Section 397 - 398: Books of Account – Companies Act, 1956 - allegations of mismanagement and connected issues?

Despite the clear regulations in the Companies Act, 1956 as to how every Company should record its transactions, maintain books of account and should submit the approved Financial Statements with the ROC, financial transactions in some closely held companies would be really interesting to note and dealing with the cases of this kind would really be very complicated. The logic behind the settled accounting principles, the provisions of Companies Act, 1956 dealing with maintenance of accounts, Accounting Standards etc., can very easily be understood. Every Company is expected to be transparent, expected to provide true picture of financial issues to the shareholders and also expected to comply with the regulations with regard to preparation and submission of financial statements with the authorities like ROC in the interests of the Company and also in public interest. Financial transactions in some closely held Private Companies would really be interesting and we can see routing the Company’s financial transactions through personal Bank Accounts of Directors or the Shareholders. This is why, most of the times, even if there exist procedural irregularities in the Companies with regard to financial issues, those are not taken so seriously at times. For example, there can be going concern which is a closely held company doing business for so many years and if any disputes come among the shareholders suddenly, the adjudicating authority may try to ascertain the true facts in the Company and much emphasis may not be laid on technicalities. This is a very complicated issue to deal with. We know the limitations of auditing and we know that it is very easy to find some procedural irregularity in any company with regard to recording financial transactions or maintenance of Books of Account. If these procedural irregularities lead to serious consequences except in exceptional cases, then, many closely held Private Companies may not survive. It is true that the provisions of Companies Act, 1956 are not directory and mandatory and we know the importance of providing true financial picture of the Company to the shareholders; and as such the consequences of procedural violations can be dealt with strictly as provided under the provisions of the Companies Act, 1956.

I would like to just highlight an observation or noting of Delhi High Court in Tarlok Chand Khanna And Another vs. Raj Kumar Kapoor And Others, 1983 54 CompCas 12 Delhi, ILR 1982 Delhi 156 regarding the maintenance of personal Bank Accounts by the shareholders in the Company and the reference is as follows:

“The opening of this account was an apparent sequel to the instructions by Khanna to the existing banker of the company with regard to the disputes that had surfaced between the two groups and which may have possibly led to the disruption of normal banking channel for the conduct of the business of the company. In any event, whatever the compulsions for the opening of this account, it was nevertheless the account of the company and even though operated upon by Kapoor exclusively, he is answerable to the company for the various transactions reflected in this account. In any event, all the directors of a company who are conducting the business of the company on its behalf or in its name are always accountable to the company for the funds or property of the company that they deal with in the course of the discharge of their duties. There was also some controversy as to how much funds each of the groups had made available to company in addition to their respective contributions to the capital. Some of the credits to which the groups are entitled are apparently duly reflected in the books of account of the company. It is possible that some of the credit entries may be exaggerated or fictitious as was alleged on behalf of Khanna with regard to the period during which has group had remained ousted from the management of the company and the affairs of the company were being managed by Kapoor. These matters can be adequately dealt with on the completion of the account of the company and the preparation and audit of the balance-sheet and profit and loss account of the company to date. If any of the groups is not satisfied with the accounts or their audit, they would be entitled to raise these matters in the next meting of the Board, as also indeed, in general meeting of the company and solicit an appropriate decision at any of the two levels to ensure that the rights and liabilities of the directors and the creditors of the company qua the company are properly reflected in the balance-sheet and they dealt with accordingly.”

Evidentiary value:

When there is litigation by or against the Company; and where there exist disputes among shareholders, the Books of Account and Financial Statements play a key role in determining the dispute. Because, the presumption normally is that the every company records true transactions as required under the provisions of Companies Act, 1956 and the presumption is rebuttable. Dealing with the evidentiary value of Books of Account and the burden of the management when there is litigation against the management, the Orissa High Court in Shanti Prasad Jain vs. Kalinga Tubes Ltd. And Ors, AIR 1962 Ori 202, was pleased to observe as follows:

“In the present case, undoubtedly all these facts were within the special knowledge of those in the management of the Company at the time and by reason of non-production of the relevant documents, the petitioner is entitled to the benefit of presumption against the Company. The petitioner had made an application filed on April 5, 1961 for production of documents including Cash Books and ledger Books of the Company for the year 1958; on the said application this Court made an order on April 7, 1961 directing the Company to produce the said documents as mentioned in the said petition; the Books of Account for the year 1958 were not produced by the Company; in any event it was for the Company to tender the Books of Account of the year 1958 in evidence and get them exhibited in court. The Company having failed to do so the Court can draw an adverse inference against the Company.”

Allegations of Mismanagement:

Every one knows as to how the financial transactions are recorded in many Private Limited Companies and how the books of account are maintained despite clear provisions with regard to maintenance of Books of Account by the Company under the provisions of Companies Act, 1956. When the dispute comes between or among the shareholders, at times, it is very easy for the aggrieved shareholder to make-out a prima facie case of mismanagement under section 398 of Companies Act, 1956. It is true that every Company should record transactions correctly and should maintain proper Books of Account. It is also true that the every Company should get the accounts audited, approved in the AGM as provided and should file the Financial Statements with the Registrar of Companies (ROC) as required. However, the procedural irregularity in maintenance of Books of Account etc., will not provide a right to the shareholders or the minority shareholders to file a petition under section 397/398 of the Companies Act, 1956 except in exceptional cases. If this is allowed, then, many companies may not function and in many companies, an investigation is to be ordered. But, however, it is very difficult to allege something against the people in control of the Company based on the procedural irregularities in recording the financial transactions and in maintaining the Books of Account as required. It is also true that the Books of Account too can be used as evidence and to draw inferences. There can’t be any hard and fast rule in this regard.

Though it is settled that a petition under section 397/398 of the Companies Act, 1956 alleging oppression and mismanagement in the Company is not maintainable solely based on procedural irregularities, it is very difficult to ascertain as to whether the irregularity was deliberate or accidental. The Madras High Court in S. Seetharaman and Others Vs. Stick Fast Chemicals Private Limited and Others, 1998 (93) CC 507, 1999 (32) CLA 480, 1999 (32) CLA 273, dealing with a case of oppression under section 397 of the Companies Act, 1956, was pleased to observe as follows:

“In a petition filed under Section 397 of the Companies Act, the petition should contain all material facts. In case of fraud, mismanagement oppressive conduct, etc., full and complete particulars must be alleged in the petition. Subsequent affidavits are not enough. The petitioner must plead all material facts necessary for granting the relief as prayed for. Facts arising subsequent to the filing of the petition cannot be relied upon. The validity of the petition will be judged on the facts alleged therein and existing at the time of its presentation. Lack of essential allegations in a petition cannot be made up by leading evidence. "Oppression" according to the dictionary meaning is any act exercised in a manner burdensome, harsh and wrongful. Oppression may take various forms like lack of probity and fair dealing in the affairs of the company to the prejudice of some portion of its members. The section confers wide power on the court to deal with such a situation in an equitable manner which it did not have in the case of a company prior to the passing of the Companies Act, 1948. To obtain any relief under this section a petition must show that the oppression arises from the way in which the affairs of the company are conducted or is attributable to an act or omission on the part of the company. Where a shareholder repaid a loan taken by the company from its bank without informing the company and took a transfer of the company security it was held not to be oppression as the shareholder had acted in a personal capacity and the conduct did not alter the position of the company. Relief may be granted under Section 397 of the Act only against the continuous acts on the part of the majority shareholders oppressive to the minority. Some isolated and illegal act do not amount to oppression. Denial of the right of inspection or other rights of a shareholder or failure to comply with formalities required in the matter of giving notice of a general body meeting or refusal to declare more than a moderate rate of dividend even though the profits earned justified a higher rate of dividend cannot taken by themselves amount to oppression. Denial to shareholders of access to the books is not oppression because there is adequate remedy against such denial in the Act. Merely because the petitioner who had a substantial shareholding was excluded from management, it cannot be said that there was oppression against a shareholder.”

Note: the views expressed are my personal and a view point only.