2025 (9) TMI 1097 - HC - Companies Law

Interim order vacated; applicants kept under Section 542(1) pending Official Liquidator evidence; may reapply later

N. Srinivasan (CDC Nominee), V. Sreenivasulu Versus The Official Liquidator, Farouk M. Irani, S/o. Merwan Rustom Irani, Maharaj Jai Singh, Shri. A.C. Muthiah, Dhanasekar (Deceased), A.L. Vadivelu, S/o. Alagappa Chettiyar, V. Sreenivasulu, S/o. V. Subbaiah And Others

HC vacated the interim order against the two applicants but refused to strike them from the respondent array or dismiss/stay misfeasance proceedings. The ... Charges against the directors and officers of the Company - Seeking a declaration that the respondents conducted the business of the First Leasing Company of India Limited (FLCIL)/ company in liquidation (the Company) fraudulently - diversion of funds or not - joint and several liability of respondents to contribute the amount which is due and payable to the creditors of the Company as per the report of the Special Fraud Investigation Office (SFIO) - HELD THAT:- The SFIO report discusses the discrepancy between the business done report and the audited financial statements at paragraph 4.65. According to the SFIO, this reveals that the directors were aware of the actual state of affairs. On correlating this section of the report with the available minutes, it appears that a report of business done in the preceding quarter was placed before the board of directors at most board meetings. For instance, as per the relevant minutes, at board meetings held on 28.03.2002 and 26.12.2001, both of which were attended by Srinivasan, the business done reports for the preceding quarters were placed before the board as per the minutes - On perusal of the minutes of the board meeting held on 25.06.2001, it appears that Srinivasan attended the meeting and was inducted on the said date as a director. The minutes do not refer to the letter but make general reference to points raised by the auditors. In the light of even the minutes of meetings being incomplete, a definitive conclusion cannot be reached as to whether the letter from M/s Fraser & Ross was discussed at a subsequent meeting. No specific allegations have been made against either applicant in the SFIO report or the affidavit in support of this application. The general allegation that both the applicants were on the board of directors and that they were consequently privy to all fraudulent transactions during their respective tenure has been made. On the basis that each applicant herein failed to discharge the fiduciary duty to the Company, the SFIO recommended that proceedings for misfeasance be initiated against them. Not only the SFIO report but the minutes of the board meetings of the Company disclose that the two applicants participated in a few board meetings during the period of alleged financial irregularity. As is also evident from discussions in the preceding paragraphs, while the available material does not lead to the inference that they were actively involved in wrong doing, their knowledge of such wrong doing and participation in meetings wherein material decisions were taken cannot be ruled out at this juncture. In spite of being specifically called upon to provide the investment agreement or analogous agreement relating to the terms and conditions on which CDC/BII made investment in the Company, neither the Official Liquidator nor the respective applicant submitted the same. Given that Srinivasan is currently the Managing Director of BII Asia, he should have been in a position to file the same. Given the fact that the respective applicant would fall within the ambit of Section 542(1) even on a more restrictive interpretation thereof than the interpretation placed by me on the said provision, the follow on question would be: what should be the standard for determining whether an application for misfeasance against such person is liable to be rejected at the threshold? Put differently, in the case of a person who is not part of the management of a company, such as a non-director employee or a third party transacting or being otherwise involved with the company, it may be relatively easy to consider and decide, at the pre-trial stage, whether an application under Section 542 is maintainable against such person - it cannot be said ex facie that there is no case under Section 542 against the respective applicant. It is, nonetheless, possible that there is no evidence against the respective applicant even after the Official Liquidator adduces evidence. In such event, the respective applicant is granted leave to reapply for the remedies declined at this juncture. The balance of convenience is not in favour of continuing the interim order against these persons and such order is likely to cause great hardship to them - the interim order dated 09.08.2024 is vacated in respect of each applicant - the request to strike off the name of the respective applicant from the array of respondents or to dismiss the application for misfeasance or stay proceedings for misfeasance against them is rejected. Application disposed off. 1. ISSUES PRESENTED AND CONSIDERED 1. Whether Section 542 of the Companies Act, 1956 may be invoked against non-executive/nominee directors in the absence of specific allegations that they were 'knowingly parties to the carrying on of the business' with intent to defraud creditors or for a fraudulent purpose. 2. What is the appropriate standard at the pre-trial stage for rejecting an application for misfeasance under Section 542 (i.e., the test for dismissal under Order VII Rule 11/Order I Rule 10 CPC or otherwise), particularly in respect of persons who prima facie fall within the statutory scope. 3. Whether interim reliefs (restraints on dealing with property, bank accounts and demat securities) granted ex parte should continue against nominee/non-executive directors where the pleading is largely general and documentary material is incomplete. 4. Procedural obligations of the Official Liquidator when the primary investigative material (an external investigative report) is relied upon and specific allegations against particular respondents are lacking or the record is incomplete. 2. ISSUE-WISE DETAILED ANALYSIS Issue 1 - Liability of non-executive/nominee directors under Section 542 Legal framework: Section 542(1) extends civil liability where, in winding up, it appears that any business was carried on with intent to defraud creditors or for a fraudulent purpose and authorises declarations that 'any persons who were knowingly parties to the carrying on of the business' shall be personally responsible without limitation. Precedent treatment: Comparative statutory language in the UK Insolvency Act (s.213) was examined and English authority (Chancery Division) interpreting 'parties to the carrying on' as not confined to managerial actors was relied upon. Domestic authorities recognising the burden on the Official Liquidator and emphasising particularity of pleading in misfeasance actions were considered. Interpretation and reasoning: The Court held that the phrase 'knowingly parties to the carrying on of the business' is broader than persons who actually manage or control day-to-day operations and therefore may embrace directors (including non-executive/nominee directors) and even third parties if they were parties to the carrying on of the business with requisite fraudulent intent. However, the Court recognised that non-executive/nominee directors may, on detailed factual assessment, be exculpated depending on their role and the documentary evidence. Ratio vs. Obiter: Ratio - Section 542's phraseology is capacious and does not automatically exempt non-executive/nominee directors; they may fall within its ambit if they were knowingly parties to fraudulent conduct. Obiter - observations on comparative UK law and broader policy considerations about nominee directors' obligations. Conclusion: Non-executive/nominee directorship per se does not bar proceedings under Section 542; liability depends on whether the person can be shown to have been knowingly a party to carrying on the business in the fraudulent manner alleged. Issue 2 - Standard for pre-trial rejection of a Section 542 misfeasance application Legal framework: Procedural thresholds under Order VII Rule 11 and Order I Rule 10 CPC (strike out/return for non-joinder or dismissal for lack of cause of action) and pleading requirements under Order VI Rule 4 CPC for allegations of fraud, misrepresentation, breach of trust or wilful default. Precedent treatment: Authorities requiring particularity in pleading fraud and recognising the heavy burden on the Official Liquidator to prove misfeasance at trial were considered; many relied cases were final disposals after evidence was led and therefore distinguishable from threshold dismissal at the pleading stage. Interpretation and reasoning: The Court formulated the test for pre-trial dismissal where the respondent clearly falls within the literal ambit of Section 542(1). If the ex facie material available at preliminary stage leads to an unequivocal conclusion that the respondent could never have been knowingly a party to carrying on the business with intent to defraud (i.e., no set of facts disclosed that could support liability), the misfeasance claim may be rejected at threshold. Conversely, where the respondent prima facie falls within the statutory scope and the available material does not conclusively negate the possibility of fraudulent participation, the matter should proceed to trial; the Official Liquidator is entitled to lead evidence and call witnesses under Section 542(1). Ratio vs. Obiter: Ratio - a twofold screening standard: (a) reject at threshold only if ex facie the respondent could never be liable; (b) otherwise require trial to test mens rea and factual participation. Obiter - guidance on distinguishing final orders in precedent where evidence had been recorded. Conclusion: Pre-trial dismissal is permissible only in clear cases where no reasonable inference of the requisite knowledge/participation can arise from the pleaded material; in all other cases, the respondent must await trial on the question of misfeasance under Section 542. Issue 3 - Continuance of interim ex parte restraints against nominee/non-executive directors Legal framework: Principles governing interim reliefs - prima facie case, balance of convenience, and irreparable injury - applied to orders restraining alienation of property and freezing securities/bank accounts. Precedent treatment: No single controlling precedent; application of general interlocutory principles and sensitivity to severe prejudice caused by freezing orders informed the analysis. Interpretation and reasoning: The Court examined the material relied upon (SFIO report and incomplete board minutes) and found absence of specific allegations or documentary proof against the applicants. Given the drastic nature of restraints and the hardship demonstrated (e.g., life savings in demat accounts), the Court concluded that a prima facie case was not made out to continue the interim orders against these particular respondents. The balance of convenience favoured vacatur of the interim restraints while preserving the substantive proceedings. Ratio vs. Obiter: Ratio - where interim restraints are drastic and pleadings/material are general and incomplete with no specific allegations against particular respondents, the prima facie requirement and balance of convenience may require vacatur of such interim orders against those respondents. Obiter - observations on the seriousness of freezing relief and potential hardship. Conclusion: The interim order of restraint was vacated insofar as it applied to the two nominee director respondents, while substantive misfeasance proceedings against them continue. Issue 4 - Procedural obligations of the Official Liquidator when relying on an investigative report Legal framework: Duty of pleadings to disclose particulars in fraud/misfeasance; Official Liquidator's powers to give evidence and call witnesses under Section 542(1); limitations of the Official Liquidator's independent investigatory machinery. Precedent treatment: Authorities requiring particulars and recognising the burden on the Official Liquidator were considered; allowance for some procedural leniency where the Official Liquidator relies on investigatory material was recognised. Interpretation and reasoning: The Court acknowledged that the Official Liquidator often depends on records and external investigation (here, an SFIO report) and may lack full documentary files. Nonetheless, the law of pleadings and fairness requires that if the Official Liquidator intends to make specific allegations against particular respondents beyond general assertions, an additional affidavit setting out such particulars should be filed after collation of evidence, and the implicated respondents be permitted to reply before evidence is recorded. Ratio vs. Obiter: Ratio - balancing the Official Liquidator's investigative constraints with the accused's right to particulars: where specific allegations will be advanced, the Official Liquidator must file an additional affidavit with particulars and afford the respondent opportunity to reply prior to evidence. Obiter - comments on practical evidentiary limitations and suggestion for procedural sequencing. Conclusion: The Court directed that if the Official Liquidator intends to make specific allegations against any respondent based on the general case, an additional affidavit with particulars must be filed and the respondent given an opportunity to reply before evidence is recorded; leave was granted to re-apply if no evidence emerges after trial. Overall disposition (procedural outcome as derived from reasoning) - The misfeasance proceedings under Section 542 were not dismissed at threshold as ex facie material was sufficient to require trial on the question of whether the nominee directors were knowingly parties to fraudulent conduct. - The interim ex parte restraints on property, bank accounts and demat securities were vacated insofar as they applied to the two nominee director respondents because no prima facie case and balance of convenience were lacking in their regard. - The Official Liquidator was ordered to file additional affidavit(s) with particulars if specific allegations are to be advanced against the respondents, and the respondents shall be entitled to reply before evidence is recorded; leave to re-apply for threshold remedies was granted if evidence ultimately discloses no case.