Nominee directors in start-ups and vicarious liability

India is a big home of start-ups. The year 2021 saw the emergence of 40-odd unicorns and Indian companies raised over $62 billion over 1,200 deals.

While all this is heartening, lawyers, Souvik Ganguly, Malika Shirzade and Aman Bagaria of Acuity Law, a Mumbai-based law firm, have pointed to a “worrying trend” in start-up – the reluctance of investors to appoint a (their) nominee director on the boards of the start-ups they invest in, essentially not exercising their right to do so.

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Now, why would they do so? To put it simply, they are scared. The rules regarding liabilities of directors are so stringent that they scare the hell out of them. This, the lawyers say, is unfortunate because the presence of an investor’s nominee on the board enhances corporate governance.

Writing in Mondaq, the lawyers argue that a company is a “juristic person”, which functions through its board of directors. Therefore, “unless otherwise recorded in any other enforceable corporate documents,” the board is where the buck stops, bearing the ultimate responsibility for all acts of commission and omission of the company. However, in practice, the non-executive directors are not engaged in the day-to-day management of the company.

Section 149(2) of the Companies Act, 2013, talks about the liability of the non-executive directors, who are not promoters or occupy key managerial positions in the company. The law is based on, well, common sense. The liability of a non-executive director is limited to only those acts which have occurred with their knowledge and only if such knowledge is attributable to the process of the board of directors. Of course, they are liable, if they have not acted diligently.

Problems and a way out

A certain amount of diligence is expected of them and if they act like dumbos they bring the liabilities upon themselves. Therefore, non-executive directors, into which categories the nominee directors of investors must fall, are protected under ‘vicarious liability’, so that they are not caught in a carpet-bombing of liabilities.

The lawyers cite the Supreme Court of India’s pronouncements in the cases of Sunil Bharti Mittal Vs CBI and S.M.S. Pharmaceuticals Vs Neeta Bhalla, to support the view that an individual can be held liable for the acts of a company only if there is sufficient evidence of the individual’s active role, coupled with criminal intent – and not merely because the person holds an office in the company.

Then what is the problem? The problem is that, in practice, it doesn’t work so well. Law enforcement agencies catch-all directors in their net, leaving the non-executive directors to battle it out in the courts – at which stage these judicial pronouncements might be useful.

So, what is the way out? There is no good one today. Perhaps a nominee director could take a ‘directors’ and officers’ liability insurance, but that does not help avoid legal battles. Sometimes investors send ‘observers’ to board meetings but that is not the same as being on the board and voting on decisions.

The investors may take indemnity from the companies for their nominee directors, but that is not good enough either because the indemnity rights are available only after the nominee director is able to establish that he has suffered a loss due to the actions of a law enforcement agency or other officers or directors of the company.

The lawyers give no solution, except that “all stakeholders in the start-up ecosystem” should recognise the important role of directors, whether executive or otherwise, in the running of a company. The legal system should make it easier for investors to appoint nominee directors, which would only help enhance the global heft of the start-up industry.

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