Madras High Court upholds validity of proviso to Section 167(1)(a) of the Companies Act, 2013

The Madras High Court recently upheld the constitutionality of the proviso to Section 167(1)(a) of the Companies Act, as inserted by the Companies (Amendment) Act 2017.

The order was passed by a Bench of Chief Justice AP Sahi and Justice Subramonium Prasad earlier this month, on a petition filed by a company secretary challenging this provision.

Whereas, the Bench expressed its disapproval over the petitioner repeatedly approaching the Court over the same issue, and the petitioner’s lack of locus over the case, it proceeded to examine the constitutionality of the challenged provision, while opining,

“we find it more imperative to settle the legal position rather than limit the contours of locus more so when the issued raised can be conveniently answered by devoting more time to the substance of challenge rather than its form.”

Law in question

Section 167 (1) (a) calls for directors to vacate their office in a company upon incurring disqualification as per Section 164 of the Companies Act, 2013.

Section 164 deals with the various circumstances in which a person would be disqualified from being appointed a director of a company.

Apart from several personal grounds for disqualification such as criminal conviction, mental illness etc. of the person, Section 164 (2) lays down that a director of a company would stand disqualified if the company does not file financial statements, or defaults on payment of other dues concerning debenture repayment, dividends declared etc. for a prescribed period of time.

As per Section 164 (2), the director of such a defaulting company would not eligible to be re-appointed as a director of that company or appointed in any other company for a period of five years from the date on which the said company fails to fulfil its commitments (as prescribed).

The proviso to Section 167 (1) (a) carved out that when a director is disqualified on account of the company failing to file its financial statements or it defaults on other dues prescribed under Section 164 (2), such person would have to vacate from director’s office in all other companies (in which he is director) but not the company that committed the default.

Grounds of challenge

As per the petitioner contended that this proviso violated Article 14 as it meted out an unequal treatment to directors of a defaulting company based on whether they are Directors in other companies or not.

It was argued that the proviso leads to unfair treatment to those directors who hold such posts in multiple companies.

It was also contended that the proviso irrationally has a detrimental effect on other, non-defaulting companies and that it punishes individual directors for the defaults of a company even when fault cannot be directly attributed to them.

Why the Madras High Court upheld the constitutionality of the proviso to Section 167 (1)(a)

The High Court, in turn, adverted to the reasons that prompted the legislature to introduce the proviso to Section 167 (1)(a) of the 2013 Companies Act in the first place.

It was noted that before the proviso was inserted, directors of a company who had defaulted under Section 164(2) would have to vacate their post as director of the defaulting company only.

A paradoxical situation followed, whereby a new director could also not be appointed to the company, since any director who was subsequently appointed to the defaulting company would be automatically disqualified and therefore mandated to vacate office.

The amendment ushering in the proviso followed a Law Commission Report of 2016. Consequently, the proviso was inserted in 2017 to rectify the anomaly as noted above. In view of this history, the Court explained the rationale behind introducing the challenged proviso.

“… if the post of Directorship is vacated under the provision (as it was) then, this post would remain vacant as these provisions would automatically apply to any individual subsequently appointed.

There were two solutions proposed to rectify this, firstly, it was recommended that vacancy of the office should only be acknowledged when the conditions under Section 164(1) are satisfied and not when there is liability under Section 164(2).

The second solution suggested that disqualification under Section 167(1)(a) read with Section 164(2) should be applicable only to the individual who was Director at the time of the default.”

In view of this backdrop, the Bench eventually explained that the object of inserting the proviso was to remedy the anomaly, while also ensuring that there is a deterrent provision to guard against the failure of a company to perform the duties prescribed in Section 164 (2).

In this regard, the Court records, inter alia,

“The object of inserting the proviso is to ensure that a person who is a Director in a Company that does not file its returns for a period of three years or does not return the money back to its investors or creditors does not continue as Director in other companies.

This proviso will also act as a deterrent from incorporating shell companies to park illegally obtained money. There is thus a rational nexus between the amendment and the object for which the amendment. was brought about in the Companies Act 2013. The contention of the petitioner that the proviso to Section 167(1)(a) is irrational, manifestly arbitrary and unreasonable, and thus must be declared as ultra vires Article 14 of the Constitution of India cannot be accepted."

The Court added,

“In our opinion, the legislative intent behind the inclusion of the proviso to Section 167(1)(a) is also to ensure good governance and inculcate a sense of security in investors through transparent disclosures and control over erring Directors…

A Director, irrespective of the nature of Directorship, by virtue of the fact that he holds the position of Directorship cannot claim immunity for the defaults of the company in the filing of returns or the business of the company … This Court can take judicial notice of the fact that people invest their hard earned money in companies in which there are persons of repute holding the position of a Director. The Director therefore cannot absolve himself of the misdeeds of the company after holding a position in the company."

The Court also relied on the Karnataka High Court judgment in Yahsodhara Shroff vs Union of India to support its conclusions. As observed in the Madras High Court’s order,

“… the [Karnataka High] Court has found that the proviso to Section 167(1)(a) must be interpreted in ordinary terms and would apply to the entirety of Section 164 including sub-section 2.

The Court has further held that this proviso can be justified on two grounds.

Firstly, it has been reiterated that the exclusion of Directors from vacating their posts in the defaulting company while doing so in all other companies where they hold Directorship has been done in order to prevent the anomalous situation wherein the post of Director in a company remains vacant in perpetuity owing to automatic application of Section 167(1)(a) to all newly appointed Directors.

Secondly, the underlying object behind the proviso to Section 167(1)(a) is seen to be the same as that of Section 164(2) both of which exist in the interest of transparency and probity in governance. Owing to these justifications, the Court thus holds that the proviso to Section 167(1)(a) is neither manifestly arbitrary nor does it offend any of the fundamental rights guaranteed under Part III of the Constitution of India.”

Agreeing with these observations, the Bench dismissed the petition.

“We are pursuaded to agree with the views of the Hon'ble Single Judge of the Karnataka High Court that present an accurate interpretation of the impugned law. The impugned provisions are intravires for all the reasons hereinabove. The writ petition is accordingly dismissed.”

[Read the Order]