Enforcement action or shoot at sight?

The fear of enforcement action often undermines the objective of achieving quality in corporate governance

Corporate India is heaving a sigh of relief. In emphatic iteration, the Ministry of Corporate Affairs (MCA) issued last week, a “standard operating procedure” directing that legal proceedings for non-compliance with company law must not be routinely taken up against independent directors and non-executive directors.

Titled “clarification” on prosecutions filed or adjudication proceedings initiated against such persons, the circular makes it clear that the key managerial personnel and whole-time directors who are associated with managing the day-to-day functioning of a company must be liable for defaults of a company. While one can think of this as a welcome development, to be cynical about it, the clarification is nothing but a reiteration of not just what the law always was since the 1990s, but also a reminder of what has been codified into the new company law that was passed in 2013.

That such a “clarification” is still required even when the law is clear tells a story of a breakdown in the enforcement machinery. The clarification, in fact, borrows from the language contained in a Master Circular issued in July 2011 to underline the same point. The 2011 Master Circular had reiterated a “clarification” issued in November 1998 that punishments for violations by a company must be directed at the officials in management and only when there is no identifiable official in management that directors should be looked at.

That the intermittent nine years also saw these principles being codified into law made by Parliament, without making a real difference, tells a story. The quality of enforcement is not only underlined by being able to bring to book those liable for default, but also in ensuring that those not liable are not harassed by enforcement action. When someone not responsible for a default is arrayed as an accused, precious time and resources get expended straining the enforcement budget. Worse, the fear of enforcement action regardless of having no role, results in quality human resources steering clear of directorship in corporate boards, undermining the wider objective of achieving quality in corporate governance.

Company law has long had a concept of an “officer in default”, who would be a person identified by the board of directors as a person responsible for the conduct of affairs and answerable for default. Yet, directors would be routinely proceeded against, not just by officials enforcing company law but also by other enforcement agencies under other laws.

The 2011 Master Circular brought in a concept of testing knowledge of the director “attributable to board processes” to test whether enforcement action must be taken. This requirement was adopted into Section 149(12) of the Companies Act, 2013. Essentially, a director of a company is indeed dependent on the management for what is presented to the board of directors. The board has to trust the management without second-guessing every move of the management and the key managerial personnel. If it did not follow such an approach, the company would not be able to function, with a collective board having to second-guess every decision of the management and undermine the leadership in the process. The same principle was also adopted in the regulations made by the capital market regulator to govern listed companies whose securities are listed on stock exchanges. Yet, day-in and day-out, enforcement action in the form of carpet-bombing and shooting at sight has been par for the course.

While the MCA has seen the seriousness of the issue and has “clarified” what is meant to have been clear, at least in the decade gone by, it is also vital to build awareness and state capacity with other enforcement agencies. Policemen in the state and central agencies continue to routinely line up all directors for enforcement action when something goes wrong. Judgments dealing with prayers to quash criminal proceedings initiated against all directors abound.

Directors across the board have also become vulnerable to attack in the public interest litigation jurisdiction, with many having to declare their assets, and their funds getting frozen pending probe. This month’s “clarification” has also asked the officials in the MCA to report even pending cases for internal “examination” and appropriate direction. Getting regulators and enforcement agencies outside the MCA should be the next target.