“Accustomed To Act” Test Under Indian Corporate Law – An Objective Critique Of The Inherent Subjectivity
Objectivity is a key attribute of any legislation. The element of objectivity is critical to ensure clarity in a way that there is little or no room for more than one interpretation. That said, history is witness to a plethora of cases of ambiguities in interpretation or legal “grey areas” which have been time and again evaluated and somewhat settled by judicial...
Objectivity is a key attribute of any legislation. The element of objectivity is critical to ensure clarity in a way that there is little or no room for more than one interpretation. That said, history is witness to a plethora of cases of ambiguities in interpretation or legal “grey areas” which have been time and again evaluated and somewhat settled by judicial intervention.
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:
| Particulars of Relationship | Rationale |
| Relationships that have been adjudicated to fall within the scope of shadow directors | |
| Official position of de jure secretary but involvement in affairs of the company | The respondent was deeply and openly involved in the company's affairs from the outset, and although he had done his best to avoid being seen to act as a director, using his office as de jure secretary and his professional status as camouflage, on some very important occasions he openly acted as a director. He was adjudicated to be a de facto director.[7] |
| Related parties X and Y (X being the parent company of Y) controlled by their director, Mr. B entering complex commercial relationships with the company Z (MoU for inter corporate deposits by X and agreement to sell along with a side letter for flats by Y). Further, Mr. A (being the KMP of Z) was related to Mr. B as follows:
| The facts established a deep entanglement between X, Y and Z being the entities of Mr. A and Mr. B, and it was noted that Mr. B held positions during the relevant period which could have been used by him to guide the affairs of Z. The various transactions between Z and the entities X and Y led by Mr. B were collusive in nature. X and Y entered into allegedly simple transactions on the basis of the advice/instructions/directions of the board/directors of Z in light of the complex relationship. The extensive history demonstrating the interrelationship between the individuals associated with the entities did not support the fact that the subject transactions are purely commercial in nature. The transactions were held to be undertaken in the passive influence of Mr. A under whose directions Mr. B and accordingly X and Y were accustomed to act.[8] |
| Mr. X being the founder of the company group and 70% shareholder in the relevant companies but not appointed as a director or in any executive capacity in the companies | Mr. X, by virtue of his being the founder and majority shareholder, can be reasonably regarded as a person in accordance with whose directions or instructions, the Board of Directors of the relevant companies were accustomed to act. Mr. X can, therefore, fall within the ambit of "officer in default". Furthermore, 70% ownership or holding in relevant companies confers on him a position of control and gives him the power to direct the management policy and appoint the majority of directors to the relevant companies. |
| Relationships that have been adjudicated to not fall within the scope of shadow directors | |
| Directors of a holding company in relation to the subsidiary company | The directors of a holding company do not ipso facto become the de facto directors of the subsidiary company. Directors of holding company were not held liable for wrongful trading by the subsidiary because either of the following could not be shown: (i) the directors were the directors of the subsidiary company; or (ii) the directors of the holding company were controlling the company from behind so as to qualify as de factor or shadow directors.[9] |
| Landlord Company, with respect to a tenant company | Advise by landlord company to tenant company that the tenant's directors must attend weekly management meetings and the tenant company should decide which creditors were to be paid, was not sufficient to make the landlord company liable as a shadow director. A complete control of company's affairs would be necessary before a person could be taken to be a shadow director.[10] |
| Directors of companies which are shadow directors | Where a company was in the position of being a shadow director of another company, it was held that by that reason alone the directors of the company would not become shadow directors of the other company.[11] |
| Nominee of investor on the board | An investor is entitled to have a nominee on the board without being branded as a shadow director. To show that a person is a shadow director, it must be proved that the de jure directors followed a consistent pattern of compliance with the instructions of the alleged shadow. Evidence that directors followed a direction from an outside influence in an isolated incident would not normally suffice.[12] |
| Ex-director and majority shareholder serving and officially designated as honorary chairman emeritus of the relevant company | The concept of shadow director cannot be equated to the inputs, advices and suggestions given by the chairman emeritus upon specifically being solicited by the company. Further, the word shadow itself indicates as something done lurking behind and normally, this term is used only when foul play has taken place by the advice of somebody. Such giving of advice upon being solicited cannot be equated to an interference. Such action would not fall within the ambit of conducting the affairs of the company. Given that the chairman emeritus was a majority shareholder of the company, as long as his suggestions are not fraught with mala fides, it has to be treated as the advice and suggestions for the benefit of the company and not as an interference.[13] |
| CEO of Company B being director in Company A, in relation to Company A | It cannot be presumed that because the director is CEO of B, he is accustomed to act on advice of B's directors in respect of A. Whether certain persons are accustomed to act in a particular manner or not is something which can be shown by instances of past behaviour or other material facts and not by mere presumptions. In the instant case, not a single instance was given of the relevant director of B having acted in his capacity as a director of A pursuant to the directions given to him by the directors of B.[14] |
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.
[1] Lok Sabha Debates, 24th August, 1955, pages 11,178 (professional capacity exemption, 1956 Act).
[2] Cyrus Investments Pvt. Ltd. v. Tata Sons Ltd. & Ors., NCLT Mumbai, Division Bench, 2018; Sai Girdhar Raj Kumar v. Arun Kapoor and Ors. 2020, Del HC, single judge; Raj Chawla v. SEBI and Anr. (2010) SCC OnLine Del 90, affirmed in SEBI v. Gaurav Varshney, (2016) 14 SCC 430.
[3] Ramaiya, relying on Secretary of State for trade and industry v. Deverell, (2000) 2 WLR 907: (2002) 111 Com Cases 303 : (2001) CLC 905 (CA) : (2000) 2 BCLC 133, (CA).
[4] Ramaiya, relying on Gramophone & Typewriter Ltd. V. Stanley, (1908) 2 KB89 (CA).
[5] Ramaiya, relying on Hydrodam (Corby) Ltd., Re. (1994) 2 BCLC 180.
[6] In Re: PNB Finance and Industries Limited and Ors. in the matter of PNB Finance and Industries Limited, WTM/SM/IVD/ID1/25069/2022-23, in reliance of the definitions under SAST Regulations.
[7] Ramaiya, relying on Kaytech International plc., (1999) 2 BCLC 351 (CA); Secretary of State for Trade and Industry v. Kaczer, (1999) 2 BCLC 351 (CA).
[8] Phoenix Arc Private Limited v. Spade Financial Services Limited and Ors. AIR 2021 SC 776. The adjudication was undertaken in context of the usage of the term “accustomed to act” and “related parties” under the Insolvency and Bankruptcy Code, 2016. However, the language is similar to the text of the 2013 Act and is accordingly contextually relevant for interpretation.
[9] Ramaiya, relying on Hydrodam (Corby) Ltd., Re. (1994) 2 BCLC 180.
[10] Ramaiya, relying on PFTZM Ltd., Re, (1995) 2 BCLC 354
[11] Ramaiya, relying on Secretary for State for Trade and Industry v. Lang. (1996) 2 BCLC 324 (Ch D)
[12] Ramaiya, relying on Re Unisoft Group Ltd. (No. 2) [1994] 1 BCLC 609 and Secretary of State for Trade and Commerce v. Becker [2003] 1 BCLC 555.
[13] Cyrus Investments Pvt. Ltd. v. Tata Sons Ltd. & Ors., NCLT Mumbai, Division Bench, 2018.
[14] In re. Swastik Textile Mills Ltd., Single Judge, 1983, Bom HC, in context of the erstwhile definition of “interconnected undertakings” under S. 2(g) of the MRTP Act (now repealed).