 "Of legal loopholes, and defaulters")
Defaulting promoters, wilful or otherwise, are known to hide behind the shield that the law provides, treating a company as a separate legal entity, distinct from its promoters, other shareholders, and directors.
Following the doctrine of limited liability, the law recognises that the liability of the shareholders of a company is limited to the extent of their contribution. That has become the ruse of many defaulters. And when lenders turn on the heat defaulters take a ride on the creaky over-burdened bankruptcy and insolvency system.
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"A promoter cannot be held liable for the company's defaults per se unless it can be shown that he acted fraudulently. A robust bankruptcy system is the only effective way of dealing with recalcitrant debtors," says Debanshu Mukherjee, senior resident fellow, Vidhi Centre for Legal Policy.
Promoters are known to issue personal guarantees to raise funds for the company. Legal experts note that any personal guarantee given by a promoter is a contractual arrangement. Enforceability of these contracts has nothing to do with the concept of limited liability, and such guarantees can only be enforced independently.
"According to Section 128 of the Contract Act, the liability of the surety is co-extensive with that of the principal debtor, unless otherwise provided in the contract," says Mukherjee.
However, there is a need to examine the terms of the guarantee to see the extent of coverage and conditions of enforcement to determine the liability in any given case, he adds.
Lifting the corporate veil
Courts are known to lift the corporate veil only when they are convinced the shield offered by the principle of a distinct legal entity has been misused. "Courts are very selective in lifting the corporate veil. However, in instances of fraud, public interest, violation of laws, and tax evasion, courts do not shy from identifying the culprit," notes Darshan Upadhyay, partner, Economic Laws Practice.
The circumstances under which courts lift the corporate veil depend on the facts of each case, say legal experts.
"Piercing the corporate veil for default may have a chilling effect on entrepreneurial activity," notes Mukherjee. The courts appear to be conscious of this.
Apart from instances of fraud, illegality, tax evasion, the Companies Act provides for situations in which the corporate veil can be lifted. Section 339 deals with liability for fraudulent conduct of business as discovered in the course of liquidation of a company. This provides for personal liability of any person, including shareholder, who knowingly is party to fraudulent conduct of a business. Though this provision of the Act is yet to be notified, its equivalent provision in Section 542 of Companies Act, 1956, is in force.
Legal experts note that the corporate veil can also be lifted at the company's request. In one case the court allowed it for ascertaining the competence of a company by taking into account the competence of the joint venture and collaborator companies, says Lalit Kumar, partner, J Sagar Associates.
Plugging the loopholes
Experts note that the proposed Insolvency and Bankruptcy Code, 2015, that is currently in Parliament might contain some of the answers to India's decadent insolvency and bankruptcy laws. To bring recalcitrant defaulters to book, the code proposes to empower creditors to initiate the process at an early stage to replace the management, and bring in new owners to a business facing financial distress.
This will help save the business as a going concern, turnaround experts say.
"The code is designed to address some specific cultural issues in the Indian context where promoters may not want to accept failure and let go at the appropriate stage," says Mukherjee.
Turnaround experts point out that despite their individual merits, action under the foreclosure law and the debt recovery tribunals is susceptible to legal challenge. This leads to a long-winding recovery process that erodes value of the assets under dispute. "Given the pressure in the banking system to recover dues, we are likely to see more instances where banks resort to forensics, and go after promoters if they have been found to have been involved in mismanagement of funds of the company," says Upadhyay.
The proposed code provides for takeover of management by insolvency professionals nominated by the creditors. Such professionals will have the flexibility to bring in turnaround specialists and consultants to achieve the desired business results. These professionals will be protected from any legal liability for anything done in good faith to turn the business around.
There is a provision in the proposed code to liquidate a company at the earliest opportunity to minimise losses for debtors and shareholders. To deal with instances of asset stripping, the proposed code provides for avoidance actions to set aside fraudulent transactions intended to siphon of assets.
"There are several instances where promoters try to sabotage the process by paying off potential bidders to keep them away from the auction process," noted a lawyer.
The way forward, feels Mukherjee, is to conduct the auctions through online platforms that follow a market driven price-discovery system.
ATTACHING PERSONAL ASSETS OF A DEFAULTING PROMOTER
Some of the key provisions for liability of promoters under the Companies Act, 2013:
Crime: Misstatement in prospectus
Punishment: Promoter of a company is liable to pay compensation to every person who has sustained loss or damage in securities subscribed based on any misleading information in the prospectus. According to Section 42 of the Companies Act, 2013, the company, its promoters and directors are liable for a penalty to the tune of up to Rs 2 crore.
Crime: Fraudulently inducing persons to invest money
Punishment: A person found guilty, under this, is punishable with imprisonment for a term of up to 10 years. The prison term would be a minimum of three years for matters involving public interest. The person is also liable to be fined that may extend up to three times the amount involved in the fraud
Crime: Non-fulfilment of discourse in relation to notice of general meeting
Punishment: A fine that may extend to Rs 50,000 or five times the amount of benefit accruing to the promoter, director, manager or other key managerial personnel or any of their relatives, whichever is more
Crime: Fraud and false statement
Punishment: Under Section 447 of the Companies Act, a person liable for fraud is punishable with imprisonment for a term that may extend to 10 years, and minimum of three years if it involves public interest. The fine could be up to three times the amount involved in the fraud
