[51]

A similar case in Thomas Marshall (Exports) Ltd v. Guinle[52], a company was importing foreign goods for resale in U.K. Its managing director formed a new import company and solicited orders on its behalf from the U.K. buyers. He imported goods from those very firms with whom he had established contact while acting for the company. He was restrained from this course of conduct. It was breach of service contract and also of the fiduciary duty.

In Fine Industrial Commodities Ltd v. Powling[53] the demand for the company’s product had fallen. The director of the company knew of an alternative product for which there was demand and he also knew of the modification of the company’s plant and machinery which was necessary for that purpose. But, instead of doing that, he created a new company and obtained a patent of the new product in the name of his new company. He was held accountable for the profits. His knowledge of the product in demand and of the fact that the company’s plant and machinery could be modified for that purpose was considered by the court to be company’s knowledge.

Another parallel case is Cranleigh Precision Engineering Ltd v. Bryant[54], a director after resigning from directorship, formed a company with another person and embarked upon manufacturing a product which embodied his own earlier invention made by him while working for the company. He and his company were restrained from doing so.

 

3.2.3 When Director may make personal use of company’s opportunity-

“Where the corporation is insolvent and defunct, its officers are free to act for themselves, since such condition is ascertainable and not easily feigned. Where the opportunity is outside the scope of corporate business, or where the corporation has shown no interest in the property, an officer may buy for himself.”[55]

 

3.2.4 Position on cessation of Directorship-

Industrial Development Consultants ltd v. Cooley[56], the Managing Director tried to get from the Gas Board a Government contract for the company. But the Gas Board plainly told him that the Government will not allow the contract to the company, but was willing to deal with him personally. He therefore, reigned from the company under the pretence of ill-health and then promptly obtained the contract for himself. Having earned a handsome profit, he had to face an action from the company to account for it.

The court held that the managing director had acted in breach of his duty and therefore, must account for it because the company grealt desired the contract and employed Cooley only in a bid to obtain it.

In contrast to this, in Peso Silver Mines case[57], a new venture was offered to the company and its directors bona fide come to the conclusion that it is not an investment that the company ought to make, the individual directors who subsequently buy the same do not violate any duty to the company even though they have consulted the company’s geologist. The directors here in good faith had rejected the opportunity to acquire the adjacent mines and then some directors used the opportunity.

 

3.2.5 Competition by Directors-

There is no breach of duty if a director competes with his company or olds some interest in the rival company or is a director in a competing company.[58] But accountability will chase a director if he uses the company’s assets for the benefit of the rival concern and this includes its business connection, goodwill, trade assets and the list of customers.[59]

If a company had given special training to a director, he may be restrained by the company from using those special skills for the benefit of the rival company.[60]

 

3.2.6 Trading in Corporate Control –

“A director who acquires property while in office will, however, be liable to account for his profit upon resale if two elements are present. He must have acquired property only by reason of the fact that he was a director and in the course of the exercise of the office of director.”[61]

 

3.2.7 Misuse of Corporate Information-

Exploitation of unpublished and confidential information belonging to the company is a breach of duty and the company can ask the director in question to make good its loss, if any. Any knowledge or information generated by the company is the property of the company, commonly known as intellectual property. Turn over of business, profit margins, list of customers, future plans, any personal use of such knowledge is equivalent to misappropriation of property.[62] Use of such information can be restrained by means of an injunction.[63] Any gain made by the use of inside information has to be accounted for to the company.

 

3.2.7.1 SEBI (Insider Trading) Regulations, 1992-

The Securities and Exchange Board of India has formulated  Regulations for preventing  and punishing the use of price sensitive  unpublished inside information in dealings with the company’s securities.

Directors dealing with their own company’s shares is not illegal. It is considered desirable that the directors of listed companies should hold the shares of their companies. As apart the remuneration package, directors are often given share options which enable them to acquire shares in their company, which they may afterwards sell. When director decide to sell their shares however acquired or to buy more shares, their trading comes to be governed by the legislation on insider trading.. “If the director has access to unpublished price sensitive information, such as information on future earnings, figures, security issues, assets disposal and purchases, etc., which if it were made public would have a significant effect on the share prices, it is illegal for them to trade on such information.”[64]

 

 

3.3. Tortious Liability of Directors: -

Directors as such are not liable for the torts or civil wrongs of their company. To make a person liable for a tort, e.g. for negligence, trespass, nuisance or defamation it must be shown that he was himself the wrongdoer or that he was the employer or principal of the wrongdoer in relation to the act complained of, or that the tort was committed on his instructions.[65]

 

 

3.4. Statutory Liability: -
3.4.1 Misleading Prospectus-                
A director is liable to compensate a person who has subscribed shares on the faith of a prospectus, which contained untrue statement. The Director should compensate every such subscriber for any loss or damage he may have sustained by reason of such untrue statement in an action in tort and also under section 62 of the Act to pay compensate. If the Director discovers a mistake in the prospectus, it is his duty to specifically point it out. The Director may also have to face criminal prosecution for untrue statement in the prospectus. He may be imprisoned for two years and fined Rs.5000.

3.4.2 Inducement to invest-
The Directors are liable to criminal prosecution for inducing or attempting to induce a person by statement or even forecast which is false or misleading to enter into or to offer to enter into any agreement to buy shares of the company. They shall be punishable with imprisonment for a term which may extend to five years, or with fine which may extend to Rs.10,000, or with both.

3.4.3 Maintenance of proper books of accounts: -
Where directors manage a company then each director shall be responsible (if there is no managing director) that the company should maintain and keep proper books of account. Default or non-compliance will make the Director punishable with imprisonment for a term not exceeding six months or fine of Rs.100 or both. In the event of winding up, failing to keep proper accounts will make him punishable with one-year imprisonment and for falsification of book imprisonment for eight years.


3.4. Liability for Unauthorised Contracts
Whatever the extent to which either the company's Memorandum and Articles of Association or resolutions of the shareholders may seek to impose limitations on a director's powers, the directors can bind the company, or authorise others to do so, by entering into a contract with a bona fide third party.

The contract will (almost always) be binding on the company. To balance this, the directors may be held personally liable for any loss caused to the company as a result of the unauthorised transaction. The directors' actions can be ratified by a separate, special resolution of the shareholders, which will relieve the directors from liability.

If a director is actually a party or associated with a party to a contract with the company, and the directors have exceeded their powers, the company can avoid the contract, and require the director to account for his gain or indemnify the company for any loss it has suffered. Any director who authorised the transaction (whether or not a party to the contract) will be so liable.

 

 

3.5 Liability of Directors for Corporate Trustees for Breach of Trust

In First Trust Co. of Lincoln v. Carlsen[66], the defendants were officers and directors of the Lincoln Trust Company, which was acting as trustee for the holders of certain bonds secured by a mortgage.  Among other things, the trust instrument provided that the Trust Company should foreclose when­ever a breach of the conditions of the mortgage should occur. The mort­gagors defaulted on interest payments, but the Trust Company never­theless advanced the amount of the interest to the bondholders without notifying them that the mortgagors had defaulted, the concealment being apparently for the purpose of maintaining the market value of the bonds. In an action brought by the successor trustee against the officers of the original trustee (the original trustee itself being insol­vent), heldy defendants were liable for damages for breach of trust in not foreclosing the mortgage and in not giving notice of the default.

The instant case presents a problem worthy of consideration in view of the growing use of corporations as trustees. A natural person acting as trustee is normally expected to perform the duties of the trust him­self, and the law has placed rather stringent limitations upon any dele­gation of his duties.1 But in the case of the corporate trustee, it is obvious that all duties must be performed by the agents of the corporation. Thus, although there are problems as to liability of the agent where a natural person is permitted to delegate some of his duties as trustee, these problems become more acute in the case of a corporate trustee.

It might be well to begin the discussion of the liability of officers of a corporate trustee with a consideration of some fundamental principles of agency. It is well recognized that in a tort action an agent cannot set up his agency as a defense, as his principal cannot authorize him to do a tortious act. The agent will, therefore, be held liable whether or not his principal did in fact direct him to do the act. In case he did the act at the command of the principal, or in the ordinary course of his employment, the principal will be held liable along with the agent. But where the agent is acting outside the scope of his authority, and the principal used due care in the selection of his agent, the principal will not be held liable. The question then arises as to how these principles fit in with the corporate trustee picture. In the first place, it is important to note that an officer of a corporation is something more than an agent.

It has been said that when a corporation is acting through an officer, such officer "acts directly and in chief, and not by delegation."  A fed­eral judge has described the officers as "the moving force itself of the corporation."  However that may be, the officers of a corporation occupy the position of agents so far as third parties are concerned, and may in general be treated as agents for the purpose of this discussion. It would seem, then, that the ordinary liabilities of an agent will attach to the officers of a corporation.

But added to the ordinary liabilities of an agent there are certain other claims of liability that arise by virtue of the fact that the agents here are not only corporate officers and therefore a very special kind of agent, but also are agents of a trustee. Since a trust relationship is involved here, there are certain duties of the corporation to the bene­ficiaries of the trust, for breach of which the corporation will be held liable.9 But are the officers as individuals liable for the corporate act?

We may start with the maxim of trust law that all who participate in a breach of trust are liable therefore. Since a corporation is an in­tangible being, it is inconceivable that it can act otherwise than through some human being. The acts of a corporate trustee, then, are those which its officers and directors say shall be the acts of the corporation. Thus, when the corporation converts to its own use funds held in trust by it or commits some other act in breach of trust, it must have done so because its officers and directors have so determined. Since the breach could not have occurred except through their connivance, it follows that the officers and directors have participated in a breach of trust, and are therefore liable under the aforesaid rule of trust law imposing liability upon those who so participate. Such is the rationale of the rule of lia­bility of officers and directors of a corporate trustee, as shown by the decided cases.

The action of the officers in advancing the corporation's money to the bondholders with the purpose of deceiving them was affirmative and willful and in utter disregard of the interests of the bondholders.

The court has found in the instant case that the defendants acted fraudulently, that the purpose of their act was to promote the selfish interests of the corporation by maintaining a market for its bonds.

But from the authorities it would appear that the defendants would have been liable even if they had acted without fraudulent intent. Such is the direct holding of the Kansas court in Sweet v. Montfelier Savings Bank &Trust Co. In that case the trust company collected a note and

mortgage for the plaintiff and retained the amount so collected as a part of its own funds, using the money for its own purposes. The defendants, officers of the trust company, offered as a defense that they did not intend to keep the funds permanently for the use of the corporation, but intended to return them on demand, and they excepted to an instruction which failed to present to the jury the question of intent to defraud. [67]

 

Thus far the discussion has been confined to cases where the breach of trust by the corporation was committed through the connivance of the officers. What, then, is the liability of the officers if they do not actually participate in the breach of trust?

 

Suppose the officers know of a breach of trust by the corporation, but do not actually take part in it. Or suppose they know nothing about the breach, but could have discovered it had they exercised ordinary diligence. Or suppose they did not know about the breach and could not have discovered it even in the exercise of ordinary diligence. The Kansas court, in the first hearing of Sweet v. Montpelier Savings Bank & Trust Co.[68], went into some detail in discussion of these problems. In that case the instruction was given that if subordinate employees committed acts of conversion of trust funds, the officers would be held personally liable, even in the absence of actual knowledge of the misappropriation, on the theory that they could have ascertained the fact of this misappropriation by the exercise of ordinary diligence. This instruction was held to be error. The court admitted that the officers would be liable for the conversion if the subordinate employees misappropriated with the knowledge of the officers, but re­fused to extend the rule to make the officers liable for mere negligence.

As to misappropriation with the knowledge of the officers, it is clear that the court was correct in holding that the officers should be liable. In principle, this situation is indistinguishable from actual participation by the officers. If the basis of the rule of liability is participation in breach of trust, it might be argued that the officers, not having partici­pated, are therefore not liable. Such argument, however, loses sight of the basic consideration that the officers are in direct control of the cor­poration. The corporation, in this situation, is sitting idly by and watch­ing funds held by it in trust be converted by its agents.

The officers had not actually, affirmatively, participated in the breach of trust, but having knowledge of the conversion and being in a position to prevent it, by virtue of their dominating position in the corporation, they may be deemed, by their failure to prevent the conversion, to have consented to it. They have given their consent to an unlawful act, to which they have no authority to consent. It is but one more step, then, to say that they are deemed to have participated in the breach.[69]

From an examination of the cases, then, these conclusions may be drawn as to the liability of officers of a corporate trustee for breach of trust: (i) for a willful breach to the use of the corporation the officers are clearly liable, on a basis of participation in breach of trust, and because of their dominant position of control over the trustee corpora­tion; (2) their liability is not restricted merely to cases of misappro­priation of trust funds, but extends to all acts ordinarily treated as breaches of trust; (3) that the officers did not intend to defraud the
cestui que trust is not a defence; (4) that a breach by other officers or employees with the knowledge of the defendant officers imposes the same liability upon the defendants as a breach in which they willfully participate; (5) that a breach by other officers or employees which is unknown to defendant officers but could have been discovered and pre­vented by due diligence may in some states impose liability upon the officers, but in the majority of states does not; (6) that a breach by other officers or employees unknown to defendant officers and which they could not have prevented by due diligence will not impose liability
upon the officers.



3.6. Other Forms of Liability
A director may incur personal liability towards the company if:

(a) he acquires non-cash assets of the company or the company acquires such assets from him (exceeding in value either £100,000 or the equivalent of 10% of the company's assets), without also obtaining the approval of the shareholders. The contract may be set aside, and the company may recover any of its loss, or his gain, from the director;

(b) the company of which he is a director makes a loan to him (which is generally prohibited, although there are some exceptions). The transaction will be voidable and, again, the company may recover any of its loss or his gain (if any, arising out of any transaction for which the loan was used) from the director;

(c) the company makes a payment by way of compensation to a director for loss of office without details of it being disclosed to and approved by the shareholders. The payment is unlawful, and as such can be recovered from the director;

(d) a payment is made to him (by the company or some third party) on the transfer of the whole or any part of its undertaking by way of compensation for loss of office or in consideration of his retirement, again without shareholder approval. The payment is held on trust for the company and as such can be recovered from him.

3.6.1 Personal Liability of Directors for Corporate Mismanagement

The theory behind the imposition of directors’ personal liability is that the risk of being found liable will make directors more attentive to their legal obligations in managing the corporation. It is felt directors will be prompted to become more active in monitoring corporate compliance with the statutory requirements. Moreover, where a corporation has violated a statutory requirement, the liability of directors provides a means of punishing that violation.

The directors of a company incur a personal liability in the following circumstances:

Express liability will usually arise only when a director has personally guaranteed the performance of a contract. Implied liability will arise when a director signs a contract for the Company or mentioning the name but failing to add the vital word "limited" or its abbreviation. This rule rests on the ordinary principle of agency that where an agent enters into a contract without disclosing that he is acting as agent he accepts personal liability. In the case of Penrose v. Martyr a bill was addressed to a company and omitted the word "Limited" in describing it. The defendant (Secretary to the Co.) signed the acceptance and was held to be personally liable by the Court of Exchequer Chamber.

 

The extent to which a personal responsibility will be im­posed upon directors is a matter of vital importance to the prospective director, the courts, and the investing public.

Directors are liable for fraud or gross dereliction of duty is an obvious consequence of the quasi trusteeship as­sumed. It is, however, in those "twilight zone" cases, where directors, being guilty of no fraud or gross negligence, have wrecked the corporation through their honest but reckless and, from a business standpoint, absurd mistakes of judgment that courts have divided.

The leading case in America on the liability of directors for mismanagement is Spering's Appeal, in which the opinion is by Justice Sharswood. In that case the financial depression after the Civil War, caused the failure of the National Safety Insurance Trust Company, a Philadelphia bank. The directors, in their effort to save the institution consumed the funds of the company in reckless and improvident investments; loans were made at usurious rates of interest in anticipation of large profits; collateral was sacrificed in a vain attempt to sustain credit; and, in the failure of the directors to assign at a time when a great part of the assets could have been saved, there was a lack of that reasonable business judgment on the part of the directors on which stockholders rely. An action was brought against the directors to recover damages resulting from the improvident investments sanctioned by the board. The court denied relief holding that directors are merely gratuitous man­datories and are to be held responsible to the corporation only where their breach of trust is of such a character as to warrant the  imputation  of   fraud  or  gross  negligence  amounting  to fraud.[71]

In Spering's Appeal, so long as the directors act in good faith, and within the scope of their authority, they cannot be held responsible to the corporation "for honest mistakes of judgment no matter how reckless and absurd, when measured by the standard of reason­able prudence and ordinary business judgment.

The case of Hun v. Cary[72] stands in dramatic contradiction to the rule laid down by Justice Sharswood in Spering's Appeal.

In Hun v. Cary,the trustees of an insolvent savings bank voted the purchase of an expensive lot in New York City as a site for a new bank building, hoping thereby to induce confidence in the financial standing of the institution and increase its deposits. The in­solvent condition of the bank was known to the trustees at the time of the purchase, but there was no suggestion of bad faith on the part of the trustees, their purpose in making the purchase being the mistaken belief as to what constituted the best inter­ests of the corporation. The charter empowered the corpora­tion to purchase a lot requisite for the transaction of the bank­ing business. The purchase was intra vires.

The court held that the facts justified a finding that the case was not one of mere error or mistake of judgment on the part of the trustees, but of improvident and reckless extravagance and that the trustees should be held liable for the loss occasioned by such action on their part. [73]

 

In both cases the improvi­dent investment was made in the interest of the corporation; in both cases there was no suggestion of fraud; in both cases the act of the directors was within the powers conferred by the charter; but in Hun v.  Cary the court held that honest but reckless improvidence in an intra vires transaction is the foun­dation of liability

In both cases the improvi­dent investment was made in the interest of the corporation; in both cases there was no suggestion of fraud; in both cases the act of the directors was within the powers conferred by the charter; but in Hun v.  Cary the court held that honest but

reckless improvidence in an intra vires transaction is the foun­dation of liability

Watt's Appeal,[74]

Justice Potter speaking for the court, holding:

"Directors are trustees or quasi trustees of the capital of the company, and liable as trustees for any breach of duty with respect to the application of it. . . .

growing conception that directors occupy a fiduciary position with reference to the corporation,and that their liability is to be judged by standards applicable to express trusteeship.

Hopkins & Johnson's Appeal [75] where it was held that directors could not use their knowledge as to the solvency of the corporation to obtain a preference over other creditors, even though their debts were valid.[76]

The rule precluding a director from obtaining any advantage or secret

profit as a result of his position is fundamental.

The rule of due care, referred to in Hun v. Gary, supra, should be applied to all directorate action and should be the measure of directorate liability whether the act complained of is intra vires or ultra vires, whether affirmative action, or the reckless and absurd exercise of judgment.

 

4. Liability to Shareholders

While a director owes fiduciary duties to the company, he owes no such duty to the shareholders. He does, however, owe to the shareholders - collectively, not individually. They could be liable for improper use of corporate assets that exist for the benefit of all shareholders or for favoring one group of shareholders over another in a takeover battle.


4.1 Liability for Infringement of Personal Rights
If the directors override the rights which the company's Articles confer upon the shareholders, by causing the company to act in a manner inconsistent with those rights, they will incur a liability, in damages, to the shareholders for procuring a breach of contract.

4.2 Statutory Liabilities
A director may incur liability for losses suffered by shareholders resulting from non-compliance with legislation. Examples include

(a) where shares are issued in breach of the statutory pre-emption rights of the existing shareholders. Any director responsible will be liable to pay compensation to any person suffering a loss;

(b) where there has been a misrepresentation in a prospectus inviting subscriptions for the company's shares. Any director responsible will, again, be liable to pay compensation;

(c) if, on a takeover, a payment is made to a director (by the company or a third party) for loss of office of in consideration of his retirement, without shareholder approval, any sum received by that director will be held on trust for the former shareholders, and as such recoverable by them.

(d) for any dishonest disclosure to the shareholders before they vote on a resolution.[77]

4.3 Shareholder Derivative Suits

Securities class action suits—filed by shareholders when alleged negligence or fraud by a company's directors or officers leads to a loss of shareholder value. Suits against companies such as Enron and WorldCom have dominated the headlines, but virtually any public company can find itself targeted by disgruntled shareholders and their attorneys. a similar type of suit known as a shareholder derivative suit or derivative action. Derivative suits are filed by shareholders on behalf of a company. They allege that the company's directors or

officers violated one or more fiduciary duties owed to the company and its shareholders. Typically, plaintiffs don’t seek to extract monetary damages, but rather they seek to protect their long-term interest in the company by imposing corporate governance and management

changes. If there is a monetary recovery, it runs to the firm, not to the individual plaintiffs.

 

4.3.1 The Basis of Liability in Shareholder Derivative Actions

There are two broad categories of breach of fiduciary duty that underlie derivative actions: duty of loyalty and duty of care. Breach of duty of loyalty is typically easier to prove. Basically, duty of loyalty means that a director or officer may not profit at the expense of the company, but instead must put the company's interests first. Suits seeking relief under the duty of care theory allege that a company's directors or officers failed to manage corporate affairs honestly and in good faith. In either case, the burden is on the plaintiff to demonstrate a violation has occurred.

 

4.4.Directors Liability to Minority Shareholders

Directors who are investment bankers, venture capitalists, CEOs or CFOs should be aware that they may be called to a higher standard of “good faith” in reviewing a transaction’s economic fairness to minority holders where their financial

expertise gives them a unique ability to evaluate, and advocate against, unfair elements of the transaction.

The Delaware Court of Chancery, in its decision in the case In Re Emerging Communications, Inc.,[78] effectively raised the bar for a showing of good faith director conduct that will be sufficient to avoid director liability. The case also makes clear that a director with the financial expertise to know that a transaction is unfair may not rely on a fairness opinion alone to carry the burden of showing that the director acted in good faith.

Jeffrey Prosser indirectly held majority control of Emerging Communications, Inc. (ECM). He proposed a two-step going private transaction, resulting in a cash-out of ECM’s minority holders for $10.25 per share. Stockholders challenged the fair value of the merger in an appraisal proceeding and sought recovery based on a breach of fiduciary duty by the ECM directors. A special committee of ECM’s board had approved the transaction following limited negotiations and receipt of a fairness opinion from Houlihan Lokey Howard & Zukin (Houlihan), the committee’s financial advisor. The court reviewed the transaction for “entire fairness,” looking to the fairness of the price and whether Prosser and his affiliates had engaged in fair dealing with the committee and minority stockholders. The court determined that neither the price nor the course of dealings was fair. The court found that directors breached their duty of care and that Prosser and his affiliates, including his personal attorney (and ECM board member) John Raynor, had breached their duty of loyalty through self-dealing and failures to disclose. The court also found that ECM director Salvatore Muoio, an investment banker with “specialized expertise or knowledge” that was on par with that of Houlihan, had breached his duty of good faith because he “knew or had strong reasons to believe” that the proposed deal value was unfair, yet he failed to vote against the deal, make his concerns known to other directors on the record, or advocate that the Board reject the deal. Accordingly, the court ruled in favor of the plaintiffs in the appraisal proceeding (awarding them $38.05 per share plus interest) and found that Prosser, Raynor and Muoio were jointly and severally obligated to pay the minority stockholders approximately $77 million, representing the difference between the fair value of ECM determined by the court of $38.05 per share and the $10.25 cash-out merger price.

 

In the recent McMullin v. Beran,[79] the recognized that the Board has special obligations to minority shareholders. The court stated that, in the absence of a majority shareholder, directors considering the sale of the corporation must diligently pursue the transaction offering the best value reasonably available for all shareholders. When a sale proposal instead comes at the behest of a majority shareholder, the duty of the directors is essentially the same — i.e., value maximization for all shareholders — but with a special obligation to protect the interests of the minority shareholders. The court held that, even though ARCO’s voting power made the outcome a forgone conclusion, the Chemical directors were required to perform a full analysis of the sale to determine whether the proposal would result in maximum value for the minority shareholders.[80]

 

5. Liability to Creditors and Outsiders

5.1 Liability on Contracts
Where the directors enter into a contract on behalf of the company, in the unlikely event of the company itself not being bound by that contract, the director may incur liability to the other party.
A director may likewise be liable under a contract made by him on behalf of the company: (a) where the contract was entered into pre-incorporation, or
(b) in respect of a transaction where the company's name has not been properly disclosed on the stationery relevant to that transaction e.g a cheque.

5.2 Potential Liability of Directors for the Breach of Fiduciary Duty to Creditors
The primary duties of the directors of a solvent company are the duties of care and loyalty to the company and its shareholders. When the directors fulfill these duties, they are usually protected from personal liability. However, officers and directors of an insolvent company also owe fiduciary duties to creditors, and are under a heightened duty to maximize value in connection with the inevitable break up of the company. Although there are several different tests to determine insolvency, it is often hard to pinpoint when fiduciary duties to creditors arise. The conservative approach to complying with fiduciary duties to creditors is to assume that a company is in the zone of insolvency if there is any substantial doubt.

Once it is determined that a company is in the zone of insolvency, officers and directors are charged with a fiduciary responsibility of protecting the interests of creditors based on an "informed business judgment" standard of care. This usually involves taking appropriate actions designed to maximize payment of the company's outstanding creditors. Directors who fail to carry out this responsibility may be subject to liability for breach of fiduciary duty. For example, a claim of breach of fiduciary duty may arise when directors favor the interests of shareholders over creditors, engage in insider transactions, prefer one creditor over another creditor with an equally valid claim (make a "preferential payment"), or continue the business longer than is justified, thereby "wasting" the remaining corporate assets.

 

The directors of the A corporation, without giving notice to creditors, trans­ferred all the corporate assets to the B corporation, which contracted to pay the debts of the A corporation. Later, the plaintiff recovered a judgment against the A corporation and, execution being returned unsatisfied, brought suit against the directors. Held, that the directors are liable.[81] Directors, who have directly caused such a fraudulent conveyance without making proper provision for creditors, should be held responsible to the parties prejudiced thereby.

 

5.3 The Liability of Directors arising on Corporate Insolvency
When a company goes into insolvent liquidation a director of the company may be exposed to a risk of personal liability.

Generally, in the event of liquidation, the liquidator has a duty to realise the assets of the company, but to do this he will have to investigate the affairs of the company, including the actions of the directors. If there has been any breach of statutory duty or there have been unlawful payments such as loans or compensation, the liquidator will claim against the director.

Specifically, there are a number of provisions in the Insolvency Act 1986 which provide for the potential liability of directors, both in the period leading up to liquidation and during the liquidation itself. These include the following matters.

(a) Fraud, etc in anticipation of winding-up.
It is a criminal offence to conceal or destroy the company's property, books, records and the like within 12 months before insolvent liquidation (or up to 5 years if done with intent to defraud the creditors). The court may also order repayment, restitution or the payment of compensation by the directors;

(b) Concealment from, and failure to co-operate with, the liquidator.
It is a criminal offence not to hand over property, books, etc to the liquidator, or deliberately to make a false Statement of Affairs;

(c) Fraudulent trading.
If a liquidator proves that a company carried on its business with the intent to defraud creditors, the court may order the directors responsible to contribute to the assets of the company. This is also a criminal offence.

 

6. Criminal Liability

6.1 Generally
A director may be held criminally liable for any offence committed by the company, where he has aided, abetted, counselled, or procured the commission of the offence.

Just as individuals owe a duty not to harm or injure others in society without justification, so do companies owe a duty not to poison our water and food, not to pollute our rivers, beaches and air, not to allow their workplaces to endanger the lives and safety of their employees and the public, and not to sell commodities, or provide transport, that will kill or injure people.

On 19th July, 2005 the Supreme Court of India ordered the government to pay a remaining $325.5 million (15.03 billion rupees) due to Bhopal gas tragedy victims. The U.S. based Union Carbide Company, now owned by Dow Chemical Co., paid $470 million in compensation to victims in 1989. But distribution of most of that money was held up by bureaucratic disputes over the categorization of victims. At last on 19th July the victims or their representatives got justice 20 years after the tragedy took place.

In 2003 Supreme Court in Assistant Commissioner, Assessment-ll, Banglore & Ors. v. Velliappa Textiles Ltd & Anr. took the view that since an artificial person like a company could not be physically punished to a term of imprisonment, such a section, which makes it mandatory to impose minimum term of imprisonment, cannot apply to the case of artificial person. However, Supreme Court in 2005 in Standard Charted Bank v. Directorate Of Enforcement [82]in majority decision of 3:2 expressly overruled the Velliapa Textiles case on this issue.