“Accustomed To Act” Test Under Indian Corporate Law – An Objective Critique Of The Inherent Subjectivity

The interplay of subjectivity and objectivity in any statute lies at the core of such statute. While objectivity is the simpler, less conflicted, and more preferred attribute of any statute, there are instances where an element of subjectivity is consciously introduced by the legislature in its wisdom. Such subjectivity typically empowers the regulators to derive multiple interpretations of the relevant language in the statute, depending on the relevant facts and circumstances. Facts and circumstances form yet another crucial aspect which extensively contribute to the making, amending, or repealing of any statute. Some common examples of such subjective phraseology include terminology such as “good faith”, “public policy”, etc.

A. Objective

When a set of facts falls within the subjective grey area of a statute, it typically leads to the possibility of multiple interpretations which may lead to two or more conclusions. At this juncture, the judicial system steps in to furnish clarity by objectively determining the subjective conflict based on the relevant set of facts.

This article is aimed at objectively evaluating one such subjective phrase of a person / entity being “accustomed to act”, which has existed in the Indian company law since 1956. Briefly put, terminology on the lines of “any person in accordance with whose directions or instructions any person or entity is accustomed to act” has been extensively used in the Companies Act, 2013 (“the 2013 Act”). The language is intended to be used as an identification metric for an officer, officer who is in default, promoter, related parties, et cetera.

On a preliminary reading, the foregoing language appears to be a residual all-inclusive language to impose stringent checks and obligations on such persons in accordance with whose directions or instructions the directors of a company are accustomed to act. However, a closer look at the language reveals a larger question which is lurking in the shadows – the meaning of the term “accustomed to act” and the extent of influence that needs to be exerted by a person (“Third Person”) for a related person (“Key Person”) to be “accustomed to act” on the wishes of such Third Person. The 2013 Act simply makes a Third Person equivalent to the Key Person in terms of responsibility and liability if the “accustomed to act” relationship is met.

Illustratively, for example, a director or board of directors of a company may hire a person providing consultancy and management services for the business operations. The company may take his advice, consider it, and act on it in its wisdom. The issue of whether the board or the director is “accustomed to act” on the view of such person is a deeper issue which will need a detailed evaluation of the relationship. This article aims to evaluate and address this tricky usage of words in the statute in further detail.

B. Evolution of Jurisprudence

The terminology of one person being “accustomed to act” on the advice, directions, or instructions of the other is not new in the 2013 Act. It has been acquired from the erstwhile Companies Act, 1956 (the “1956 Act”). It is also not exclusive to company law but finds place in various other statutes including the Insolvency and Bankruptcy Code, 2016 and has been evaluated by Indian courts in multiple other contexts.

Insofar as the Indian Company Law is concerned, the terminology was first introduced, proposed, and discussed in the report of the company law committee, 1952 (the “Bhabha Committee Report”) which was a pre-cursor to the 1956 Act. The language was proposed to be relevant to check relationships between parties which were not evident such as that between a lender and the management of a company. The language was, at that time itself, dissented to by Shri Mohanlal L. Shah who estimated that the “language is vague and its import is not clear. In actual application, it would lead to a good deal of confusion resulting in disputes and litigation.” It is pertinent to note that at this stage, the Bhabha Committee Report was influenced and guided by the then existing English Companies Act, 1948 and the language was, indeed, inspired by the text of that Act.

The language was also discussed and finds place in the speech of Shri R.R. Morarka explaining the joint committee report on the bill in the Lok Sabha Debates^[1]. Shri Morarka explained the following reasons which led to the adoption of the language in the English Companies Act, 1948:

• There is a possibility of situations where there are directors who are not shareholders themselves. The real shareholders are outsiders. They merely nominate the directors. The real seat of power is somewhere else. The directors are only the nominees of the shareholders and they act only according to the wishes of the shareholders who do not come on the Board of the company, but who remain outside. These directors who are only the creatures of such shareholders, carry out the wishes of the shareholders, in which case, where a liability arises, the shareholders where the power really resides escape, and the directors who are their creatures are roped in. In order that this may not happen, the section was enacted there.
• Nominee shareholdings.

Subsequent to the Bhabha Committee Report, the 1956 Act was enacted which included the language in various places in the 1956 Act. S. 7 of the 1956 Act expressly provided interpretive guidance on the language by excluding advice given in a professional capacity from the ambit of the otherwise inclusive language. The essence of the foregoing exemption is captured in the 2013 Act, more particularly sections 2(60) (definition of officer who is in default), 2(69) (definition of promoter), and 2(76) (definition of related party) thereof.

Subsequently, Report of the Commission of Inquiry on the Administration of Dalmia-Jain Companies was released which explained the concept of shadow directors and recommended more stringent compliance. The report explained that the subject language was a legislative attempt to cast responsibilities on persons who conceal their identities behind dummies but retain full control. It also evaluated the impact of such language and mentioned that the board of the relevant companies under investigation had a 'sorry state of affairs' and that the boards comprised paid employees and young and inexperienced relatives who pleased helplessness at the time of fixing responsibility. Such persons termed themselves as nominee / dummy / benamidar directors who were there on the board to actually only carry out the directions of that other person.

Subsequently, after the enactment of the 1956 Act, the J.J. Irani Report of the Expert Committee on Company Law in 2005 (the “Irani Committee Report”) again reflected on the subject language. The Irani Committee Report, while discussing the aspect of interested shareholders, evaluated the term “accustomed to act” to address situation where low-level employees or unexperienced relatives of shareholders find their way into the boards, with 'shadow directors' pulling strings and acting as real decision makers. The Irani Committee Report further mentioned that shadow directors are persons who tend to operate from behind the scenes by adopting a framework of attributability of directions to such persons, if the board is accustomed to act on their instructions in any or all matters.

Subsequently, the 2013 Act in its current form was enacted after the relevant language was revisited and re-interpreted in view of changing times and circumstances. In view of the above, the intention behind the ambiguous phraseology is to have the ability to hold responsible those persons who truly control the company and can pull the strings by appointing as directors their own puppets or subservient.

C. “Accustomed to Act” – How to interpret?

While the legislative and jurisprudential evolution of the “accustomed to act” trigger throws significant light on the meaning and intent behind the broad and undoubtedly ambiguous phraseology, it still leaves an interpretational challenge as to who can and who cannot fall within this ambit. This is because in different set of facts, the same person may or may not be held to be “accustomed to act”. There is no clear answer but there are various precedents, both Indian and foreign, which can be evaluated to curate an indicative guidance on good corporate governance and practice.

An evaluation of the existing jurisprudence and precedents conclusively indicates that the intention behind the “accustomed to act” trigger is the ability to identify, and to allocate responsibility upon, shadow directors. Although the term “shadow directors” does not find place in the Indian statute, the concept has been read into the statute by Indian courts through reliance on the “accustomed to act” language, particularly in the context of the definition of “officer in default”.^[2] An interesting aspect is the exemption of actions done in a “professional capacity”. The exception however, usually, applies to well defined professional relationships such as chartered accountants, company secretaries, and lawyers and would not typically extend to other relationships which may be camouflaged in the name of professional capacity. The term 'shadow directors' has been the subject matter of detailed judicial analysis, key parameters of which are set out as follows:

• Shadow directors are those, other than professional advisors, with real influence over the whole field of the company's affairs and corporate activities. The concept of “direction” and “instruction” do not exclude the concept of “advice”.^[3]
• A shadow director need not necessarily be an individual but it also may be a body corporate, such as holding companies in relation to directors of subsidiaries.^[4]
• In order to establish whether a person is a shadow director, it must be shown that the directors did not exercise any discretion or judgment of their own but acted in accordance with the directions of the alleged shadow director.^[5]
• Shadow directors may qualify as promoters under the 2013 Act if they have an instrumentality in formulation of plan, policy or decision making of the company. The foregoing test is directly linked to the definition and concept of control. The definition of control is an inclusive definition which sets forth the following parameters to be applied to each case: (i) right to appoint a majority of directors; (ii) right to control the management; and / or (iii) right to control policy decisions. Such parameters can accrue to a person or group of persons in the following ways: (a) shareholding; (b) management rights; (c) shareholders' agreements; (d) voting agreements; or (e) in any other manner. The question of 'control' is a mixed question of law and fact.^[6]

Having set out broad descriptive contours of the meaning of shadow directors who may well qualify as directors by virtue of the “accustomed to act” relationship, set out below is a glimpse of how the subjective concept has been objectively applied by courts of law:

D. Concluding Analysis

Upon a perusal of the above analysis, it is settled that whether a person is “accustomed to act” under the 2013 Act is a mixed question of law and fact. In view of inherent subjectivity in the language, the surrounding factual matrix is the most sensitive and important criterion for body corporates. The facts are none other than the affairs of the company, as determined and conducted by the persons in control, whether actual or constructive and direct or indirect. Although the 2013 Act has objectively described the terms “control” and “related party” in all other aspects such that it is free from ambiguity, the specific element of being “accustomed to act” has been left subjective. While risk of this grey area may be practically challenging to bridge completely for both boards and the shadow directors, if any, a cautious and informed approach towards corporate governance and compliance can undoubtedly assist boards in reducing and managing the risk. Some examples of such good corporate governance policies and practices are as follows:

• ensuring that all corporate relationships are contractually well documented on an arm's length basis;
• periodic financial, compliance and legal audit of all relevant corporate relationships;
• transparent and streamlined procedure to procure active and informed participation of the board in decision making;
• adoption of an incentive-based whistleblower policy to identify any leakage;
• periodic consented background checks on the members of the board to generally identify persons influencing the board members in exercise of their decision-making rights;
• avoidance of complex transaction structures which mirror control like relationships such as indirect influence on decision making; and
• internal control and risk management processes for approval of any suspect transactions such as related party transactions, monetary transactions without any written agreement, transactions which do not appear to be in the ordinary course of business such as lending or borrowing of unusually high amounts, complex structures involving convoluted flow of funds or shares amongst multiple parties, etc.

Having said that, any corporate policy or decision aimed at managing the “accustomed to act” trigger should always be inspired by the legal intent. An ideal objective could be to ensure that there are no shadow directors and if there are, then such shadow directors are informed and aware of them being as responsible as actual directors. Implementation of robust corporate strategy would help boards in efficiently rowing the corporate boat amidst troubled waters giving refuge to shadow directors on whose whims and fancies the actual director(s) may be “accustomed to act”.

Views are personal.