Authored by- Shivangi Maheshwari
INTRODUCTION
The present article explains the rationale behind the strict application of Section 167(1)(a) of the Companies Act, 2013 (herein referred to as ‘Companies Act’) where the director must vacate the offices in all the other companies except the defaulting company. In addition, the constitutional validity of Section 167(1)(a) and the prospective application of Section 164 and Section 167(1)(a) have been examined. There have been several cases in the High Courts, one of which is Mukut Pathak & Ors v. Union of India[1], where the directors of companies have filed a case seeking clarification with respect to the validity and application of the aforementioned Sections. The article emphasizes the goal of the lawmakers in bringing such strict provisions which were to tighten the noose of defaulters for non-filing of financial statements annually as it holds stakeholders in grave obscurity.
Section 164 of the Companies Act deals with the appointment as well as re-appointment of directors of a company. It specifies the circumstances and situations under which a person shall be disqualified, i.e., become ineligible to serve as a director of a company. Section 167 deals with the vacation of directors in which the office of a director shall become vacant in case such a person faces disqualification under Section 164.
The relevant extract of the provision under the aforesaid sections are mentioned below:
Section 164. “(2) No person who is or has been a director of a company which—
(a) has not filed financial statements or annual returns for any continuous period of three financial years, or (b)…..,
shall be eligible to be re-appointed as a director of that company or appointed in another company for a period of five years from the date on which the said company fails to do so.”
Section 167. “(1) The office of a director shall become vacant in case—
(a) he incurs any of the disqualifications specified in section 164;
[Provided that where he incurs disqualification under sub-section (2) of section 164, the office of the director shall become vacant in all the companies, other than the company which is in default under that sub-section.]”
STRICT APPLICATION OF SECTION 167(1)(A)
Section 167(1)(a) automatically applies to any person who served as the director of a company that has defaulted under Section 164(2). In principle, the directors of a company who default in filing financial statements or annual reports for three consecutive financial years have to resign as directors of all other companies except the defaulting company. The proviso to Section 167(1)(a) must be interpreted in ordinary terms and would be applicable to the whole of Section 164. The Karnataka High Court in the case of Yashodhara Shroff v. Union of India [2] based their judgment on two grounds. Firstly, to avoid the situation where the position of Director in a company remains vacant permanently due to the automatic extension of Section 167(1)(a) to all newly named directors, the directors must be prevented from vacating their positions in the defaulting company. Secondly, the main objective of the proviso to Section 167(1)(a), similar to Section 164(2), is to promote transparency and accountability of government.
A disqualified director must vacate the directorship of other companies in the interest of good governance and inculcate a sense of security in investors through transparent disclosures and control over erring Directors. Regardless of the nature of the directorship, a director cannot claim immunity for the company’s defaults in the filing of returns or the conduct of the company’s business, merely because he holds the position of a director. The director thus cannot absolve himself of the misdeeds of the company after holding a position in the company, and the subsequent removal of the director from the board of other companies is justified.Additionally, a great deal of responsibility is borne by the directors of a company since they are responsible for actions and affairs of the company which is visible to the public even superficially and have the potential to affect potential investors.
WHETHER PROVISO TO SECTION 167(1)(A) IS CONSTITUTIONALLY VALID
The proviso to Section 167(1)(a) of the Companies Act provides that where a director incurs disqualification under Section 164(2) of the Companies Act (i.e. disqualification of director of a company which inter alia has not filed its financial statements or annual returns for a period of three consecutive financial years), the office of such director shall become vacant in all the companies, other than the company which is in default. In the case of G. Vasudevan v. Union of India [3], the Hon’ble Madras High Court (“Court”) decided on the constitutionality of the proviso to Section 167(1)(a) of the Companies Act, 2013 dealing with the vacation of office of a director of a company.
The aforementioned provision was challenged by the petitioners as ultra vires Article14 and Article 19(1)(g) of the Constitution of India (“Constitution”). They claimed that the concerned proviso causes unfair treatment to the directors in multiple companies by mandating vacation of directorship in companies other than the defaulting company. It is arbitrary in nature and restricts his/her freedom to carry on business. The Court upheld the constitutionality of the concerned proviso and observed that the exclusion contemplated under the proviso to Section 167(1)(a) of the Companies Act (i.e. the director of the defaulting company continuing to be a director in such company) was introduced to prevent the anomalous situation where the post of a director remaining vacant in perpetuity owing to the automatic application of Section 167(1)(a) of the Companies Act. The Court also noted that the object of inserting the aforementioned proviso was to ensure that a person, who is a director in a company failed inter alia to file its annual returns/financials for three consecutive financial years, does not continue to be a director in other companies.
The corresponding provision to Section 167, i.e., Section 274(1)(g) of the Companies Act, 1956has been held to be constitutionally valid. The validity of the above provision was challenged in Saurashtra Cements Ltd v UOI [4], where it was held not to be ultra vires Article 14 of the Constitution of India. It was noted that the primary objective of the provision was the protection of the investors, as well as the promotion of good governance. Furthermore, the Court stated that the provision could not be regarded as unconstitutional merely because it does not provide for disqualification of directors on the grounds of failure to pay the term lenders.
WHETHER SECTION 164(2) AND SECTION 167(1)(A) HAS PROSPECTIVE APPLICATION
Given that section 164(2) became part of the Companies Act 2013 on April 1, 2014, the issue regarding its retrospective application came to the limelight. The Hon’ble Supreme Court in Pyare Lal Sharma v Managing Director and Ors[5] stated that the principles of natural justice demand that no one should be punished for actions that were not illegal on the day they were committed.
Under the 1956 Act, disqualification on the ground of non-compliance ground was limited to public companies. Even for public companies, the 1956 act did not provide for an automatic vacation of the disqualified director’s office. As a result, the retrospective application of Section 164 of the 2013 Act is applicable to only public companies.
Thus, to put it in perspective, if a company’s directors failed to file financial statements, annual returns, or to make payments against loans, debentures, or dividends in any financial year prior to April 1, 2014, the company’s directors are excluded from the ambit of this provision as it will be applicable only to future financial years (FY), i.e. the FY beginning from 1st April 2014 and not to prior FYs.
The stakeholders have expressed interest in knowing whether exemption from disqualification of directors under clause (a) of sub-section (2) of Section 164 of the Companies Act, 2013, would apply to companies who have filed Balance Sheets and Annual Returns before April 1, 2014. The Ministry of Corporate Affairs (MCA) vide circular dated October 15, 2014, clarified that disqualification under clause (a) of section 164(2) of the Companies Act, 2013 shall extend only to prospective defaults, if any, by companies that registered their balance sheets and annual returns on or after 1st April 2014 but prior to the launch of CLSS-2014.
Finally, the Delhi High Court took the stance regarding Sections 164(2) of the Companies Act, 2013 wherein a director was disqualified on account of default in filing financial statements while applying the provision retrospectively. In the landmark case of Mukut Pathak &Ors. vs Union of India &Anr.[6]. The director failed to file the financial statements for the financial years 2013-2014, 2014-2015, and 2015-2016. The Hon’ble Court observed that Section 164 (2) of the Act can apply retrospectively in case of failure for not filing returns for Financial Years prior to 2014. While aligning with the rulings of High Courts of Madras, Gujarat, and Karnataka, the Hon’ble Delhi High Court reinstated that operation of Section 164(2) in the present case and held that it does not amount to retrospective application of a penal provision.
Furthermore, when the question arose as to the provisos to Section 167(1)(a) of the Companies Act, 2013 [inserted via the Companies (Amendment) Act, 2018 w.e.f. 07.05.2018] application, the Delhi High Court stated that the directors would not be required to demit their office if he incurs disqualification under Section 164(2) for a period prior to the Companies (Amendment) Act, 2018 which came on effect from 7th May 2018. The Court, while relying on the decision of the Bombay High Court in Kaynet Finance Limited v. Verona Capital Limited [7], read down the provisions of section 167 of the Act to apply only to cases of disqualification falling under section 164(1) of the Act and not section 164(2) of the Act. Accordingly, the Court held that the petitioners would be disqualified to act as directors of the defaulting company but would not demit their post in other (non-defaulting) companies. However, if the director suffers disqualification incurred under section 164(2) on or after May 7, 2018, Section 167(1)(a) and Section 164(2) will apply strictly, and the director would be required to demit their offices in all the other company other than the defaulting company.
CONCLUSION:
The issue of disqualification of a director is very crucial as it impacts the working and management of the defaulting company along with having serious consequences for the other companies in which the person is a director. There have been various judgments of High Courts that deal with the issue of the legality of the aforementioned provisions and their applications. The Apex Court is yet to give its decision regarding the same.
FOOTNOTES:
- Mukut Pathak &Ors v. Union of India, WP. No.9088 of 2018
- Yashodhara Shroff v. Union of India (2019) SCC Online Kar 682
- G. Vasudevan v. Union of India and Ors.(WP No.32763 of 2019 and WMP No.33188 of 2019)
- Saurashtra Cements Ltd v UOI, 136 Comp. Cas. 1 (Guj.)
- Pyare Lal Sharma v Managing Director and Ors1989 AIR 1854, 1989 SCR (3) 428
- Mukut Pathak &Ors v. Union of India, WP. No.9088 of 2018
- Kaynet Finance Limited v. Verona Capital Limited (W.P.(C) 9088/2018)