The Chilling Effect Of Section 164(2) Under Companies Act, 2013 On Directors

Disqualification of Directors for reasons beyond their control is a controversial issue of corporate governance under the Companies Act, 2013 (“Act”). In this article, the authors discuss the ramifications faced by Directors due to the controversial provisions of “disqualification” under the Act.

Disqualification of Director under the Act

Section 164 of the Act prescribes factors for disqualification of a Director. Any Director disqualified under this provision is disqualified to act as a Director for five years in all companies, without a pre-decision, or post-decisional opportunity of hearing. 

Section 164 is in two parts-

• Section 164(1) deals with the eligibility factors specific to an individual, e.g., unsound mind, criminal antecedents, insolvent, etc.;
  
• Section 164(2) deals with the eligibility based on factors that are attributable to operations of a company, like not filing Financial Statements continuously for a period of three financial years. 
• The intent of the legislature in introducing Section 164(2) of the Act was to bring transparency in corporate governance and ensuring filing of Financial Statements by entities, at regular stipulated intervals. 

DIN De-Activation v. Temporary Disqualification 

Rule 11 of the Appointment Rules provides that the cancellation or deactivation of DIN is contemplated under only in the following circumstances, (i) DIN is found to be duplicated or obtained by fraudulent means; (ii) on the death of concerned individual; (iii) on the individual being declared of unsound mind; and (iv) on the individual being adjudged as insolvent.

While the legislature contemplated temporarily disqualifying Directors as a deterrent to delayed filing of Financial Statements, the Central Government proceeded to de-activate the Director Identification Number (“DIN”) of Directors of non-compliant companies.

DIN is a mandatory lifetime unique identity number allotted by the Central Government to a Director (new, proposed, or existing) under Rule 10 of the Companies (Appointments and Qualifications of Directors) Rules, 2014 (“Appointment Rules”). Ministry of Corporate Affairs’ (“MCA”) maintains a database directory of DINs for purposes of identification, signature verification on statutory filings, fraud detection, etc.

The issue of de-activation or cancellation of DIN as a consequence of disqualification of Director was a subject matter before the Kerala High Court in a case titled Zacharia Maramkandathil Mohan v. Union of India & Ors. [WP (C) No. 21628 of 2020]. In this case, the Kerala High Court held that the DIN of a Director cannot be deactivated or cancelled as a consequence of Directors being disqualified by operation of Section 164(2) of the Act.

This conclusion was based on Karnataka High Court’s decision of Yashodhara Shroff vs. Union of India & Anr. [Writ Petition No. 52911 of 2017] which held that ineligibility of Directors under Section 164 of the Act is in the nature of suspension and is only for a temporary period of five years. Therefore, this temporary suspension cannot be treated as a perpetual measure. In both these cases the High Courts directed the Central Government to restore DIN of disqualified Directors. 

Retrospective Operation of Section 164(2)

There is still ambiguity as to the retrospective operation of Section 164(2) of the Act. 

The High Court of Kerala and Karnataka have held that since Sections 164(2) was brought into effect from April 1, 2014, the continuous 3-year period of default should commence only from the Financial Year 2014-15. These High Courts held that the provisions of Section 164(2) must be given prospective operation and the continuous default period of 3 years should commence from or after April 1, 2014. 

However, the Delhi High Court in the case of Mukut Pathak and Others vs. Union of India [Writ Petition No. 9088 of 2018] has held that Section 164(2) of the Act can apply to failure in filing Financial Statements for the financial years prior to 2014-15 i.e., the year in which the said Section came into force. 

However, the findings of the High Court of Kerala and Karnataka seem to be the correct position, as it is a settled principle of law that no statute shall be construed to have retrospective operation unless such a construction appears by necessary implication, which is missing in Section 164(2) of the Act. Be that as it may, there is a conflicting position of the High Courts as of today and the Supreme Court has not taken a view on the retrospectivity of Section 164(2).

Conclusion

The above decisions bring a much-needed clarity in a major aspect of corporate governance pertaining to cancellation of DIN of Directors, arising from disqualification under Section 164 of the Act. 

However, the Courts have failed to give relief to Directors viz-a-viz the penal disproportionality of Section 164(2) i.e., disqualification of Directors based on factors that are attributable to operations of a company.

The Karnataka High Court imposed a strict liability on Directors by observing that that Section 164(2) was designed to create a liability of disqualification thereby imposing a corresponding duty on Directors, to ensure that Financial Statements are filed timely.

However, the authors believe that above position taken by the High Court requires reconsideration as all non-compliances under Section 164(2) of the Act such as non-filing of Financial Statements, are not directly attributable to the Director. The ongoing pandemic and resulting lockdowns are also a testament that non-filing of Financial Statements of a company can be a result of many factors beyond the control of a Director. 

Therefore, disqualifying a Director on this account without a pre or post decision opportunity of hearing is a clear violation of principles of natural justice, which is a right enshrined in the constitution. It would be interesting if any High Court or Supreme Court consider this aspect of principles of natural justice and provide the much-needed respite to such Directors who get unnecessary penalized without any fault of theirs.