Ratification of Director’s Breach of Duty: Opportunity to Evade Liability?

[Arjun Tyagi is a fourth year B.A., LL.B. (Hons.) student at National Law University Odisha.]

Directors of companies owe fiduciary and ‘statutory’ (section 166 of the Companies Act 2013) duties to the company, its employees and the shareholders. Common law principles provide ratification of breach of duty by directors, if the shareholders pass a resolution agreeing to absolve directors from liabilities arising from the breach. It is an extension of the Common law principle which provides that ‘those who owe duties, can be released from the legal obligations arising from those duties by those to whom the duties are owed’. Shareholders, hence, are vested with the powers of ratifying irregularity in running of the company, thereby absolving directors from their personal liability to the company.

The validity of any ratification by shareholders pursuant to passing of a special resolution is subject to the nature of breach of duty by the director, as not all breaches of duties can be ratified by shareholders. Firstly, the shareholders cannot ratify a breach of duty arising out of an act ultra vires the company. Secondly, in cases where the directors are the shareholders, they cannot ratify their own breach of duty. Thirdly, this process of ratification is subject to a transparent disclosure of all facts and nature of breach of duty so as to enable the shareholders to take an informed decision.

This post analyses the case of Terrascope Ventures Limited v. Securities and Exchange Board of India, wherein the Securities Appellate Tribunal (Mumbai) recently (2 June 2022) upheld the validity of shareholders’ ratification to breach the duty of care of directors. Through this analysis, the post seeks to examine the principle of ratification by tracing its prevalence in Common law jurisdictions while examining the validity and applicability of the principle vis-à-vis the Indian law.

Factual Background

Terrascope Ventures Limited, previously known as Moryo Industries Limited, undertook a preference issue of 63,50,000 shares pursuant to a special resolution passed under section 81(1A) of the Companies Act, 1956 on October 1, 2012. An extraordinary general meeting was held on the same day, and the shareholders/public were informed that the proceeds collected through the preferential issue would be utilized for: (1) capital expenditure including acquisition of companies/business, (2) funding long term working capital requirements, (3) marketing, (4) setting up of offices abroad, and, (5) for other approved corporate purposes.

Order of the Securities and Exchange Board of India

Proceeds utilized in variance with the object of the issue

SEBI conducted an investigation into the trading activities of the company from 15 January 2013 to 31 August 2014. The adjudicating authority in its order noted the proceeds received from the preferential issue were utilized in variance with the objectives stated in the notice given in the EGM and were instead employed for “purchasing shares of other companies and extending loans and advances to other companies and entities” which was in violation of regulations 3 and 4 of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003.

Violations of non-disclosure

The adjudicating officer further noticed that the company had failed to disclose the variance in utilization of the proceeds to the Stock Exchange and had thus violated obligations under section 21 of the Securities Contracts (Regulation) Act, 1956 read with clause 43 of the Listing Agreement  (which requires listed companies to furnish a statement to stock exchanges indicating the variations between projected and actual utilization of funds). Furthermore, no explanation regarding variation in proposed and actual utilization was provided in the directors’ report in the annual report of Moryo for the FYs 2012-13 and 2013-14.

Ratification by the shareholders

On 29 September 2017, the shareholders of the company passed a special resolution ratifying all the acts, deeds and things done by the Company vis-à-vis the utilization of proceeds from the preferential issue. The adjudicating officer noted that such post facto ratification of misdeeds by the company was not valid in law. The adjudicating officer noted that the utilization of proceeds, though did not result in any disproportionate gains, a penal liability still arises as provisions under the regulations are violated (penal liability is neither dependent upon the intention of parties nor gains accrued from such delay: Akriti Global Traders Ltd. v. Securities and Exchange Board of India, 2014 SCC OnLine SAT 154).

The order levied a fine of Rs. 1 crore on the company and Rs. 25 lakh each on the directors under section 15 HA of the SEBI Act, 1992 and section 23E of the Securities Contracts (Regulation) Act, 1956.

Order of The Securities Appellate Tribunal, Mumbai

The SAT in its order reversed the order by SEBI essentially holding that:

• Admittedly, the utilization of the proceeds from the preferential issue was executed in variation of the objects issued, however, the shareholders had subsequently ratified the variance. The tribunal held this post-facto ratification of breach of duty as valid in law. The tribunal in its order noted the nature of “ratification” i.e., ‘the making valid of an act already done’ (National Institute of Technology vs Pannalal Choudhury (2015) 11 SCC 669); a principle derived from the Latin maxim ‘ratihabitio mandato aequiparatur’.
• The tribunal further ordered that since the variance in the utilization of the proceeds was ratified by the shareholders, it was no longer a ‘variance’ and thus it no longer needed to be reported to the stock exchange, and did not hence violate clause 43 of the Listing Agreement.

Tracing the Principle of Ratification by Shareholders in Common Law

In most of the common law jurisdictions, the power to ratify a director’s breach of duty is statutorily provided. Section 239 of the UK Companies Act 2006 applies to the ‘ratification by a company of conduct by a director amounting to negligence, default, breach of duty or breach of trust in relation to the company’. The law requires an ordinary resolution to be passed by the shareholders to ratify such breach wherein votes of directors or ‘connected persons’ are disregarded. If members of a company ratify or approve conduct, the Australian Corporations Act 2001 (section 239(2)) provides that the court while adjudicating such ratification may refer to: (a) how well‑informed about the conduct the members were when deciding whether to ratify or approve the conduct; and (b) whether the members who ratified or approved the conduct were acting for proper purposes.

Ratification of Breach of Duty by Shareholders – Indian Perspective

The Companies Act 2013 unlike its common law counterparts, does not statutorily provide for ratification of director’s breach of duty by shareholders and thus leaves this principle in a grey area. Section 166 of the Act mentions the duties of directors; however, provides no mechanism for ratification in cases where such duties are breached. Thus, the applicability of this principle in India remains unclear. The only trace of directors being absolved from liabilities arising from their breach of duty can be found in section 463 of the Companies Act 2013, which provides Courts with the powers to grant relief in certain cases after paying heed to the prevailing circumstances.

In the case of D.R. Banaji (Dr.) v. Manilal T. Patel, the Bombay High Court held that directors cannot take recourse to ratification of their breach of duty in cases where such directors are the sole shareholders.

Conclusion and Suggestions

Most common law countries statutorily recognize power of shareholders to ratify the breach of duty of directors, thereby absolving them from corresponding liabilities. However, Indian laws are statutorily devoid of providing any such power to shareholders and only recognize power of the courts to absolve directors from their breach of duty after due regard to circumstances of the case. Since there is no statutory mention of shareholders’ power to ratify directors’ breach of duty, there lies no enabling mechanism which provides the conditions where ratification would be deemed to be legally valid.

Since India lacks a well-developed judicial recognition to the principle of ratification, strict adherence to director’s fiduciary duties must be observed. In the instant case, the directors of Terrascope Ventures Limited, apart from owing duties to their shareholders, were required to report the variance in the utilization of proceeds to the Stock Exchange pursuant to section 21 of the Securities Contracts (Regulation) Act, 1956 read with clause 43 of the Listing Agreement. The adjudicating officer appointed by SEBI had correctly held that post facto ratification by shareholders absolving the directors from their breach of duty was invalid in law.

The latest order by the Securities Appellate Tribunal, which upheld the legal validity of such ratification, proves to establish a dangerous precedent. While the company laws in other common law jurisdictions specifically provide the process and conditions where directors’ breach of duty can be ratified by shareholders, the Companies Act 2013 provides no such provision. Additionally, these countries have clearly interpreted the provisions overtime and have established the required jurisprudence vis-à-vis the conditions necessary for shareholders to approve directors’ breach of duty. Since Indian legislation lacks the necessary clarity, this lacunae in law could be exploited by errant directors, who would be encouraged to take recourse to ratification by shareholders in order to escape from possible liabilities arising out of the breach of duty of care.

Furthermore, it is important to safeguard the rights of minority shareholders (voting against ratification), in cases where the majority shareholders decide to ratify directors’ breach of duty. The practice of ratification of the breach of duty by shareholders leaves rights of disgruntled minority shareholders questionable, especially because the Companies Act 2013 remains expressly silent on the rights of such shareholders. Hence, violation of regulations by directors should be penalized without leaving a possible recourse to shareholders’ ratification.

– Arjun Tyagi