Relief and Prevention of Mismanagement

Introduction:

Corporate democracy is reckoned with the number of shares one has, which has an effect on the number of votes. The persons in control of the majority can abuse their power, which may lead to minority shareholders suffering a loss. Some protection has to be afforded to them. In this background comes the rule of judicial interference and non-interference in the matters of company. This project describes the law relating to prevention of oppression and mismanagement in India, which provides the courts with the armoury of discretion in cases where the above said rule becomes unjust.

The courts are vested with the discretionary power to provide just and equitable remedies in both the systems. The courts have been able to refine the law from within the scope of archaic provisions. The need for consolidation of law has been recognized, and has been statutorily implemented in India. The § 398 [1] of the Companies Act, 1956 is implemented with the judicial rationale of safeguarding the rights of minority shareholders in a company against the whimsical acts of the Board of Directors as well as the other shareholders, being a part of the majority group, and in turn controlling the day to day affairs of the company.

§ 398 – Remedy and Prevention of Mismanagement:

The true test of corporate governance is the manner in which the majority addresses minority interests [2] . All shareholders equally contribute to the conscience of the body corporate [3] . But, the corporate democracy is reckoned with the number of shares and not with the number of individuals involved [4] . Thus, there is a certain power on the holders of a majority of shares and a possibility that this power may be abused. Various approaches have been taken to check this abuse by courts and legislatures.

§ 398 provides for relief in cases of mismanagement. For a petition under this provision to succeed, it must be established that the affairs of the company are being conducted in a manner prejudicial to the interests of the company or public interest at large, or that, by reason of any change in the management or control of the company, it is likely that the affairs of the company will be conducted in that manner. The objective behind this is to afford protection to those whose voices are downed by the percentage holding of a company and to who’s detriment any act carried out to be subjected to judicial supervision.

A major principle relating to majority rule and shareholder protection was brought in Foss v. Harbottle [5] , which spoke of judicial non-interference. Courts refuse to interfere in the management of the company at the instance of a minority of its members who are dissatisfied with the conduct of the company’s affairs by its board of directors, or by or under the direction of the members of the company who control a majority of the votes which may be cast at its general meetings. Exceptions to this rule were simultaneously evolved, inter alia, on grounds of fraud on minority, ultra vires action, and control in the hands of wrongdoers and oppression and mismanagement [6] . Some of these exceptions are not logically deducible from the principle, and are either the result of historical accident or of a conscious desire by the courts to exclude the rule when it works unfairly. One of the exceptions, which have been statutorily recognized in India, is an action on the grounds of oppression and mismanagement. Thus, it can be affirmatively said that this exception has become a rule. It is the description of the rule and its nature that is the scope of the words below. What we have witnessed is a partial revolution in judicial attitudes.

It must be established for a successful petition under § 398 that the affairs of the company are being conducted in a manner prejudicial to the interest of the company or public interest, or that, by reason of any change in the management or control of the company, it is likely that the affairs will be conducted in such manner. Relief against mismanagement runs in favour of the company and not to any particular member or members [7] . It is not necessary for the court to find cause for winding up in order granting relief. § 398 enables the court to take into consideration outside interests affected by corporate operations. There must be present and continuous mismanagement.

Some of the instances, which have been held to be mismanagement:

(i) Absence of basic records.

(ii) Drawing considerable amounts for personal purposes.

(iii) Misuse and misapplication of companies’ finances.

(iv) Not filing documents with Registrar of Companies.

(v) Continuation in office by director beyond the term.

(vi) Directors not holding qualification shares.

(vii) Sale of assets at glaringly low price.

(viii) Neglecting the assets.

(ix) Sale by tender in collusion with the borrower company.

(x) Violations of provisions of law and of memorandum or articles of association.

(xi) Making of secret profits.

(xii) Siphoning of funds, etc.

Public Interest:

A thing is said to be in public interest where it is or can be made to appear to be contributive to the general welfare [8] . Public interest cannot be allowed to be confused with public opinion. The expression ‘a matter of public or general interest’ does not mean that which is interesting or gratifying curiosity or a love for information or amusement, but that in which a class of community have a pecuniary interest, or some interest by which their legal rights or liabilities are affected [9] .

The expression is not capable of a precise definition and has not a rigid meaning and is elastic and takes its colours from the statute in which it occurs, the concept varying with the time and state of society and its needs. Thus, what is public interest today may not be so considered a decade later. In any case, the expression cannot be considered ‘in vacuo’, but must be decided on the facts and circumstances. In the case of a company intended to operate in a modern welfare State, the concept of public interest takes the company outside the conventional sphere of being a concern in which the shareholders alone are interested. It emphasizes on the idea of the company functioning for the public good or general welfare of the community, at any rate, not in a manner detrimental to public good.

The words in the § 398 of the Companies Act, 1956, “in a manner prejudicial to public interest” were added by an amendment [10] wherein there can be judicial interference even when it is not prejudicial to just shareholders [11] but also public at large. The expression is an ‘elusive abstraction’ meaning general social welfare or ‘regard for social good’ and ‘predicating interest of the general public in matters where regard for social good is of the first moment’ [12] . It must relate to the good life of those with reference to whom it is used. In the case of a company, the concept of public interest takes the company outside the conventional sphere of being a concern in which the shareholders alone are interested along with emphasizing the idea of the company functioning for the public good or general welfare of the community at any rate not in a manner detrimental to the public good.

Relevant Cases:

According to Palmer [13] , the rule in Foss v. Harbottle [14] is a phrase used to refer to two distinct, but linked, propositions of law. The first proposition, which is that the court will not ordinarily intervene in the case of an internal irregularity if the matter is one which the company can ratify or condone by its own internal procedure. The second is that where it is alleged that a wrong has been done to a company, prima facie, the only proper plaintiff is the company itself.

Foss v. Harbottle

An action was brought by two shareholders, ‘F’ and ‘T’ of a company on behalf of themselves and all other shareholders against the directors and solicitor of the company, alleging that by concerted and illegal transactions they had caused the company’s property to be lost. It was alleged that the directors were acting in concert and effecting various fraudulent and illegal transactions whereby the property of the company was misapplied and wasted. It was prayed that the defendant make good the losses suffered by the company and the question was that of maintainability of suit.

The Court held that the action could not be brought by the minority shareholders. The wrong done to the company was one which could be ratified by the majority members. The company was the proper plaintiff for the wrongs done to the company, and the company can act only through its majority shareholders. The majority of the members should be left to decide whether to commence proceedings against the directors or not.

Rajahmundry Electric Supply Co. v. Nageshwara Rao [15]

Similarly, in this case, the Honourable Supreme Court observed that, the courts will not in general intervene, at the instance of shareholders in maters of internal administration, and will not interfere with the management of the company by its directors so long as they are acting within the powers conferred on them under the Articles of Association of the company. Moreover, if the directors are supported by the majority shareholders in what they do, the minority shareholders can, in general do nothing about it.

One may notice that the aforesaid decisions are essentially a logical extension of the principle that a company is a separate legal entity from the people who compose it. The rule, as applied to the companies, however, appears a little more complicated. After all, the directors who have been fraudulent have injured the company. The company is composed of members. Losses to the company affect all the members, not simply the majority or minority or any particular member, yet the mere injury is not enough. The plaintiff must show that the injury has been caused by a breach of duty to him. Therefore minority shareholders, under § 398 of the Companies Act 156 have an option to approach the court only and if there has been a blatant injury caused to the company and them by the fiduciary breach of duty by any of the directors or majority shareholders by a particular act which cannot be ratified by the internal setup and mechanism of the company by the Articles of Association of the company.

Scope of Powers of the Tribunal under § 398:

Powers of the Tribunal under § 397 and 398 are fairly wide, although the Company Law Board has to be satisfied that the conditions of relief exists presently and not in reference to some possible conduct in the future as decided in Peerless General Finance & Investment Co. Ltd. v. Union of India [16] . In fact the Board may make any order for the regulation of the conduct of the company’s affairs, upon such terms and conditions as may, in the opinion of the Board, be just and equitable in all the circumstances of the case. Apparently the only limitation seems to be the overall objective of the sections, and therefore, the order must be directed to bringing to an end the matters complained of. The Tribunal can grant relief against a respondent who is no longer a member and such relief can possibly extend to requiring him to purchase the company’s shares, as was held in the case of A Company, Re [17] . However, an attempt has been made under § 402 to define the powers of the Tribunal.

In situations of irreconcilable disputes, the usual approach of the CLB has been to order the rival groups to part ways in the interests of the company and those of the public financial institutions having large stakes in it. The CLB can direct the partition of the assets of even a listed company and reducing the capital of the company to that extent.

Harikumar Raja v. Soverign Dairies Industries Ltd. [18]

In a significant judgment the Madras High Court held that where a company committed large number of irregularities including allotment of share against illusory consideration, accounts not audited since 1977, Annual General Meeting not convened, annual returns not filed and prosecution launched against persons concerned in the company for failure to comply with provision of the Companies Act, it appears to be a straight forward case under § 397 and § 398.

It was held that not only the company was mismanaged; certain actions of the company were prejudicial to the interests of the company and of the other shareholders. It was further held that the scope of power of the court (now CLB) [19] is not subject to any limitation in the matters of under § 397 and § 398 and relief seeking members need not be sent elsewhere for getting the relief.

The all pervasive powers in these matters include the power to alter Articles without a resolution of a company and without being placed before the General Meeting and to order the rectification of the register of members without recourse to laid down procedure. The court, inter alia, supersession of the Board of Directors, declared allotment of shares two of the respondents illegal and appointed a receiver to convene and hold AGM without audited accounts. It also ordered the constitution of a new Board of Directors.

Irani Committee and Minority Protection:

Though by law majority rule always prevails, yet there are safeguards to protect the interests of minority shareholders. As per § 399 of the Companies Act, 1956 and other judicial decisions, minority (even a single member) can file a petition to the Company Law Board praying relief against oppression and mismanagement.

Lack of time appears to have compelled the Irani Committee to avoid not merely statistical information to support its conclusions but also involvement in problems that are offbeat. Its treatment of `minority interests’ provides an illustration. Chapter VII of the Companies Act, 1956 which has as many as 14 § and deals with applications for relief from oppression and mismanagement from concerned members has undergone no significant amendment from 1956 except for the power conferred on the Central Government in sub-§ (6) of § 408 enabling removal of an auditor and appointment of another in his place in certain circumstances. It is of the utmost importance that the objectives with which the company concept has been evolved should not be ignored in dealing with any of the special problems that its abuses may cause. There can hardly be any doubt that the concept of incorporation was expected to facilitate the pooling of financial and manpower resources on a scale which an individual enterprise could not ordinarily command or mobilize.

If the shareholders were large in number and did not participate in the day-to-day running of the business, they could not be saddled with the liability which the incompetence of those who were put in charge of the business might have led to, except to the extent of their own subscription to the capital of the corporation. The malpractices to which some of those in charge of a company resort do not appear to have been visualized when the medium was devised.

The Government cannot, therefore, disclaim its responsibility to prevent any adverse development detrimental to the public interest and the interest of the subscribers in minority who have no influence on the control and management of the corporation in which they are members in minority. To contribute to risk capital is one thing. To be victims of self-seekers who contravene the law, in order to feather their individual nests, is quite another.

One can appreciate the existence of a `partnership company’, that is, a company which is formed by the partners of a `firm’ converting themselves by incorporation into members of a company to take advantage of the limited liability benefit conferred by a company. It becomes a mockery when the `partner’ is ousted by oppressive tactics and the company becomes a one man company, the shares being acquired by the aggressive partner from the person who has been ousted by him either in his own name or in the names of members of his family or friends or employees.

The new breed of one man owned companies emerging, as a consequence of the stereotyped solution built into the law, are that the law is no longer `neutral’. One who carries on a business with the mask of a company is being given an unfair advantage vis-à-vis one who conducts it transparently as his individual venture.

There is no element of punishment for wrongdoing, even where oppression and mismanagement are established by the victim as facts. Far from being penalized or punished in any manner, the aggressive `controller’ of the company is rewarded for his misdeeds. The victim is asked to make his exit from the company, with the market or intrinsic value of the shares in which he has invested. No compensation or damages will be available to him for being pushed out for no fault of his.

The law is weighted in favour of the unscrupulous. `Might is right’ may be a matter of expediency serving to save an industrial unit from a break-up. It can hardly be in public interest. There should be a provision in Chapter VII of the Companies Act, 1956 for levy of a penalty on those who flout the law with impunity, in addition to whatever settlement may be effected.

§ 397 and § 398 of the Act can be invoked only if the impugned mismanagement or oppression is continuous or has relevance to the existing situation. The law may or may not be of avail where misdeeds are sporadic and have no repercussion or effect on current rights and privileges. This may not be equitable particularly where there is no alternative remedy which is not prohibitively expensive and time consuming for undoing the wrong done.

It is incorrect to assume that it is only the shareholders in majority who oppress the minority. Cases in which management is hijacked and control is seized by shareholders in minority through means which are not fair or reasonable are not as rare as one may imagine. As a point of fact neither § 397 nor § 398 mentions minority shareholders or minority interests also significantly it was the Irani Committee which highlighted the interests of minority shareholders in this context.

Acts not held as Mismanagement:

Building up of reserves or non-declaration of dividend especially when it does not result in devaluation of shares – V.J. Thomas Vetton v. Kuttanand Rubber Co Ltd. [20]

Merely because company incurs loss it cannot be said that it is mismanaged by the authority – Chennabasappa Kothambari v. Multiplast Industries (Karnataka) (P.) Ltd. [21]

Removal of Secretary by majority decision of Board of directors unless it is shown that the removal has prejudicially affected the interest of the company or the general public interest – Dr. V Sebastian v. City Hospital (P.) Ltd.

The mere keeping of the moneys of the company in a Term Deposit is not bad business practice or in any case such mismanagement as would warrant interference under § 398 of the Act. The single act of letting out the premises of the company is not sufficient to attract this section. Allegations that the property of the company have been let out at low rents without any proof as to what higher rents were available as also an unsubstantiated allegation that premium amounts were misappropriated were held to be not sufficient in invoking the provisions regarding mismanagement – Jaladhar Chakraborty v. Power Tools and Appliances Co. Ltd. [22]

Where the directors of a company in financial difficulties arrange with the company’s creditors that the creditors may become shareholders and directors instead of remaining as creditors, was not an act of mismanagement or oppression so far as existing shareholders are concerned but done bona fide in the best interests of the company – Suresh Chandra Marwaha v. Lauls (P). Ltd. [23]

Termination of the services of a works manager who only held 10 shares was not in itself an act of mismanagement under the Act. – Modern Furnishers (Interior Designers) (P).Ltd. In re [24] .

Removal of some of the Directors from office which was held to be valid was found to be not a state of mismanagement of the company’s affairs.- Siddaramappa Bapurao Patil v. Ratna Cements (Yadwad) Ltd. [25]

Mismanagement cannot be held in pre-production stage – S. Seetharaman v. Stick Fast Chemicals (P.) Ltd.

Mere breach of fiduciary duty resulting in the loss of interest of the company or public interest is not a ground for interference by CLB under § 398 (1) (b) of the Act; there must be material change in management or control of the company. – Gordon Woodroffe and Co. Ltd. v. U.K. Gordon Woodroffe Ltd.

Removal of existing directors and appointment of new directors cannot be challenged in a petition under § 398. It is only when the new directors misconduct the affairs of the company that it may be said that they had been working to the prejudice of the company. – Rai Saheb Vishwamitra v. Amar Nath Mehrotra. [26]

Condition for maintaining petition under § 398:

In order to grant relief under § 397 and § 398, a petitioner must show three things:

The facts pleaded, justified the making up of a winding up order on the “just and equitable grounds”, but the winding up would unfairly prejudice the shareholders including the petitioners who support the petition but an order passed under § 402 of the companies act would grant them appropriate relief

The affairs of the company are being conducted in a manner oppressive or mismanaged to some part of the members/ shareholders including the petitioners. It is to be noted her that the § does not require that the oppressed members should be the majority. “Shareholders with a minority beneficial interest may, by having voting control, be able to oppress those with the majority, beneficial interest”. The oppression or mismanagement complained of must be suffered by the share holders in their capacity as shareholders and not in their character as directors. The expression employed in the § “the affairs of the company that are being conducted” indicates, not isolated acts of oppression “but a continuing process, and one continuing down to the date of the petitioner”. It is pertinent to note that it is not enough if it is established that the company’s affairs have been conducted unwisely or inefficiently or carelessly. Under such circumstances also, shareholders can contend that he has lost confidence in the manner in which the affairs of the company are being conducted. That is not sufficient. That does not amount to oppression or mismanagement; “nor is resentment at being out voted ground for relief under this section”.

To wind up the company would unfairly prejudice the oppressed members.

Conclusion:

In modern law, giving the courts the power by statute to control the exercise of discretion by persons or institutions on grounds of “unfairness” is hardly novel. Yet such open-ended legislation, which in effect involves a sharing of the legislative functions between the Parliament and the courts, always present the courts with the challenge of how to develop on a case-by-case basis the criteria by which the imprecise concept of fairness can be given operational content. Even if courts did not have the discretion in cases of unfair prejudice, oppression and mismanagement, considering the equity foundations of court, the law would not remain as it is now.

Though by law majority rule always prevails, yet there are safeguards to protect the interests of minority shareholders. As per § 398, § 397 and § 399 of the Companies Act, 1956 and other judicial decisions, minority (even a single member) can file a petition to the Company Law Board praying relief against oppression and mismanagement. Shareholders have the opportunity to present their case to the regulators (SEBI) to obtain redress for their rights. Disclosure by the Board of their material pecuniary interest, relationship, arrangement vis-à-vis the company/firm they represent should be disclosed in advance prior to their appointment in the company.

To facilitate shareholders participation in the general meetings, on select items of business, the system of postal ballot has been already in place. Foreign Institutional Investors do have an equitable treatment in the policy decisions of the management and notice of the meetings should be sent to them. The system of corporate governance in India does provide for greater transparency, better and timely financial reporting. Financial Disclosures have been broadened with adoption of Accounting Standards and in order to strengthen the system of audit, more responsibilities have been added to the auditor who has to remain independent in the course of his assignment and the Companies Act, 1956 do provides for de-linking of relation of auditor vis-à-vis of his auditee company. Members of the chartered accountancy profession have to observe the Code of Conduct and Ethics of the Institute while exercising their work.

The SEBI is now contemplating a proposal to bring a system model for rating of corporate governance. Hence implementation rather than enacting is of much more major importance in the scope of corporate governance and in the field of viability of rights afforded their protection is necessary. The minority as well as the majority groups in variety of cases need to be afforded protection for their rights and therefore such provisions against oppression and mismanagement of the dominant controlling group in justified.