Nov 22, 2019

Director Disqualification – An insight into Delhi High Court Judgement

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The disqualification in case of the directors of private companies under the Companies Act, 2013 (Act) has become one of the most controversial debate throughout the Country. In fact, the Madras, Gujarat and Karnataka High Courts have given a unanimous opinion that Section 164(2) applies prospectively and thus, for the financial year 31.03.2014 in case of private companies, no default on part of these directors would be triggered under Section 164(2) of the Act. Also, the Bombay High Court also passed an interim order in favour of the Petitioners for staying the disqualification.

Post the decision of the Bombay High Court, an appeal was preferred before the Hon’ble Supreme Court and the matter is pending as on date. In the meanwhile, the Delhi High Court on November 4, 2019 (Judgment) in the batch matters of disqualification of directors took a different view as that of other High Courts and held that Section 164(2) of the Act operates prospectively but such operation would entail taking into account failure to file the financial statements pertaining to financial year ending 31.03.2014 on or before 30.10.2014. Various other concerns with respect to principles of natural justice, vacation of office, etc. have been explained in the said Judgment.

The disqualification incurred under Section 164(2) of the Act for default on the part of concerned companies in filing the annual returns and financial statements for the financial years 2012-2014, 2013-2015 and 2014-2016 for which 3 lists were published by the Ministry of Corporate Affairs (Ministry) on its website, subsequently the Director Identification Number (DIN) and Digital Signature Certificates (DSC) of these disqualified directors were deactivated by the Ministry.

The Petitioners in the batch matters raised various contentions which were broadly divided into four categories—

  1. Firstly no opportunity to be heard or show cause notice was issued to the petitioners being in violation of principles of natural justice.
  2. Secondly, provisions of Section 164 of the Act, being penal in nature, could not be applied retrospectively.
  3. Thirdly, question on interpretation of Section 164(2)(a) as default arises in filing annual returns and financial statements for a period of three consecutive years only.
  4. Fourth, the defaults under Section 164(2) result in the directors being disqualified from being appointed/re-appointed as directors but does not result in them demitting office as a director.

In the said Judgment, the Court also clarified that the controversy involved in the present petition is limited to interpreting the provisions of Section 164(2) and Section 167(1)(a) of the Act and does not challenge the constitutional vires.

The Court framed a number of questions in order to clarify the controversies with explanations as recapitulated herein—

  1. Whether the provisions of Section 164(2)(a) are retrospective?
  2. Mainly the concerns were raised with respect to private companies, as Section 274(1)(g) of the Companies Act, 1956 (similar to the provisions of Section 164 of the Act) was applicable to public companies only, whereas, after introduction of Section 164 of the Act with effect from 01.04.2014 became applicable on private companies as well.

    Considering the change in law, the question of default in relation to the financial year 2013-2014 under Section 164(2)(a) (came into force on 01.04.2014) remained perplexed.

    The Judgment referred to various cases explaining the retrospective operation of a law, the driving observation specifically drawn from the case of Queen v. The Inhabitants of St. Mary, Whitechapel: (1848) 12 QB 120, wherein the Court had observed as follows—

    the statute which is in direct operation prospective cannot be properly called a retrospective statute because a part of the requisites for that action is drawn from the time antecedents to its passing.

    The question whether a law is retrospective has to be viewed in the context whether it divests a person of accrued rights, or creates new obligations, or attaches a disability in respect of transactions or actions done in the past.

    Keeping the above in view, it is also observed that even though the financial year ending 31.03.2014 had ended prior to Section 164 of the Act coming into force but the provisions related to holding of AGM, filing of financial statements and annual return with the ROC were into effect and in case of default of any such provisions, the penal provisions provided under the Act became applicable . There is no reason for excluding such default for the purposes of considering defaults in respect of three financial years as contemplated under Section 164(2) of the Act.

    Plainly, a director cannot contend that he had acquired a vested right not to be penalised for this default as it pertains to filing returns for a financial year that had closed prior to Section 164 of the Act coming into force.

    Relying on the principle that only because an enactment draws on events that are antecedent to its coming in force does not render the said enactment retrospective, it is inferred that merely because the returns pertain to a period prior to 01.04.2014 is of no relevance considering that the default in doing so has occurred after the provisions of Section 164 of the Act had become applicable.

    Basis the above observations, it is concluded that disqualification of directors premised on the defaults committed prior to Section 164 came into force could not be sustained pertaining to the financial year 2011-12 and 2012-13 as the financial statements/ annual returns were to be filed prior to 01.04.2014, whereas for financial year 2013-14 even though the Section 164(2) being prospective in its operation would entail taking into account failure to file the financial statements pertaining to the financial year ending 31.03.2014 on or before 30.10.2014.

    As stated in the preamble herein above, the Hon’ble High Courts of Karnataka, Gujarat and Madras in  Yashodhara Shroff v. Union of India: W.P. No. 52911/2017 and connected matters, Bhagavan Das Dhananjaya Das v. Union of India and Ors.: W.P. Nos. 25455/2018 and other connected matters and Gaurang Balvantlal Shah v. Union of India: Manu/GJ/1278/2018, have held that default on account of non-filing of financial statements, annual return for financial year 2013-14 cannot be considered for determining whether a director had incurred the disqualification under Section 164(2) of the Act.

  3. Whether a prior notice and an opportunity of being heard was required to be afforded to the petitioners before including their names in the impugned list and whether the impugned list is void as being violative of principles of natural justice?
  4. As the disqualification of a director has grave consequences, the questions of principle of natural justice and opportunity of being heard arose in the present batch matters since the disqualification triggers immediately on happening of the events covered under the Section 164(2) of the Act without any action/ requisite on part of the Ministry.

    The Court observed that in Union of India v. J.N. Sinha: (1970) 2 SCC 458, the Hon’ble Supreme Court had observed that the rules of natural justice do not supplant the law but supplement it. It is trite law that parties whose rights and interests are likely to be affected adversely, must be provided an opportunity of representing his case. Such a requirement is may be accepted as an intrinsic part of fair procedure. However, the principles of natural justice are only meant to supplement the law, they are read as a part of the decision making process only in cases where such principles are not excluded expressly or by necessary implication.

    The question whether such principles are required to be read into any law must be considered in the context of the basic scheme of that statutory provision.

    In this regard, the Court upon referring to various judgments dealing with applicability of principle of natural justice in context of the procedural fairness answered the applicability of the audi alteram partem1 rule under the provisions of Section 164 (2) of the Act. The following is observed by the Court—

      “65………. Section 164 (2) of the Act merely sets out the conditions, which if not complied with would disqualify an individual a person from being reappointed or appointed as a director. To put it in a converse manner, the said sections sets out a qualifying criterion for directors to be appointed or re-appointed, in negative terms. This provision does not entail any decision-making process on the part of the Authorities administering the Act. No Authority is required to exercise any discretion or take any judicial or quasi-judicial decision regarding disqualification of a director. The Authority is also not required to pass any order disqualifying an individual. Clearly, in these circumstances, the rule of audi alteram partem would be inapplicable. As noticed above, such rules are meant to supplement the law to ensure procedural fairness. Such principles are also to be followed while taking administrative decisions to ensure fairness in action……..”

    In light of the above, the Court held that principles of audi alteram partem are not applicable given the nature of the provisions of Section 164(2) of the Act. However, on assuming that disqualifying a director entails an administrative decision for which a qualitative decision is to be taken, the rule of affording a prior hearing cannot be readily inferred as a part of Section 164(2) of the Act. This is so because the same would have the effect of obstructing and rendering the provision i.e. the immediate consequences arising therefrom as inefficient.

    Basis the above observations, the Court rejected the contention that the impugned list is void as having been published without following the principles of natural justice.

  5. Re: Interpretation of provisions of Section 164(2) of the Act.
  6. It was contended by the petitioners that where a director is disqualified to act as director of the concerned company that had committed defaults as contemplated under Section 164(2)(a) of the Act but they are not disqualified to act as a directors of companies that are not in default. It was further contended that in terms of Section 164(2) of the Act, a director of a defaulting company would not be eligible for being reappointed in that company or being appointed in any other company for a period of five years. The word ‘appointed’ and ‘re-appointed’ cannot be read as synonyms and since two separate expressions – ‘appointed’ and ‘reappointed’ – have been used by the legislature in the same statutory provision, the same must be given different meanings.

    On the strength of the aforesaid principle, it was contended that a person who has incurred the disqualification under Section 164(2) of the Act, cannot be appointed in any other company but can be re-appointed in which he is already holding the position as director.

    Considering the above contention, the court observed that no person who is or has been a director of defaulting company shall be eligible to be re-appointed as a director of ‘that company’ or appointed in any ‘other company’ and thus, the expression ‘other company’ is used to refer to all companies other than the defaulting company as specified Section 164(2) of the Act. Most importantly, it is clarified that the term appointment would include any ‘reappointment’ as well. Thus, such director will not be eligible for either appointment or re-appointment in any company including the defaulting company and companies in which he was appointed as director at the time of occurrence of default.

  7. Whether the directors incurring a disqualification under section 164(2) of the Act, would demit their office as a director in all companies in terms of section 167(1)(a) of the Act?
  8. Upon plain reading of Section 167(1)(a) of the Act indicates that a Director would demit office if he incurs the disqualification under Section 164 of the Act i.e. both under sub-section (1) and sub-section (2). Further vide Companies (Amendment) Act, 2018, the Central Government with effect from 07.05.2018, introduced a proviso to Section 167(1)(a), whereby it was provided that any director , who 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.

    It was contended by the petitioners that vacation of office as mandated under Section 167(1)(a) of the Act as it stood prior to introduction of the proviso could apply only to individuals who incurred the disqualification as specified in Section 164(1) of the Act not to those who incurred the disqualification under Section 164(2) of the Act.

    Keeping the above contention under consideration, the differentiation between Section 164(1) and 164(2) of the Act is also explained such that the conditions as set out in the former disqualify a person from being appointed as a Director are directly attributable to him/her like being of unsound mind, declared as insolvent, etc. whereas, in the latter the defaults committed by a defaulting company, which results in the directors of that company incurring the disqualification being vicariously responsible for such defaults. It is possible that a particular director may not be, in fact, directly responsible for such defaults; nonetheless, he is disqualified to act as a director on account of being responsible for the affairs of the defaulting company by virtue of his holding the office of a director.

    The court observed that any person who is or has been a director of a company, which commits the defaults as set out in clauses (a) and (b) of Sub-Section (2) of Section 164 of the Act, incurs the disqualification for being appointed/reappointed as a director. If the provisions of Section 167(1)(a) of the Act are applied in such a case, all directors of such a defaulting company would demit their office as directors immediately on incurring the disqualification under section 164(2) of the Act. In addition, such directors would also cease to be directors of any other company in which they are directors. This results in an absurd situation where a defaulting company can never appoint a director. This is so because as soon as the person– who is otherwise eligible for being appointed as a director and has not incurred any disqualification either under sub-section (1) or (2) of Section 164 of the Act – is appointed as a director of a company that has committed the defaults as stipulated in clauses (a) or (b) of Section 164(2) of the Act; he would immediately incur the said disqualification and consequently demit office of not only that company but any other company in which he is a director.

    Considering the above contentions and observations,  the Court concurring with the views of Hon’ble Bombay High Court in Kaynet Finance Limited v. Verona Capital Limited2 concluded that the petitioners would not demit their office on account of disqualifications incurred under Section 164 (2) of the Act by virtue of Section 167(1)(a) of the Act prior to the statutory amendments introduced with effect from 07.05.2018. However, if they suffer any of the disqualifications under Section 164(2) on or after 07.05.2018, the clear implication of the provisos to Section 164(2) and 167(1)(a) of the Act are that they would demit their office in all companies other than the defaulting company.

  9. Whether the act of the respondents in deactivating the DIN of the directors is sustainable?
  10. The process as required under Section 153 of the Act for obtaining DIN does not restrict a person who has been temporarily disqualified from acting as a director, to apply for DIN. Also, where a director is temporarily disqualified, he is not required to give up this identification number.

    Further, the Court observed that neither any of the provisions of the Act nor the Rules framed thereunder stipulate cancellation or deactivation of DIN on account of a director suffering a disqualification under Section 164(2) of the Act.

    Similarly, there is also no provision supporting the respondents’ action of cancelling the DSC of various directors.

    Basis the above observations, the Court concluded that the action of deactivation of DIN and DSC is unsustainable.

    Crux of the Judgment

    In finality to the discussion in the Judgment, the Court concluded as follows—

    1. Found no infirmity with the impugned list to the extent it includes the names of the petitioners as directors disqualified under Section 164(2) of the Act.
    2. Rejected the contention that the impugned list is void as having been drawn up in violation of the principles of natural justice.
    3. Although, the petitioners cannot be stated to have demitted their office as directors by virtue of Section 167(1) of the Act.
    4. The respondents directed to reactivate the DIN and DSC of the petitioners.

Conclusion
The judgment of the Single Bench of Delhi High Court is surely debatable being in contrast to the view of Bombay, Madras, Gujarat and Karnataka High Courts. The questions pertaining to the disqualification of directors will remain pending before the Hon’ble Supreme Court but for immediate action, the aggrieved petitioners may opt for preferring an appeal before the Division Bench of the Delhi High Court.

1 Meaning- ‘listen to the other side’

2 Appeal Lodging No. 318 of 2019 in Arbitration Petition No. 716 of 2019 and Notice of Motion Lodging No. 662 of 2019, decided on 09.07.2019

AUTHORED BY

Mr. Ankit Singhi

Partner & Head - Company Law Advisory

ACS,LLB

ankit@indiacp.com

+91 11 40622208

Ms. Siddhi Anand

Associate

ACS, LLB

siddhi@indiacp.com

+91 11 40622240

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