Thursday, October 30, 2008

Would increase in percentage holding because of buyback trigger the Takeover Regulations?

(Note:- SEBI had issued a press release on October 27, 2008, that I had discussed here, whereby, inter alia, SEBI announced its decision to exempt increase in shareholding on account of buyback upto 5% from applicability of creeping acquisition requirements. I had pointed out that a view is possible to hold that the increase on account of buyback should not trigger the Takeover Regulations and hence the exemption is not needed. Since there were some queries of readers on this point and also since Mr. Umakanth V. rightly highlighted this issue in more detail in this comment to my post, I thought I could share here an article on this issue that I had written earlier tin August his year in Bombay Chartered Accountants' Journal. This article, with some minor changes, is reproduced below.)

1) Would increase of Promoters’ percentage holding consequent to a buyback of shares attract the Takeover Regulations? Would the increase be counted for the creeping acquisition limits? Would an open offer result if the specified limits are exceeded? Would and should all or any of these be the result when the Promoters have not acquired a single further share? These are questions facing Promoters and listed companies as many of them go for buyback of shares to what is being claimed to be an attempt to boost the price of the company’s shares to a “fair” value. To understand this issue and see how a strange solution is proposed by SEBI and, even more strangely, accepted by companies and their promoters, let us first consider some background.

2) A peculiar problem arises when a listed company proposes to carry out buyback of its shares. It arises more out of a mathematical consequence than anything else but results in companies and their Promoters facing a dilemma and a delay. To describe it briefly, the issue is whether the increase in Promoters’ holding in a company arising solely as a result of buyback attract the Takeover Regulations? To give an example, let us say the Promoters of a listed company presently hold 40% of the share capital of, say, Rs. 10 crores, of the Company. The Company proposes to carry out a buyback (and let us say it will be successful) of 20% of its capital. The capital would reduce to Rs. 8 crores but the holding of the Promoters would remain at Rs. 4 crores. However, in mathematical terms, the holding of the Promoters would have thus increased from 40% to 50%? Since the Takeover Regulations permit only 5% acquisitions per year, would this limit said to have been exceeded?

3) In these times of dismal stock markets where many listed companies strongly believe – rightly or wrongly – that the market is undervaluing their shares and look at buyback as a serious option to correct this, this problem is being faced by many such companies.

4) Before we try to understand how this problem arises in law, see the obvious sense of absurdity involved here. The buyback is being carried out by the Company and the Promoters are not acquiring a single share. In other words, the quantity of shares held by them continues to remain the same. However, their percentage of holding increases. But this is not on account of any act on their part – at least not directly by way of acquisition – but is on account of an indirect consequence of the Company acquiring shares of other shareholders. The net consequence though is that their holding increases from and in the example given above increases higher than the maximum annual percentage permitted.

5) The Promoters of such companies are facing a dilemma and are concerned as to the possible consequences of the action of the company carrying out buyback of shares. Note that the problem arises not only when the 5% limit is exceeded. It even arises when the increase is less than 5% since in such a case, the Promoters would be concerned since it could be held that they would have to limit their further acquisitions only for the excess upto 5%. For example, if the net increase on account of buyback is 3%, they could be held to have to limit their increase only to a further 2%.

6) Incidentally, to cover yet another category of affected persons, it could happen that a person holding, say, 14% shares, may find his holding increasing beyond 15%. In the normal course, acquisition of shares in a listed company where the holding becomes 15% or more requires an open offer to be made. The issue then is whether such increase in holding to 15% or beyond on account of buyback of shares would also require an open offer to be made.

7) Further, at times, because of the buyback, even limits provided for other purposes such as that of continued listing may also get exceeded on account of the buyback.

8) Let us consider what the law provides.

9) Let us look first at the provisions relating to buyback. Clearly, these provide for buyback of shares and are not the source of the confusion (there are some provisions that restrict buyback when they conflict with continued listing requirements but these are not discussed here). However, it is worth considering these provisions not only for background of the issue but also since we need to understand what really happens in case of buyback of shares and whether the Takeover Regulations could possibly get attracted.

10) Readers would be quite familiar with buyback of shares under Section 77A and related provisions of the Companies Act, 1956 read with the SEBI Buyback Regulations since they are exactly one decade old now. Buyback of shares is simply the opposite of a fresh issue of shares where monies are received by the Company and shares issue. Buyback involves returning of monies by the company against which shares are taken back. Also, as per the clear provisions of law in India, buyback involve cancellation of the shares and thus an immediate and irrevocable reduction of capital. The point also is that by virtue of the so-called purchase of shares, there is no real purchase and holding of the shares by the Company and the only purpose for which it holds for a very short time the shares so purchased is to cancel them.

11) The buyback of shares needs approval of the Board of Directors and, under certain circumstances, the shareholders. At least in theory, the buyback of shares is not a decision exclusively of the Promoters and their involvement is to the extent of their participation in the Board and, if required, in the general meeting of the Company as shareholders.

12) However, despite this, without any act on their part, their shareholding increases. This point is important also, since, as we will see later on herein, the Takeover Regulations require expressly an act of purchase of shares by an acquirer.

a) In fact, ironically, the holding of the Promoters increases not on account of something they do but on account of something they do not do. Their holding increase not by a purchase of shares but by their not participating in the buyback.

13) Let us then consider the requirements of the Takeover Regulations.

14) An acquisition of shares may attract, keeping this discussion focused on the principal two categories of provisions, the requirements of disclosure of acquisitions under Regulations 7 and the requirements of making a public announcement under Regulations 10, 11 and 12. Incidentally, all these four Regulations require, though with only minor differences in language, “acquisition” of shares or voting rights. Thus, simplified a little, if a person acquires shares whereby his holding becomes more than 5% of the equity share capital of a listed company, he is required to make, under Regulation 7, disclosures in the prescribed manner. If a person holding 15% or more shares and acquires further shares amounting more than 5% of the capital in one financial year, he is required to make an open offer under Regulation 11. And so on.

15) The question is whether an increase in the shareholding of a person arising solely out of buyback of shares and without such person acquiring a single further share would attract any of the aforesaid Regulations? Prima facie, the answer seems to be no.

16) However, as several recent cases of buybacks or proposed buybacks show, the Promoters are adopting a peculiar, though obviously conservative and safe, solution to this dilemma. They are not going ahead with a buyback of shares based on the above interpretation. They are also not approaching SEBI under the Informal Guidance route seeking clarification that the provisions of the Takeover Regulations should not be attracted in such a case. Instead, they are approaching the Takeover Panel for exemption from the provisions of open offer as contained in Regulations 10/11/12. Strangely, the Takeover Panel and SEBI are taking a view, effectively as evident by some of the exemptions granted, that the Takeover Regulations are indeed attracted. However, in view of special facts and merits of the cases that have been published, formal exemption is being granted from the requirements of open offer.

17) Thus, for example, ICI India Limited has sought to carry out a buyback of shares and because of such buyback of the shares, the holding of the Promoters would increase from 50.83% to beyond 55% of the share capital of the company. The acquirer approached the Takeover Panel seeking exemption from the requirements of Chapter III of the Regulations. Several features of merit of the case were highlighted. There would not be any change in control of the Company on account of the increase. The buyback was at a price that was substantially higher than the book value of the shares. The obvious fact that the acquirer was not participating was also emphasized. And so on. Taking all these factors into account, SEBI granted exemption from the relevant provisions of Chapter III to such increase.

18) Similarly, exemption was granted to the Promoters of Natco Pharma Limited where their shareholding would have increased from 62.28% to 63.37% on account of a buyback. Exemption was also given to the Promoters of Abbott India Limited where their holding would have increased from 61.70% to 65.14% on account of the proposed buyback.

19) It is submitted that strictly speaking, a passive increase in holding of Promoters or other substantial shareholders is not something that could attract the requirements of open offer under the Takeover Regulations. Therefore, there is no question of granting exemption but in fact of clarification that the requirements of open offer are not attracted. Alternatively, if policy demands, the Regulations should be amended to specifically provide that even passive increases should attract such requirements of open offer and other requirements.

20) Of course there is another side to it also. Promoters cannot claim to be totally helpless in the matter of the increase of their shareholding on account of buyback. Practically speaking, it would normally they who would, through their control of the Company, propose the buyback. Also, they would be the ones who would vote for the buyback. They would also be the ones in most cases finalizing the terms of the buyback – or at least laying down the proposed terms of buyback. Finally, the increase in their holding happens because of their non-participation in the buyback which they were instrumental in proposing and approving. However, all this still cannot change the express provisions of law.

21) It has also to be realized that there could be some peculiar results also. Persons who may be substantial shareholders may find their holding increased though they are not Promoters. For example, a person holding 14% may find his holding increased to, say 16% on account of a buyback. It could be argued that to avoid such increase he should have participated in the buyback. However, just as saying that such a person should be required to make an open offer would be unfair, so would saying that such a person should have sold his shares would be unfair.

22) The conclusion is that there is a lacuna in the Regulations that creates the confusion. And filling this lacuna requires more than a simple provision that all increases on account of buybacks would be deemed to be acquisitions. There has to be a considered solution taking into account increases of holding of Promoters and non-Promoters as also covering situations where the holding may go beyond the maximum permitted for continued listing.


23) However, considering that all concerned appear to be happy with the status quo, we will continue to see the untidy solution of grant of exemption where exemption is not required, instead of a tidy law where internal inconsistencies between the two Regulations are removed.

(C) Jayant Thakur, CA

Systemically Important Non-Deposit accepting NBFCs allowed to raise funds by Perpetual Debt Instruments

Reserve Bank of India has amended, vide a circular/notification, the Directions relating to acceptance of deposits and Prudential Norms for Non-Deposit accepting NBFCs and has enabled raising of funds through Perpetual Debt Instruments by systemically important non-deposit accepting NBFCs. This would help them, inter alia, raise their Capital for capital adequacy purposes. It would help such an NBFC to increase the Tier I Capital upto 15% of its Tier I capital as per the previous financial year and balance to be taken as part of Tier II capital (both as per the formula given).

The approach, as the word "Perpetual" intended to indicate, is conservative and these would not be easily redeemable. The basic terms of such PDI are given in the Circular and are quite detailed.

Jayant Thakur, CA

Tuesday, October 28, 2008

Creeping acquisition allowed between 55-75%/increase through buyback exempt upto 5%

Vide a press release dated October 27, 2008, SEBI has announced its decision to allow upto 5% creeping acquisitions between 55%-75% holding. However, the creeping acquisition between this slab can be only by “open market purchases in the normal segment” and not through bulk/block/negotiated deals or through preferential allotment.

It is not clear whether a person holding between 50 and 55% and who needs to acquire another 5% will need to have two types to acquisitions – one upto 55% and another type thereafter.

It has also been decided that if the holding of the Promoters increases on account of buyback of shares by the company, an increase upto 5% per annum would also be automatically exempt. The question that arises is whether increase of the holding of the Promoters on account of buyback of shares did otherwise attract the Takeover Regulations? – readers’ views are solicited. SEBI though has stated that exemption for such increase “was required to be sought”. Thus, if one agrees to the view that such exemption is required to be sought then now there is a relief but only upto 5%. However, if one takes a view that such increase does not require such an exemption, then such a limit would not apply.

The exemption of 5% increase on account of buyback is apparently only to the Promoters though the wording is not wholly clear. It is also to be seen whether this 5% exemption is all throughout between 15-75% or even beyond.

The above are only decisions and the actual amendments have yet to be made. Let us discuss more when the amendment is announced.

Jayant Thakur, CA

Saturday, October 25, 2008

Companies Bill Introduced in Parliament

Close on the heels of the Limited Liability Partnership Bill, the much anticipated Companies Bill, 2008 was introduced in Parliament on October 23, 2008. The Government’s press release carries the salient features of the Bill, which is set to usher in the most significant changes to company law since perhaps 1956 when the current Companies Act was brought into being.

Both the Limited Liability Partnership Bill, 2008 as well as the Companies Bill, 2008 are available on the website of PRS Legislative Research, which has shaped into an excellent public resource extensively covering the lawmaking process in India.

Due to the enormity of the changes, any brief discussion of the Bills will be an exercise in futility, but we will attempt to discuss their various provisions, the accompanying concepts and doctrines and their implications over several posts in the near future.

Friday, October 24, 2008

Amendment to Clause 49 - some thoughts

Some thoughts on the amendment to clause 49 vide circular dated 23rd October 2008 as referred to in my earlier brief note here.

Clause 49 of the Listing Agreement requires that the Board of a listed company should consist of at least 50% non-executive directors. Further, if the Chairman is an Executive Director, at least 50% of the Board members should be Independent Directors and one-third otherwise.

To this basic provision, SEBI required, by circular dated April 8, 2008, that if the Chairman is a promoter or related to any promoter, or person occupying management positions at the Board level or at one level below the Board, at least one-half of the Board of the company shall consist of independent directors.

Now, by circular dated October 23, 2008, SEBI has required that the clause be further amended to include a clarification in relation to the words “related to any promoter”. The circular requires the following Explanation be inserted in the relevant sub-clause:-

Explanation-For the purpose of the expression “related to any promoter” referred to in sub-clause (ii):

a. If the promoter is a listed entity, its directors other than the independent directors, its employees or its nominees shall be deemed to be related to it;

b. If the promoter is an unlisted entity, its directors, its employees or its nominees shall be deemed to be related to it.

The clarification was necessary since the word “related” would be difficult to apply in respect of non-individuals, as “related” would normally be understood as being a “relative” to and thus can apply only to individuals.

The implication of the amendment thus is that directors (other than independent directors where the entity is listed), employees and nominees of the promoter “entity” would be deemed to be “related to the promoter”. Thus, if the non-executive Chairman is one of such persons, then the Board would need to consist of at least 50% Independent Directors.

The Explanation applies only to “entities” which is a vague word but, as stated earlier, I think it is intended to mean persons other than individuals. Thus, as far as individuals are concerned, the concept of “related to any promoter” remains unchanged. Thus, the clause would apply if the Chairman is a relative of such individual promoters though this is not clarified, nor, for that matter, the term “relative” defined. The term “relative” is also defined differently at different places. This lack of clarity, though, is likely to be faced only in marginal cases.

Thus, this new Explanation actually enlarges the definition of “related” and many persons who were otherwise not so “related” would now be deemed to be related and if such a person is a non-executive Chairman, then the Board would need to have at least 50% Independent Directors. This may particularly of concern to those companies who may have, following the circular of April 8, 2008, appointed such a person as Chairman, thus escaping the requirement of having at least 50% Independent Directors. Now, such companies will have to change the Chairman or have at least 50% Independent Directors.

Which brings us to the question when is this amendment effective from? The circular says that the amendment has to be “implemented” before March 31, 2009 by existing listed companies.

A comment perhaps wishful thinking is whether the time given till March 31, 2009 is for the latest amendment or does it apply to even the earlier requirement of April 8, 2008 too, as duly amended. In simpler words, does this mean that listed companies now have time upto March 31, 2009 to either have a non-“related” Chairman or have at least 50% Independent Directors? This concern is important since the circular of April 8, 2008 did not give any time for making such changes and the strict legal view could be that it would be effective immediately. Making such a significant change is not easy and one would have expected some time. It is of interest also that the reports by stock exchanges of compliances also have to be given by March 31, 2009. It is also curious that why such a long time of six months is given for implementing such an amendment when no such time was given for the original amendment. All this makes me wonder whether the extended period is for all the amendments. To put it simply, do all affected listed companies now have time upto March 31, 2009 to get an “unrelated” Chairman or to upgrade to a Board having at least 50% Independent Directors? Despite some ambiguities, a strict reading of the clauses and circular does not allow such a view. If SEBI has intended otherwise, a clarification would help.

It is provided that all the employees of the “entity” would be deemed to be so related. This is strange as the entity may have thousands of employees and all such employees would thus become “related”.

In parting, see how a simple requirement, easy to grasp in its spirit, is made elaborately complex ad nauseam by provisos, explanations and exceptions.

© Jayant Thakur, CA


Thursday, October 23, 2008

Amendments to Clause 49 of Listing Agreement

SEBI has issued a circular dated 23rd October 2008 and amended 49 of the Listing Agreement to provide a clarification regarding independent directors. The clarification is to the original circular which, inter alia, provided for change in the proportion of independent directors depending on whether or not the Chairman is a Promoter or related to the Promoters, etc.

This amendment provides an explanation to define the words "related to any Promoter". Essentially, it seeks to list the persons who are deemed to be so related.

This Explanation, while clarifying some issues, creates, at first impression, some fresh doubts and questions, which I am listing here for now and will provide some inputs in a day or two.
- The circular says that "amendments", for already listed companies, have to be given effect to by 31st March 2009. Does this mean that this extension is given for all amendments in the original circular?
- Does it mean that "relatives" are not deemed to be related since the definition seems to be exhaustive?

and so on.

Jayant Thakur

SUPREME COURT RULES ON THE MEANING OF “INTERNATIONAL COMMERCIAL ARBITRATION”, WITH CONSEQUENCES FOR FORUM SHOPPING

The case of TDM Infrastructure Pvt. Ltd. v. UE Development India Pvt. Ltd., decided by a single judge bench of the Supreme Court in May 2008, is an important judgment dealing with the issue of forum shopping with respect to seats of arbitration, and arbitration laws. In TDM Infrastructure, the facts were these: the two parties to the dispute were companies registered under the Companies Act of 1956. However, the directors and the shareholders of the petitioner company were residents of Malaysia and the Board of Directors of the petitioner also sat in Malaysia. The respondent entered into a contract with the petitioner, which also contained an arbitration clause. This arbitration clause mandated that the law applicable in case of a dispute would be the Indian Arbitration Act of 1940 and amendments thereafter.

Subsequently, differences arose between the parties. When the arbitration agreement was resorted to, the Respondent proposed an amendment to the arbitration clause by changing the venue of arbitration to Kuala Lumpur, Malaysia, and applying the law of Malaysia, and the Malaysian Arbitration Act of 2005. This proposal was rejected by the petitioner, subsequent to which both parties proposed nominees that were rejected by the other party. Therefore, an application was made under Sections 11(5) and 11(6) of the Arbitration and Conciliation Act of 1996 for the appointment of a sole arbitrator.

Section 11 of the Arbitration & Conciliation Act, 1996 deals with the procedure to appoint arbitrators. Section 11(12) states that only in cases of International Commercial Arbitration, the Chief Justice of India can exercise jurisdiction to appoint an arbitrator. In all other matters i.e. domestic arbitration, the appointment of the arbitrator has to be carried out by Chief Justices of High Courts. Thus, the matter hinged upon the issue whether this was a case of International Commercial Arbitration.

Section 2(1)(f)(ii) of the Arbitration & Conciliation Act defines International Commercial Arbitration as an arbitration where at least one of the parties is a body corporate which is incorporated in any country other than India. Section 2(1)(f)(iii) also defines International Commercial Arbitration wherein a party is a company or an association or a body of individuals whose central management and control is exercised in any country other than India.

It was contended by the UE Development group that as TDM Infrastructure Group is incorporated in India, it should also be legally deemed to be situated in India notwithstanding the fact of its directors being foreign nationals. Thereby, as both the companies would be incorporated in India, Section 2(1)(f)(ii) would not be applicable and the matter would be one of domestic arbitration. On the other hand, TDM Infrastructure raised the contention that as its central management and control is exercised from Malaysia, its day-to-day management does not take place in India. Therefore, as per Section 2(1)(f)(iii), it was International Commercial Arbitration and the Chief Justice of India could appoint the arbitrator.

The Court held that if both the companies are incorporated in India, the arbitration agreement concluded between them shall be construed to be a domestic arbitration agreement and not an International Commercial Arbitration. The Court also placed Section 2(1)(f)(ii) on a higher pedestal than Section 2(1)(f)(iii) remarking that the latter will only be applicable in cases where Section 2(1)(f)(ii) does not apply in its entirety. Thus, the Court limited the application of Section 2(1)(f)(iii) to cases where the body corporate is an association or a body of individuals unregistered or unincorporated under Indian Companies Act, 1956.

The importance of this case lies in the fact that the Court has restricted the scope for forum-shopping by companies in order to choose national arbitration laws that are most conducive to their interests. By holding that a company incorporated in India can only have Indian nationality, and therefore, an arbitration between two such companies would necessarily be a domestic arbitration, and by further observing that it is part of Indian public policy that Indian nationals should not be permitted to derogate from Indian law, the Court has made its stance clear in this regard. Also, this stance adds greater certainty and clarity to the determination of jurisdiction of the High Courts and the Supreme Court to appoint arbitrators.

By Gautam Bhatia & Venugopal Mahapatra

LLP Bill Introduced in Parliament

The new Limited Liability Partnership Bill, 2008 was introduced in Parliament on October 21, 2008. This supersedes the previous Bill of 2006, which was withdrawn. The salient features of the new Bill are set out in the Government’s press release as follows:

“(i) The LLP will be an alternative corporate business vehicle that would give the benefits of limited liability but would allow its members the flexibility of organizing their internal structure as a partnership based on an agreement.

(ii) The Bill does not restrict the benefit of LLP structure to certain classes of professionals only and would be available for use by any enterprise which fulfills the requirements of the Act.

(iii) While the LLP will be a separate legal entity, liable to the full extent of its assets, the liability of the partners would be limited to their agreed contribution in the LLP. Further, no partner would be liable on account of the independent or un-authorized actions of other partners, thus allowing individual partners to be shielded from joint liability created by another partner’s wrongful business decisions or misconduct.

(iv) LLP shall be a body corporate and a legal entity separate from its partners. It will have perpetual succession. Indian Partnership Act, 1932 shall not be applicable to LLPs. Since LLP shall be in the form of a body corporate, it is also proposed that the relevant provisions of the Companies Act, 1956 may be made applicable to LLPs at any time in the future by Notification by Central Government, with such changes or modifications as appropriate.

(v) An LLP shall be under obligation to maintain annual accounts reflecting true and fair view of its state of affairs. Since tax matters of all entities in India are addressed in the Income Tax Act, 1961, the taxation of LLPs shall be addressed in that Act.

(vi) Provisions have been made in the Bill for corporate actions like mergers, amalgamations etc.

(vii) While enabling provisions in respect of winding up and dissolutions of LLPs have been made in the Bill, detailed provisions in this regard would be provided by way of rules under the Act.”
This new Bill takes several important strides. First, the limited liability partnership (LLP) is being made available to all types of business or professional activities thereby broadening its utility; in the earlier Bill, the LLP structure was available only for certain types of professionals such as accountants and lawyers. Second, the LLP’s features almost replicate those of a company, e.g. there is no limit on maximum number of partners, the LLP would be a separate legal entity (unlike a partnership under the Partnership Act, 1932) and the LLP can undertake transactions such as mergers and acquisitions. Further, it also provides powers to the Central Government to make provisions of the Companies Act applicable to an LLP. These features make it a viable alternative to private limited companies (or perhaps even public limited unlisted companies).

In the end, however, whether it is a successful mode of conducting business (especially for small and medium enterprises) would depend on the availability of tax benefits that will likely be introduced by way of amendments to the Income Tax Act, 1961. If the tax benefits are substantial and provide tax-pass through at the entity level to LLP, those may confer a distinct advantage over companies that are not only taxed on the income they earn, but also on distributions of profits that they make to their shareholders.

While the LLP Bill is an important step, it is perhaps time to also start thinking about the next logical step, which is to consider the introduction of an entity such as the “limited partnership” (LP). Most other significant jurisdictions have already introduced LLP structures, while many of them have also introduced the LP structures. The LP structures are found to be conducive to the venture capital (VC) and private equity (PE) industry. LPs usually have two kinds of partners, i.e. general partners who assume unlimited liability and limited partners whose liability is limited to the extent of their contributions. This structure also enables general partners, who are usually the managers of the LP to take their returns in the form of ‘carry’. World over, most VC and PE firms are structured as LPs for this reason.

It is curious to note, however, that the lack of an LP structure under Indian law cannot be said to have crippled the VC and PE industry in anyway. That is perhaps owing to the availability of “trusts” as a suitable mechanism to deal with such entities. For instance, domestic venture capital firms (and even mutual funds) are established as trusts, where there is a trustee company and the investors are beneficiaries in the trust. While the trust structure does provide sufficient flexibility, the downside from the legal standpoint is that parties are compelled to rely on trust law (the Trust Act, 1882), which is not only a general law but has been enacted over a century ago before modern types of business activities were ever contemplated. For this reason, the availability of an LP structure as a separate mechanism would help engender a more vibrant VC and PE market in India.

Monday, October 20, 2008

British decision on lifting the corporate veil: Clarity or more confusion?

Considerable difficulty arises in trying to find a coherent set of principles to govern issues related to 'lifting the corporate veil'. Courts have relied upon several factors in deciding whether to ignore the existence of the corporate entity – ‘fraud’ or ‘sham’, ‘single economic entity’, ‘agency’, ‘tax evasion’, ‘determination of nationality’ etc.


In the early 1990s, in a landmark judgment in Adams v. Cape Industries [1991] 1 All ER 929, the Court of Appeal rejected the argument of ‘single economic entity’. The Court refused to ignore the legal form to look at the economic substance. In a recent judgment in Hashem v. Shayif, Justice Munby of the England and Wales High Court considered in depth several cases on the corporate veil issue, and concluded that for the veil to be lifted; that defendant must have control of the entity, and there must have been some impropriety.


Now, although Adams v. Cape rejected the ‘single economic entity’ argument, it left open the door for agency-based arguments. In this context, ‘agency’ would mean not just a formal contractual relationship but also a ‘factual’ agency. It needs to be considered, then, whether the Justice Munby’s judgment closes the door on agency-type arguments as well because of the insistence on impropriety. Further, at times, Courts have relied on an “interests of justice” rationale to lift the veil. Hashem v. Shayif categorically rejects this approach.


The important conclusions reached by the Justice Munby are as follows [in paragraphs 159 to 164 of the judgment]:

  1. Ownership and control of the company are not sufficient to justify the piercing of the corporate veil.
  2. The Courts cannot pierce the corporate veil merely because it is thought to be in the interests of justice.
  3. The veil can be pierced only if there is some impropriety.
  4. Again, mere existence of impropriety is also not sufficient. The impropriety must be linked to the use of the company structure to avoid or conceal liability.
  5. It is essential to show both control and impropriety in the sense mentioned in point 4.
  6. The test for lifting the veil is – is the company a façade at the relevant time? Whether it is a façade or not is determined by factors 1 to 5. If the answer is “no, it is not a facade”, the veil cannot be lifted at all.


Further, Justice Munby notes that whenever the Courts have lifted the corporate veil, “… the wrongdoer controlled the company, which he used as a façade or device to facilitate and cover up his own wrongdoing … in each of these cases there were present the twin features of control and impropriety.” Thus it would appear that the only way in which the veil can be lifted in by proving the existence of a façade. Agency-type arguments (such as “the company so habitually acts according to the wishes of the defendant that it is should be treated as an alter-ego”) are not sufficient to lift the veil because of the element of “impropriety”. Indeed, specific agency-based arguments were raised before the Court – Justice Munby however said that for any question of lifting the veil, the above factors were the essential test.


It would appear that the judgment has at least one good element – it brings in an amount of certainty in an area where rational principles harmonizing all the cases are hard to find. But, does it restrict too far the understanding of when the veil can be lifted? If so, to what context should the principles derived in the judgment be restricted? Leading authorities including Gower, Palmer and Pennington suggest several grounds on which the veil has been lifted. These include ‘evasion of obligations’, ‘protection of public interest’, ‘abuse of corporate form’, ‘countering fraud, sharp practice and oppression’, ‘disguise of the controlling hand’, ‘substance over form doctrines’ etc. Can all these categories be collapsed into a single category of ‘fraud/sham’?


Also, Courts are often unclear when they use the phrase “lifting the corporate veil”. In a seminal article in the Modern Law Review (May 1990), Prof. S. Ottolenghi characterized judicial action in “corporate veil” cases to be of four types:

  1. Peeping behind the veil – merely for the purpose of looking at the controlling persons and for nothing more. This is done in seeing whether a company is a “wholly-owned subsidiary”, an “associated enterprise” etc.
  2. Penetrating the veil – for the purpose of fastening liability on the shareholders for the acts of the company or for granting shareholders direct interest in a company’s assets. This does not mean that the company is treated as non-existent; but that despite the company being existent, certain factors require the Court to directly look at the shareholders.
  3. Extending the veil – lifting the veil over one company and then pulling it down to include another entity in the same veil. This is the approach in both ‘single economic entity’ and ‘factual-agency’ arguments.
  4. Ignoring the veil – entirely ignoring the existence of the company as a ‘façade’ or a ‘sham’.


There would be nothing wrong with Justice Munby’s approach if the case dealt with only the 4th category – nonetheless, the arguments made before him required him to look at all the categories listed above. Accordingly, he claims to lay down principles which would cover all these categories. But, does the existing case law justify this approach? Or has Justice Munby sacrificed correctness at the altar of clarity?


I will try to answer these questions in a separate post shortly. The judgment itself is available here. A discussion is available on the British Corporate Law and Governance blog here.


Sunday, October 19, 2008

Supreme Court exempts Co-Operative Banks from claiming under Recovery of Debts Due to Banks and Financial Institutions Act

The case of Greater Bombay Co-Op Bank Ltd. v. United Yarn Tex. Pvt. Ltd. and Ors., decided by a three judge bench of the Supreme Court finally settles the long-ranging debate about the interplay between Debt Recovery Tribunals and Co-operative Banks that had brought about a series of conflicting High Court decisions. The question in this case was whether the mechanism for the recovery of debt by Co-operative banks was to be in accordance with the provisions of their respective Co-operative Societies Acts, or with the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (RDB Act). The matter had assumed much commercial significance as large sums of public money had been locked up in litigation due to this unresolved question.

Section 5 (c) of the Banking Regulation Act, 1949 (BR Act) defines a banking company as any company which carries out the transaction of banking in India. It is pertinent to note here that the definition of Banking Company does not include Co-operative Banks per se. However, Section 56 of the Act states that the provisions of the BR Act would apply to Co-operative Banks, unless it has been provided otherwise. The RDB Act, 1993 which provides for setting up of special Tribunals for the speedy recovery of loans by banks and other financial institutions borrows the definition of banks from Section 5(c) BR Act. Therefore, if this definition were to be construed narrowly, since it does not specifically include Co-operative Banks, the latter would not come under its ambit. However, if a broad scope is given to the definition, then Co-operative Banks would be included.

Strong legal and pragmatic arguments were addressed by both the sides. Principal contentions for excluding Co-operative Banks from the ambit of RDB Act are as follows. First, that Cooperative Banks set up under various state legislations and the Central Enactment of The Multi-State Co-Operative Societies Act, 2002 already possess effective machinery for recovery of loans of their own. Secondly, as the statement of objects and reasons in case of RDB Act provides the main aim was to speed up recovery of loans from Banks and financial institutions. Merely because cooperative societies carried out the certain functions of banking, they are not banking companies and the provisions of RDB should not be extended to them. Thirdly, it was raised that Section 56 of BR Act creates only a legal fiction by construing references to banking companies to Co-operative societies and the same should only be limited to the BR Act. Fourthly, Co-operative Banks are excluded from the specified list of banking companies under Section 2(d) of the RDB Act. Fifthly, unlike as under Section 2(c)(v) of the Securitisation Act, 2002 where the Parliament specifically by notification had brought Co-operative banks under the ambit of ‘banking companies’ by way of notification, no such notifications were issued for RDB Act.

On the contrary it was contended that the RDB Act should be construed broadly to include Co-operative Banks, as they perform essential banking functions and their business is not restricted only to the members of cooperative societies. Further the transaction of banking by cooperative banks is “patent, manifest and direct and it can neither be incidental nor ancillary”. Also, the RDB Act being a special statute dealing with recovery of loans by banking companies should have precedence over Co-operative Societies Acts which are general in their application.

The apex Court came to the conclusion that the Cooperative Societies are to be excluded from the application of RDB Act, 1993 for the following reasons. First, on the ground that the RDB Act had specifically restricted the reliance on BR Act to only Section 5(c), thereby impliedly excluding references to Co-operative Banks. Buttressing its conclusions, it remarked that co-operative banks had an alternative cheap redressal forum for recovery of loans which was absent in case of other financial institutions. Thereby, the RDB Act was specifically enacted to establish special tribunals for other financial institutions as significant amount of public money was blocked in litigation preventing its optimum utilization and “recycling of funds for the development of the country”. [About Rs 5622 crores of money belonging to public sector banks was locked up in around 304 pending cases]. Thus, the Court observed that if Debt Recovery Tribunals are further over-burdened with Co-operative Bank cases, then it will inevitably lead to defeating of the whole objective of speedy recovery of cases.

It is submitted that this judgment lays down the correct law on the twin counts of statutory interpretation, as well as pragmatic and policy implications. By a plain interpretation of the relevant provisions, reading the words as they were without alterations or modifications, the only conclusion could be that that which was not included in the provision was not meant to come within its ambit. Secondly, on the grounds of policy, given that Co-operative Banks already possessed a mechanism of their own which was performing well, there as no reason to burden DRTs, and thus defeat the purpose behind the RDB Act. Furthermore, as the Court observed, this would also facilitate the circulation of money and speed up litigation in the commercial sector, both of which are important to achieve in the context of economic development.

By Gautam Bhatia & Venugopal Mahapatra

Important Judgment on the Levy of Penalties in Civil Liability Laws

In a crucial judgment on the scope of penalty provisions in tax and other civil liability laws, the Supreme Court has significantly broadened their scope (Union of India v. Dharmendra Textile Processors, CA Nos. 10289 – 10303 of 2003, decided on September 29, 2008, per Pasayat J.). The judgment of the three-judge Bench on a reference from a Division Bench overrules the important decision in Dilip Shroff v. JCIT. The following is an argument that it has done so unsatisfactorily.


What is most dubious about the Court’s reasoning is its application of the same principle across enactments. At issue were four provisions – Section 271(1)(c) of the Income Tax Act, 1961, Section 11AC of the Central Excise Act, 1944, Rules 96ZQ and 96ZO of the Central Excise Rules, 1944, and Section 15D(b) of the SEBI Act, 1992. All of these provisions levy penalties for infractions of various kinds, and the question before the Court is usually whether intent to commit the infraction in question is required to impose the penalty, or whether it is automatic. There has been considerable conflict on this question – it has held that there a mens rea requirement is present in s. 271(1)(c) – after much disagreement - and absent in s. 15D(b) of the SEBI Act.


Section 271(1)(c) provides the a penalty may be levied if the AO is satisfied that the assessee has “concealed the particulars of his income” or “furnished inaccurate particulars of such income”. However, before an amendment in 1964, penalty could be levied only if the assessee had deliberately furnished inaccurate particulars. At first sight, the 1964 amendment dispensed with mens rea by omitting the word ‘deliberate’. This had disastrous implications for assesses, because in effect it meant that penalties would be levied for legitimate disagreements with the assessing officer, or where mere inadvertence resulted in inaccuracy. A good example is where the assessee employed a valuer to value property for the purposes of capital gains, and found himself having to pay penalties because the Registered Valuer disagreed with his valuation.


An important recent decision on s. 271(1)(c) – Dilip N Shroff v. JCIT, (2007) 6 SCC 329 thus gave much needed relief to assesses, and held, albeit on dubious reasoning, that the burden of proof was still on the assessee. It is possible to justify this conclusion by resorting to the Explanation to the section which provided, even after the 1964 amendment, that penalties would not be levied if the assessee satisfied the AO that there was a bona fide explanation for the inaccuracy. This meant that mens rea was retained, although the burden of proof was apparently shifted to the assessee, a position supported even by the CBDT (CBDT Instruction No. 1130, dt. 31-3-1978). However, Dilip Shroff relied not on this but that held Section 271(1)(c) is a penal provision, and must therefore include mens rea. This conflicted with several other judgments of the Court, and it is no surprise that in Dharmendra Textile Processors, a Division Bench referred the matter to a larger Bench, which has now overruled Dilip Shroff.


The three judge Bench has now overruled Dilip Shroff, largely because of Dilip Shroff’s conclusion that s. 271(1)(c) is a penal provision. In fact, this was the basis of the referral by the Division Bench, because the Court in SEBI v. Shriram Mutual Funds (AIR 2006 SC 2287) had held that there is no question of mens rea for a provision imposing liability for the breach of a civil, as opposed to a criminal obligation. In that case, it had been held that s. 15D(b) of the SEBI Act requires no mens rea, since it imposes penalties on collective investment scheme companies for failure to comply with the terms of the registration certificate. Thus, the Court in this judgment rightly pointed out that Dilip Shroff had erred on this point.


However, it seems that Dharmendra Textile Processors is not correct either, for two reasons. First, the question before the Court was not s. 271(1)(c) at all, but whether s. 11AC of the Central Excise Act contained a mens rea requirement. Counsel for the assessee relied on Dilip Shroff, and the referring Bench, instead of distinguishing it and considering s. 11AC on its merits, held that “the basic scheme for imposition of penalty under s. 271(1)(c) of the Income Tax Act, Section 11AC and Rule 96ZQ is common”, and referred Dilip Shroff for reconsideration. Section 11AC provides that penalty may be levied if there is fraud, collusion or wilful misstatement or suppression of facts – a clear mens rea requirement. Rule 96ZQ(5) on the other hand provides that penalty is payable if the “amount specified” is not paid by “the date specified” – a clear abrogation of mens rea. This question, therefore, must turn not on the general characterisation of a provision as penal or otherwise, but on its language. Secondly, Dilip Shroff was decided rightly, albeit for the wrong reasons. Without going into detail, the effect of Explanation 1 makes it amply clear that burden of proof is shifted to the assessee only after a prima facie finding of mala fide furnishing of inaccurate particulars.


Unfortunately, the implications of the judgment are not confined to tax law – it is now likely that any provision imposing penalties for the breach of civil obligations will be construed as placing the burden of proof on the person paying it, or will be construed as not having a mens rea requirement at all. This may well be the case, but it depends on the provision in question, and not on whether it is considered penal or not.



The Tax Evasion Debate Revisited

An earlier post here had looked at the interrelation between the ratios of Azadi Bachao Andolan and McDowell on the issue of tax evasion, and concluded that the stricture against tax evasion laid down in McDowell hadn’t been completely laid to rest by Azadi, and that there still was scope for challenging a proposed transaction as being motivated purely by tax avoidance. A recent decision of the Bombay High Court in CIT v. Walfort Share & Stock Brokers Ltd. revisits this debate, partially reading down, and partially expanding the decision in Azadi.

The assessee (respondent), a member of the Bombay Stock Exchange, had entered into a transaction of purchasing dividend bearing units of Chola Freedom Technology Fund and then redeeming them at a loss after receiving the dividend on them. The dividend earned was then sought to be exempted under s. 10(33), Income Tax Act, and the loss was sought to be set off as a business loss against its other income. This loss was disallowed by the Revenue on the ground that there was no business purpose behind the transaction, and that the only motive was to manufacture a ‘loss’ to set off against other income. Thus, it, being a tax avoidance transaction, was challenged by the Revenue.

The Income Tax Act had been amended w.e.f 1-4-2002 to weed out such transactions. However, this transaction having been entered into prior to this amendment, the Revenue’s only grounds of challenge were the reality of the transaction and the motive.

First, it was contended that the loss was an artificial loss, and hence could not be allowed as a valid business loss under the Act. The Court rejected this contention, albeit on slightly dubious reasoning. The Court held that if the loss was to be considered artificial, s. 94(7) would be rendered otiose, since the loss would anyway have been disallowed. The Court went on to say that the only way then s. 94(7) could be given meaning was if it made a heretofore disallowable loss allowable and then didn’t allow it in certain cases. While this reasoning achieved the desired result, it is submitted that a simpler approach would have been to hold that the amendment was prospective (which the Revenue was in agreement with) and that its very introduction meant that the law prior allowed the loss.

Secondly, and more relevant for the purposes for the tax evasion debate, the Revenue placed reliance on McDowell to argue that the transaction of purchase and sale was a composite one for the purposes of creating an artificial loss, and should not be treated as two independent transactions. The assessee, represented by Mr. Dastur, contended that after the decision in Azadi, a transaction which is within the bounds of the law cannot be questioned on grounds of any underlying motive. The Court rejected the Revenue’s contention by restricting McDowell to facts, and following the ratio in Azadi. What is of particular interest here is the caveat retained by the Court, in stating, “in the absence of any allegation that it was a sham transaction”, the assessee would be entitled to set off the loss. As pointed out in the
previous post, the language of Azadi leaves open the door open for lifting the corporate veil in cases of sham transactions, or when the two corporate entities formed a single economic unit. This decision further seems to reaffirm that conclusion, thus narrowing the popular import of Azadi. Ironically, what the Bombay High Court also does is inadvertently widen the scope of Azadi. A second reading of Justice Reddy’s opinion in McDowell showed that he did not impose an absolute bar on tax avoidance measures, but mandated an inquiry into “whether the transaction is such that the judicial process may accord its approval to it”. On the facts of that case, he had concluded that, for several policy reasons, the arrangement should not be approved. However, the facts there did not concern international investment and DTAAs. Given the other policy justifications that do weigh in favour of allowing limited treaty shopping in the case of DTAAs and international investment, those policy reasons may not have as much force in a case similar to that in Azadi. Thus, even within the ambit of permissible tax avoidance as laid down by Justice Reddy, it may be possible to justify the decision in Azadi. Such an interpretation, would whittle down the scope of the decision in Azadi, but would serve to reconcile the two decisions. What the decision in Walfort does is apply the Azadi logic to a case far removed from any DTAA issues. In fact, on the facts of Walfort, the policy imperatives seem to argue against a pro-assessee decision. By so applying Azadi, it has, in a way, widened the scope of Azadi, and possibly completed the departure from McDowell, subject to the sham exception.

Wednesday, October 15, 2008

Legality of Derivatives: Emerging Signs

Readers will recall that over the last few months several companies had entered into derivative transactions with banks wherein they were required to pay significant amounts of money to banks. When faced with claims from the banks, these companies challenged the validity of these derivative transactions in various courts in India, including on the ground that derivatives constituted wagering contracts that were void under the Contract Act.

Recent newspaper reports seem to indicate that courts are willing to uphold the claims in favour of the banks. LiveMint reports that in a September 15 judgment, the Bombay High Court ordered Sundaram Multi Pap Ltd to pay ICICI Bank Ltd the dues arising out of contracts for structured derivatives. The order is available here. However, this order was passed in a winding up petition, and the court has not analysed the legality of derivative transactions.

In a further development, LiveMint reports that the Madras High Court has indeed ruled on the substance of the transactions, again in favour of the banks. This was a case involving Axis Bank and Rajshree Sugars and Chemicals Ltd. It appears that the court has ruled that derivative contracts are not wagering contracts and further that the debt under such contracts qualify for recovery by the banks through the Debt Recovery Act. A further detailed analysis will have to await a review of the judgment once it is available.

For previous discussions on this topic, see: Trading in Futures – Financial Instruments of Mass Destruction?, Derivatives - a constructive critique and More on the Indian Derivatives Saga

Anti-Competitive Agreements: What can we Expect from the Competition Commission?

(We are very pleased to welcome Farhad Sorabjee as a guest contributor on the Blog. Mr. Sorabjee is a partner at the Mumbai offices of J. Sagar Associates and leads the firm’s competition practice. His contributions will certainly bolster the competition law focus on this Blog.

In the following post, he considers the nature of penalties that competition authorities worldwide have imposed under their respective laws, which may serve as an indication as to what might be expected from India’s Competition Commission)

“The bringing into operation of the Competition Act, 2002 brings with it not only extensive merger and acquisition scrutiny and the investigation of abusive practices by a dominant undertakings, but also a slew of wide-ranging controls, checks and potential investigations into inter-corporate agreements.

Agreements subjected to scrutiny in competition law fall into two broad divisions:

(i) Horizontal agreements, which would include agreements between independent undertakings operating and supplying to the same market to fix prices or apportion markets (by class or geographical region, for example), or restrict output with a view to controlling prices in a market. Perhaps the most striking example of an international cartel mechanism is the Organisation of Petroleum Exporting Countries, commonly known as OPEC, but that is another story.

(ii) Vertical agreements, which would include agreements between independent undertakings at different stages of the production and distribution chain: between manufacturer, wholesaler, retailer and consumer, or agents or third parties standing in their shoes as such.
It is significant that it has repeatedly been stated that cartel restriction and chastisement is a fundamental duty of any competition authority. A leading authority on the law and enforcement of competition states that “… if competition policy is about one thing, it is surely about the condemnation of horizontal price fixing, market sharing and analogous practices: on both a moral and practical level. There is not a great deal of difference between price-fixing and theft…” (Richard Whish: Competition Law, 5th Edn). And again, “… (the) pursuit of the…cartel ought to lie at the heart of any competition authority’s agenda ”. The EU Commissioner while addressing a conference on competition policy referred to cartels as cancers on the open market economy.

Indications emanating from the Competition Commission, and indeed its website in itself, clearly suggest that the commission has already initiated inquiries and obtained reports regarding certain sectors of industry, both manufacturing and services, which are reputedly prone to the existence of cartels and price-fixing and bid-rigging.

The treatment of cartels has been harsh and punitive worldwide. Fines imposed in cases of cartel activity have been colossal. In the Vitamins cartel case, fines imposed by the EU Commission totalled € 855.23 million. Fines in the US on the major participants amounted to US $ 462 million, in Canada, Canadian $ 84.5 million and in Australia, Australian $ 26 million. In Graphite Electrodes the total fines imposed amounted to US $ 434 million (the criminal proceedings are reported in United States v. UCAR International Inc; Criminal No. 98-177). The European Union itself imposed fines totalling close to €2 billion in 2001.

Under section 27 of the Competition Act, the competition commission may levy a penalty of up to 10% of the average of the turnover for the last three preceding financial years upon each of such person or enterprises which are parties to such agreements. In case any agreement referred to in section 3 has been entered into by a cartel, the Commission may impose upon each producer, seller, distributor, trader or service provider included in that cartel a penalty of up to three times of its profit for each year of the continuance of such agreement or ten per cent of its turnover for each year of the continuance of such agreement, whichever is higher.

A further facet of the dangers involved is the possibility of affected parties approaching the common law courts and criminal courts for recovery of individual damages or criminal prosecution of employees and executives.

In the US, in the case of the Lysine cartel, three jail sentences and fines of $120 million were imposed (United States v. Michael D. Andreas, Mark E. Whitacre, Terrance S. Wilson and Kazutoshi Yamada 1999 WL 51806 (N.D. Ill.); Criminal No.: 96-CR-00762). In the Sotheby's/Christies price-fixing cartel case, Alfred Taubmann, the chairman of Sotheby's was sentenced to one year’s imprisonment (2002-1Trade Cases P 73, 645, upheld 297F 3d 161 (2nd Cir, 2002)). In the landmark Vitamins cartels case ([2003] CMLR 1030; OJ [2003] L 6/1), senior executives of Roche and BASF also served terms of imprisonment in the US for their roles in this cartel. Only a few days ago, four British Airways executives (past and present) have been charged with dishonestly agreeing to fix the price of air transport passenger services between British Airways and Virgin Atlantic Airways. They could face up to five years in jail and an unlimited fine. Incidentally, Virgin is the whistleblower seeking leniency in the case.

The Competition Commission in India has drafted ‘Lesser Penalty’ regulations to allow for whistleblowers, which provides for 100% waiver if the applicant is the first to make a disclosure by submitting evidence which in the opinion of the Commission may enable it to (i) form an opinion that there exists a prima facie case and (ii) it did not have at the time of the submission of evidence by the applicant sufficient evidence to form an opinion

Agreements to not raise prices, the geographical division of markets between colluding undertakings, agreements to restrict credit to customers or to offer discounts, notify each other of price changes, fail to maintain price lists, make recommendations to distributors, restrict production, fix quotas for the market, would all be anti-competitive in nature.

In the case of bidding and tendering, impermissible practices would include level tendering (all bidders bidding at the same level to offset the power of the tenderee), and rotation bidding (where members rotate the lowest bid between themselves, the rest bidding higher deliberately).”

© Farhad Sorabjee

Tuesday, October 14, 2008

Links on Competition Law

(The following post contributed by R.V. Anuradha points to some recent information and materials pertaining to competition law)

1. What will the Competition Commission of India (CCI) look like? LiveMint considers some of the names of people being considered for membership of the CCI.

2. Other interesting developments in the recent past are a US Department of Justice (DOJ) paper on Unilateral Conduct that seems to have caused quite a bit of furore in the US, with the Federal Trade Commission (FTC) openly disagreeing with the DOJ approach. Following are 2 interesting links on this issue:

(i) FTC Commissioners React to Department of Justice Report, "Competition and Monopoly: Single-Firm Conduct Under Section 2 of the Sherman Act" - http://www.ftc.gov/opa/2008/09/section2.shtm

(ii) US DOJ Report "Competition and Monopoly: Single-Firm Conduct Under Section 2 of the Sherman Act" - http://www.usdoj.gov/atr/public/reports/236681.pdf
India's approach under section 4 read with section 19(4) of the Competition Act on “abuse of dominance” veers more towards the European Commission (EC) approach. Article 82 of the EC Treaty deals with abuse of dominance, and the elements identified under section 4(2) of India's Act are very similar to Article 82's categories. The EC had issued a discussion paper on Article 82 sometime back.

SEBI moves to tighten insider trading norms by prohibiting opposing transactions

In an earlier post, Mihir had remarked that while arguments for legalizing insider trading are interesting, there is a long way to go before they are actually accepted by legal systems. SEBI’s recent move to tighten insider trading norms is a case in point. ET reports that SEBI will soon amend its regulations to ban insiders from any opposing transaction within a period of six months. ‘Insider’ has been defined quite widely, and includes any ‘officer’ of a company who owns more than 10 %, either directly or indirectly. ET's detailed analysis of this proposal is available here.

Friday, October 10, 2008

Top 200 World Universities

Here is a link to the list of top 200 universities around the world:
http://www.timeshighereducation.co.uk/hybrid.asp?typeCode=243&pubCode=1

Any idea why so few are from India?

Wednesday, October 8, 2008

Welcome to our New Contributors

Over the last few weeks, we have been fortunate to have several new contributors join us. This has significantly expanded the scope of the discussion on this Blog into areas that were hitherto not focused on, such as taxation, arbitration and international trade. To briefly introduce them:

Jayant Thakur is a practising Chartered Accountant in Mumbai, with interests in securities and corporate laws. He has a keen interest in writing and has written numerous articles in various business newspapers such as the Economic Times, Business Standard and Financial Express, and also in various professional journals. He has also authored books on “Mergers and Acquisitions”, “Takeovers of Companies”, Law Relating to Non-Banking Financial Companies” and “ESOPS – Law and Practice”.

The bright and enthusiastic team of students from the National Law School of India University, Bangalore comprises V. Niranjan, Mihir Naniwadekar and Shantanu Naravane (all in their IV Year) and Venugopal Mahapatra and Gautam Bhatia (all in their III Year).

B.N. Harish is a corporate lawyer and founding partner of Narasappa, Doraswamy and Raja, based in Bangalore. R.V. Anuradha, is a partner at Clarus Law Associates in Delhi, with her specialisation being international trade law and competition law.

It is my pleasure to welcome them (belatedly though) to the team.

Some Thoughts on the P-Note Volte Face

In an earlier post, Mihir highlighted some key decisions taken by SEBI earlier this week. One decision regarding P-Notes merits greater discussion.

A little less than a year ago (October 16, 2007 to be precise), SEBI introduced bold measures to curb the use of participatory notes (P-notes) and other offshore derivative instruments (ODIs) by foreign investors in the Indian stock markets. In a nutshell, P-notes are instruments that derive their value from an underlying financial instrument such as a share traded on an Indian stock exchange. They are issued by foreign institutional investors (FIIs) to various offshore investors on the strength of underlying equity, derivatives or other securities that are held by the FIIs.

In its October 2007 decision, SEBI adopted a two pronged approach. First, it announced restrictions on the issuance of ODIs by FIIs to investors offshore in respect of underlying securities in the cash market (e.g. by imposing quantitative limit of 40% of assets under custody of the FIIs) and entirely prohibited the issuance of ODIs where the underlying securities are derivatives. Second, SEBI instead encouraged offshore investors (such as hedge funds) to register themselves with SEBI as FIIs or sub-accounts rather than to continue to participate in the Indian stock markets through indirect routes such as ODIs, thereby calling on them to come in through the “front door”.

It appears that one of the key drivers for those changes was the need on the part of the RBI (as the foreign exchange regulator) to stem the flow of foreign exchange into India and to curb the rise of the Rupee against other foreign currencies that was the trend in 2007. Whatever the underlying reason may have been, the changes signalled a move towards engendering a culture of transparency in the markets. In other words, offshore investors in Indian markets were encouraged to invest directly rather than use indirect (and possibly opaque structures) to invest. This objective has been partially achieved as it resulted in several foreign investors (including hedge funds) registering themselves as FIIs or sub-accounts. SEBI data reveal that “391 FIIs and 1160 sub-accounts have been registered since October 31, 2007”. Furthermore, although there was fear initially that these strong measures would cause a flight of foreign capital, newspaper reports indicate that no such thing ever occurred on any significant scale.

However, on Monday (October 6, 2008) the SEBI board decided to remove all the restrictions imposed by SEBI in October 2007. In other words, the position was reverted to that which existed pre-October 2007, whereby P-Notes and other ODIs can be issued by FIIs without any quantitative restrictions. While this move has been hailed in some quarters as enabling a further opening up of the Indian capital markets, it does present several difficulties which cannot be ignored.

First, the timing of the change perhaps partly explains the regulatory motive. Present today is the contagion effect of the global crisis. Not only have the Indian markets been sliding downwards, but there is threat that the global crisis could affect emerging markets such as India in a more acute way. Hence, it appears that both SEBI and RBI have taken measures to revitalize the Indian markets (both on the equity side as well as the debt side), nearly simultaneously. SEBI’s decision to reverse the policy on P-Notes (and hence boost the capital markets) was accompanied by RBI’s decision to reduce the cash reserve ratio (CRR) by 50 basis points (and hence boost the debt markets by making more funds available for lending). Clearly, the decision on P-Notes seems to have been made with a view to attracting more foreign capital. As in October 2007, what drove the decision regarding P-Notes is foreign exchange and capital controls. As an aside, the other instrument which Indian regulators often use to calibrate the flows of foreign exchange is external commercial borrowings (ECBs), which as we have seen a few weeks earlier were further liberalized by the RBI, consistent with the need to activate the debt markets.

The concern that therefore emerges is the constant blurring of the distinction between capital controls and securities regulation. Regulation of instruments such as P-Notes falls within the domain of securities regulation (with SEBI being the regulator on this count). SEBI’s role is to determine the efficacy of such instruments on their merits, such as depending on who the investors are, whether they should be registered with SEBI, what types of disclosure and transparency requirements (fashionably called the KYC-norms) they should be subjected to, and the like. SEBI’s role is that of a stock- or securities-market regulator. But, when decisions are driven by foreign exchange and the need to relax capital controls, and not necessarily with a view to investor-protection, there is a doubt as to the precise nature of the role being played by SEBI. Both in October 2007 as well as now, both SEBI and RBI appeared to have collaborated in decisionmaking, and decisions were arrived at based on foreign exchange requirements and not necessarily with a view to investor protection.

Second, and more importantly, the current proposals signal a move away from transparency. P-Notes enable their holders to obtain economic benefits from (and of course bear the risk of) the Indian markets without actually investing in them. They can (notionally or virtually) enter and exit the Indian markets without being registered with the Indian securities regulator. They are also not subjected to the trading and settlement systems on the Indian stock exchanges. This is all on account of the fact that it is the FIIs that hold the underlying securities on the strength of which P-Notes are issued. When P-note holders are offshore, issues of extraterritoriality are intensified. Without being registered with SEBI, it is not possible to obtain adequate disclosures or information from these entities. These difficulties were experienced in fact by SEBI in the UBS and Goldman Sachs cases (discussed here) where it unsuccessfully attempted to obtain disclosures and undertakings from offshore investors. In this context, it is not entirely clear what the justification for reverting to a more opaque regime is. That too when securities regulators the world over are adopting a more cautious approach in the wake of recent events arising from the global credit crisis, and due to the pervading sense of doubt over the success of free-market capitalism.