Even since the subprime crisis erupted last year, there has been an extensive debate about the role of credit rating agencies in exacerbating the crisis. Questions have been raised whether the rating agencies ought to have raised the red flag much earlier than they actually did, thereby protecting the interests of investors who placed reliance on their reports.

The debate over rating agencies largely focuses on two key issues. First, there is an utter lack of competition among rating agencies. Worldwide, there are three main rating agencies, Standards & Poor, Moody’s and Fitch, and as far as India is concerned, the two main agencies are CRISIL and ICRA (both of which are affiliated to two of the worldwide agencies). It is alleged that this lack of competition does not incentivise the rating agencies to improve the quality of their ratings practices. Second, there is the issue allegiance. Currently, it is the issuers of securities who remunerate the rating agencies, owing to which, the argument goes, the rating agencies tend to provide more optimistic ratings to issuers so as to help better market and sell their securities. On the other hand, there are proposals for rating agencies to be remunerated by the investors instead, as it is the investors who rely on the rating reports. The debate on these issues continues, although there are increased efforts by governments in various countries to rein in the activities of credit rating agencies through stringent regulation.

In this context, there are two interesting columns. The first by Jaimini Bhagwati in the Business Standard tackles the first issue of competition and suggests the establishment of a public sector rating agencies. He states:

"One of the reasons why CRAs have been found wanting is that S&P and Moody’s are in duopoly in most financial markets and a corrective measure would be to increase the level of competition. Higher competition and a better balance between income maximisation and investors’ interests could be achieved in India by the setting up of a majority government owned CRA. It is high time that benchmarks are set for the credit rating function since it provides critically important inputs for debt and equity issuance and investment activities. A public sector CRA should be conservative in its creditworthiness assessments and provide guidelines for investors on how best to interpret its credit ratings.

To summarise, for CRAs there is a near duopoly situation internationally and in India. The ratings provided by private sector CRAs have been inconsistent with market signals and rating agencies have pushed for higher earnings at the cost of investor interests. Further, it is likely that if this quasi-regulatory function is left exclusively to private sector CRAs, ratings would continue to be governed by profit maximisation considerations. It follows that it is necessary to set up an Indian public sector CRA to increase competition and provide benchmark standards."In a separate column in the Hindu Business Line, Roopa Kudva of CRISIL deals with the second issue of who should remunerate the credit rating agencies, in which she defends the present position of the issuers paying for the rating rather than the investors, and also highlights some of the other issues involving the rating industry. She justifies the status quo as follows:

“The complaint against the issuer-pays model — where the entity issuing debt pays for the rating — is that it compromises the quality of analysis and ratings. Some suggest an investor-pays model instead, while others recommend third-party involvement such as a regulator.

Will the investor-pays model work? When a rating is assigned, the investor is generally not known. If investors were to pay for ratings, then only those paying will have access to the ratings. Lenders and the market cannot benefit from the ratings. Today, all the ratings are available to all — including retail investors — free of charge, and are widely disseminated by agency Web sites and the media because the issuers pay for them.

The issuer-pays model also gives rating agencies easy access to company managements, which provide insights into strategy that might otherwise not be widely known, and help the rating agencies evaluate them better. It is hard to imagine this level of information-sharing under an investor-pays model.

The issuer-pays model enables rating agencies to provide a quality and depth of analysis to the market that public-information-based opinions and model-driven approaches cannot.”

One usually tends to lament that the Indian securities regulator, SEBI, has been unsuccessful yet in its prosecution of insider trading cases. Several high profile cases were initiated by SEBI only to be overturned by the appellate authorities. This tends to be on account of the fact that insider trading cases are difficult to prove.

A new case initiated by the Securities and Exchange Commission (SEC) in the US highlights some of these difficulties even in that regime (which has a treasure trove of judicial precedents in insider trading cases). The Deal Professor has an interesting take on the action:

“The S.E.C. complaint alleges that Mr. Cuban learned about a planned PIPE (private investment in public equity) offering by Mamma.com, in which he was the largest individual shareholder with 600,000 shares. PIPE deals are a sure-fire sign that a company’s finances are in bad shape, and the market’s response to such transactions is almost always negative.

According to the commission, although Mr. Cuban was told that the information was confidential, he sold all his shares to avoid the hit they were sure to take after the announcement of the PIPE deal. The “loss avoided” is estimated at $750,000 — a pittance to someone like Mr. Cuban, who made his money by selling Broadcast.com to Yahoo for $1 billion.

Mr. Cuban’s Mamma.com sale occurred in June 2004, more than four years ago. What took so long to bring the case? News reports indicate that the S.E.C. did not learn of the transaction until early 2007, so the case was already old before it got started. No criminal charges have been filed. Indeed, criminal charges can often slow down a securities case because the prosecutors need to conduct their own investigation.”Aside from the insider trading issue, the report also questions whether securities regulators ought to be focusing on more pressing matters rather than pursuing dated insider trading actions:

“The S.E.C. needs to establish its presence as the market policeman, there to protect investors. Yet in recent years the commission, whether by choice or legal restriction, allowed wide swaths of the market to go largely unregulated. The courts rejected the S.E.C.’s assertion of authority to regulate hedge funds. The commission let Wall Street firms increase their leverage and employ their own internal risk assessment models, allowing them to invest heavily in mortgage-backed securities and other real estate investment vehicles. That decision allowed companies like Lehman to put themselves at risk when the housing market cratered. There was no cop within a hundred miles of that decision.

So the commission decides to pick a fight with Mark Cuban in a case that may not be all that easy to win. The typical insider trading case involves someone with a fiduciary responsibility to a company, such as an officer, employee or outside adviser, who trades in the shares. Mr. Cuban was an investor in Mamma.com, and its management sought to interest him in the PIPE deal, which did not make him very happy. But owning shares in a company does not make one a fiduciary, and there are no restrictions on the right to sell one’s shares.”

In a case decided less than a month back, a special (3 member) bench of the Bombay ITAT considered and decided a number of tax issues arising with respect to entities dealing in shares and securities. Given the considerable attention devoted on late to financial institutions and mutual funds, this decision is one of enormous significance.

The Bench considered three appeals together, one by the Revenue in a case involving M/s Daga Capital Management Pvt. Ltd., and two by assessees (M/s Cheminvest Ltd., New Delhi and M/s Maxopp Investments Ltd., New Delhi). Daga Capital dealt in shares and securities, and had incurred expenditure in the form of losses incurred in dealing in shares and securities and also interest on the moneys borrowed for the purposes of purchasing shares. There was some income earned in the form of dividend, which was exempt under s. 10(33), Income tax Act. The Assessing Officer allowed the losses to be deducted, but didn’t allow the interest on moneys borrowed, on the basis of s. 14A, Income Tax Act. S. 14A(1) states: “For the purposes of computing the total income under this Chapter, no deduction shall be allowed in respect of expenditure incurred by the assessee in relation to income which does not form part of the total income under this Act.” The AO held that the interest was expenditure incurred ‘in relation to’ to the dividend income, which ‘did not form part of total income’ due to the exemption under s. 10(33). On this basis, he disallowed the expenditure. On appeal, the CIT(A) reversed the decision, which was appealed against by the Revenue. The cases of Cheminvest and Maxopp also involved allowability of interest on moneys borrowed for purchasing shares. However, the facts differed slightly, in that, the two were investment companies with largely stable shareholding and not too many transactions in shares.

In this factual matrix, the three major issues arose before the Court: (1) relationship between s. 14A and the rest of the Act; (2) the retrospectivity of ss. 14A(2) & (3), which are procedural provisions dealing with computation under s. 14A(1); and (3) the meaning on ‘in relation to’ as used in s. 14A(1). Of these, the first and the third and relevant for the purposes of this discussion, while the second was decided largely on the basis of the presumption of retrospectivity of procedural and clarificatory provisions, relying on the recent decision of the Supreme Court in Gold Coin health Foods Ltd. [(2008) 304 ITR 308 (SC)].

With regard to the first issue, all the members of the tribunal were unanimous in holding that the provision overrode the rest of the provisions of the Act. The assessee had contended that if an amount is deductible as business expenditure under s. 36, it cannot be disallowed under s. 14A. The Tribunal rightly held that such an interpretation would render s. 14A nugatory and should be rejected. Thus, irrespective of the allowability of expenditure under any other provision, if covered by s. 14A, the expenditure would be disallowed.

I now come to the crux of the case, the meaning of ‘in relation to’, on which the Vice-President of the Tribunal dissented from the other two members. The tribunal had before it two decisions of the Supreme Court – a 11 judge bench decision in H.H. Maharajadhiraja Madhav Rao Jivaji Rao Scindia Bahadur of Gwalior v. Union of India [(1971) 1 SCC 85] and a 2 judge decision in Doypack Systems Pvt. Ltd. V. Union of India [(1988) 2 SCC 299]. In Scindia, the Court had held that ‘in relation to’ meant ‘dominant and immediate connection’. On the other hand, Doypack held that the phrase includes ‘direct and indirect connection’. The Vice-President relied on a couple of Supreme Court dicta to hold that the meaning of a phrase as decided by prior decisions can be considered relevant when determining the meaning of the phrase when subsequently used by the legislature, which is deemed to be aware of these decisions. Given that Doypack was a smaller bench and had failed to cite Scindia, he opined that Doypack need not be followed. Thus, ‘in relation to’ required a dominant and immediate connection, which would have to be determined based on the intent of the parties. Having made this finding on law, he applied it to the facts at hand. He held that in the case of Daga Capital, the intent at the time of borrowing the money was to use it for purchasing and selling shares and securities and not making an investment. Hence, the expenditure was not in relation to the exempt income, and was allowable. However, for the other two assessees, he held that given the scarcity of share transactions entered into by them, their intent was to hold investments and not to trade in shares. Hence, the expenditure was not allowable due to s. 14A.

The majority of two members, in a decision marked by acute and literal statutory interpretation, held that even the expenditure incurred by Daga Capital should not be allowed. Starting first with the conflict between Scindia and Doypack, they disagreed with the view that the meaning of phrases in one statute could be blindly imported into another. On the other hand, they opined that the context in which the phrase was used in the statute is significant. Applying this, they held that while Scindia dealt with constitutional interpretation, Doypack dealt with a tax-related matter, and was of greater relevance. They also held, interestingly, that the phrase in question in Scindia was ‘relating to’ and not ‘in relation to’ further detracting from its application to the issue at hand. In addition, they opined that even applying the ‘dominant and immediate’ test, the expenditure would be disallowed. For arriving at this decision, they applied the but-for test, stating that it was only due to the moneys borrowed that the dividend income was earned, thus satisfying the ‘dominant and immediate’ test. On the interpretation of the statute, they pointed out that the provision does not talk of looking at the expenditure and then looking for income resulting from it. Instead, it mandates an examination of the exempt income followed by an examination of the expenditure which has been incurred ‘in relation to’ such exempt income. Thus, the dissenting decision, in their opinion, put the proverbial ‘cart before the horse’. They supported this interpretation by pointing out that the Rules meant for computation under s. 14A provided for interest and similar other indirect expenditures, which would not have been the case had the provision to be read narrowly. Next, the assessee contended that Rule 8D used the term ‘value of investment’, suggesting that only expenditure meant for an investment was envisaged by the provision and not money spent in something like trading in shares and securities. The members again drew a distinction between ‘value of investment’ and ‘value of assets held as investment’, holding that the former refers to any money spent, while the latter would refer to money spent in the form of a long-term investment. Finally, dealing with the argument of intent, they held that intent was irrelevant now that the ‘dominant and immediate’ test was rejected. Also, since there was no distinction drawn in the Act between directly and incidentally earned income, the mere fact that the dividend income was incidentally earned had no tax implications. Finally, the Tribunal looked at a few decisions prior to the introduction of s. 14A, which had held that if the business in indivisible, expenditure in relation to all the income should be allowed, notwithstanding the fact that some of the income was tax-exempt. The Tribunal observed that s. 14A was introduced precisely in order to remedy this situation. Hence, even if the business was indivisible, the tax-exempt income was to be computed and the expenditure proportionately spent in relation to it to be determined.

Thus, as things stand today, the interpretation of s. 14A, with regard to allowability of expenditures on exempt income is as follows:
• The first inquiry is to determine the income which is exempt under any provision of the Act
• Next, determine the expenditure which is, in any way, related to this income
• Such expenditure as is related is not allowed, the rest is
• The intent of the parties at the time of making the investment is not relevant
• Allowability of the expenditure under any provision of the Act is overridden by s. 14A
• Indivisibility of the business is not relevant, and the tax-exempt income is to be computed and the expenditure proportionate to it to be determined and disallowed

A previous post on this Blog by Mr. Jayant Thakur raises valid issues regarding corporate governance and government-owned companies. Although I am in agreement with the position stated, it may be useful to highlight certain other complexities this matter gives rise to. I initially began by writing a comment to his post, but owing to its length, decided to post it separately as a supplement. Here are the additional issues:

1. As pointed out in Mr. Thakur’s post, Government companies that raise finance from the capital markets ought to be subject to the same requirements that other companies are subject to. Listed government companies too have minority shareholders (banks, financial institutions, both domestic and foreign, and the general public) like any other listed company in the private sector. It is curious as to why the minority shareholders in Government companies should be given separate treatment (indeed inferior protection from a corporate governance standpoint) compared to shareholders in other listed companies. SEBI’s current order impliedly seeks to make such a distinction.

2. Is there a reversal in SEBI’s position? For the last few years, since introduction of the new corporate governance norms (i.e. the amended clause 49 of the listing agreement), SEBI has been publicly adopting a stern stance that government companies will not be given any waiver from compliance with the listing agreement. In fact, one of the reasons for the delay in implementation of the 2004 amendments to clause 49 until January 1, 2006 was for companies (especially government companies) to put in place mechanisms such as independent directors and audit committees. That position also seems to be the genesis for the notices issued last year under which the present adjudication took place. However, the recent adjudication orders will certainly soften the regulatory stance towards government companies.

3. The SEBI orders also expose serious lacunae in the regulatory oversight with reference to corporate governance, and may necessitate a review of the entire mechanism for implementation of corporate governance. On its merit, it may not be possible to go to the extent of criticising the SEBI order as being bad in law. What may perhaps deserve some criticism is the law itself. The current scheme on corporate governance is administered through the listing agreement. Therefore, SEBI and the stock exchanges have privity with, and cause of action against, the companies that are parties to the listing agreement and not any against dominant or controlling shareholders (e.g., the Government in case of a government-company). Whenever there is a violation of the listing agreement, various actions may be initiated against the listed company, one of which would be to seek to delist the company from the stock exchanges. But, the irony of it all is that when actions such as delisting are initiated against the company, it is the minority shareholders that suffer although the corporate governance mechanisms through the listing agreement were set up to protect their interests in the first place.

Of course, this is not an issue peculiar to India, as most other countries (including U.S., Singapore, China, etc.) administer their corporate governance mechanisms through the listing agreement. However, it is necessary to ponder whether there could be other mechanisms available to ensure compliance with corporate governance norms, which measures target not only the listed company but also its dominant shareholders. One solution may be to incorporate some of the corporate governance norms under company law that may have wider application and recourse to a larger number of players in the corporate governance arena. Such a move appears to have been taken, at least partially, with the Companies Bill, 2008 introducing requirements as to independent directors, which is otherwise within the realm of SEBI.

4. Moving from a technical level towards a softer element of corporate governance, one always finds that good governance is a matter that ought to be inculcated in the corporate actors (whether they be companies, directors, officers, auditors, dominant shareholders, etc.) and there would be limitations in mandating corporate governance through law. In other words, corporate governance involves more substance than form, more spirit than the letter of the law. From that perspective, compliance or otherwise of corporate governance norms by government companies has an important signalling effect. Strict adherence to these norms by government companies may persuade others to follow as well. But, when government companies violate the norms with impunity, it is bound to trigger negative consequences in the market place thereby making implementation of corporate governance norms a more arduous task.

Gail, ONGC, Indian Oil Corporation, etc. have, as per Orders of Adjudicating Officer (see, e.g., Indian Oil order here and others available on SEBI site) allegedly violated Clause 49 of the Listing Agreement since they allegedly delayed the appointment of Independent Directors. These orders are perhaps of the earliest of orders of adjudication of violation of requirements in relation to Corporate Governance under the Listing Agreement.

Apart from revealing SEBI's approach in dealing with violations of Clause 49, these Orders bring out strange reasoning underlying the dropping of the proceedings without levy of penalty in any of these cases. Essentially, the reasoning is as follows. These companies are Government Companies. Appointment of Directors on these Companies, under Articles, is to be made by the President - effectively by the concerned Ministry. The Companies have been diligent in follow up with the Ministry for appointment of Independent Directors in accordance with Clause 49. The Company cannot be held liable for delay by the Ministry/majority shareholders. Taking these and other factors into account - using the euphemistic term "peculiar facts and circumstances" - the proceedings against these companies have been dropped without levy of any penalty.

To some extent one has undoubtedly to consider the underlying realities of a Government Company in which majority shares are held by the Government of India. However, one cannot leave it at that in view of the reasoning given. The point is, can a Company validly give a reason that it did the follow up required with its dominant shareholders who, incidentally, had powers codified under the Articles too. Would the same relief be given to, for example, an MNC whose majority shares are held by a foreign parent where the Company had made similar petitions to its parent company? Would the same reasoning apply also to a situation where a promoter family holds majority shares and also similarly neglects?

Further, for how long and to what extent can a Government Company continue escaping norms applicable to listed companies to which it bound itself by becoming a listed company in which the public have a stake and which stake is the resulting of raising of huge funds?

Generally, questions would also arise whether the Company as a corporate entity and/or its minority shareholders should suffer on account of defaults of majority shareholders more so when there are clauses in the Articles that make the Company helpless in taking any action?

I reiterate that Government Companies do have "peculiar facts and circumstances" and, on the positive side, perhaps it is commendable enough that SEBI initiated proceedings (interestingly, these proceedings were consciously started after receiving preliminary replies). But, then, such orders raise more questions than give answers.

- Jayant Thakur, CA

In a previous post, I had discussed the preliminary and procedural aspects of the decision of the Madras High Court on legality of derivative transactions. This post considers the substantive aspects of the decision.

In the case of Sumitomo Corporation v. CDC Financial Services (Mauritius) Ltd. and Ors., delivered by a two judge bench of the Supreme Court, the basic issue was whether, in case of a conflict, Section 10(1)(a) of the Companies Act, 1956 would take precedence over Section 50 of the Arbitration and Conciliation Act.

The facts of the case were as follows: In 1984, Sumitomo Corporation (appellant) entered into a Joint Venture Agreement with two of the respondents, which clearly specified the rights and obligations of the parties, and also included an arbitration agreement. Subsequently, in 2005, the parties entered into another agreement for transfer of shares, which also included an arbitration agreement. In May-June 2006, a dispute arose between the parties in relation to the interpretation of the Joint Venture Agreement with respect to the powers of nomination to the board of directors. The Respondents filed a petition before the Company Law Board, Principal Branch, New Delhi, seeking redressal under Sections 397, 398 and 402 of the Companies Act, 1956. The appellant filed an application seeking reference to arbitration under Section 45, or Section 8 of the Arbitration and Conciliation Act. On the Company Law Board’s refusal to do so, the appellant filed an appeal under Section 50 of the Arbitration and Conciliation Act in the High Court of Delhi. The High Court found that it lacked territorial jurisdiction over the matter, as Section 10(1)(a) of the Companies Act would take precedence over Section 50 of the Arbitration and Conciliation Act. Aggrieved by this, the appellant came before the Supreme Court.

Section 50(1)(a) of the Arbitration and Conciliation Act provides that an appeal shall lie from an order refusing to refer the parties to arbitration… to the Court authorized by law to hear appeals from such order (Emphasis Supplied). On the other hand, Section 10(1)(a) of the Companies Act provides that the Court having jurisdiction will be the High Court having jurisdiction in relation to the place at which the registered office of the company concerned is situated. Moreover, Section 10F specifically provides that an appeal from a decision made by the Company Law Board would lie to the High Court. Therefore, in order to determine territorial jurisdiction, the first thing the Court had to determine was which of the provisions – Section 50(1)(a), or Section 10(1)(a) - would be applicable. The controversy is whether the High Court to which the appeal lies under Section 10F from an order of the CLB is the High Court within whose territorial jurisdiction the registered office of the Company is situated or is it the High Court having jurisdiction in relation to the place at which the Company Law Board makes the order under appeal.

The appellants contended that the correct forum for hearing the appeal was provided under Section 50 of the Arbitration Act and not any provision under the Companies Act. Section 50 of the Arbitration Act specifically provides for appeal against orders refusing to refer the parties to Arbitration under Section 45 of the Arbitration Act. It was further contended that Arbitration Act is a ‘complete code’ in itself as far as arbitration law is concerned. Moreover, being a special statute dealing specifically with the law of arbitration, it should have precedence over any similar provisions under Companies Act. Therefore, it contended that the appropriate Court authorized by law under Section 50 is the Court having jurisdiction at the place where the Company Law Board heard the matter, which in this case, was the Delhi High Court.

On the contrary, it was argued that as per Section 50, the appropriate forum for hearing the appeal from the orders of Company Law Board is the High Court within the jurisdiction of which the Registered Office of the company in issue is situated (the Madras High Court, in the present case). This is in accordance with Section 10F read with Section 10(1)(a) of the Companies Act.

The apex Court giving precedence to Section 10(1)(a) r/w Section 10F observed that only the forum which is authorized to hear appeals from the Company Law Board would possess the jurisdiction to hear such appeals. It is a specific appellate forum and not every Court exercising civil jurisdiction can entertain such appeals. And as per Section 10F & 10(1)(a), it is the High Court within whose territorial jurisdiction the Registry office of the Company in issue is situated.

The Supreme Court observed that the appeal always lies to the Court which is authorized to hear the appeal. It is not the Court which would have possessed original jurisdiction had the matter been brought to it at first instance as a suit. Therefore, the appeal would not lie to the High Court having jurisdiction in relation to the place at which the Company Law Board makes the order under appeal. Thus, reading Section 10(1)(a) with Section 10F, the Court concluded that Madras High Court had the territorial jurisdiction to hear the matter, as the Registered Office was situated within its jurisdiction.

Therefore, the important of this judgment lies in settling the law on the point of precedence in the event of a conflict between provisions of two of the most important and topical acts in modern commercial law, the Companies Act and the Arbitration and Conciliation Act.

- Gautam Bhatia & Venugopal Mahapatra

The Companies Bill, 2008, which has been introduced in the Lok Sabha, contains two entities that are fairly novel in the Indian corporate scenario, and it might be useful to briefly discuss these two types of entities. They are: (i) one person company (OPC); and (ii) “small” company.

One Person Company

Under the existing Companies Act, 1956, a company can be incorporated with a minimum of two shareholders (in the case of a private limited company) and seven shareholders (in the case of a public limited company). Similarly, there is also a requirement to have minimum number of directors, which is two directors in the case of a private limited company, and three in the case of a public limited company. This often gives rise to several practical difficulties. For instance, certain affairs of the company cannot be carried out without the presence of at least two shareholders or directors at shareholders general meetings and board meetings respectively.

However, these requirements have, to some extent, lost their relevance in recent times, especially in the case of very closely held companies, because they can simply be overcome by introducing nominee shareholders and nominee directors. For instance, if one person (i.e. a legal person, being an individual or company) intends to form and operate a company, all that person needs to do is to find another person to act as a nominee to satisfy the two-shareholder requirement. Similarly, it is possible to find one or more friendly individuals to act as directors to satisfy the minimum director requirement. Since these requirements have become largely procedural in nature, the introduction of an OPC is welcome.

The OPC will act as a useful substitute to sole proprietorships, whereby single individuals carrying on business activity can take advantage of limited liability, which is not available in the case of a traditional sole proprietorship. In the case of an OPC, since the company would be a separate legal entity, the shareholder will not be liable for the debts of the OPC itself, subject of course to certain exceptions such as lifting of the corporate veil. This will perhaps help individuals structure their businesses in a more organised fashion, which would also help them raise finances from time to time in the form of equity or debt.

In the Bill, the OPC has certain special provisions applicable to it. The name of an OPC should carry the words “OPC Limited” so that the persons of dealing with it are aware of its character. The OPC is also exempted from some of the procedural requirements under the Bill, such as the need to hold a shareholders’ annual meeting. The OPC is required to have only one director on its board.

Relevant clauses in the Bill: 3(1), 5(1)(a), 13(1), 85(1), 120(1), 132(1)(a), 171, 421

Small Company

The Bill defines a small company as a company, other than a public company, whose (i) paid-up share capital does not exceed a prescribed amount that shall not be more than Rs. 5 crores (Rs. 50 million), or (ii) turnover does not exceed a prescribed amount that shall be no more than Rs. 20 crores (Rs. 200 million). The reference to a company “other than a public company” would mean that a “small company” would necessarily have to be a private company or an OPC.

Small companies are eligible to take advantage of certain simplified provisions of company law. The most significant of these benefits relates to a simplified procedure for amalgamation of small companies (in clause 204 of the Bill) that can be effected without prior approval of the National Company Law Tribunal.

Relevant clauses in the Bill: 2(1)(zzzg), 204, 421

How Far Does This Benefit OPCs and Small Companies?

Apart from the simplified provisions discussed above, both OPCs as well as small companies are required to comply with all the provisions of the Bill as in the case of other companies. However, clause 421 of the Bill provides that the Central Government may direct that certain provisions of the Bill shall not apply to a private company, OPC or small company. Hence, the simplification process is largely left to subordinate legislation and in the hands of the executive. The flexibility available to these entities can be determined only once such exemptions have been granted.

While the introduction of such new entitles are welcome in that they assist small businesses, there is a fundamental question regarding the approach adopted. One of the objectives of simplifying company law is to ensure that it caters all types of businesses at different points in the spectrum, i.e. with large listed companies at one end and small companies at the other. However, the starting point in the Bill seems to be the law as it applies to large listed companies, replete with all the detailed provisions. From that starting position, exceptions and carve outs are being made for small types of entities.

This does not account for the fact that a substantial number of companies that are registered in India are small private companies as opposed to the large public and listed companies. For example, the Annual Report (2007-08) issued by the Ministry of Company Affairs indicates that as of March 31, 2007, there were 7,43,678 companies, out of which 6,53,024 were private limited companies, while only 90,654 companies were public limited companies (out of which only a small percentage would be listed companies).

Therefore, unless OPCs and small companies are exempt by the Government from the operation of a large number of onerous provisions in the Bill (that are otherwise meant to apply to public companies and in certain cases to private companies), the objective of achieving simplification of company law for small and medium-size business would be difficult to achieve.

(In the following post, our guest contributor Karthik Seshadri examines the issue of misrepresentation arising out of the judgment of the Madras High Court in Rajshree Sugars v. Axis Bank. For a background of the case and issues involved, please see Niranjan’s earlier post)

In what can be termed as a locus classicus on the subject pertaining to Derivative transactions and their validity, Mr. Justice V.Ramasubramanian of the Madras High Court[1] has gone on to hold that “prima facie” the derivative transactions – option contracts – swap contracts etc., that were entered into by an exporter with a bank in order to hedge its risk against foreign exchange fluctuation were valid. The exporter in the instant case had taken a stand that the contracts were void ab initio as being hit by Section 23 (opposed to public policy), Section 30 (Wagering contract) of the Indian Contract Act, 1872 as also being opposed to provisions of the FEMA, 1999.

The Learned Judge in an exhaustive judgment and in a very characteristic manner dealt with all these objections and negatived the claim of the exporter. While dealing with the case on hand, the Learned Judge was confronted with a situation wherein the exporter was able to produce material to show that the Bank (counter party) had in fact represented to the exporter that US Dollar would never reach the stipulated level vis a vis the Swiss Franc to be faced with a situation where the exporter actually found itself in, prompting it to file the suit. The Learned Judge brushed aside the contention that there was no misrepresentation since both parties had no control over or knowledge as to how the currency would fluctuate. Is that the test? Was it correct on the part of the Bank to have made such a statement? What is level of diligence required of a Bank to make such a statement? This paper seeks to examine those aspects.[2]

Bank & Customer - Misrepresentation:

There was an economic slowdown happening in the United States of America with the “Sub Prime” crisis, ever since July-August 2007. This snowballed into a major crisis leading to credit squeeze, fall of major banks like Lehman Brothers, Bear Stearns collapsed and several others were either on the verge of a collapse or were putting up a “brave face”. Between January 2008 & March 2008 this started having an impact on Foreign Institutional Investors (FIIs’) and they started pulling out of the stock market in India as well. The Bombay Stock Exchange & National Stock Exchange started witnessing a slide as these institutions started pulling out of the market.

My wife & I, as any prudent middle class family would do, have invested our hard earned money into various security instruments, viz., shares, mutual funds, debt bonds, fixed deposits etc. Our investments are “advised” by a “new age bank”[3]. During one of our visit to the bank, the bank manager subtly told us that if we had some “spare cash” that we were looking to invest in, the ideal situation would be to invest into structured products that have been launched by certain mutual funds. That the returns on these structured products were linked to the NIFTY or the stock index; and that the structured products were capital guaranteed products. Since the NIFTY had come down to around 4000 levels, it would be very lucrative to invest in these structured products. The returns if calculated based on data on the movement of NIFTY over the years would show that the investor can get a return of about 15-18% annualised. Sounds very attractive and interesting for any investor in a sliding market!

Now, technically what was the manager doing? Was he providing an advise? Was it an advise that a normal, average man likely to rely upon and take a decision? Was the manager duty bound to explain any risk attached to the investment decision? What would happen to these structured instruments if the markets collapsed further and takes a very long time to recover?

In common law there are three kinds of misrepresentation and they are:

In the Indian scenario, the law is governed by Section 18 of the Indian Contract Act, 1872.[8] The question therefore is, whether the bank manager or the agent dealing with the exporter in the ordinary course of business and selling the derivative product to the exporter is making any positive assertion to the exporter. Was not the bank under a duty to inform the exporter of the pit falls of the transaction? When the bank made a statement that the dollar would never reach the stipulated level vis a vis the Swiss Franc, was that statement that can be called a positive assertion, made out of experience, statistical data and a statement that the exporter relied upon, since it came from a person whom the exporter had no reason to doubt?

Role of Reserve Bank of India – Is there any duties cast on the Bank?

The Reserve Bank of India in exercise of its powers issued a Master Circular governing Foreign Exchange Derivative Contracts[9]. The RBI has mandated that in respect of foreign exchange derivative contracts both involving the rupee and not involving the rupee, banks should ensure that in the case of:

i. Swap structures where premium is inbuilt into the cost;
ii. Option contracts involving cost reduction structures;

• such structures do not result in increase in risk in any manner; and
• do not result in net receipt of premium by the customer

RBI has also prohibited the banks from offering leveraged swap structures or a swap route to become a surrogate for forward contracts for those who do not qualify for forward cover.

A reading of the Circular would suggest that the Reserve Bank of India as the primary regulator has imposed certain restrictions in the manner in which a Foreign Derivative Contract is entered into. A duty has been cast on the banks to ensure that certain foreign derivative contracts do not result in increase of risk in any manner nor result in net receipt of premium by the customer. The duty imposed on the banks automatically call for the banks to exercise due skill & care while providing advise to its customers and requires them to protect the client/customer from any “increase in risk”.

If that is the mandate, was such skill and care exercised by the banks? Did the banks protect its customers from any increase in risk? Even a prima facie look into the various derivative contracts would show that such application of skill and care was lacking. Further, when the bank asserts to its customer that the US Dollar would never reach the levels vis a vis the Swiss Franc, such a statement, it is submitted, apparently shows that the bank did not exercise due skill and care required of it. When the bank manager informed me that it would be attractive to invest in a structured product, certainly there was no disclosure of risks or application of skill and care expected of a bank.

Exporter getting a benefit on part of the contract – Does it make a difference?

A reading of the judgment of Mr. Justice V. Ramasubramanian would indicate that the Learned Judge was convinced that the exporter could not claim that the contract was illegal as they had derived a benefit from the same in part. It is respectfully submitted that such a view is contrary to law. Merely because a person derives a benefit from an illegality, it would not make an illegal transaction valid. The person who derived the benefit from such illegality ought to return the same. If after adopting an objective test, the court comes to a conclusion that a particular transaction is illegal, then all parts of the transaction are liable to be set aside.

Conclusion:

Though the judgment of the Learned Single Judge is not the end of the road for the exporters and they have many more battles to fight. The current trends in foreign exchange situation could be a better solution for the exporters and the bank alike. Many transactions are getting knocked off and in some cases we have started witnessing negotiated settlements. After all, a commercial solution is better than a legal one. Or is it?
----------------------------------------

[1] Order dated 14.10.2008 by Hon’ble Mr. Justice V.Ramasubramanian, in CS No. 240 of 2008, High Court, Madras

[2] To understand a little more on Derivative transactions in India and more particularly how they were entered into in Tirupur, readers are urged to read S.Gurumurthy, …”Amstrong Palanisamy”, The Hindu, 04th & 05th July 2008.

[3] New age bank – is meant to denote a bank that markets various security products aggressively including helping customers decide in their investments in mutual funds, also through their business arms act as share brokers, provide what is termed as retail banking aggressively.

[4] Derry vs. Peek; (1889) 14 App. Cas. 337.

[5] It was first seen in the case of Hedley Byrne v. Heller; [1964] A.C. 465 where the court found that a statement made negligently that was relied upon can be actionable in tort.

[6] Esso Petroleum Co Ltd v. Mardon; [1976] 2 Lloyd's Rep 305.

[7] Section 2(2) Misrepresentation Act 1967 in England, however, allows for damages to be awarded in lieu of rescission if the court deems it equitable to do so. This is judged on both the nature of the innocent misrepresentation and the losses suffered by the claimant from it.

[8] 18. "Misrepresentation" means and includes­ -

(1) the positive assertion, in a manner not warranted by the information of the person making it, of that which is not true, though he believes it to be true ;
(2) any breach of duty which, without an intent to deceive, gains an advantage to the person committing it, or any one claiming under him, by misleading another to his prejudice or to the prejudice of anyone claiming under him ;
(3) causing, however innocently, a party to an agreement to make a mistake as to the substance of the thing which is the subject of the agreement.

[9] RBI Master Circular No./6/2007-2008 dated July 02, 2007

Further to posts here regarding amendment to SEBI Takeover Regulations allowing persons holding 55-75% to acquire further 5%, see report in ET dated 5th November 2008 that says that this permission may soon be reversed.



Readers may recollect that this new amendment allowing such 5% increase was without any time limit and also not a recurring annual feature. Apparently it was to allow Promoters to acquire shares from the market since the prices were, as per perception, too low. This mopup may help restore prices to what they think are fair prices.



Now the ET report is like a "Last few days of SALE - buy quickly" signboard! Whether Promoters will respond is to be seen.



The ET report also shows how multiple authorities may come in each other's way and at times even carry on a perverse turf war. The Finance Ministry's logic for the demand for withdrawal of this amendment is that the public's holding would go down to below minimum public holding . Why, would you ask, should the public holding go down below public limits when the maximum limit for Promoters' holding is 75% even after the amendment? That is because the Finance Ministry wants to treat some categories of shareholders as non-public shareholders though as per SEBI's definition, these would fall under public shareholding.



The ET report is actually about the Finance Ministry's decision to defer the proposal to delist companies who do not have minimum public holding. ET says that this deferment is because the Ministry feels that the prices of shares today are too low and interestingly, a study by the Ministry has "revealed" that there is no relationship between Q1 and Q2 corporate profits and the "sharply lower valuation of blue-chip scrips". The Finance Ministry might "reveal" the "fair prices" of these shares so I can borrow and then rush and buy them!



- Jayant Thakur

The issue of whether a buyback of shares will trigger an open offer under the Takeover Regulations has been the subject-matter of extensive discussion on this Blog. In addition, one of our guest contributors, Somasekhar Sundaresan, has a guest column in the Business Standard, which details the issues involved and makes some proposals for change. He states:

“It is true that promoters in control of the company could use their control to expend company money to buy back shareholders and enjoy the consequential hike in stake. However, should Sebi desire to impose an open offer obligation pursuant to a buy-back, Sebi ought to correspondingly remove the ban on promoters participating in the buy-back.

There is another legislative option. Sebi could make it mandatory that the promoters refrain from voting on buy-back proposals, both at the level of the board decisions and at shareholder meetings, if their stake were to go up beyond 5 per cent. If the rest of the shareholders and the board were to implement the buy-back without the promoters voting, then an involuntary increase of any level of percentage holding of the promoter ought not to result in an open offer.”The essence of this approach is to consider whether the promoters have been instrumental in the buy back (through exercise of control) or not.

It is necessary to note, however, that SEBI has announced amendments to the Takeover Regulations (discussed here and here) since publication of the above column.

1) SEBI amended vide notification dated 30th October 2008 the Takeover Regulations Takeover to, in essence, permit an acquirer, with persons acting in concert with him, to increase his holding by 5% by acquiring additional shares or voting rights upto 5% through open market purchases or pursuant to buyback of shares by the target company. This was following a Press Release discussed here and since this Press Release raised concerns on whether increase in buyback can trigger the Takeover Regulations, I submitted an article discussing it here.

2) The notification amends Regulation 11(2) by inserting a 2nd proviso (lets call it the “2nd Proviso” here) and there is also a consequential amendment to Regulation 11(2A). There is another amendment to 11(2). Here are some thoughts and issues.

3) This new creeping acquisition is not available annually and repetitively, unlike the creeping acquisitions upto 55%. Thus, the acquirer will be able to increase his holding by another 5% only. To give an example, the holding of 58% can be increase upto 63% only. It is not as if such a person can go on increasing 5% every year.

a) Having said that, there is no time limit for acquiring this additional 5% and it can be done even in stages. One could say that this facility has been introduced to deal with the low market prices today. However, there is no restriction of time or stock market indices and one can acquire this additional 5% even if the markets have boomed again! Of course, SEBI could drop this facility at that time!!4) Also, the maximum holding after this additional acquisition can be only upto 75%. Thus, for example, a person holding 73% can acquire only an additional 2% and not 5%.

a) The Regulations recognize the fact that there could be two maximum Promoters’ holding – 75% and 90%. However, there is no special concession in the 2nd Proviso for companies where Promoters could otherwise hold upto 90%.5) Acquisitions are permitted only through open market purchases in normal segment on the stock exchange or pursuant to buyback of shares by the Company.

a) Such acquisitions cannot be through bulk deals/negotiated deals/preferential allotment.

b) A query was raised by a reader here whether purchases through open offer would also be permitted? I think the better view seems to be acquisitions through open offer route are not covered. Firstly, the requirement is that the acquisition should be through “open market purchase in normal segment of the stock market” (the words “stock market”, incidentally, were missing in the Press Release). These words by themselves should be sufficient to rule out open offers. One could of course then ask what was the need of specifically prohibiting increase through “preferential allotment”. This prohibition seems to mere emphasis and clarification and not intended to change the meaning of the earlier words though often clarifications, even this one, create fresh ambiguities!

c) To deal with yet another query here, what would happen to pending applications for exemptions before SEBI in case of possible increase through proposed buybacks? I think the application may not serve any purpose now. However, note that the exemption is a limited one in quantity and range and otherwise and hence if you are asking for more, then you may need to modify your application. Also, since SEBI has now given a general exemption, it could be that SEBI may not want to allow anything more unless there are special circumstances. 6) Can an acquirer buy a single lot of shares through the open market? This is important from many angles and in fact demonstrates the conflicting objectives of SEBI/small shareholders and the Promoters. SEBI apparently wants that the acquisition should be from retail shareholders or at least the opportunity should be available to all equally and fairly. However, the reality also can be that large quantity of shares may be with shareholders such as FIIs, etc. If the Promoters try to buy from the open market, it is possible that the low liquidity may result in sharp increase in the price even by few purchases. Bulk sellers may agree to sell at an agreed price, though little higher than the market or, in these pathetic times, even lower!!! – considering that there may not be many buyers.

a) To come back to the issue, can the Promoters acquire such large lot of such sellers, albeit through the stock market in normal segment? While strictly speaking such purchase would be an open market purchase in the normal segment of the stock exchange, remember that the amendment specifically prohibits bulk deals though these are meant to be different. SEBI also seems to have a paranoid view of synchronized deals and even holding them indiscriminately to be false, manipulative, etc. Readers’ views are solicited.7) To deal with a query/comment, this facility of additional 5% increase in holding is not limited to Promoters only but applies to any acquirer and persons acting in concert with him. This issue may of course be academic since there may hardly be cases where a person holds 55% and is not a Promoter.

8) Now, thus, there would be two categories of creeping acquisitions. One creeping acquisition is for the slab 15-55% where an additional 5% is permitted in any manner, whether through open market purchases or otherwise including preferential allotment. The second slab is the newly introduced one. Also, remember that upto 55%, one can acquire additional 5% every financial year.

9) How will the amendment affect a person holding between 50-55% and who, if he acquires 5%, crosses 55%? There are more than one complication here and let me raise some issues. Let me take for this purpose an example of an acquirer holding 53% (I am rounding off figures for simplification).

a) Can he acquire, firstly, 2% under any form of purchases under creeping acquisition under Regulation 11(1) and further purchases under the new 2nd proviso only through the restricted route of open market purchases/buybacks? I seek readers’ views but I think that, on balance, he should be able to acquire 2% under 11(1) to reach 55% and further purchases only under the new 2nd proviso to 11(2). However, I must admit there, strictly and technically, there is scope for holding the other view is also possible particularly if the purchase is through one lot and shoots, for example, straight by one shot to additional 5% as for example in a preferential allotment. Readers - any comments?

b) Will such person, after having acquired 2% (or even 5% under another interpretation and circumstances) under Regulation 11(1) be restricted to a further acquisition only 3% (0%) or can he acquire yet another 5% under the new 2nd proviso? The answer seems to be he can acquire yet another 5%. In fact, this would allow a person to acquire about 10% (using rounded off figures for simplicity) in a single financial year – 5% under 11(1) and another 5% under new proviso to 11(2). Thus, a person holding 50% can increase his holding to 60% in a single financial year.10) Now let us consider the amendment by the 2nd Proviso permitting creeping acquisition also through buyback of shares. Let us consider what the amendment is first and then consider the earlier controversy surrounding it and what is the change, if any.

a) The amendment permits an acquirer to “acquire..additional shares or voting rights… (provided)…the acquisition is made through open market…. or the increase in the shareholding or voting rights of the acquirer is pursuant to a buy back of shares by the target company” (emphasis supplied).

i) Thus, if a person holds, say, 55%, his holding, post-buyback can increase upto 60% under the 2nd Proviso.

ii) However, this is not simple as it may sound because of peculiar mathematics. Let me explain as follows. The persons have to between 55-75% for such increase. The buyback would affect differently for different holdings. To give an example, if a person holds 55%, a mere 8% buyback would result in increase of his holding by 5% (55/92% is 59.78%, i.e., there would be a 4.78% increase). A person holding 60% would find his holding increased by 5% at 7% buyback and at 70%, at just 6% buyback. This problem would effectively limit the buybacks that a Company could carry out to 8% only, as compared to the maximum legal 25%. Of course, the simple solution is that the Promoters should also sell their shares to the appropriate level to ensure that net increase is only 5%. This may defeat the purpose of really giving retail investors a chance to sell their shares through this amendment. Also, in case of open market buyback, there is the issue of Promoters not being permitted to offer their shares.b) I had written an article here on the issue as to whether increase in percentage holding arising solely out of buyback of shares would amount to acquisition under the Takeover Regulations and thereby trigger an open offer or be counted as part of creeping acquisitions, etc. My view was that, on balance, even considering the fact that buybacks are initiated by the Promoters, the express law does not result the Takeover Regulations being triggered (whether for open offer, creeping acquisitions, etc.). This may be an anomaly and even an unfair loophole but I had suggested that to remove this, the law had to be specifically amended rather than bringing it indirectly through grant of exemptions.

c) To recollect further, in essence, the argument is that Regulation 10, 11 and others require a specific acquisition of shares or voting rights. If there was no acquisition, these Regulations do not get attracted. A buyback of shares results in an increase in percentage holding without any such acquisition. While the Promoters cannot shrug off the issue saying that the increase is on account of the company’s decision when they are in control of the Company, the fact remains that the express provisions of law do not cover, in my view, increase in percentage purely through buybacks. SEBI, however, apparently required or permitted a practice by companies to seek an exemption for such increase and then worsened it by assuming in the Press Release that this is also the law. The amendment following such press release also maintains this stand and assumption of SEBI that increase in percentage holding through buyback should attract the said Regulations without amending 10, 11 and other Regulations. So where does this new amendment leave the view that percentage increase through buyback should not be counted for 10, 11, etc.?

d) Let us repeat here the exact wording of the 2nd proviso. It permits an acquirer to “acquire..additional shares or voting rights… (provided)…the acquisition is made through open market…. or the increase in the shareholding or voting rights of the acquirer is pursuant to a buy back of shares by the target company” (emphasis provided). Clearly, even this amendment is self-contradictory when it permits an acquirer to acquire additional shares and then clarifies that increase through buyback is also covered. Further, a strict view can be that even if increase through buyback is to be covered, it would be solely for the purposes of this clause only. You cannot, thus, require a person holding 14.99% shares whose holding increases to, say, 15% on account of buyback to make an open offer. Nor, being consistent, can you require a person holding 25% and whose holding increases to 30.1% on account of buyback, to make an open offer.

e) However, while we could debate endlessly, consider the context earlier and now particularly by the amendment. The reality is that Companies/Promoters have already been making applications for exemption for increase on account of buyback. SEBI has also expressly and publicly granting such exemptions on a case to case basis discussing the merits. SEBI has then issued a Press Release indirectly stating its view that it holds increase through buyback as a creeping acquisition. The recent amendment further substantiates this view/assumption of SEBI and all of this is public knowledge. Consider also this in the background of the reality that it is the Promoters who really push the buyback and it is the Promoters who may not participate in the buyback which they pushed and which results in such increase. All of this still cannot change the express law. But, surely, a Judge interpreting this law, which requires a purposive interpretation, would want to inquire the Company/Promoters how he should ignore all these realities and also hold the amendment to be effectively redundant? Perhaps the time has come to accept this “change”, howsoever shabby, and live with it!11) SEBI has also made what seems to be a consequential amendment to 11(2A). Consistent with Regulation 11(2), Regulation 11(2A) provided that if a person holding between 55-75/90% seeks to acquire, he can do so only by an open offer. Now, the word “only” has been dropped, apparently to suggest that one can acquire upto 5% under the 2nd Proviso but one could also go straight through the open offer route also. This seems to be the intention though the wording could have been better.

12) There is yet another interesting amendment to Regulation 11(2). Regulation 11(2) prohibits acquisition of “additional shares”. These words are amended and now read “additional shares entitling him to exercise voting rights”. I confess I do not understand this amendment and its intent. The Takeover Regulations define shares as shares carrying voting rights including securities that entitle the holder to receive shares with voting rights but excluding preference shares. The amendment now says that the additional shares should be such that should entitle the acquirer to exercise voting rights. Numerous questions arise of which I do not have answer and seek readers’ views:-

a) Does this mean that, for acquisitions under 11(2), only shares presently carrying voting rights are now covered? Does this mean, therefore, that, for example, fully convertible debentures can be acquired? But then, what would happen at the time of their conversion?

b) Why have not these additional words included in the 2nd Proviso which is freshly made? The 2nd Proviso obviously is intended to be an exception to 11(2) and in such case, how can it have broader scope then 11(2) itself? Of course, under the 2nd Proviso one has to acquire “shares or voting rights” through open market on the stock exchange and hence this issue may be academic.

c) Why has 11(1) not also been so amended? Does this mean that creeping acquisition upto 55% may be of any type of “shares” but thereafter, only by acquisitions of additional shares with such voting rights?

SAT has recently decided here on the issue on whether, when and at what price would an open offer have to be made when Share Warrants are exercised. I am highlighting here just some interesting facts and decisions, simplifying them a little, to emphasize some interesting issues.

The Promoter of the target company, Genesis International Corporation Limited, was issued 3530000 Share Warrants therein at an Exercise Price of Rs. 19 per share in early 2007. The Promoter exercised Share Warrants in 2008 whereby his holding increased from 50.48% to 60.48%. He made a public announcement for open offer but there were disputes with SEBI regarding pricing. The Promoter submitted that the offer price should be Rs. 19 being the Exercise Price and also for this purpose calculating the price with reference of the date of allotment of Share Warrants. SEBI argued that the reference date should the date of allotment of the equity shares on exercise of the Share Warrants or the date of the public announcement for the open offer (it actually held to be the latter though the difference was of a few days only).

The difference between the open offer consideration as per these two prices, as per the Promoter, was Rs. 24 crores, apparently apart from interest that may arise. (the price determined by SEBI is not known but I did some back of the envelope reverse calculations and this price appears, assuming I am right, to be about Rs. 102 as compared to Rs. 19).

It appears that there was no dispute on whether an open offer arises in such facts or not (although this issue otherwise also appears to be well accepted, this decision is a good reference of record of this point).

The issue rather was whether the open offer arises when the Share Warrants were allotted or when the shares were allotted on their exercise. SAT held that it is when the shares, which carry the voting rights, are allotted that the open offer gets triggered. SAT observed, “We agree with the learned senior counsel for respondent no.1 that it is the acquisition of voting rights that triggers the provisions regarding public announcements and public offers contained in the Regulations. Acquisition of securities without voting rights, including convertible warrants as in the present appeal, will not, by itself, necessitate any public announcement or public offer.”

SAT further referred to various provisions and concluded – “Therefore, in the present case, the requirement of public announcement arises only with the allotment of shares and not with the allotment of warrants”.

The answer to the issue of pricing then would logically follow and SAT held accordingly that “Therefore, the reference date for computing the offer price should be 28.6.2008, the date of the BoD meeting when the shares were allotted and not 16.12.2006, as the appellant has taken nor 21.6.2008, the date of the public announcement, as decided by respondent no.1”

Note the fine distinction, though of few days, drawn by SAT. It held that it is the date of the Board Meeting where the shares were allotted that would be the reference point and not the date of the public announcement for the open offer. With due respect, I am not sure how right this view is but see the decision where SAT has given detailed reasoning in paragraph 7 for this view.

SAT finally held that SEBI should issue a fresh communication within 2 weeks and allow a reasonable time for opening the offer and thereafter only provide for interest. With due respect, I submit as follows. The decision of SAT is dated 15th October 2008. Let us say that the offer starts on 1st January 2009. If one compares with the date held by SAT of June 2008, then shareholders would receive almost Rs. 30 crores (again as per rough back of the envelope calculations) after six months – because the acquirer chose to litigate the issue and which was decided against him. Even at the 10% interest rate decided by SEBI (which the Hon’ble SAT does not appear to have changed), the interest comes to Rs. 1.50 crores. With due respect, I submit that such interest, which is not “costs” that are awarded or not awarded as per facts, should have been required to be paid in the circumstances. I am not saying at all that the appellant was wrong in pursuing the matter in appeal – I am asking why should the shareholders suffer on this account? Also, surely, the appellant had full use of the money and, perhaps, as a cautious person, put it in interest bearing fixed deposit.

Having said the above, it is possible that, in this particular case, though exact facts are not available, the shareholders may not have really suffered. This is because, as per statement of the appellant recorded in the decision, the higher price was on account of substantial increase in the price recently. However, open offer pricing usually applies the average price of an earlier period and therefore, possibly, the recent price could have been much more  than the higher open offer price held by SAT (yes, I admit my laziness in not looking up the price tables of this period - J). In that case, they had opportunity to exit at such higher market price and so in reality may not have reason to argue that they have suffered a lot, I respectfully submit again that the issue of interest remains a matter of concern.

All in all, I think the decision settles for the record some issues that are regularly faced by listed companies and Promoters.

© Jayant Thakur, CA

SEBI has amended the Takeover Regulations to permit creeping acquisitions vide a notification dated 30th October 2008. I had highlighted here the Press Release that announced the decision of SEBI for this purpose. Following some queries by readers, and also certain points by Mr. Umakanth, more specifically on a concern expressed by me on whether increase in percentage holding arising out of buyback of shares could per se and automatically the Takeover Regulations as SEBI seemed to have taken for granted, I reproduced here an article I had written earier this year for a professional journal, BCAJ, earlier this year on this issue.

Now that the amendment has been made, it is worth discussing in more detail and I will give some of my views later tonight or by tomorrow. I will try to incorporate the points and suggestions (and very learned differing opinions too) of readers in this piece to follow.


- Jayant Thakur, CA

In an earlier post, I looked at a recent judgment of the England and Wales High Court by Justice Munby in Hashem v. Shayif. It appears from the judgment that the only case in which the corporate veil could be lifted was where the company was a façade. In order to support this conclusion, Justice Munby relied on several cases, but most prominently on the decision of the Court of Appeals in Adams v. Cape Industries plc., and on an observation by Lord Keith in the House of Lords decision in Woolfson v. Strathclyde Regional Council that “it is appropriate to pierce the corporate veil only where special circumstances exist indicating that it is a mere façade concealing the true facts.”

A significant fallout of the decision in Hashem v. Shayif is its refusal to distinguish between various grounds on which the corporate veil can be lifted, specifically ‘agency’ and ‘single economic entity’, and this aspect perhaps merits greater discussion.

In Woolfson, as the judgment itself notes, the line of argument based on agency was not pressed before the Court by the parties. Thus, the Court was not required to consider agency-based arguments at all. That left the Court with the arguments relating to ‘single economic entity’ and ‘façade’. It is in this context that the Court held that a façade was a necessary requirement for lifting the corporate veil.

Woolfson rejected the ‘single economic entity’ argument. However, that does not mean that it negated agency-based arguments also. The distinction between these two kinds of arguments is in fact strengthened by Adams v. Cape Industries, which rejected the ‘single economic entity’ rationale expressly, but rejected the agency arguments only on the grounds that an agency was not established in the facts of the case. Thus, the position arising from Adams is that a group of companies cannot be treated as one on the sole ground that the companies are part of the same economic group. However, if it can be established that a company habitually acts according to the wishes of one shareholder, then a factual agency can very well be established. This would allow the Courts to lift the corporate veil.

A ‘single economic entity’ argument is based on the fact that two or more companies are part of one economic group, while a ‘factual agency’ argument is based on the degree of control over a company by another (legal or natural) person. Rejection of one argument does not mean rejection of the other.

To this extent, then, Hashem v. Shayif does not appear to lay down the correct principle of law.

I now turn to the position in India. In my last post I had stressed that Adams was a judgment in the early 1990s. That was for the specific reason that one of the important Indian cases on the point – State of UP v. Renusagar – was decided in 1988. In Renusagar, therefore, the Court did not have the benefit of the decision in Adams. The Court proceeded, therefore, on the basis of prior English law which had accepted the ‘single economic unit’ argument. Thus, Renusagar seems to support the conclusion that a ‘single economic entity’ argument would succeed in India.

Renusagar cited the (quite controversial) decision in LIC v. Escorts, saying “… the corporate veil should be lifted where the associated companies are inextricably connected as to be, in reality, part of one concern. It is neither necessary nor desirable to enumerate the classes of cases where lifting the veil is permissible, since that must necessarily depend on the relevant statutory or other provisions, the object sought to be achieved, the impugned conduct, the involvement of the element of the public interest, the effect on parties who may be affected.” Further, the Renusagar decision went on to note, “It is high time to reiterate that in the expanding of horizon of modern jurisprudence, lifting of corporate veil is permissible. Its frontiers are unlimited. It must, however, depend primarily on the realities of the situation. The aim of the legislation is to do justice to all the parties. The horizon of the doctrine of lifting of corporate veil is expanding.”

If this was the last word of the Indian judiciary on the point, then one could say that in India the corporate veil could be lifted on grounds of ‘single economic entity’ as well as ‘public interest’; thus signifying a significant difference in the Indian and UK positions. However, Indian Courts have not been entirely unaffected by the changes in British law. In so far as taxation-related ‘veil’ issues are concerned, Azadi Bachao Andolan is often understood as restricting the application of “substance over form” doctrines. This might mean that Courts will tend to be less open to lifting the veil on assessments of hypothetical motive. (An earlier note on this blog has analysed how far Azadi actually goes in this direction.)

Among the Indian decisions which have taken into consideration the developments in British law is the judgment of the Madras High Court in Novartis v. Adarsh Pharma. In this case, an argument was made that the corporate veil could be lifted only in cases where the corporate form was abused leading to unjust and inequitable results. The Court considered several cases and held that “(The Court is) not inclined to agree with the submission … that only when the corporate entity is abused for an unjust and inequitable purpose, the Court should not hesitate to lift the veil … the Court can investigate the relationship between the parent company and the subsidiary company and lifting the corporate veil depends on the facts of each case.”

The Court took this stance after noting Adams. Nonetheless, the Court held that a ‘single economic unit’ argument could work in certain circumstances. These circumstances would depend on the factual control exercised. This view is strengthened by the Supreme Court decision (cited in Novartis) in New Horizons v. Union of India “(It is not impermissible to treat) a subsidiary as the agent or the alter ego of its parent, provided the facts of the case justified such a conclusion. However, it would seem that the facts would have to reveal a very high degree of control by the parent over the subsidiary before a Court would conclude that an agency relationship had been established…” This, thus, accepts the Adams position of leaving open the ‘factual agency’ grounds; while recognizing that the factual burden is not an easy one to discharge.

To conclude, the following broad principles can be drawn from the existing case-law:

1. Single economic entity: In England, the mere fact of a two companies constituting a ‘single economic entity’ is not sufficient to lift the corporate veil. In India, Courts are more likely than English Courts to accept this argument, considering that there are Supreme Court judgments which have done so. However, later decisions seem to have noted the change in the English position and have impliedly gone by the Adams trend.

2. In India, the ‘single economic entity’ argument has not been clearly distinguished from ‘agency’ arguments. Perhaps, this is the reason why ‘single economic entity’ arguments have not been rejected outright. It is to be hoped that Indian Courts draw the distinction between these arguments before entirely rejecting the ‘single economic entity’ argument.

3. Factual Agency: In England as well as in India, ‘factual agency’ is a ground to lift the veil. Although on facts this is a difficult ground to establish, there is no authority to reject the argument on law. The test is whether it is reasonable to assume that transactions entered into by the company were entered on behalf of one individual / another company. It must be shown that the company so habitually acts according to the wishes of that other individual / company, that it is justifiable to treat the two as one legal entity.

4. Façade: In light of the existing case-law, Justice Munby’s decision must be confined to “façade” arguments only. On the issue of façade, the decision offers valuable guidance. In order to establish a façade, there must be a showing of impropriety. The impropriety must be linked to the use of the company structure to avoid or conceal liability.

5. Public Interest: In England, public interest – standing alone – is not a ground to lift the veil. It might still be open to argue on the basis of public-interest in India. The Courts will rely on this ground when lifting the veil is the most ‘just’ result, but there are no specific grounds for lifting the veil. Thus, ‘public interest’ may in some cases be used by Indian Courts to lift the veil even when the strict test for establishing a façade is not satisfied.(I would like to thank Mr. V. Umakanth for his invaluable suggestions regarding this post)

A previous post had noted that the Madras High Court has recently upheld the legality of the so-called exotic derivatives, holding that they qualify for recovery through the Debt Recovery Tribunal. The following is an analysis of that judgment – Rajshree Sugars & Chemicals v. Axis Bank Ltd. (MANU/TN/0893/2008, C.S. No. 240 of 2008, decided on 14 October 2008).

The well-reasoned and comprehensive decision of the Court covers many aspects important to corporate law – primarily the legality of derivatives, but also the jurisdiction of the civil court in such a transaction vis a vis the Debt Recovery Tribunal, the permissibility of granting injunctions against proceeding in the DRT etc. The plaintiff (“RSC”) was an exporter of sugar, and consequently had several External Commercial Borrowings (ECB’s) from foreign banks. Correspondingly, many of its receivables were also in foreign currency. RSC had entered into an “ISDA Master Agreement” with Axis Bank (“the Bank”), an internationally standardised format under the aegis of ISDA – the International Swaps and Derivatives Association. As the Court noted, the normal practice is for specific deals to ‘flow out’ of this Master Agreement. There were 10 deals of this sort between RSC and the Bank, and the dispute arose out of the tenth, OPT Contract No. 727.

The structure of OPT 727 is becoming increasingly commonplace. It is described in detail in the judgment, but its essence was that RSC would receive $100,000 if 1 USD never touched 1.2385 Swiss Franc within a fixed period, between what is known as the “trade date” and the “fixing date”. Correspondingly, RSC was obliged to buy $20 million USD from the Bank if the exchange rate touched 1.3300 at that rate. On the happening of certain other contingencies, there was to be no exchange of principal. The Court found that the object of the transaction was for the plaintiff to hedge its receivables against foreign exchange fluctuations. As it happened, the plaintiff received a sum of $ 100,000 from the Bank and later claimed that the contract was “knocked out”, with no liability for either party. The Bank challenged this claim, and the plaintiff approached the Madras High Court seeking a declaration that the contract it had entered into was void.

Several important questions are answered in the course of the judgment. These are summarised at the end of this post. To briefly discuss the contentions, the fulcrum of RSC’s case was two-fold – first, the transaction is a “wagering contract” and is void as it contravenes Section 30 of the Contract Act, and secondly, that it is not supported by “an underlying transaction” and is therefore opposed to RBI Circulars and is void as per Section 23 of the Contract Act. RSC also made arguments specific to the circumstances of its case – that the Bank failed to study the “risk management policy” and that its own CFO exceeded his authority in entering into the transaction. I will discuss these contentions (particularly wagering and public policy) in detail in a subsequent post.

Here I examine two preliminary contentions the Bank raised, as these are also likely to be of commercial importance – first, that such a suit is not maintainable as the proper forum is the Debt Recovery Tribunal, and secondly, that no injunction can be given in such cases against the Bank proceeding in the DRT, since the DRT is not “subordinate” to the High Court.

On the first preliminary point, the Court noted that although ‘debt’ is defined widely in the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (Section 2(g)), this does not automatically bar a civil suit, which is permissible on narrow grounds set out by the Suprem