Non-executive directors needn't get caught up in cases of corporate fraud

Mint

01-05-2025

The Gensol-BluSmart crisis has drawn corporate fraud in India's startup ecosystem into the spotlight. It has sparked a debate over a 'fake it till you make it' culture and whether it's driven by sheer greed, naive optimism or intense pressure to keep the company's stock on an ever-rising curve.
While the causes remain debatable, the consequences of corporate fraud follow a predictable path. Once discovered, law enforcement agencies and regulatory bodies spring into action. Probes are launched, notices are dispatched and litigation ensues.
One may expect these proceedings to target executive directors, who are responsible for running the business and its affairs. But that is not the case. They invariably implicate all board members, including those who serve in non-executive roles, such as nominee directors appointed by private equity firms.
This occurs despite the stark difference between the roles of executive and non-executive directors. The latter play a limited role on the board. They represent the shareholders that nominate them. As their involvement is usually restricted to attending board meetings, they often have no clue, let alone knowledge, of any fraud. Nonetheless, they find themselves arrayed with those accused of carrying out the
fraud
.
Noticing this, the ministry of corporate affairs (MCA) came out with a circular dated 2 March 2020, drawing attention to a provision in the Companies Act of 2013. This provision limits the liability of non-executive directors to wrongful acts that occur with their knowledge (attributable through board processes), consent or connivance, or where they do not act diligently.
In the light of this, the MCA required that the specified criteria be satisfied before non-executive directors are arrayed in any civil or criminal case under the Companies Act. The MCA also instructed registrars of companies (RoCs) to ensure that sufficient evidence exists of their involvement before proceeding against them.
To comply with the law's mandate and avoid liability, non-executive directors can take preventive measures.
First
, it is crucial for them to demonstrate that they acted diligently. This involves dedicating adequate time and attention to the company's issues, especially those that may raise red flags. They must remain sceptical of management actions until they independently evaluate them. Rather than accepting rosy narratives or optimistic portrayals, they should pose incisive questions to discern the true picture of the company's operations.
Second
, non-executive directors must act decisively upon detecting signs of corporate wrongdoing by notifying management and insisting on prompt corrective action. Problems arise when, instead of confronting the management, they succumb to pressure, overlook fraudulent conduct in fear of repercussions or dismiss it as an isolated incident. Such responses are not prudent, and by the time this realization dawns, it is often too late. They risk being accused of negligence or wilful blindness, as they can be presumed to possess constructive knowledge. Non-executive directors must speak up if they detect signs of fraudulent activity, as their silence can be used against them.
Third
, non-executive
directors
must keep a record of any instances of having highlighted red flags. Should these concerns pertain to an issue being addressed through a board or shareholder resolution, they must ensure their dissent is noted and accurately recorded in the meeting minutes. Plus, any correspondence with management should be preserved as evidence.
By taking these steps, non-executive directors can shield themselves from liability should a fraud be eventually uncovered.
However, the reality is that they are only able to escape punishment, not the process. They still get caught in the crossfire between regulatory bodies and the fraud's perpetrators. These bodies may include the Securities and Exchange Board of India for listed companies and Reserve Bank of India for banks and financial institutions.
Non-executive directors could also get embroiled in civil and criminal proceedings pursued by various agencies such as the local police, Enforcement Directorate and Serious Fraud Investigation Office. Even if the charges levelled against non-executive directors lack evidence or merit, they are forced to endure arduous and lengthy proceedings before they can be exonerated.
This process can be extremely taxing; they incur litigation costs, face inconvenience, undergo stress and suffer reputational harm. They may even need to resign from their board positions in other companies, especially those which operate in tightly regulated sectors. This is because, in many such sectors, maintaining a 'fit and proper' status is essential for directors.
At the end, the real question that needs to be answered is whether it is possible to shield non-executive directors from this ordeal without neglecting evidence that may point to their involvement.
This is precisely what the MCA circular aims to address. By adopting a balanced approach, it sanctions the prosecution of non-executive directors only in cases where there is
prima facie
evidence of their participation. Rather than indiscriminately implicating all board members, it calls for an initial assessment before tagging them with executive directors. The need of the hour is for regulatory bodies and enforcement agencies to embrace the circular's intent and enforce it in letter and spirit.
These are the authors' personal views.
The authors are, respectively, head of the private equity and financial services regulatory practice; and member, private equity and M&A, at Nishith Desai Associates.