India Knowledge@Wharton carries a discussion (or a mutual interview of sorts) between Wharton professors Jitendra Singh and Harbir Singh and former SEBI Chairman M. Damodaran on several issues pertaining to Indian corporate governance, including the role of independent directors. The discussion is rich in that it dissects several fundamental issues of Indian corporate governance, such as whether it is prudent for Indian corporate governance to follow other models or whether it should develop a model of its own, a matter that we constantly endeavour to focus on this Blog. It examines the position and role of independent directors in an Indian setting, given the existence of controlling shareholders (or promoters). The discussion is also radical and provocative at some level – for example, there is a suggestion that Indian regulations should consider two-tier boards (similar to those present in certain civil law countries such as Germany and China) that is likely to lead to better monitoring and governance of companies. While the emergence of this line of thought in India is noteworthy, its practicality and likelihood of success is far from being guaranteed. Overall, it is an interesting and thought-provoking discussion.
Friday, November 20, 2009
Thursday, November 19, 2009
The SEBI-NSDL Controversy
The recent decision of the SEBI to set aside as ultra vires two orders passed by a Special Committee set up by it has led to a huge furore in commercial and legal circles. The origin of the controversy was the appointment of CB Bhave as the Chairperson of the SEBI at a time when SEBI was investigating the propriety of the actions of the National Securities Depositary Limited (“NSDL”), in relation to several past events. The fact that CB Bhave had been the CMD of NSDL prior to his appointment as Chairman of SEBI, lead to an obvious conflict of interest. In order to avoid this conflict, it was decided that the investigation be carried out by an independent Committee. The investigation was completed and an order delivered in December 2008. In a departure from usual practice, the SEBI did not disclose the findings till November this year, when it also declared that the two orders were ultra vires and hence void. The basis of this conclusion was that
a. The Board had delegated its authority to the committee to dispose of three quasi-judicial proceedings pending against NSDL.
b. The committee, however, entered findings that the Board failed as a regulator, while disposing of two matters relating to IPO Irregularities and DSQ Software Ltd.
c. These findings against the Board are outside the confines of delegation and therefore, these are without the authority of law.
d. These findings, which have vitiated these two orders, cannot be severed from the rest of the orders. Hence these orders are null and void and are non est.
e. The third order (in the matter of Rajnarayan Capital Market Services Limited) is in order since it does not have similar findings.
Much has been said about the effect of such a decision on the accountability of the SEBI, and the real suspicion that the decision is in bad faith. However, there are also two important legal issues that arise from this decision of the SEBI, which is what I focus on here. These are:
First, does the SEBI have the power to declare an order of the Special Committee as ultra vires? Secondly, even if it has this power, was the order here in fact ultra vires and liable to be declared void?
On the first issue of the powers of the SEBI, they are comprehensively covered by Chapter IV of the SEBI Act (these powers have also been discussed earlier). The structure of the Act broadly envisages action of two types- taken by the SEBI itself (ss. 11, 11A and 11B), or by an Investigating Authority appointed by the SEBI (s. 11C). The decisions taken by either of these are appealable only to the Securities Appellate Tribunal (ss. 15T, 15Y and 20A). Besides this appeal mechanism, the Central Government can also be appealed to (s. 20), and it can also take other action against the decision of the Board or the Investigating Authority (ss. 16 and 17). This schema suggests that the SEBI has no review power over the actions of the Investigating Authority, which is what has led some to argue that the decision in the NSDL case was also incorrect. However, it is important to appreciate that the nature of the Committee and the Investigating Authority is fundamentally different. The Committee was exercising the powers of the SEBI under ss. 11 and 11B, which were delegated to it under section 19. There is nothing in the Act to suggest how the exercise of this delegated power can be controlled. Admittedly, such a power has arguably never before been exercised by SEBI (there is a dispute over whether it was exercised on 2006). However, given that the Special Committee was the first body of its sort under the SEBI framework, there is limited value that can be garnered from past precedent. This necessitates reliance on general administrative law principles on sub-delegation. Usually, the controversy over sub-delegation is focussed on whether the delegate has the power to sub-delegate. Given section 19, this isn’t in issue here. The other issue is the extent to which the delegate can exercise control over the sub-delegate. While this has been a point of serious contention, the more supported view seems to be that the delegate continues to retain authority over the matter that has been sub-delegated. Though some decisions like the UK Court of Appeals in Blackpool Corporation v. Locker, [1948] 1 KB 349) and the Employment Appeal Tribunal in Department For Environment Food & Rural Affairs v. Robertson, [2004] ICR 1289 (affirmed on a different point in Robertson v. Department For Environment Food & Rural Affairs, [2005] EWCA Civ. 138, para. 41), have departed from this view, they have been criticised as proceeding on a mistaken understanding of ‘sub-delegation’ (Jackson, 66 LQR 363, 376). In any event, these decisions also only restrict the rights of the delegate during the delegation, and do not prevent it from revoking the delegation. Thus, there seems to be nothing to prevent SEBI from reviewing the exercise of the delegated powers by the Special Committee, especially when what it purported to review was not the decision per se, but the scope of the decision.
This is not to say that the exercise of this power was appropriate on the circumstances here. In fact, while I believe that SEBI has the power to revoke the authority granted to the Special Committee or to declare it void, there is no doubt that the power was incorrectly used here, for two reasons-
First, the very reason for the constitution of the Special Committee was to avoid all conflicts of interest resulting from Mr. CB Bhave’s previous position on NSDL. The fact that independent and not existing members were chosen for the Committee clearly shows that the mere recusal by Mr. Bhave was considered insufficient to counter the conflict of interest. Subjecting the decision of this independent body to the review of the very body that may be influenced by a conflict of interest seems incorrect and undesirable. In these special circumstances, I think the review by the SEBI was inappropriate, and could not be remedied only by Mr. Bhave’s recusal.
Secondly, the SEBI declared the orders of the Special Committee ultra vires because they consider the role of the SEBI instead of focussing only on NSDL. Further, these observations on the functioning of the SEBI are considered to be so fundamental as to constitute an integral part of the decision. However, a reading of the orders suggests nothing of the sort. In fact, after a few passing mentions during the text of the order dealing with the IPO scam, in the penultimate paragraph 94, the members specifically state, “It would not be appropriate for us to leave this matter without expressing our concern about the failure of SEBI to carry out its regulatory role adequately”. This shows that the observations were ancillary to the other findings of the members, far from being integral and inseparable from their other findings. Further, of the three orders, only the ones pertaining to the IPO scam and DSQ Software were annulled. The third order regarding Rajnarayan Capital Market Services Ltd. was affirmed on the basis that the Committee had made no such observations outside the scope of its mandate. However, as rightly pointed by one of the several discussions of this issue, this distinction is incorrect. Even the RCMSL order contains a recommendation to the SEBI, in paragraph 35. The only difference is that there are no general observations or strictures against the SEBI. This lends force to the argument that the other orders were held ultra vires not due to the consideration of SEBI’s conduct, but because of what they said about SEBI’s conduct. This conclusion also finds support in the fact that the SEBI refused to disclose the orders for about 11 months.
In sum, SEBI’s decision to declare ultra vires the decisions of the Special Committee appointed to look into the NSDL matter is incorrect. However, the problem with the decision is less the lack of competence of the SEBI to take the decision, but more the propriety of the decision on its merits. Hence, while the apprehension over the decision and its implications is justified, doubting the competence of the SEBI to make such a determination would be directing the disapprobation at the wrong target.
Monday, November 16, 2009
Some Literature on Governance and Social Responsibility
Professor Balasubramanian of IIM Bangalore has posted two interesting papers.
In the first paper, Addressing Some Inherent Challenges to Good Corporate Governance, he examines certain specific issues arising due to the concentrated ownership in Indian listed companies. Specifically, he notes:
While the objectives of good governance, namely creation, protection and equitable distribution of shareholder value, have long been recognized, their full achievement in practice has been dogged by challenges emanating from various sources like dominant shareholders, autocratic executive managements, inefficient independent auditors, inefficient enforcement mechanisms, and so on. Standing out prominently among these challenges is the potential for controlling shareholder dominance often abetted, unwittingly or otherwise, by inefficient board surveillance over the executive.He then considers two specific issues, both involving corporate decision-making, one at the board level and the other at the shareholder level.
Although Indian listed companies are mandated to have independent directors, Professor Balasubramanian notes that independent directors have not been conferred significant powers. For instance, independent directors are to vote on the board like any other directors, which means that they can be outvoted (unless, of course, independents constitute a majority on the board, which is almost a rarity). Furthermore, quorum requirements do not require the presence of independent directors. The solution he proffers is that independent directors should be given affirmative votes or veto powers on specific matters, particularly those that involved conflict of interest or self-dealing transactions. While this will certainly empower independent directors, it will also impose significant responsibility and accountability that such individuals have to property discharge.
At the shareholder level, he advocates the concept of interested shareholders, whereby those who are interested in a resolution (e.g. controlling shareholders in a self-dealing transaction) ought not to participate in the voting process. Current law does not impose any duties on shareholders to abstain from voting at a general meeting, except in certain limited circumstances imposed by SEBI, as discussed earlier on this blog.
In sum, Professor Balasubramian’s recommendations are in furtherance of the recognition that corporate governance norms in India ought to be tailored to suit the structures and environment that operate in the Indian business context.
The second paper, Governing the Socially Responsible Corporation - A Gandhian Perspective, explores the linkages between corporate governance and Gandhian philosophy. The paper considers Gandhian traits relating to trusteeship, truth, non-violence, and the like, in the corporate context. For example, the element of trusteeship is inherent in directors’ fiduciary duties (e.g., loyalty) towards a company; truth is the basis for corporate disclosures and securities regulation; non-violence carries with it principles of social responsibility whereby the activities of corporations ought not to cause harm to its larger group of stakeholders. The paper also has a useful set of dos and don’ts in corporate governance viewed in this light.
Sunday, November 15, 2009
'Principal place of business' - Oral Arguments in Hertz v. Friend
An earlier post had discussed the issue in Hertz v. Friend, which calls upon the United States Supreme Court to determine what is the ‘principal place of business’ of a corporation having operations in more than one State. The Court heard the matter on 10th November, and the transcript is available here. Unfortunately, while it makes interesting read, the potential the case seemed to have for a discussion on general corporate law theory remains unrealised. A majority of the arguments focussed only on the policy behind the Class Action Fairness Act, with a very limited discussion of concepts like ‘headquarters’ or ‘gaming the system’.
The idea of ‘headquarters’ formed a substantial portion of the petitioner’s arguments, where he was required to discuss the effect of following a headquarter-rule for determining the principal place of business. The headquarter was defined as the place from which the corporation is ‘directed and controlled’. The ultimate test the petitioners seemed to be advocating is that there is a strong presumption in favour of the headquarters being the principal place of business, which can be rebutted if it is proved to be a sham. As to the defendants contention that ‘principal place of business’ was a term of art borrowed from bankruptcy laws, the petitioner argued that they are two terms referring to the same thing.
The defendants focussed more on the policy behind the CAFA, and suggesting that the Congressional intent clearly sought to depart from the headquarters being considered the principal place of business. It was contended that following the headquarters test would allow corporations to ‘game the system’, and should not be allowed. Justice Scalia responded by suggesting that ‘gaming the system’ should not really be a concern since it wasn’t much of a concern in determining the citizenship of individuals. In conclusion, the respondents submitted that the ‘principal place of business’ has to be determined with reference ‘first to the location of employees, tangible properties and production activities, and then second to income earned, purchases made and where sales take place’.
Thus, the oral arguments failed to churn up the discussions on corporate law that could have been expected, and barring the few issues mentioned above, focussed entirely on the policy behind the CAFA and diversity jurisdiction in the US in general. It now remains to be seen what the Court finally chooses as the primary basis of its decision.
Saturday, November 14, 2009
Bits of Interest
1. Siddharth Shah, et. al., offer suggestions for amendment of the SEBI Takeover Code in light of its review by the Takeover Regulations Advisory Committee (TRAC);
2. Shantanu Surpure and Rashi Saraf compare and contrast the regulations in the US and India regarding insider trading, and point to the difficulties in successful investigation and prosecution of violations;
3. Sandeep Parekh critiques SEBI’s approach in the IPO scam cases;
4. T.T. Ram Mohan views Government disinvestment in public sector undertakings from a governance perspective;
5. The Reserve Bank of India (RBI) announces draft guidelines with a view to liberalising the regime governing derivatives in foreign currency by permitting certain types of put and call options, while prohibiting others;
6. The Economist analyzes the acquittal of two Bear Stearns hedge fund managers who were prosecuted for lying to investors about the state of their funds. They are said to have exchanged e-mails that “showed the two panicking behind the scenes while reassuring investors in public.” The collapse of the two Bear Stearns hedge funds in 2007 exhibited the first signals of the financial crisis. This case has some similarities with that of a stock analyst at Merrill Lynch during the Internet bubble years, but the latter case resulted in a different outcome;
7. Noted economist Dani Rodrik disfavours the removal of capital controls. He notes: “Prudential control on capital flows makes a lot of sense. Short-term flows not only wreak havoc with domestic macro-economic management, but also aggravate adversary exchange-rate movements”. He adds: “You can oppose capital controls because you believe financial markets are on the whole a force for good, and that any interference will therefore generate efficiency losses. Or you can oppose controls because you think that they can be easily evaded and are therefore doomed to remain ineffective. What you can’t do is oppose capital controls because they are both costly and ineffective.” All of this is surely music to RBI’s ears.
8. Finally, the Harvard Law School Forum has some lessons for M&A advisors in drafting their engagement letter to protect themselves from third-party liability, at least as a matter of New York Law.
Yet Another Controversy over Section 14A
Earlier posts here had discussed the decision of a Special Bench of the Bombay ITAT in Daga Capital and the possible inequities that could result from its interpretation of section 14A. The most significant one was that expenditure could be disallowed even if no nexus was established between the expenditure and tax-free investment income. To quote from an earlier post explaining the inequity,
Section 14(A)(2) provides that if the Assessing Officer (AO) ‘is not satisfied’ with the assessee’s claim as to the amount of expenditure relatable to exempt income, he shall determine the amount of expenditure ‘in accordance with such method as may be prescribed’. This prescribed method in provided in Rule 8D of the Income Tax Rules, according to which the amount of expenditure disallowed is proportionate to the amount of tax-free investments made, irrespective of the source of the investment. Thus, the mode of computation uses the proportion of the investment vis-a-vis the total assets of the company, to determine what proportion of the total expenditure should be disallowed. Further, section 14A(3) provides that this mode of computation applies also when the assessee claims that no expenditure has been incurred by him in earning the tax-free income. An archetypical case would be when an enterprise has sufficient reserves of interest-free funds to make a tax-free investment. In such a case, there is no question of there being any expenditure in relation to earning tax-free income, since the funds invested in the earning of the income have been internally provided. In such a case, ideally, there should be no disallowance of deductions for expenditures that may have been incurred in other activities of the business. Prior to the decision in Daga Capital, there were a few decisions, specifically in the context of section 14A, stating that the burden was on the Revenue to show the link between the expenditure incurred and the tax-free income earned. However, after the broad interpretation of the provision and the retrospective application of the computation provisions vide Daga Capital, the position seems to have undergone a change. This means that even if an enterprise has not, in fact, borrowed for the purposes of making tax-free investment, but borrowed for other purposes, it still would be denied deductions to the extent worked out by Rule 8D.
Two decisions of the ITAT had sought to alleviate the inequity of the position, by creating a presumption in favour of the assessee in certain cases or by holding that the extent of disallowance cannot be increased on an application of Rule 8D.
However, the Punjab and Haryana High Court in CIT v. Hero Cycles has finally done that which the Tribunal could not do due to rules of precedent- it has held that notwithstanding the application of Rule 8D, the establishment of a nexus between the expenditure incurred and the tax-free income has to be established by the Revenue. On facts, one of the units of the assessee had incurred interest expenditure, and the assessee as a whole had earned some tax free dividend income. The Revenue sought to connect these two together, and apply Rule 8D to disallow the expenditure. However, the CIT(A) found on facts that the interest expenditure had been set off elsewhere, and the dividend income was earned from the investment of tax free money. Based on this finding of fact, the CIT(A) upheld the assessee’s contention.
This decision was appealed against by the revenue to the High Court. Relying on its August 2009 decision in CIT v. Winsom Textile Industries Ltd., the Court affirmed the order of the CIT(A), opining that “[d]isallowance under Section 14A requires finding of incurring of expenditure where it is found that for earning exempted income no expenditure has been incurred, disallowance under Section 14A cannot stand”. While the decision doesn’t seem remarkable in itself, given the concerns expressed after Daga Capital, it serves as an assurance to assessees incurring expenditure and earning tax-free income through different parts of their business.
However, another twist to the issue is provided by the recent order of a Third Member of the Ahmedabad ITAT in Kanel Oil v. JCIT. Discussing the hierarchy between a Special Bench decision and the decision of a non-jurisdictional High Court, the Third Member held that the High Court would override only if there was no other conflicting High Court decision on the issue, and if the High Court decision was not per incuriam. On facts there, the Third member held that the High Court had ignored certain statutory provisions, rendering it per incuriam. On this basis, he held that the Special Bench decision would override the High Court. The merits of this decision, and the competence of a lower court to determine whether the decision of a higher court is per incuriam can be the subject of much independent debate. However, what is relevant here is to note that if Kanel Oil is to be followed, the position may be unsettled even after Hero Cycles. The computation scheme under Rule 8D(2)(ii) and (iii) specifically provides for disallowance even if there no nexus between the expenditure and the income. On this basis, it may be possible to argue that Hero Cycles ignores the text of Rule 8D, and being the decision of a non-jurisdictional High Court, need not be followed in Bombay, where Daga Capital’s Special Bench order would continue to hold fort.
In sum, Hero Cycles seemed to have provided a certain panacea to assessees concerned about the precise scope of Rule 8D and the decision in Daga Capital. However, the degree of relief afforded has been lessened by the uncertain implications of Kanel Oil.
Thursday, November 12, 2009
A Round-up on Recent SEBI Reforms
Earlier this week, SEBI announced a slew of capital market reforms. This comes in the wake of recovery in the markets as well as the Government’s intention to undertake disinvestments in public sector undertakings (PSU). The principal reforms and their impact are discussed below.
Small and Medium Enterprises (SMEs)
SEBI has established a separate regime for listings by SMEs. Companies listing on the SME segment need not comply with the eligibility norms for initial public offerings (IPOs) and follow-on public offerings (FPOs) that are applicable to other companies. However, in order to ensure that only financially sound investors invest in these markets, a minimum application size of Rs. 100,000 has been prescribed. SMEs are eligible to access capital markets under this category so long as their paid-up capital is no more than Rs. 25 crore (Rs. 250 million). If the paid-up capital exceeds this amount, then such company’s listing would be transferred to the main board. In addition, provision has been made for a market-making mechanism for SMEs, and some relaxations have been made for accounting and financial disclosure requirements
These moves are expected to enable companies in the SME segment to access capital markets without being subject to onerous conditions.
Price Discovery in FPOs
In a significant move, SEBI has introduced an additional method of book building for FPOs. Under this scheme, there would only be a floor price set by the company, and bidders would be free to bid at any price above that. Bidders would be allocated shares on the basis of the price they have quoted. In other words, different bidders will be allocated shares at different prices, a novelty in the Indian scenario. However, there is one exception, and that is retail investors would be allotted shares at the floor price. This not only protects retail investor interest, but also pays some regard to the sophistication of institutional investors who are comparatively financially savvy.
While the motive for the introduction of this method may perhaps be relatable to the government's embarkation on the road to disinvestment and the need to fetch as high a price as possible for its shares in PSUs, its success in broader terms may not be free from doubt. It is not clear why companies may adopt the FPO route (which tends to be quite elaborate) rather than use the qualified institutional placement (QIP) route which has been offered to listed companies in a simplified form (and has indeed gained popularity).
One significant question that has been raised pertains to why this option has been made available only to FPOs and not to IPOs. Curiously enough, the price of shares of listed companies is readily available through the discovery mechanism in the secondary markets, which is itself some indication of the value of the company's shares. On the other hand, unlisted companies that are proposing to undertake an IPO do not have the benefit of such a price set by the markets. The current mechanism for IPOs requires the issuing company to indicate a price band, which the investors are bound by. The IPO mechanism does not call for investors bidding at differential rates, although it is precisely in that case that such a mechanism may be more useful than in the case of an FPO where the market price itself provides some guidance. It is possible though that if this additional mechanism is successful in FPOs, there would be a strong case for its introduction in IPOs as well.
(Update – November 14, 2009: The Financial Express has a column by Rajesh Chakrabarti that examines the new FPO pricing option in detail, which also refers to a research paper by Amit Bubna and Nagpurnanand Prabhala)
Miscellaneous Matters
Several other measures have been introduced to enhance the capital markets. These include:
- streamlining the timing of financial disclosures by listed entities;
- interim disclosures of balance sheet items by listed entities;
- simplification of requirements for fast track issues for listed companies desirous of undertaking FPOs or rights issues; and
- voluntary adoption of IFRS by listed entities having subsidiaries.
Other Reforms
Prior to this, SEBI also announced certain secondary market reforms. These are based on the recommendations of the Secondary Market Advisory Committee:
1. A discussion paper outlines the guidelines for incorporating conditions or clauses in powers of attorney issued by clients to the stock brokers or depository participants; and
2. A circular allows SEBI registered stock brokers to provide access to clients through authorised persons. The detailed eligibility conditions for authorised persons as well as the roles and responsibilities of the relevant parties are set out in detail.
Sunday, November 8, 2009
Auxiliary Activities and Permanent Establishments
We have discussed on several occasions the extent to which a liaison office of an MNC is taxed, and more generally, the concept of a “permanent establishment”. A series of decisions in 2009 has introduced some clarity in the analysis of what constitutes a permanent establishment and what does not. To briefly recapitulate, although s. 9(1) of the Income Tax Act, 1961, enumerates circumstances where income is “deemed to accrue or arise” in India, primarily through a business connection test, several DTAAs provide that income earned in one Contracting State may be taxed in the other Contracting State only if it is attributable to a permanent establishment in that State. Permanent establishment is invariably defined in these treaties, but often excludes entities that only perform “auxiliary activities” in the taxable State. It is thus important to determine what legal principle distinguishes an “auxiliary activity” from other activities, and this question arose most prominently in the context of the taxation of liaison offices.
In February 2009, the Delhi High Court held in UAE Exchange Centre v. Union of India (313 ITR 94) that the exclusionary clause of auxiliary activities must be construed broadly. In that case, the parent company, incorporated in UAE, performed remittance services for NRIs in UAE, where it transferred funds to the NRI’s family in India, on the payment of a fee. The contract was concluded in UAE and payment was received by the company in UAE, denominated in local currency. However, the company also used liaison offices in India to effect the transfer, and the liaison offices consequently had access to the company’s server in the UAE. The liaison office would then download the particulars of the remittance, make the necessary demand draft and despatch it in accordance with the instructions of the remitter. The Revenue argued that the contract was in effect performed by the liaison office – for the essence of the contract was the remittance of money – and that this could consequently not be regarded as “auxiliary”. The AAR had accepted this contention. The Delhi High Court quashed this order, and observed that “but-for” test is inappropriate in construing the exclusionary clause – in other words, the fact that the contract could not have been performed without the aid of the liaison office’s activities is not determinative of its status as an “auxiliary” activity or otherwise. The Court held that the test is broader, and that it was auxiliary because it was in “support” of the main activity entered into in the UAE, for payment in the UAE. In what is likely to be of some importance in subsequent cases, the court also observed that “[o]rganisations and companies operate transnationally. There is an eagerness to bring to tax by States income, by employing deeming fictions so that incomes which ordinarily do not accrue or arise within the taxing State are brought within the States' tax net. It is in this context that the expression "permanent establishment" appearing in the DTAA has to be viewed.” The case is also important for the proposition that the AAR constitutes a “Tribunal” for the purposes of Art. 227 of the Constitution.
This view has been followed. In Cable and Wireless Networks (315 ITR 72), decided in July, a branch office of a UK corporation performed network designing, network management services and other support activities. The AAR held that it did not constitute a permanent establishment since the activity is auxiliary. Similarly, in KT Corporation (181 Taxman 94), a Korean corporation opened a liaison office in New Delhi for the purpose of communicating with Indian banks and other commercial entities. The AAR referred to the OECD Model Commentary’s analysis that the activity must form an “essential and significant part of the enterprise as a whole” and held that the LO did not constitute a PE, relying on Morgan Stanley as well as UAE Exchange. In Hyosung Corporation (314 ITR 343), the AAR reached a tentative conclusion to the same effect.
Thursday, November 5, 2009
Law Firms and Joint Ventures
A few months ago, we had posted about a paper by Professor Jayanth Krishnan on issues that revolve around the opening up of the Indian legal sector to foreign law firms. He has now released the results of another interesting piece of research titled The Joint Law Venture: A Pilot Study that examines the rate of success or failure of joint ventures between law firms by looking closely at the “joint law venture” model followed over the last decade in Singapore. Here is the abstract:
This pilot study evaluates the effectiveness of law firms entering into joint ventures, an increasingly eyed business model particularly by American and British lawyers seeking to expand into promising financial markets. One country at the center of the joint venture experiment has been Singapore. With the strong encouragement of the Singaporean government (which has long embraced foreign investment), various elite law firms from the United States and Britain have been partnering with domestic Singaporean law firms for over the past decade. Because these foreign firms were traditionally barred from practicing Singaporean law on their own, the ‘joint law venture,’ or JLV as it came to be called, was initiated to provide the Americans and British with an opportunity to access the highly-desired, lucrative local market – through the use of their Singaporean joint venture colleagues. In return, the Singaporean firms were to benefit by gaining international legal contacts, learning ‘best practices’ from their foreign counterparts, and enhancing their reputations by being tied to prestigious law firm powerhouses.
Until now, no work has fully investigated whether these JLVs have actually fared as well as their advocates had hoped. Therefore, based on fieldwork conducted in Singapore, including in-depth interviews of the relevant parties, this project fills this gap – uncovering how due to economic misalignment, cultural misunderstandings, and a sheer breakdown of necessary human relationships, in more cases than not the JLV has been a failed business model. For these reasons, I argue that American and British law firms may wish to think seriously before pursuing the JLV route – not just in Singapore but perhaps even in other markets in which they are already present or are contemplating entering.
Wednesday, November 4, 2009
E-Voting in Indian Companies
Public (or retail) shareholders in a company usually exhibit traits that result in “collective action problems”. This refers to the difficulties that arise in achieving consensus among a diffused set of shareholders who do not play an active role in the company. These problems are exacerbated by the heterogeneity of interests and differing levels of information available with these shareholders. For these reasons, public shareholders seldom participate actively in general meetings of the company. In most cases, decisions of general meetings are a foregone conclusion as resolutions proposed by the board and management (with the tacit approval of the majority shareholders) are only put through the formal motion at the meetings. Public or minority shareholders make their appearance in small numbers, and their votes cast are not sufficient to cause any dent to the majority decision. Such problems are compounded because general meetings (which are often held in locations that are not prominent or easily accessible) require shareholders to be present in person or by proxy.
A solution to this problem was devised about a decade ago, which was voting through postal ballot. Section 192A of the Companies Act, 1956 provides that listed companies are required mandatorily to obtain resolution of shareholders through postal ballots on certain matters, and optionally on other matters. However, this has failed to achieve the intended result.
It has now been proposed, as reports (here and here) suggest, that online voting be introduced. There would be no legal or regulatory hurdle to begin with as the explanation to Section 192A states: “For the purposes of this section, "postal ballot" includes voting by electronic mode.” Hence, it is a question of prescribing the appropriate mechanism for electronic voting, which is an exercise reportedly being undertaken by the depositories.
Although it would be difficult to estimate the true extent of change that this proposal would usher in, it is certainly a move in the right direction. Electronic voting may motivate more shareholders (including individuals) to exercise their corporate democratic right with greater convenience, and this may signal greater acceptance of shareholder activism in the Indian context by addressing the collective action problems (at least partially).
Tuesday, November 3, 2009
Legal Risks and Financial Sector; Capital Controls
Recent developments in the financial sector have witnessed a sea-change in the nature of legal risks faced by banks and financial institutions. Regulators, banks and financial institutions, as well as their legal advisors (both in-house and external) are required to constantly keep pace with the change. In that context, a recent speech by Shyamala Gopinath, Deputy Governor of the Reserve Bank of India (RBI), contains an interesting account of the legal risks in the present environment, and the steps taken by the RBI to address those risks. The issues highlighted range from those relating to OTC derivatives, enforcement of security arrangements, and the effectiveness of bankruptcy laws (including from a cross-border perspective). While some of the issues carry international implications and have been highlighted due to the financial crisis, others are specific to India.
On a separate note, the Economist has a column that deals with capital controls in emerging economies. Commenting on RBI’s policy, it observes that it is difficult to argue against capital controls, especially given the Indian economy’s resilience in the wake of the global financial crisis: “Having avoided the Asian financial crisis in the 1990s and escaped the worst effects of the most recent meltdown, India’s cautious liberalisers feel they have won the argument this time around. It is hard to disagree.”
The column also describes the undue complexity of India’s capital control regime:
For starters, they are needlessly complex, because India’s policymakers like to retain as much room for manoeuvre as possible. They police capital flows by banning some trades, imposing quotas on others, lifting a price control here or tightening a registration requirement there. This makes life needlessly difficult for foreign investors. The rules are hard to interpret and changes are impossible to predict. One private-equity fund and its investors reckon this confusion and ambiguity cost them $8m in lawyers’ fees. This accomplishes the policymakers’ aim of deterring foreign capital, but not quite in the way they intended. By raising the cost of doing business, the regulatory thicket acts as an implicit tax on investing in India. Its policymakers could achieve the same effect through simple rules and explicit taxes. The $8m that is now spent on lawyers could be given to the Indian government instead.There is certainly a case for simplification of various rules relating to capital flows. More importantly, the rules ought to be clear with very little left for interpretation.
See also a related report in the Economist.
Friday, October 30, 2009
United States Supreme Court considers a corporation's 'principal place of business'
An important question, with significant implications for contemporary corporate law theory will be heard by the United States Supreme Court on November 10. The matter in question is Hertz Corp. V. Friend (08-1107), which poses the question of which State can be considered to be a corporation’s ‘principal place of business’.
The issue has arisen against the backdrop of a class action against the company, for the violation of state wage and labour laws. The suit was filed in a California State Court, in response to which Hertz Corp. removed the action to Federal district court. Before the Federal district Court, the respondents argued that Hertz’s principal place of business was California, hence it was a Californian citizen, and not different from any other plaintiff. On this basis, it was contended that the matter be remanded back to the State Court. The district court, relying on the ‘place of operations’ test, considered several factors like ‘the location of employees, tangible property, production activities, sources of income, and where the sales take place’, and concluded that since Hertz Corp.’s business in California was ‘significantly larger than any other state in which the corporation conducts business’, California was its ‘principal place of business’ in the United States. This decision was affirmed on appeal by the Ninth Circuit, whose decision is available here.
In its petition for certiorari before the Ninth Circuit Court of Appeal, and now before the United States Supreme Court, Hertz contends that the different circuits in the country are applying four different tests to determine the ‘principal place of business’, necessitating some clarity from the Supreme Court about the appropriate test to be used. The Seventh Circuit uses a ‘nerve center’ test focussed on the location of the ‘corporate brain’ or the corporate headquarters; the third circuit looks at the corporation’s center of activity, while some other circuits rely on the totality of the corporation’s activities (the Fifth, Sixth, Eighth, Tenth, and Eleventh Circuits). Of these, for a wide range of reasons, Hertz advocates the use of the ‘nerve center’ approach, according to which, its principal place of business would be New Jersey and not California. It is also supported in this view by the United States Chamber of Commerce. The respondents contend that though the tests being used are different in nomenclature, they result in very similar conclusions. Further, the Congress has specifically preferred the use of ‘principal place of business’ over ‘place of incorporation’ in §1332 of the Class Action Fairness Act of 2005 (“CAFA”). The ‘principal place of business’ being a term of art borrowed from bankruptcy law, it must be decided the way it is in bankruptcy law, i.e., by considering a wide range of factors, and not only the place of incorporation.
This has given rise to issues of whether corporations having a presence in more than one State should be allowed to chose which jurisdiction they can be sued in, and to what extent the theoretical headquarters of a corporation can be given precedence over the practical headquarters of its operations. Thus, the issue is of great significance, not only in the specific context of the CAFA, but also in corporate law theory in general. Particularly, given the similar controversy that has arisen around tax avoidance and multi-national corporations, the hearing on November 10, and the subsequent decision is of great interest. A more detailed discussion of the issues involved is available here, and copies of the briefs in the matter are available here.
Thursday, October 29, 2009
Changing Advertising Practices in India - The End of "Puffery"?
The Government's proposed “Advertising Code” for food and health products is an interesting development , particularly in light of developments in India over the past three years or so on the subject. This blog has discussed emerging trends in India on the norms governing advertising practices.
To briefly recapitulate, the law does not proscribe comparative advertising, which is a near-ubiquitous practice in today’s commercial world. It does not even require that the advertisement be true and accurate in every respect. English law for a long time was that an advertisement that was mere “puffery” could not form the basis for any action in law. This was based on the belief that an advertisement that is so exaggerated as to be clearly untrue is unlikely to cause any reliance on the part of the consumer who sees it, and consequently does not have to be regulated as strictly as advertisements that purport to be factual but are not. For example, an advertisement claiming that drinking a particular soft drink is the route to becoming a millionaire is clearly “puff”, and is less misleading than claiming that the soft drink is superior on account of the fact that competing drinks contain pesticides. This principle was accepted in India as well, until 2008, when the Madras High Court held that the peculiar circumstances of the Indian consumer make the doctrine inappropriate in Indian law. The Supreme Court and the majority of the High Courts had held otherwise, and the only real restriction on comparative advertising was that it could not "disparage" the goods of a competitor.
In this context, it is interesting to note that the Government’s proposal to introduce an Advertising Code appears to primarily tackle misleading and “puffed” advertisements in food and health products. The proposal has emerged under the framework of the Food Safety & Standards Act, 2006 [“the FSSA Act”], under which the Food Safety and Standards Authority of India has been set up [FSSAI]. The FSSA Act prohibits unfair trade practices and “misleading and deceiving advertisements”. The FSSAI notes although commercial advertising is a protected activity Art. 19(1)(a) of the Constitution of India, no law governs it, except guidelines drafted by the Advertising Standards Council of India [“ASCI”]. Those guidelines, however, have no binding force and are intended to function as self-regulation guidelines.
The Code proposes radical changes to existing commercial practices. The restrictions are that advertisements cannot disparage “good dietary practice”, encourage “excessive consumption”, suggest “portion sizes” that may be appropriately consumed and so on. The Code practically makes puffery illegal by prescribing that “advertisements should not mislead consumers…to believe that the consumption of the product advertised will result directly in personal changes in intelligence, physical ability or exceptional recognition, unless supported with adequate scientific evidence”. It also requires that “celebrities or prominent” people not promote food in such a way as to “undermine a healthy diet”. A copy of the entire Code is available here.
The merits of the regulation apart, it is important to consider a few serious questions of enforcement. For one, since the Code, as will inevitably be the case, is phrased in broad terms, it seems more appropriate that this be part of a self-regulation model. If, on the other hand, the FSSAI decides to enforce it, it may have to evolve suitable institutional support to be able to assess not only what advertisements offend the Code, but also whether there is parity in treatment. For example, s. 5(a)(1) of the Federal Trade Commission Act in the United States empowers the FTC to prevent advertisements that are inconsistent with the Act, in addition to the normal remedy of seeking an injunction from a civil court. Similarly, the United Kingdom in 1962 set up the Advertising Standards Authority to regulate advertising. When the ASA finds a particular advertisement to be inconsistent with the guidelines in the UK, the normal practice is for the owner of the advertisement to remove it, thus establishing a model of self-regulation.
Thus, the Madras High Court’s opinion of 2008 appears to have anticipated these developments. After noticing the law in England and the USA, the Court had observed then that “…it is doubtful if false claims by traders, about the superiority of their products, either simplicitor or in comparison with the products of their rivals, is permissible in law. In other words, the law as it stands today, does not appear to tolerate puffery anymore. I do not know if "Puffing" which is only a twin sister of "bluffing", permitted by English courts in the past, still has the sanction of law even in England, after the advent of 'legacy regulators' such as CAP, Oftel, Ofcom, Clearcast etc…”
Powers of SEBI and SEC Compared
In his column in the Business Standard this week, our guest contributor Somasekhar Sundaresan argues that, if one were to go by the rule book, SEBI has greater powers than the SEC. He lists out several significant powers of SEBI that can be exercised without intervention of the court. Here are some excerpts:
Take the Raj Rajaratnam case itself. The SEC has had to file a complaint before a court (see http://www.sec.gov/ litigation/complaints/2009/comp21255.pdf) asking the court to pass orders to disgorge the alleged gains earned by way of insider trading, to restrain the accused from acting as officers or directors of any issuer of securities, and to pay civil monetary penalties under the US securities laws.In India, SEBI itself is armed with powers to take each of the aforesaid actions in absolute terms — not just as interim measures.
On an almost daily basis, SEBI issues directions under Sections 11 and 11B of the SEBI Act asking people not to deal in securities or to access capital markets or to be associated with capital markets. SEBI has wide powers to issue “such directions as it deems fit” with the only touchstone of rationale being the “interests of the securities market”.
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Chapter VIA of the SEBI Act, 1992 empowers SEBI to inflict monetary penalties directly without the intervention of any court. Adjudicat-ing Officers, who are employees of SEBI, acting as quasi-judicial officers have the power to impose civil monetary penalties. These penalties can be as high as Rs 25 crore or three times the benefit gained due to the violation.
SEBI has also written subordinate legislation in the form of regulations governing market intermediaries registered with it to impose disciplinary penalties ranging from censure to cancellation of registration.
The only area where SEBI does not have powers for direct action without an intervention of a court is the ability to send people to jail. Section 24 of the SEBI Act requires SEBI to file a complaint before a criminal court to get an accused convicted and jailed for contravention of any provision of the SEBI Act, or rules or regulations made under it.
'Business connection', 'Attribution' and the withdrawal of Circular 23 of 1969
Through Circular No. 7 of 2009, the CBDT has withdrawn Circular No. 23 of 1969 (“Circular 23”). Circular 23 explained the position relating to ‘business connection’ under Section 9 of the Income Tax Act, 1961.
The Circular was relied upon in the arguments in the Morgan Stanley case before the Supreme Court; as also by the Bombay High Court in SET Satellite. These decisions had laid down the broad proposition that in an international transaction, if the non-resident compensates its permanent establishment (“PE”) at arms-length price, no further profits of the non-resident would be attributable to the PE in India.
The principle enunciated by the Supreme Court in Morgan Stanley on the question of attribution of income to India is as follows:
This was followed by the Bombay High Court in SET Satellite:
“In our opinion considering the judgment, if the correct arm’s length price is applied and paid then nothing further would be left to be taxed in the hands of the foreign enterprise…”
In both these cases, Circular 23 was cited before the Court; yet it did not for part of the Court’s reasoning. In SET Satellite, on this issue, the Bombay High Court directly followed Morgan Stanley (the decision has been previously discussed here). In Morgan Stanley itself, Circular 23 is mentioned in the Supreme Court judgment only when the Supreme Court notes that the AAR placed reliance on the Circular. No reliance is placed on the Circular in the reasoning/conclusion of the Supreme Court itself. The reasoning of the Court is premised on the conceptual relation (and not a relation introduced solely by Circular 23) between a correct transfer pricing analysis and attribution of profits. This relation has been discussed in the previous post on SET Satellite.
Circular 23 stated that “Section 9 does not seek to bring into the tax net the profits of a non-resident which cannot reasonably be attributed to operations carried out in India.” Concerns might be raised as to whether the withdrawal of the Circular changes this basic position.
Circular 23, in paragraph 1, itself states that it is a consolidation and restatement of previous clarifications (or the scope of the corresponding Section in the 1922 Act). Paragraph 3 of the Circular again clarifies that “The following clarifications would be found useful in deciding questions regarding the applicability of the provisions of section 9 in certain specific situations…” From this, it is evident that the Circular does not even purport to lay down any specific legal principle; it only discusses the application of the principle in Section 9 to various fact situations.
Conclusion:
There is at least an arguable case that the withdrawal of the Circular makes no difference to the legal position – either on attribution to PEs or on extent of income taxable under Section 9. What, then, was the need to ‘withdraw’ the Circular? The CBDT claimed that there was misuse of the Circular which resulted in assessees claiming relief not in accordance with the provisions of Section 9. Perhaps, the CBDT wanted to give the Revenue wider scope for ingenuity in argument; however, in my view, the legal position would remain unchanged.
Wednesday, October 28, 2009
A Reiteration of Separate Legal Entity
A recent decision of the Punjab and Haryana High Court in CIT v. Panchratan Hotels has re-emphasised the notion of separate legal entity, albeit in the context of the law of taxation.
Here, the assessee was Panchratan Hotels, and had declared losses for the said assessment year. On 31.7.1992, the shareholders of the company had changed, through a transfer of 100% shareholding from the original shareholder to the new shareholders. On this basis, the CIT contended that there had been a succession of business for the purposes of section 170 of the Income Tax Act. Under section 170, in cases of succession, the predecessor is assessed in respect of the income of the previous year in which the succession occurs, up to the date of succession. On this basis, the CIT contended that the assessment for the year 1.4.1992 to 30.7.1992 was required to be made in the hands of the old company and subsequent assessment from the period 31.7.1992 to 31.3.1993 in the hands of the new company.
For deciding this issue, the Court was required to answer two questions-
(a) Whether the transfer of shares amounted to a succession of business under section 170?
(b) Even if it did, whether section 170 applied to the company whose shares had been transferred?
The Court did not answer the first question conclusively, only noting the argument that a transfer of shares may also amount to a succession under section 170. It based its decision more on the second question, since it was of the opinion that section 170 cannot apply to the facts in issue. The Court observed that the transfer of shareholding would only change the identity of the shareholders and not the identity of the company, which is a separate legal entity. Thus, while the concept of succession would apply to the transferor and transferee of the shareholding, it would not apply to the company whose shares are transferred. In the words of the Court-
Even if for the sake of arguments, we accept that the transfer of shares amounts to transfer of capital assets in terms of Section 2(47), then also in our considered view, Section 170 will not apply. A bare reading of Section 170 shows that the transfer of the business should be from one assessee to another. Person under Section 2(31)(iii) of the Income Tax Act includes a company. Under Company Law, a company is a juristic person. The share holders are not the owners of the company. It is the company itself which is its own owner having its own seal and succession. Where shares are transferred, at best this would be a transfer vis-Ã -vis, the person who was the holder of the shares to the person to whom the shares are transferred. Therefore, individually when Mr. Kapoor has sold his share to M/s.General Sales Limited then it may amount to a transfer when considering the incomes of Mr. Kapoor or M/s.General Sales Limited. Section 170 may be attracted to both the previous and subsequent owner of the shares but cannot apply to the company itself. This is no transfer as far as the assessee, i.e., M/s. Panchratan Hotel is concerned.
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The company is a juristic person having its distinct legal entity separate from that of the shareholders. The change in the share-holders of the company does not change the legal identity of the company.
On this basis, the Court reversed the finding of the CIT, and held that the transfer of shares did not result in the change of identity of the company, but only resulted in a change of the owners of the company. While this seems a reiteration of an accepted principle of corporate law, it assumes greater significance in light of the ongoing Hutch-Vodafone tax dispute, where the central question is whether the transfer of the shareholding of a company having assets in India amounts to transfer of those assets situated in India. In that context, this decision affirming the concept of a separate corporate entity, especially in a tax context assumes is of considerable interest. A copy of the judgment is available here.
Monday, October 26, 2009
Supreme Court Reaffirms Dharmendra Textiles
Earlier posts here have considered the issue of whether the penalty under section 271(1)(c) of the Income Tax Act, 1961 is a criminal, quasi-criminal or civil liability, which in turn has implications on whether mens rea is needed for awarding penalty under the section. The Supreme Court had held in Dilip Shroff that mens rea is needed for the non-disclosure of penalty to result in penalty, but this was subsequently overruled by the Court in Dharmendra Textiles. This was followed by decisions of some High Courts and Tax Tribunals narrowing the applicability of Dharmendra Textile to facts, making it possible that a subsequent consideration of the issue by the Supreme Court may reverse the position again.
However, having been presented with the opportunity in CIT v. Atul Mohan Bindal, the Supreme Court has specifically reaffirmed Dharmendra, holding that the penalty is a civil liability, and hence no mens rea is required under the provision. The Court held-
A close look at Section 271(1) (c) and Explanation (1) appended thereto would show that in the course of any proceedings under the Act, inter alia, if the Assessing Officer is satisfied that a person has concealed the particulars of his income for furnished inaccurate particulars of such income, such person may be directed to pay penalty. The quantum of penalty is prescribed in Clause (iii). Explanation 1, appended tosection 271(1) provides that if that person fails to offer an explanation or the explanation offered by such person is found to be false or the explanation offered by him is not substantiated and he fails to prove that such explanation is bona fide and that all the facts relating the same and material to the computation of his total income has been disclosed by him, for the purposes ofSection 271(1)(c), the amount added or disallowed in computing the total income is deemed to represent the concealed income. The penalty spoken of in Section 271(1)(c) is neither criminal nor quasi criminal but a civil liability; albeit a strict liability. Such liability being civil in nature, mens rea is not essential.
It had been discussed earlier that the issue before the Court in Dharmendra Textiles was section 11AC, Central Excise Act, and not section 271(1)(c), Income Tax Act. On this basis, there was scope for the argument that the finding on section 271(1)(c) was obiter and could be departed from. However, after the decision in Bindal, this line of argument has been unquestionably foreclosed, and the nature of penalty under section 271(1)(c) is now a strict civil liability, with no requirement of mens rea. A summary of the decision is available here.
Saturday, October 24, 2009
UN Corporate Law Tools project: Corporate Structures and Governance and Human Rights
The United Nations has been developing a project on Reports on Corporate Law Tools, which involves leading law firms from across the globe working with UN Special Representative John Ruggie to analyse how corporate structures in different legal systems foster respect for human rights. The idea behind the project is found in this note prepared by the Special Representative.
The Indian report consists primarily of answers to the several questions framed. Some of the specific questions include:
+ Briefly explain the broader legal landscape regarding business and human rights.
+ Did incorporation or listing of companies historically, or does it today, require any recognition of a duty to society, including respect for human rights?
+ To whom are directors’ duties generally owed (i.e. to the company, non-shareholders etc.)?
+ Are companies required or permitted to disclose the impacts of their operations (including human right impacts) on non-shareholders, as well as any action taken or intended to address those impacts, whether as part of financial reporting obligations or a separate reporting regime?
+ Are institutional investors, including pension funds, required or permitted to consider such impacts in their investment decisions
According to the executive summary of the report, in relation to the role of directors, “Directors are in a fiduciary relationship vis-Ã -vis their companies. They are therefore required to act in a bona fide manner for the benefit of the company. In certain circumstances, the directors are required to extend their duty of care to the shareholders and other third parties (including creditors and employees). Whilst the Companies Act does not mandatorily require directors to consider non-business related impacts, the requirement may be read into the duties of directors not to carry out business in a manner which is prejudicial to public interest. Certain environment protection statutes also impose obligations on companies (and their directors) to consider and prevent environmentally harmful activities. Additionally, given that the Courts have been active to condemn cases of grave violation of fundamental rights by companies, it would be advisable for directors to be circumspect of any human rights violations in which their companies could get involved…”
Theoretically, institutional investors can exhibit shareholder ‘activism’ in two ways – either by challenging management decisions, or by relying on the markets to immediately exit the company in the event of any governance irregularities. Typically, these are referred to as the ‘voice’ and ‘exit’ strategies. In requiring institutional investors to adopt the ‘voice’ strategy rather than the ‘exit’ strategy, one factor which must be taken into account is that the institutional investor also has a duty to its customers to ensure a good return on the customer’s investment. The practicability of requiring institutional investors to play an ‘activist’ role is therefore problematic, considering that for customers, ‘exit’ may often be economically the best option (at least in the short-term).
Friday, October 23, 2009
RBI extends time limit for Auditors' Certificate for NBFCs - leaves fundamental issues unaddressed
Auditors of non-banking financial companies (NBFCs) have to submit a certificate every year to the Reserve Bank of India on whether the NBFC is engaged in the business of a non-banking financial institution (NBFI). The certificate also gives the income/asset pattern for making it eligible for classification under various categories. The last date for submission of this certificate for the immediately previous financial year ended on 31st March was 30th June (e.g., the last date for FY ended 31st March 2009 was 30th June 2009). This requirement was under the respective Prudential Norms Directions for deposit accepting and non-deposit-accepting NBFCs.
RBI has now changed this deadline of 30th June. Now, Auditors will need to submit such certificate within one month of the finalization of the balance sheet but in any case not later than 30th December (note that its 30th December and not 31st December). You can find the circular here (the circular contains the amending notifications too).
This extension was obviously needed since otherwise an NBFC would have been, for all practical purposes, required to finalize its accounts by 30th June (actually even earlier).
However, certain fundamental issues remain unresolved. How does an auditor certify whether the NBFC is engaged in the business of an NBFI? For most practical purposes, the legal requirement is that if an NBFC's "principal" business is of certain financial and similar activities, then it is deemed to be engaged in the business of an NBFI. How does one determine what is "principal" business? RBI has issued certain clarifications that one could look at the mathematical majority of assets and income as of the yearend. This has the advantage of mathematical certainty but creates numerous practical problems. Recent upturns and downturns in financial markets have ravaged the income and asset patterns of several NBFCs and yearend positions are often misleading.
RBI's view can be held to be contradictory and beyond the express provisions of the Act particularly if because of a temporary and a mere yearend change, it would mean that the NBFC is no more eligible to retain its certificate of registration. Also, whether a company is an NBFC and whether an NBFC continues to remain an NBFC is an issue that has implications even beyond the RBI Act since there are numerous cross references in other laws.
Of course, the reality also is that RBI does not appear to take a hyper-technical and strict stand and instead of going literally by its own clarification, it does look at the facts. But the NBFC would surely feel insecure when its own auditors may have to certify that it is no more an NBFC merely because of a yearend mathematical position and that too of just one year.
- Jayant Thakur
Thursday, October 22, 2009
Corporate Bonds: Clearing and Settlement
SEBI last week issued a circular prescribing the procedure for clearing and settlement of corporate bonds. This is an important step in the development of a robust corporate bond market that has not yet fully evolved in India, and appears to have been welcomed by the markets.
The SEBI Updates blog has a post describing the history of regulation of the Indian corporate bond markets.
Wednesday, October 21, 2009
Much Ado About Executive Compensation
Over the last few weeks, significant attention has been drawn to the issue of executive compensation, following observations by the Minister for Corporate Affairs that there ought to be moderation in CEO salaries in India. Two factors seem to have triggered such attention. One, which carries political overtones, is the Government’s own measure of austerity. The other is the raging debate on CEO pay that is ongoing in countries such as the U.S. and the U.K., partially as a result of the collapse of companies in the banking and insurance sectors. Salil Tripathi has a column in the Wall Street Journal that provides a nice perspective of the issues.
There is, however, one key aspect of management in Indian companies that has been ignored in this debate. In countries such as the U.S. and the U.K., CEOs and other senior managerial personnel rely on compensation received from the companies in the form of salary and other perks. Apart from stock options or some shareholding (usually as a result of exercise of options), CEOs do not hold any significant stake in their companies. Moderating executive compensation in such scenario carries some logic to it. On the other hand, CEOs in India in large measure take on a different character. They are not truly employees of the company; they also control the companies. A substantial part of corporate India, including public listed companies, consists of family-owned businesses. In those cases, the CEOs not only receive compensation from the company in the form of salary, but by virtue of shareholding and control, such CEOs may receive other economic benefits in the company, such as dividend and an appreciation in the value of shares of the company. It is trite to believe that in these circumstances, the CEO is incentivised purely by the salary obtained from the company; rather, it is the benefits of shareholding and control that operate as key incentives.
Given this scenario, too much is being attributed in the Indian context of a CEO here or there agreeing to a significant drop in salary or even giving up salary altogether. Reduction in such CEO salary may, at some level, indicate a sense of austerity, but it may mean less when seen in the overall context of the various commercial incentives of a CEO in a family-owned business. In that sense, the debate of CEO-pay seems misplaced to a large extent in the Indian corporate context. It is perhaps a case of shadow-boxing. Of course, there may be a handful of companies that are truly management-driven, or in the case of Government-owned companies, where CEOs rely solely on compensation received in the form of salaries, but those appear to be more the exception than the rule.
It may augur well for the Government instead to redirect its efforts to ensure that the benefits of control are not abused in such companies so that minority investors are protected, thereby ensuring the robustness of the capital markets.
Corporate Governance Accreditation
In Singapore, there is a proposal for listed companies to seek voluntary accreditation of their corporate governance processes and framework from an independent body. This is akin to the ISO certification process. As this report suggests, while such accreditation will better inform retail investors regarding corporate governance practices followed in a company, this could also be riddled with difficulties. For example:
Management time and accreditation costs are just two of the key issues.Looking at a parallel concept, India has witnessed the emergence of corporate governance ratings, which are offered by the leading rating agencies. However, the track record of the concept’s success is dismal, as very few companies have in fact availed of such rating. At a broad level, there exists of the issue of impartiality and independence of any rating or accreditation body, including the question who pays for such rating. More than that, a rating or accreditation process may cause corporate governance to taken on a process-oriented character (more than it already is) and may deviate attention from issues of substance.
Another is how effective the body will be in raising corporate governance standards.
Blue chips already have much higher levels of corporate governance than smaller companies. It is possible that having an accreditation body will just reinforce that divide - blue chips get the certification easily while the ones which do need to pull up their socks sit back and do nothing.
Another concern is that investors will start relying on the certification and be lulled into complacency and fail to do their homework.
All it takes is for one bad egg to appear and investors will complain that the accreditation process is a failure.
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At the end of the day, an accreditation body may just add layers to the upholding of corporate governance standards without significantly improving the end result.
Companies already get detailed guidance from the code of corporate governance. Investors would be better served if companies followed the code in letter and in spirit rather than be distracted by other processes as well.
The Insider Trading Debate Resurfaces
With the SEC recently charging hedge fund manager Raj Rajaratnam and others for insider trading, the debate regarding the scope of insider trading and its (un)desirability in capital markets has resurfaced. SEC’s complaint filed in the District Court in New York indicates that Rajaratnam, through his hedge fund Galleon, had traded in stocks of 10 different companies while in possession of inside information that was provided to him by various tippers. The U.S. Justice Department has also filed complaints in the court. This not only raises issues regarding liability of “tippees” under the relevant laws, but also casts light on various trading practices involved in the hedge fund industry.
As we have noted on this blog earlier, it is quite an onerous task on the authorities to prove insider trading, but the difference in the Galleon case is that prosecutors are armed with court-authorised wire-taps. There is nevertheless a great deal of scepticism about the likelihood of the authorities being able to take matters to their logical conclusion. While some observers find that there is very little to distinguish between insider trading and legitimate market research by hedge funds, others argue that the current complaint may be driven largely by political considerations (given the call to rein in hedge fund industry).
A Comment on Indirect Acquisitions
(In response to the previous posts by Avinash Balasubramanian and Somasekhar Sundaresan (here and here), we have received the following comment from Tarun Mathur)
In the present case, the most important game is played by the dates of the events which, determines – (1) when does the Ranbaxy Laboratories Ltd. (“RLL”) became the PAC of the acquirer (Daiichi)? and consequently (2) Whether Regulation 20(4)(b) of the Takeover code is at all applicable in the present case for calculation of the offer price?
Facts in brief are as follows:-
i. In January 2008, Ranbaxy Laboratories Ltd. (“RLL”) acquired 44% of the shares of (the target company) ZLL. Consequently, a public offer was made by RLL to the shareholders of ZLL at Rs.160/- per share.
ii. On June 11, 2008, the Acquirer (“Daiichi”) entered into a Share Purchase and Share Subscription Agreement (“SPSSA”) to acquire 129,934134 fully paid up equity shares representing 30.91% of the current issued, subscribed and fully paid up equity share capital of RLL and to subscribe to shares representing 11.00% of the current issued, subscribed and fully paid up equity share capital of RLL and to 23,834,333 warrants of RLL, each warrant exercisable for one equity share of RLL.
iii. Thereafter, the Acquirer made a public offer on June 16 2008 to the remaining shareholders of RLL to acquire shares representing 22.01% of the issued, subscribed and fully paid up equity capital of RRL. Pursuant to the public offer, the Acquirer’s shareholding in RLL increased from 30.91% to 52%, thus, making RLL a subsidiary of Acquirer.
iv. The open offer was consummated/ completed on October 20, 2008 (as per term “offer period” as defined in Regulation 2(1)(f) of Takeover regulations)
v. As on October 20 2008 Ranbaxy Laboratories Ltd. (RLL) held 46.85% of the issued, subscribed and paid-up capital of the Target Company and as a result of the Acquirer’s acquisition/subscription in RLL, on October 20, 2008, the Acquirer indirectly acquired 46.85% of the issued
vi. Since the acquisition of RLL by the Acquirer had also led to an indirect acquisition of ZLL, the Acquirer, after having made the open offer to the shareholders of RLL, decided to make the public offer to the shareholders of ZLL. This was done so on 19 January 2009 as per the requirements of Regulation 14(4) if the Takeover code. The offer price for the said offer to the shareholders of ZLL is Rs.113.62/-.
vii. Now, the grievance of ZLL is that - the Acquirer is bound to make the said offer at Rs.160/- (as had been offered by RLL to the shareholders of ZLL in January 2008) instead of Rs.113.62/.
Views
1. Regulation 20(4) of the Takeover Regulations deals with the requisite offer price which an acquirer should pay to the target company to acquire its shares as per the formula laid down. The offer price should be a fair price and should exhibit the proper valuation of the shares of the target company. The offer price should be such that it does not ultimately lead to the unjust enrichment to the shareholders and it should also not be detrimental to the shareholders. In the present case, the query pertains to the interpretation of Regulation 20(4)(b) for determining this fair and appropriate price for the shares of the target company.
The wording of the Regulation 20(4)(b) is as follows:-
“…(b) price paid by the acquirer or persons acting in concert with him for acquisition, if any during the twenty-six week period prior to the date of public announcement”. Here the word “or” is to be read as a disjunctive word and not be read as “and”.
The application of this provision is confined to any price paid by acquirer or PAC within the 26 weeks prior to the date of PA. Here, I agree with the assertion of Mr. Sundaresan, that the intention of Regulation 20(4) (b) is to calculate the price paid by the acquirer or the PAC individually and/or when they are acting in concert for fulfilling their common objective of acquiring the shares of the target company. Consequent to this provision if we read Regulation 20(12), it puts two situations for determining the offer price of the shares:-
(i) with reference to the date of the PA of the Parent company (here it is 16 June 2008), or
(ii) with reference to the date pf PA for the acquisition of Target company (here it is 19 January 2009)
whichever is higher.
The literal interpretation of this provision leads to the conclusion that- the reference date in this case would be the date of the PA of the Parent company (i.e., 16 June 2008) and as per Regulation 20(4)(b) the price paid by PAC within 26 weeks of the date of PA is to be considered for the calculation of offer price. And in this case, since RLL acquired the shares of ZLL within 26 weeks (i.e., in January 2008)- this date has to be considered to for the calculation of offer price.
This is one set of views.
2. Another set of views is that:-
For the purpose of acquisition under Takeover Regulations the words/entities- ‘the acquirer’ and ‘persons acting in concert’ could be considered to be a composite class, i.e., both the classes have come together for a common objective for the purpose of substantial acquisition of shares or voting rights or gaining control over the target company, pursuant to an agreement or understanding (formal or informal). Also, it may be noted the said ‘acquirer’ and the said ‘persons acting in concert’ are acting as a composite class only for the purpose of the specific takeover transaction. The concerned entities may not be considered as having a relationship of ‘acquirer’ and ‘persons acting in concert’ for any other takeover/acquisition transaction. Now, here the question arises- when does the acquirer (Daiichi) and the PAC (RLL) came together to acquire the target company (ZLL) or more clearly when does RLL became the PAC of ZLL?... 16 June 2008. The answer is – “No”, because-
(1) that at the time of making of the public announcement by the acquirer, in respect of the shares of RLL, RLL was only a target company whose shares were being acquired and therefore, and cannot be taken as a person acting in concert with the acquirer in terms of Regulation 2(1)(e) of the Takeover regulations. It became a PAC of Daiichi Sankyo only on 20 October 2008, when the acquisition of 46.85% shares of RLL was completed- when RLL became the subsidiary company of Daiichi Sankyo.
(2) Also, as on 16 June 2008, the Daiichi Sankyo had no common objective or purpose, with RLL (in terms of Regulation 2(1)(e) of the Takeover code, for substantial acquisition of shares or voting rights of or gaining control over ZLL.
So, since the acquirer and the PAC became a composite class only on 20 October 2008, the reference date for calculation of offer price as per Regulation 20(12) of the SEBI Takeover code should be only 19 January 2009 (which is the date within the three month consummation period) and not the date of the PA of the Parent company, since on 16 June 2008 RLL is only the target company and not the PAC of Daiichi and since the takeover/ substantial acquisition of shares is transaction specific, the date 16 June 2008 holds no relevance. The only relevant date here is 20 October 2008 when RLL finally became the PAC (in form of subsidiary company) of Daiichi for the purpose of acquisition of shares of ZLL. So, therefore, the requirements of Regulation 20(4)(b) are not at all applicable in this case.
To me both these views appears to be even- balanced, it would be interesting to know how would the honorable Supreme Court react to this ambiguity, if in case this case reaches to the apex court.
- Tarun Mathur
Sunday, October 18, 2009
SAT on indirect acquisitions - correct in letter and spirit
Earlier this month, the Securities Appellate Tribunal (“SAT”) opined on the computation of the minimum offer price for an indirect takeover of a listed company. An interesting critique of this opinion was published on this blog the next day. The SAT had disposed of two appeals (Appeals No. 137 and 139 of 2009) by a common order. I respectfully disagree with the critique on the blog. In my view, the SAT decision is the correct one, both in letter and spirit of the Takeover Regulations.
(Disclosure: I appeared for the Petitioner in Appeal No. 139, a long-term investor in Zanotech. My client is therefore a beneficiary of the SAT’s opinion, which I believe renders an accurate opinion. My stand ought to be regarded as non-independent because of where I sat during the proceedings. However, the raison de etre of a blog is to debate issues – hence this post should be read subject to this disclosure of interest).
Factual Backdrop:
It would suffice to recap the facts thus: Ranbaxy acquired shares of Zanotech at a price of Rs. 160 per share to take a stake of over 44% in Zanotech in January 2008. Within a period of 26 weeks from the purchase at this price, in June 2008, Daiichi agreed to acquire shares of Ranbaxy by way of purchase from Ranbaxy promoters and by subscription to fresh shares of Ranbaxy. The deal was pathbreaking, was priced at a fantastic premium to the then prevailing price of Ranbaxy (a 31% premium to the previous day’s closing price and an 80% premium to the price that had prevailed a few months prior to the deal), and stunned the world.
Regulatory Provisions
The agreement to effect such a transaction (which would take Daiichi to over 63% ownership of Ranbaxy’s equity) triggered an obligation to make an open offer to shareholders of Ranbaxy for Ranbaxy shares and to shareholders of Zanotech for Zanotech shares. Regulation 14(1) of the Takeover Regulations required Daiichi to make an open offer for Ranbaxy within four days of the agreement. Regulation 14(4) of the Takeover Regulations provided Daiichi a time leeway of three months from the consummation of the Ranbaxy acquisition for making an open offer for Zanotech.
The minimum offer price for Daiichi’s open offer for Zanotech shares was regulated by Regulation 20(4) of the Takeover Regulations, since the shares of this target company were “frequently traded” within the meaning of the term in the Takeover Regulations, and by Regulation 20(12), which regulates the manner of price computation for deferred open offers made in the case of indirect acquisitions.
In a nutshell, in terms of Regulation 20(12), the provisions of Regulation 20(4) have to be applied to the price of the consequential target company (in this case, Zanotech), notionally at two points in time – once at the time of the public announcement for the main company (in this case, the public announcement for Ranbaxy), and then at the time of the public announcement for the consequential target company (Zanotech). The higher of the two computations would be regarded as the minimum offer price.
In other words, the provisions of Regulation 20(4) have to be applied mutatis mutandis at both points in time, and the higher of the two price computations would be the minimum offer price. Regulation 20(4) requires the minimum offer price to be the highest of the following:-
(a) the negotiated price paid by the acquirer;
(b) the price paid by the acquirer or persons acting in concert with him during the 26 weeks preceding the date of the public announcement;
(c) the average of the weekly high and low closing prices during the 26 weeks preceding the date of the public announcement; and
(d) the average of the daily high and low prices during the two weeks prior to the date of the public announcement.
The parameters in (c) and (d) above were indeed not relevant for the controversy because the market price was lower than the price offered by Daiichi to shareholders of Zanotech. The issue in controversy before the SAT was therefore the application of Regulation 20(4)(b), which corresponds to (b) above.
Daiichi’s position, which was endorsed by SEBI, was that Regulation 20(4)(b) had no application to the case. Their contention was that the price paid by Ranbaxy for its acquisition of shares of Zanotech ought not to be factored into the computation on the ground that when Ranbaxy had bought a 44% stake in Zanotech in January 2008, Ranbaxy had not been in concert with Daiichi. Their argument was: for applying Regulation 20(4)(b), one would have to determine whether Ranbaxy had donned the cap of a “person acting in concert” with Daiichi when the acquisition in question (in January 2008) had been effected. If the answer were to be in the negative, in their view, the price paid by Ranbaxy for shares of Zanotech ought to be ignored for the open offer for Zanotech by Daiichi, although it was the enjoyment of ownership of this stake that triggered the open offer in the first place.
It should be noted that when Regulation 14(4) was inserted into the Takeover Regulations, the provisions of Regulation 20(12) were correspondingly inserted into the scheme of the Takeover Regulations. Therefore, the position in law was that if one were to give a leeway of time for making an open offer belatedly, the provisions of Regulation 20(4) would have to be notionally applied at two different points of time, with the higher of the two computations being adopted as the minimum offer price.
Moreover, Regulation 20(4) provides that any price paid by a person acting in concert for shares of the target company during the preceding 26 weeks ought to be taken into account. Regulation 20(4) does not condition the application of Regulation 20(4)(b) to the price paid by a “person acting in concert” with the words “provided such person had been acting in concert at the time of such acquisition”. So long as a person is acting in concert when a public announcement is made, any acquisition by him in the preceding 26 weeks would have to be considered as one of the price factors for purposes of Regulation 20(4).
Example of Consequences
The interpretation sought to be provided in the earlier critique on the blog proceeds on the footing that one would have to determine whether the person now acting in concert had been acting in concert at the time he acquired shares – a position not available in the Takeover Regulations, and rightly so. If such a position were to be accepted, any acquirer making an open offer would be at liberty to ignore the price paid by a person now acting in concert, although those very acquisitions led to the open offer threshold being reached, on the simplistic ground that when he acquired shares, he had not acted in concert with the acquirer now making the offer.
An example would make this clearer. Assume Mr. A, Mr. B and Mr. C independently and without any common objective or concerted action acquire shares of varying proportions, each less than 5% of XYZ Ltd., a listed company, between January and March of a calendar year. In April, a merchant banker who sees the opportunity for a deal by bringing them together, invites them for a discussion, and they collectively resolve to form a company called ABC Ltd. to make an open offer for shares of XYZ Ltd. In other words, the concert is born in April.
ABC Ltd. now agrees with a shareholder holding 2% shares in XYZ Ltd. to acquire shares that would take the collective holding to beyond 15% in XYZ Ltd. and therefore makes an open offer under Regulation 10 of the Takeover Regulations. ABC Ltd. could also make a voluntary open offer to acquire shares of XYZ Ltd. In either example, ABC Ltd. would be the acquirer, and each of Mr. A, Mr. B and Mr. C would be persons acting in concert.
If the position endorsed in the earlier critique on this blog, and indeed the position taken by Daiichi and SEBI were to be adopted, the price paid by each of Mr. A, Mr. B and Mr. C would have to be totally ignored on the ground that when they acquired shares taking them up to just below 15%, they had not acted in concert. Therefore, the acquisition of the very shares that took them to the threshold of a trigger under the Takeover Regulations would have to be regarded as wholly irrelevant. Such a position would be a travesty, conflicting with the very purpose of including the criterion of price paid in the preceding 26 weeks – a requirement similar to those found in takeover laws across the globe.
In other words, the very price paid by each of Mr. A, Mr. B and Mr. C would have to be disregarded for an open offer by ABC Ltd., a company formed by them subsequent to their acquisitions – a position that would require infliction of considerable violence to the provision i.e. by reading into the regulation a further proviso (incorporating non-existent words set out in bold italics above). Such an interpretation would require introduction of a requirement to check the state of mind of the person who acquired shares to ascertain existence of concert at the point of acquisition, although such person is currently indeed a person acting in concert.
In the example given above, another consequence would be that since the persons acquiring shares had not been concert when they acquired it, their holding should not be regarded as triggering the requirements of an open offer under Regulation 10 – an absurdity, because the Takeover Regulations do not require consideration of the state of mind when the acquisition was made to trigger an open offer obligation, as indeed they do not require consideration of the state of mind for computation of the minimum offer price for such an open offer.
When a provision of law is crystal clear, it ought to be applied as it is. If a person were to be in concert when the public announcement is made, any and every acquisition made by him in the 26 weeks prior to the public announcement would have to be factored into the computation of the minimum offer price. This is because the collective acquirers (including the person now acting in concert) would enjoy the benefits of the collective ownership, and the price paid for such collective ownership is a fair criterion for inclusion in determination of the minimum offer price.
In the same example given above, if any of Mr. A, Mr. B or Mr. C were to acquire a single share in April after the birth of concert, Daiichi, SEBI and the critique on this blog, would have that price considered for computation of the minimum offer price, but would ignore the prices paid between January and March on the ground that during that period there had been no concert.
There is no leeway in Regulation 20(4)(b) to impose such additional convoluted criteria to determine the state of mind in relation to each historical acquisition to ascertain if there had been concert at the relevant time. Such a position under Regulation 20(4)(b) does not change merely because the acquisition is an indirect acquisition and Regulation 20(12) has been applied.
Mutatis Mutandis Application
Moreover, Regulation 20(12) requires a mutatis mutandis application of Regulation 20(4) at two points in time. If one could legitimately argue that a person who is now in concert was not in concert when he acquired shares within the 26-week period prior to the first public announcement, and therefore the price for those acquisitions should be ignored, one could equally be able to legitimately argue that during the first public announcement the consequential target company was not the target company at all, and therefore Regulation 20(4)(b), which deals with the price of the “target company” ought to have no application.
Since, Zanotech is now the “target company” (in the public announcement made in January 2009), the mutatis mutandis application of Regulation 20(4)(b) would have to be effected as if Zanotech had hypothetically been the target company in June 2008 (when the open offer for Ranbaxy had been announced). Similarly, if Ranbaxy is now a person acting in concert with Daiichi in January 2009, the provisions of Regulation 20(4)(b) would apply to acquisitions by Ranbaxy made in the 26-weeks prior to June 2008 by way of a mutatis mutandis application. Any contrary reading of such hypothetical application would be an absurdity because one could well argue that Zanotech had not been the target company in June 2008 and therefore, its share price movements were irrelevant in June 2008.
It is an admitted fact that Ranbaxy acquired shares of Zanotech at a price of Rs. 160 within the 26 weeks preceding Daiichi’s open offer for Ranbaxy. Daiichi therefore got into the agreement to invest in Ranbaxy in June 2008, with eyes open and fully aware that within a period of 26 weeks preceding its deal, Ranbaxy had made acquisitions at Rs. 160. Had Daiichi done the Ranbaxy deal after 26 weeks of Ranbaxy’s last acquisition of Zanotech shares, indeed, the price paid by Ranbaxy would have become irrelevant because Regulation 20(4) would let only price paid in the preceding 26 weeks to be taken into account. The law is after all about drawing a clear line on the ground and treating people on either side of the line in a specific predictable manner.
Indeed, when Daiichi paid for shares of Ranbaxy, it is presumed to have read Ranbaxy’s balance sheet, which included the 44% holding in Zanotech acquired at a price of Rs. 160 per share, and therefore when it valued Ranbaxy, it did not ignore the value of Zanotech shares in Ranbaxy’s balance sheet. Daiichi is also presumed to have read the Takeover Regulations and the deeming provision imposed by Regulation 20(12) read with Regulation 20(4), when it agreed to take over Ranbaxy in June 2008.
Letter and Spirit Served
Even from a spirit perspective, it is noteworthy that the Takeover Regulations require sharing with the common shareholder the benefits provided to the seller of substantial shareholding. When Daiichi paid the promoters of Ranbaxy the fancy price it paid, it was indeed also paying for Ranbaxy’s holding in Zanotech.
As a matter of administrative convenience, in indirect acquisitions, one does not sparse the value paid for the business of the target company across individual assets forming part of the target company’s business. However, what is clear is that the sellers of Ranbaxy shares fully realized the value of Ranbaxy’s shareholding in Zanotech. Such value was not being assessed for being shared with shareholders of Zanotech. In the circumstances, the least one would do is to apply the provisions of the Takeover Regulations as they are, and take into account the price that was paid by Ranbaxy for the very acquisition of 44% stake in Zanotech. The inclusion of such a price factor, a statutory requirement, was being frustrated, thanks to considerable violence to the plain and logical provisions of Regulation 20(4)(b) by reading non-existent words into it viz. the requirement of determining whether at the time of each prior acquisition, the person who acquired shares had been acting in concert, regardless of him being in full concert when the public announcement is actually made.
Therefore, not only a plain reading of the Takeover Regulations, but also the spirit of the Takeover Regulations loudly and clearly show how the price of Zanotech ought to have been computed. The decision of the SAT, therefore, in my respectful submission, is faultless.
