Section 5 of the Andhra Pradesh Protection of Depositors of Financial Establishments Act, 1999, has been making headlines, courtesy Nagarjuna Finance.

The section says "where any financial establishment defaults in the return of a deposit either in cash or kind, or defaults in the payment of interest, every person responsible for the management of the affairs of the financial establishment including the promoter, manager or member of the financial establishment shall be punished with up to 10 years' imprisonment and with up to Rs 100,000 fine."

That's the punishment awaiting 17 persons mentioned in the First Information Report filed by the Andhra Pradesh police, if the charges of defrauding 100,000 depositors are proved against them in a court.

Most of the persons mentioned in the FIR were directly in charge of the management of the company, which shut shop sometime in 2001-02, and the police have already arrested three of them. The spotlight is now on a couple of former non-executive or independent directors, one of them being JM Financial [Get Quote] chairman Nimesh Kampani.

Since Kampani is in Dubai for official work, the police have issued an international lookout notice against him, which means he could be detained on his arrival in India.

The issue at stake is this: Nagarjuna Finance had collected Rs 98.3 crore (Rs 983 million) from depositors between 1997 and 1998 (a period when Kampani was a board member), but failed to repay them later. As many as 94 cases have been registered by depositors against the non-banking financial company of the Hyderabad-based Nagarjuna group.

While the police have their own logic, the action against the company's independent directors, who were not involved in the day-to-day management of the firm, has kicked up a storm.

A closer examination of the records show there may be some merit in the argument that a criminal case against these independent directors may be a case of the police going overboard. Here are a few facts:

<B>Fact number 1: </B>Kampani resigned from the company's non-executive directorship in April 1999. Linking him to non-repayment of deposits after that period may be a bit stretched.

<B>Fact number 2: </B>The auditors' report of Nagarjuna Finance for the year 1998-99 says clearly "the company continued to repay deposits during the year, as a result of which outstanding deposits as at the close of the year were down to Rs 119 crore (Rs 1.19 billion), from Rs 191 crore (Rs 1.91 billion) as at the beginning of the year, implying a repayment of over Rs 72 crore (Rs 720 million) during the year."

<B>Fact number 3: </B>The auditors' report for the year 1999-2000 says, "Your company during the last three years had an unblemished track record of having repaid over Rs 275 crore (Rs 2.75 billion) of fixed deposits which constitutes over 73 per cent of the highest levels of deposits held."

<B>Fact number 4: </B>Going by the auditors' reports, it's obvious that the company's repayment problems with depositors started only after 2000, which was much after Kampani exited the company as non-executive director.

<B>Fact number 5: </B>The Andhra Pradesh Protection of Depositors of Financial Establishments Act did not cover NBFCs till 2003, as they were specifically exempted from the purview of "financial establishments". In 2003, the Act was amended to delete the exemption as the State Legislative Assembly felt that this was excluding a sizeable cross-section of financial establishments from the regulatory framework. While it was a much-needed step, the fact is that Kampani was not involved with the company after April, 1999.

<B>Fact number 6: </B>The role of independent directors in the '80s and the '90s was not as it is today. The board then used to have 'outside directors' who would provide their expertise on matters concerning the company and were not involved with the day-to-day affairs of the company. Today, an independent director is expected to also be concerned also with the protection of interests of minority shareholders.

<B>Fact number 7: </B>The JJ Irani Committee on corporate governance also recommended that the non-executive/independent director should not be held liable for contravention of any provisions of law that happens without his knowledge or consent or connivance.

The police and the courts will of course decide the course of events, but the point that is being made by India Inc is that the defaults by Nagarjuna Finance started more than a year after Kampani left the company, as the auditors' reports show.

It is true that issues of corporate governance can be raised since close to 100,000 depositors - 70 per cent of whom are senior citizens - are involved. It is equally true that a majority of independent directors are passive onlookers when the boards take controversial decisions.

But treating an independent director who had resigned well before the defaults started as a criminal may have far-reaching implications. As it is, the basket of people available to become independent directors is very small. Examples like this will mean that the basket will shrink further.