In order to address the scores of shell companies in existence, the Ministry of Corporate Affairs (MCA) introduced a range of measures in the wake of the 2017 demonetization exercise. One of them pertains to the disqualification of directors in companies that have failed to file financial statements or annual returns for a continuous period of three financial years, as prescribed under section 164(2)(a) of the Companies Act, 2013. Often, such disqualification operates as a disincentive against directors, thereby preventing them from lax monitoring that may lead to non-compliance with rules under company law. Accordingly, on 15 September 2017, the MCA published a list of 74,920 directors who were disqualified on account of failure by their companies to file their annual returns for a consecutive three-year period. Certain directors mounted a challenge, which came before a single judge of the Delhi High Court in Mukut Pathak v. Union of India. On 4 November 2019, the Court pronounced its decision on various aspects relating to disqualification of directors, which are worthy of discussion.
Whether disqualification can be retrospective
At the outset, there was no controversy on the proposition that the provisions of section 164(2) of the Companies Act, 2013 would operate prospectively. This was particularly of relevance because the erstwhile provision in the form of section 274(1) of the Companies Act, 1956 applied only to public companies, but the provision currently in operation applies to private companies as well.
However, the more specific question in this case was whether, in computing the consecutive three-year period for purposes of section 164(2) of the Companies Act, 2013, the financial year 2013-14 ending on 31 March 2014 can be taken into account. This is because the provision came into effect only on 1 April 2014. The three-year period in question was 2013-14, 2014-15 and 2015-16. The MCA’s disqualification decision incorporated the financial year 2013-14, which was technically prior to the date the statutory provision came into force. The affected directors challenged this decision. The Delhi High Court, however, came to the conclusion that, despite such interpretation by the MCA, the application of section 164(2) was nevertheless prospective in nature.
The Court’s reasoning went that even though the financial year in question relates to the period prior to the effectiveness of section 164(2) of the Act, the date when the default occurred was after the date of effectiveness because the requirement of holding an annual general meeting to consider the financial statements arises only after such date. In the Court’s words:
46. The penal consequences of not filing returns for three consecutive financial years would be attracted on section 164 of the Act coming into force. Section 164 of the Act came into force on 01.04.2014 and thus, the failure of a company/its directors to file annual returns (for three financial years) thereafter would result in the directors incurring the disqualification as specified under Section 164(2) of the Act. It is of little consequence that such defaults relate to filing annual returns that pertain to a period prior to 01.04.2014. Undisputedly, the concerned companies (and vicariously the petitioners) were obliged to file the financial statements for the financial year 2013-14 after 01.04.2014. As noticed above, the failure to do so would be in violation of Section 137(2) of the Act and this Court finds no reason why such defaults should not be considered for the purposes of Section 164 of the Act. Merely, because the returns to be filed 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.
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52. Concededly, Section 164(2) of the Act operates prospectively. However, such prospective 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. This Court is of the view that the taking into account such default does not amount to a retrospective application of Section 164 of the Act ….
The Court found that a mere reference to an antecedent event is insufficient. Consistent with its finding, the Delhi High Court refused to sustain two other lists of disqualification of directors, one that pertained to the three year periods 2012-13, 2013-14 and 2014-15 and the other 2011-12, 2012-13 and 2013-14 because these clearly related to cases where the defaults had occurred in the period prior to 1 April 2014.
In arriving at its conclusion, the Delhi High Court also disagreed with decisions of the Karnataka High Court (Yashodhara Shroff v. Union of India), Madras High Court (Bhagavan Das Dhananjaya Das v. Union of India) and Gujarat High Court (Gaurang Balvantlal Shah v. Union of India) in this regard. This conflicting positions adopted by different High Courts gives rise to a great deal of uncertainty, and it is necessary to await a pronouncement from the Supreme Court to put rest to matters.
Disqualification and the Principles of Natural Justice
The disqualification of directors generally takes two forms. In the first, a disqualification occurs automatically upon the fulfilment of certain conditions stipulated in the Act. In the second instance, disqualification arises only when a court or other authority orders the same. In such cases, the disqualification is not automatic and could potentially be contested by the affected director. Although not expressed in the above terms, a question arose in the present case as to whether the principles of natural justice ought to be applied in the case of disqualification of directors, and whether the directors need to be given an opportunity in the form of a hearing to defend themselves before the disqualification takes place.
The Court adopted the view that the principles of natural justice cannot be applied in a dogmatic fashion, and it depends upon the requirements stipulated in the relevant statutory provision. It found that, under section 164(2) of the Companies Act, there is no decision-making process on the part of any authority that requires the exercise of any discretion to determine whether an individual is to be disqualified. In that sense, in terms of the jargon set out earlier, such a disqualification is “automatic”. Hence, the Court concluded that the exclusion of the audi alteram partem rule does not result in any procedural unfairness. The requirement of a hearing cannot be readily inferred from section 164(2). Here too, there is a divergence of judicial opinion. This decision echoes the opinion expressed in Yashodhara Shroff and Gaurang Balvantlal Shah, and deviates from Bhagavan Das Dhananjaya Das, which expressed a contrary view. The Supreme Court will again have to step in to resolve the uncertainty on this count.
Appointment or Reappointment of Directors
The Delhi High Court was called upon to interpret a specific portion of section 164(2) of the Companies Act, which stipulates that a defaulting director shall not “be eligible to be re-appointed as a director of that company or appointed in other company for a period of five years from the date on which the said company fails to do so”. The disqualified directors took up the contention that this language does not preclude such directors from being appointed afresh on any other companies, since the prohibitive language in respect of other companies relates only to reappointment and not new appointments. Here, the Court simply noted that a “plain reading of Section 164(2) does not indicate this legislative intent” and that “the term appointment would include any ‘reappointment’ as well”. While it is hard to quarrel with the conclusion, the Court has not offered sufficient reasoning to support its interpretation, and dismisses the contention of the disqualified directors on the basis of legislative intent and semantics, neither of which it addressed in the required detail.
Scope of Disqualification
The next question relates to whether the directors disqualified under section 164(2) would demit office as a director in all companies where they hold such position. Here, the Court distinguished between two sub-sections of section 164. Sub-section (1) relates to instances where the disqualification arises due to circumstances that personal to the director, such as insolvency and conviction of the director of certain offences. On the other hand, sub-section (2) refers to matters pertaining to the company rather than the director, including the issue in question, viz. non-filing of financial statements and annual returns for a consecutive three-year period. In the latter circumstances, the Court observed that the disqualification applies “vicariously” as the directors may not be directly responsible for the circumstances that led to disqualification. Hence, in such cases, the functioning of directors in companies where the default has occurred remains unaffected. If not, all directors would immediately demit office in defaulting companies, which would remain without a board, something that the legislation would not have intended.
The Court also noted that that legislative amendment that took effect in 2018 added a proviso to section 164(2) stating that any director would not incur disqualification for a period of six months. However, the Court refused to accept that argument that this amendment is clarificatory in nature, and found that the proviso was not applicable to the period before it was introduced, i.e. retrospectively. It was clear that Parliament intended for directors to immediately vacate office for disqualification under circumstances personal to the director under section 164(1), but for other circumstances involving the company (where disqualification arises vicariously), the Court found that the directors “would not demit their office on account of disqualifications incurred under Section 164(2)” for the period prior to the statutory amendments in 2018. However, for the period following the amendments, the directors would demit office in all companies other than the defaulting company.
Deactivation of DIN
The disqualified directors challenged MCA’s action of deactivating their Director Identification Number (DIN). After examining the provisions of the Companies Act relating to DIN, the Court found that the purpose of the DIN was to administer the provisions of the Act in an efficient manner, and that directors need to give up their DIN merely because they have been disqualified temporarily, i.e., on a time-bound basis. The Court noted:
108. It is important to note that whereas a DIN is necessary for a person to act as a director; it is not necessary that a person who has a DIN be appointed as a director. Section 164(2) only provides for temporary disqualification for a period of five years for a person to be appointed/re-appointed as a director. Thus, it is not necessary that the DIN of such person to be deactivated.
Conclusion
In all, the decision of the Delhi High Court in Mukut Pathak follows a series of High Court decisions on the question of disqualification of directors that the MCA carried out en masse as a prong in its strategy to tackle the issue of shell companies. Clearly, the MCA action has widespread implications given that it relates to tens of thousands of directors around the country. This series of litigation calls High Courts to interpret the scheme of the Companies Act, 2013 relating to director disqualifications. As is evident from the above discussion of the Delhi High Court ruling, there is not only divergence among High Courts on key issues of interpretation, but there continue to be loose ends that perpetuates avoidable uncertainly that effects large scores of the corporate population. Ultimately, the onus is likely to fall on the Supreme Court to resolve the differences. The intervening legislative amendments have sought to address the open issues to some extent, but they too suffer from some ambiguity.
