Monday, December 29, 2008

All-pervasive lack of governance in the system

I wrote the following in my column in Business Standard today:-

It is always tempting to write a ‘year that was’ piece towards the end of December. This column will not do so. Instead, it seeks to look at three unrelated current events that would remind one of how another year may go by, but the poor quality of governance remains unresolved in India.

At the political level, the Mint published a pseudonymous open letter to Prime Minister Manmohan Singh – the pseudonym ‘Athreya’ purported to protect the identity of the author, stated to be a serving civil servant. The piece contained no scandalous or mouth-watering exposé. It was a general critique of how poorly India is being governed – quite the type of piece that the ex-columnist finance-minister-turned-home-minister P. Chidambaram would have written when not in government.

Opposition MPs tabled the piece in Parliament. Rather than use Parliamentary diplomacy, Mr. Chidambaram chastened the shielded bureaucrat author for not having the guts to come out in the open. The Minister was perhaps not just technically and legally correct, but even tactically right. His brief was indefensible on merits – he could not have said much against the merits of the general critique. Athreya’s clichéd truisms underlined how weak the government has been on so many counts – indeed as have been many of earlier governments.

On the corporate side of society, the Satyam-Maytas deal exposed how Corporate India is left with little moral authority to critique the political side of the spectrum. A listed software company agreed with its “promoters” (legal definition: persons in control over the company) to acquire their equity stake in two real estate companies. Under Indian law, interested parties are not permitted to participate in the decision in any manner, and the decision ought to have been taken solely by non-promoter directors.

The independent directors unanimously decided to do the deal. The deal would be India’s largest-ever related-party transaction – USD 1.6 billion would flow from the listed company (over 90% owned by public shareholders) into the hands of the promoters, and the software company would pay to gain real estate interests. Six out of Satyam’s nine-member board are “independent directors” (as defined in securities regulations) and comprise four pedigreed academicians, a former Union Cabinet Secretary (in his day, perhaps ranking higher than the Mint’s Athreya) and one of the founders of Intel’s Pentium chip. These worthies had won for Satyam the Golden Peacock award for corporate governance this year.

The market screamed murder. Some investors said they would go to any lengths to actively frustrate the deal. The stock price tanked over 50%. Funnily, the deal was called off overnight.

With the deal, the gloves too came off. Independent directors suddenly claimed to have opposed the deal at the board meeting. Initial talk of the valuation having been justified is no longer being underlined. In hurried self-cleansing, Mr. T.R. Prasad, the former Cabinet Secretary spoke to the media about the concerns he had raised at the board meeting. It did not matter to him that either he had believed his concerns had been addressed or he never really raised any serious concern – remember the board decision had been unanimous.

Not one independent director spoke of why they suddenly lost conviction to stand by the deal they had unanimously approved. The chairman of the unanimous board decision, Mr. M. Rammohan Rao, the Dean of the Indian School of Business (a school to which Satyam or its promoters are said to have made donations), is reported as having said that the board had been “concerned” but had decided to “take the risk” and “see how the market reacts”. Only one independent director Ms. Mangalam Srinivasan had the humility to admit in writing that regardless of concerns expressed, she did not positively voted against the deal. She resigned owning moral responsibility.

While on governance, it is noteworthy that the Securities and Exchange Board of India (“SEBI”) recently announced a Code of Conduct to regulate its own Board of Directors. The Code of Conduct entails disclosure of conflicts of interest, and procedures for dealing with conflicts. However, since governance goes beyond board-level discipline, on an unrelated note, SEBI has been left red-faced as the year draws to a close.

A news report was published on December 22 that SEBI had directed an open offer to be made for shares of a listed company at a high premium to current market price. SEBI clarified the next day that the news report was false. It turned out that SEBI’s letterhead had been forged. However, at least one full trading session went by and the price skyrocketed without the news being clarified.

The administrative governance of the judicial system, which often criticizes the public and private arms of our society, too has little to be proud about – suits filed two decades ago are still being tried in the Bombay High Court.

As the year draws to a close, the lack of standards in governance in every walk of our life is apparent. We are moving into election year – where the Indian people will decide who will govern them for a scheduled term of another five years.

Saturday, December 27, 2008

The Year That Was

A year ago, while ushering in 2008, there were strong signals that suggested challenging times were in the offing for the corporate sector. The global financial markets were reeling from the effects of the sub-prime crisis, and pundits had predicted the effect would be devastating. Those predictions, alas, turned out to be true – only the severity of the crisis was far greater than imagined at first.

As far as Wall Street is concerned, we saw the stand-alone investment banking industry being wiped out – with leading investments banks being converted into commercial banks, some being merged with larger entities and one entity (Lehman Brothers) being doomed into bankruptcy. The more fortunate companies in the manufacturing and services sectors managed to squeeze out some form of lifeline or the other from the Government – the insurance giant, AIG, and a couple of auto companies are illustrations of this outcome. The effects of the crisis were not confined to the US. It affected companies in the UK and Europe and even resulted in the collapse of the Icelandic economy. The problems were compounded by shenanigans in the financial sector – the noted ones occurred, coincidentally, in the beginning and the end of the year – the Societe Generale derivatives trading fraud in January and the Bernard Madoff scandal in December.

Although the Asian economies initially appeared immune from the crisis, they eventually became engulfed in it. Most stock indices across Asia have taken a beating, including the BSE and NSE in India. The overwhelming effects of the crisis have also percolated to the real sector in large economies such as a China and India that export goods and services to the developed nations. The available evidence leaves very little reason for proponents of the decoupling theory to rejoice. As a final blow, the terror attacks in Mumbai have adversely affected investor sentiment, and it will take some time and significant positive measures from the Government to reverse this trend.

As far as Indian corporate law and governance is concerned, there is a mixed bag. The year 2008 has witnessed significant legislative efforts to reform Indian partnership law and company law. The Limited Liability Partnership Bill has already been passed by both houses of Parliament, while the Companies Bill is currently pending consideration. These laws have the potential to significantly alter the framework of business entities in India. The Competition Commission too has issued detailed proposals for merger regulation.

On the securities regulation front, two developments are worthy of mention. First, the change of guard that occurred in SEBI this year – with Mr. C.B. Bhave taking over the helm of affairs - has brought about structural and functional changes within its organisation. SEBI’s recent efforts to infuse transparency in its operations are a path-breaking move and deserve to be emulated by other governmental authorities. Second, SEBI has adopted several measures throughout the year to prop up the sagging markets (both primary and secondary). On the primary markets front, share offering processes were streamlined – the ASBA process (applications supported by blocked account) was introduced for public offerings, the timeline for rights offering was reduced and the minimum pricing norms for qualified institutional placements (QIPs) was relaxed. On the secondary markets front, SEBI enhanced creeping acquisition limits for promoters to enable them increase their stakes in companies during depressed market conditions. In a volte face, SEBI also reversed its earlier decision on participatory notes (P-notes) by removing all restrictions on issuance of P-Notes by foreign institutional investors. It is not entirely clear if these measures have been met with success yet; they appear to be knee-jerk reactions and piecemeal in approach.

SEBI also undertook measures to strengthen the corporate governance regime in clause 49 of the listing agreement. The definition of “independent directors” was made more stringent. However, the experience with enforcement of corporate governance norms calls for pessimism. SEBI let several public sector undertakings off the hook from implementing the minimum independent director rule. The year draws to a close with the lingering aftertaste of the Satyam Computers episode that leaves one quipping about the efficacy of India’s corporate governance norms and culture.

The foreign investment regime has witnessed a few changes this year. The Government introduced Foreign Currency Convertible Bonds as a new form of investment. Further, in order to boost foreign flow of capital into India, two key changes were made: ADRs/GDRs now enjoy more flexible minimum pricing norms, and ECBs are subject to less onerous conditions in most sectors. These relaxations have not had any significant impact on investment flows yet: some may argue they are too little, too late.

Apart from the legislature and the executive, the judiciary too has been somewhat active during the year on corporate and commercial matters. The Bombay High Court’s decision in the Vodafone tax case is bound to have great implications on M&A activity in the country. Courts across the breadth of the country were busy trying cases involving banks and their clients that entered into currency derivative transactions – some clarity in the position has begun to emerge lately. Finally, both SEBI and SAT have ruled on several matters surrounding securities regulations, such as insider trading, takeover regulations and public offerings.

Overall, 2008 has been an eventful year on the corporate and financial standpoint. But, the several lows the year witnessed only leave cause for optimism in the future as we enter 2009.

On a final note, this season also marks the first anniversary of this Blog. Its first post appeared on December 26, 2007. I would like to take this opportunity to thank all the contributors for their excellent posts on various areas of corporate and business laws and for fostering healthy debate and discussion on Indian corporate legal issues in a manner widely disseminated and easily available to the interested reader. Last, but not the least, I would like to thank our readers for their wonderful support on an ongoing basis and for their comments and feedback.

Wishing all of you a New Year filled with success, happiness and prosperity.

Wednesday, December 24, 2008

Pyramid Saimira: SEBI Investigation

A couple of days ago, the media carried reports of SEBI having directed one of the promoters to make an open offer to the shareholders of Pyramid Saimira Theatres Limited at a price that is at a substantial premium to current market price. However, just a day later, SEBI put out a clarification that it had issued no such letter, which appears to have been forged. Sensing some foul play, SEBI has ordered an investigation, including on allegations of price manipulation. While the company has alleged fraud, others have suggested there are larger issues of corporate governance involved.

Tuesday, December 23, 2008

FIPB Overrules Press Note 1 Objections

Press Note 1 of 2005 issued by the Department of Industrial Policy & Promotion (DIPP) requires foreign companies to obtain the prior permission of the Foreign Investment Promotion Board (and thereby making the automatic route for investment inapplicable) if they had a joint venture with another Indian partner in the same field. This condition is applicable for joint ventures existing in January 2005 (when the press note was issued). Due to Press Note 1, the FIPB in practice requires applicants (being the foreign investors) to support their applications with a no-objection letter from their previous Indian joint venture partner, thereby conferring significant de facto powers to such Indian partner.

As we had discussed earlier, there is considerable pressure for Press Note 1 to be removed altogether, or at least its effects diluted. In the meanwhile, in a proposal by Ralf Schneider to set up a wholly owned subsidiary in India, the FIPB has engaged in a rare move overruling the objections of the previous Indian joint venture partner, Larsen & Toubro Limited (L&T). This would allow Ralf Schneider to proceed with its new Indian venture without having to obtain the no-objection of L&T. Details of this case are available in a report in the Business Standard.

(Update: The Business Standard link does not appear to be working, and hence the report is extracted below:

“The Foreign Investment Promotion Board (FIPB) has cleared a proposal by German plastic moulding major Ralf Schneider to set up a wholly-owned subsidiary in India, setting aside objections raised by its former Indian partner Larsen & Toubro (L&T) under Press Note 1 of the Foreign Direct Investment (FDI) policy.

This is the second time the FIPB has struck down Press Note 1 objections from an Indian partner, the first being in October 2006 when FIPB cleared a proposal by the US-based Guardian group over objections from the VK Modi group of Gujarat Guardian.

Press Note 1 is a guideline that requires foreign companies with joint ventures or technical partnerships in India to obtain a “no-objection certificate” from their Indian partners if they propose to set up the same or a similar line of business in India.

It has been the source of tension between several Indian companies and their foreign partners, a prominent example being French foods major Groupe Danone’s attempt to get a no-objection certificate from the Wadia group, with which it has an equity tie-up in Britannia, for fresh investments in India.

Ralf Schneider had tied up with engineering giant L&T in 1992 for a technical partnership that expired in 2007. A few months ago, L&T invoked Press Note 1 blocking Ralf Schneider’s entry on grounds that the German company’s plans would hurt the Indian company.

L&T had argued that one of its business units makes the same equipment that Ralf Schneider intends to make in India. Sources added that the company thought the German firm’s entry would create confusion in the market with two producers offering the same product using the same technology.

Ralf Schneider had countered L&T’s argument saying Press Note 1 should not be applicable in this case since the tie-up was a technical one and not a financial one and that it had expired last year.

FIPB had initially agreed that the proposal attracted Press Note 1. Later, it set up a committee to discuss the issue with the two former partners.

An L&T spokesperson declined to comment on the FIPB order.”)

Wednesday, December 17, 2008

Analysis of Recent SAT Rulings on Insider Trading and FUTP Against Dilip Pendse

(The following post is contributed by Bhushan Shah, an Indian lawyer currently pursuing a dual degree LL.M from New York University School of Law and National University of Singapore)

The Securities Appellate Tribunal (‘SAT’ or ‘Tribunal’ ) recently set aside two orders (collectively referred as ‘Impugned Orders’ ) passed by market regulator i.e. Securities Exchange Board of India (‘SEBI’) against the former high profile managing director of Tata Finance Limited’s (‘TFL’) Mr. Dilip Pendse. The Impugned Orders were passed on December 29, 2006 and December 28, 2007.

In Appeal No. 90 of 2007, SAT turned down the charges of insider trading stating that SEBI has failed to apply the fundamental principles of law. In Appeal No. 22 of 2008, SAT set aside SEBI’s order of banning Pendse from trading in the securities market for his alleged illegal transactions in the shares of Global Telesystems Limited (‘GTL’) on the ground of lack of evidence.

Let us analyze each of the judgments separately.

A. APPEAL NO. 90 OF 2007 - INSIDER TRADING CASE

Facts

1. Pendse and one Mr. Jaivant Talaulicar (‘Talaulicar’) were the managing director and director respectively of TFL and also directors of Niskalp Investment (‘Niskalp’), an investment company and wholly owned subsidiary of TFL.

2. SEBI’s investigation revealed that Pendse aided Talaulicar through counseling and organizing deals on his behalf in the shares of TFL and thereby violating insider trading regulations.

3. SEBI alleged that Talaulicar and his family sold one lac shares of TFL on March 30, 2001 through an off market transaction at negotiated price of Rs 69 per share to one JIP Investments (‘JIP’) which is a sub broker of JHP Securities Private Limited (‘JHP’) member of BSE. SEBI also found out that on the same day JIP received Rs. 70 lacs from JHP who received it from Niskalp. In other words, the purchase of the shares was funded by Niskalp. Later in May 2001 JIP sold these shares to a broker at prevailing market price of an average of Rs. 35 per share for which JIP received a consideration of Rs. 34.21 lacs. The total amount was far less than JIP paid to Talaulicar in March 2001. Talaulicar then paid a sum of Rs. 34.79 lac (the difference between the two sale prices). JIP paid this amount to JHP which in turn paid to Niskalp.

4. When Talaulicar was examined by the Adjudication Officer of SEBI (‘AO’), he stated that he wanted a loan of Rs 75 lacs from TFL to purchase a house in Goa. Pendse being the managing director of TFL at that time denied the application as Talaulicar was a director and this would raise an issue under Section 295 of the Companies Act, 1956. In the circumstances, Talaulicar requested Pendse to sell off his (Talaulicar’s) personal and family’s one lac TFL shares. In consideration of TFL shares Pendse handed over cheques of Rs 69 lacs.

5. On the basis of the statement given by Talaulicar, SEBI was of the view that Pendse had aided Mr. Talaulicar by a way of counseling and organizing the transfer of shares on his behalf in a circular manner and thereby was guilty of insider trading and violated Regulation 3 of the Insider Trading Regulations. However, Pendse denied having committed any offence and specifically pleaded that he was not involved in any transaction with Talaulicar for sale of his one lac TFL shares. Pendse further requested for cross examination of Talaulicar.

6. The AO on a consideration of the material collected during the investigation came to the conclusion that Pendse had aided in organizing the trades on behalf of the Talaulicar. Therefore, under Section 15J of the SEBI Act, the AO imposed a monetary penalty of Rs. 150,000/- on Pendse.

SAT’s Decision

7. SAT held that there was no evidence that Pendse handed over cheques for Rs. 69 lacs to Talaulicar as consideration for the sale of one lac TFL shares. The broker through whom the sale was arranged categorically denied the claim that anyone had approached him for funding Talaulicar or his family. Further, the Tribunal established that Talaulicar himself is an insider and did not require any counseling or assistance for trading of the above mentioned one lac TFL shares.

8. The core issue, whether Pendse was guilty of insider trading or counseling and aiding Talaulicar was decided by solely relying on the statement of the latter and without being validated through any other evidence. The AO has solely relied on the statement of Talaulicar for holding Pendse guilty. Failing to offer witness for the cross examination violates the principles of Natural Justice. Talaulicar ought to have been cross examined before holding Pendse guilty.

9. Further the SAT refused to accept the evidence gathered by the private body (i.e. investigation report prepared by the committee of Tata Group) on which the AO had relied, as the order of any adjudication authority ought to be based on an independent investigation and not be influenced by extraneous factors.

10. The Tribunal concluded that assuming the funds really flowed from Niskalp to broker and then to Talaulicar, there has been no evidence that Pendse was responsible for such alleged losses. Therefore, the SAT turned down the charges of insider trading charges as against Pendse on account of failure to adhere to the fundamental principle of permitting cross examination of a person on whose statement such charges were established.

B. APPEAL NO. 22 OF 2008 – GTL ILLEGAL CARRY FORWARD CASE

Facts

1. SEBI received a complaint from TFL regarding the illegal carry forward transactions in the shares of GTL by Pendse. As per the investigation of SEBI, Nalini Properties Private Limited (‘Nalini’), a company controlled by Pendse, had executed certain transaction in shares of GTL in year 2000.

2. The Show Cause Notice (‘SCN’) alleged that the transaction had actually not been executed and by only passing the book entries relating to this transaction, Nalini and others indulged in falsification of accounts and records.

3. On the basis of the allegation, SEBI debarred Pendse from dealing in securities market for two years for violating the Securities Contract Regulation Act, 1956 (‘SCRA’) and SEBI (Fraudulent and Unfair Trade Practice relating to the Securities Market) Regulation, 1995 (‘FUTP Regulation’).

SAT’s Decision

4. The first allegation of SEBI was that Pendse breached Section 13 of SCRA. SEBI alleged that Pendse through Nalini executed “off-market transaction” (not being covered by spot transaction under Section 18 of SCRA), which is deemed to be invalid and illegal. However, Pendse argued that these transactions were clearly through a broker of the stock exchange and therefore they were in accordance with the requirement of the Section 13 of SCRA. The SAT accepted the argument of Pendse and ruled that Pendse did not violate Section 13 of SCRA. The SAT further rejected the argument of SEBI that transaction was in breach of notification under Section 16 of SCRA since the same was not alleged in the SCN or the SEBI Order.

5. The second allegation of SEBI was that the charge of violation of Regulation 6 of the FUTP Regulation i.e. Pendse sold 25000 shares off market to a broker at Rs. 1400 and when the shares were finally sold on stock exchange by Niskalp, the latter got a price of only Rs 125 per share. Thus there were substantial losses incurred by Niskalp through chain of fictitious transaction which was created by Nalini. TFL also complained to SEBI regarding the transactions which were created by Pendse. SAT rejected the allegation on the grounds that there was no evidence to show that the accounts and records were falsified to perpetrate the alleged fraud. Further it was pointed out that SEBI and SAT are not concerned with the dispute between TFL and Pendse .

6. Therefore, on the above grounds stated, SAT struck down the Impugned Order pending against Pendse.

Conclusion

After reading the judgments carefully one can observe that Pendse through his controlled companies and associates may be involved in some kind of circular trading. However SEBI officer while drafting of SCN and the Impugned Orders failed to gather proper evidence in support of the charges levied against Pendse and failed to incorporate all the grounds for providing their case as required under the laws of India.

Therefore the orders had to be set aside on the grounds of failure to adhere to the principles of Natural Justice. To avoid these kinds of situations in future, SEBI ought to streamline its investigation and adjudication processes so that its actions are not struck down on procedural grounds such as lack of evidence or failure to comply with natural justice, let alone on substantive legal issues. This will help the market regulator to work more efficiently and hold manipulators liable for their actions.

The “Madoff Scheme” and Failure of Regulation

The expression “Ponzi scheme” is not something we are terribly familiar with in India. To be honest, I heard of this concept only a couple of years ago. But now, these words are resonating in the media after the alleged fraud by Bernard Madoff came to light last week. New York Times’ City Room Blog has some background about Charles Ponzi:

““He had his nose pressed against the glass,” Mr. Zuckoff, a professor of journalism at Boston University and a former reporter for The Boston Globe, said in a phone interview on Monday. “He was not linked with Wall Street and New York, though he had dreams of being like Rockefeller.”

"Mr. Zuckoff’s book “Ponzi’s Scheme: The True Story of a Financial Legend,” published by Random House in 2005, traces how Mr. Ponzi duped tens of thousands of people out of millions of dollars in a short-lived craze that became the defining confidence scheme of its time. It was brief, lasting only from December 1919 to August 1920.

Born in northern Italy, Mr. Ponzi emigrated to Boston in 1903, at age 21. Soon he had learned English, held jobs as a waiter and bank teller and served time for forgery and smuggling (or what might be called human trafficking today, since it involved illegal immigrants from Italy).

Essentially, the scheme he devised involved buying postal reply coupons in European currencies at fixed, outdated rates of exchange and then redeeming them in the United States for dollars, generating a guaranteed profit.

“With successive waves of people entrusting him with their cash, Ponzi needed only enough money to pay off those people redeeming their coupons,” David Margolick wrote in The Times in a 2005 review of Mr. Zuckoff’s book. “Of course, with the prospect of increasing their savings exponentially every couple of months, few ever redeemed anything.”

Mr. Ponzi was convicted of mail fraud in 1920 and served time in federal and state prisons before he was deported to Italy in 1934, never having become a citizen. He died penniless in Rio de Janeiro in 1949 and was buried in a pauper’s cemetery there.”
However, the Deal Professor points to some differences between the Ponzi scheme and the “Madoff scheme”:

"The term “Ponzi scheme” is used with regularity to describe just about any type of securities fraud that involves a fast shuffle in which the promoter diverts assets from a get-rich-quick investment program. Perhaps we should dub a new type of fraud, the “Madoff scheme,” in light of the $50 billion fraud that prosecutors say Bernard L. Madoff perpetrated on a range of supposedly sophisticated hedge funds, financial institutions and wealthy individuals.

Charles Ponzi made his money hawking an investment in international postage stamps that promised to double investors’ money in 90 days, sucking in 40,000 people who lost millions.

Judging from the indictment, Mr. Madoff’s program was, in many ways, the exact opposite of the pyramid schemes that offer outsized returns on investments in everything from solar-powered gadgets to the latest social-networking site.

Rather than preying on retail clients dazzled by visions of quick riches, Mr. Madoff catered to the very rich, promising not great wealth — they already had that — but the steady returns that would keep their assets safe and secure.

The Madoff scheme is built on trust, rather than naked greed, although it is hard to describe his clientele as altruistic when they were happy taking in steady annual returns to pad their millions (or billions) in assets. By delivering what is reported to be consistent growth of 10 percent to 12 percent per year, regardless of the market environment, he played on the desire of his investors for enough money to keep them in the top 1 percent of the world’s richest.

Who roots for the hare over the tortoise, anyway? The widely admired trait of our leading investment gurus, like Warren Buffett and Bill Gross, is the slow-and-steady approach of the long-term investor who shuns the latest fads and ignores quarterly earnings hiccups. This was a stay-rich-for-a-long-time plan."
What is puzzling is how Madoff managed to conduct his operations in a clandestine manner for several years all the while staying outside the purview of the regulator. The losses he built up reveal a startling amount of $50 billion – the number that is currently doing the rounds. This is said to be an all time record amount as far as financial frauds are concerned – but, I am tempted to ask what the ado is all about, since 2008 has been a year of financial records and lows anyway! Even though inspections and investigations were conducted by the SEC in the past, they did not unearth anything untoward. Curiously enough, newspaper reports suggest that finally it was Madoff who turned himself in before he was found out. The New York Times has a report on SEC’s previous investigations:

“The company was registered by Mr. Madoff as an investment adviser in September 2006. The commission as a practice tries to examine advisers within a year of registration, and then at least once every five years afterward. But commission officials said Mr. Madoff’s firm had never been examined.

Sixteen years ago, the agency sued two Florida accountants who had collected more than $440 million from investors to be managed by Mr. Madoff. The agency sued the accountants, but not Mr. Madoff, who said he did not know that the accountants were selling securities that had not been registered.

The agency said at the time that a court-appointed trustee had concluded all the money invested was accounted for. Former commission officials recalled that they closely examined the firm at the time and did not uncover evidence that Mr. Madoff had broken any rules.

In 2005, an examination by the commission’s office of compliance, inspections and examinations scrutinized the broker-dealer unit of the firm. It found that the unit had three relatively minor technical violations.”
There will certainly be a lot of soul-searching regarding the role and powers of the SEC in the days and months to come. This also serves as a reminder that detecting and acting upon financial and securities frauds is a tremendously onerous task, and may not always meet with success. In India, we are often quick to lament (including sometimes on this Blog, I must admit) about SEBI’s inability to succeed before the Securities Appellate Tribunal (SAT) in a greater number of its actions for insider trading, fraud, stock manipulation and the like. If the world’s leading securities regulator with a longer history and superior enforcement resources has missed its target by a wide margin, SEBI’s record perhaps deserves a more considerate response.

Companies Bill, 2008: No advisory services by auditors

One of the important measures taken in the Companies Bill, 2008 is to prevent Chartered Accountants from offering actuarial, advisory and management services to companies which have engaged them as statutory auditors. Section 127 of the Bill provides:

An auditor appointed under this Act shall provide the company only such other services as are approved by the Board of Directors or the audit committee, as the case may be, but which shall not include any of the following services, namely:-

(a) accounting or book-keeping services;

(b) internal audit;

(c) design and implementation of any financial information system;

(d) actuarial services;

(e) investment advisory services;

(f) investment banking services;

(g) rendering of outsourced financial services; and

(h) management services.


The Economic Times carries a report on this change, which would be welcome from the perspective of accountability in company audits. The report is linked here. The following is an extract:

The proposal forms part of the Companies Bill 2008, currently pending before the Lok Sabha. The move is expected to usher in greater independence in the audit function and infuse greater confidence in the minds of investors on the credibility of financial statements. At present, the statutory auditors are barred from providing accounting and internal audit services for their clients, but are allowed to deliver consultancy and advisory services.

The initiative assumes significance in the wake of a slowdown in the economy where companies may hire consultancy services from their statutory auditors who may turn a blind eye to discrepancies in financial statements...

(For previous discussions on the Companies Bill, 2008 on this blog, see this link)

Monday, December 15, 2008

ARBITRAL PROCEEDINGS AND THE JURISDICTION OF COURTS

The case of Vijay Kumar Gupta v. Renu Malhotra, recently decided by the Delhi High Court, deals with the important issue of the definition of the word “Court” in the Arbitration and Conciliation Act, as well as the pecuniary jurisdiction of the High Court.

In 1998, the decree-holder filed a petition before the Delhi High Court for appointment of an arbitrator under Section 11 of the Arbitration Act. The petition was valued at Rs. 5 lakh, which was within the pecuniary jurisdiction of the High Court. While the arbitration proceedings were pending, the judgment debtor filed two petitions before the Court under Sections 27 and 37(2)(b) of the Act. During the pendency of the petition under Section 37(2)(b) the arbitrator passed an award in favour of the decree holder. The judgment debtor assailed this award under Section 34 of the Act, in the Delhi High Court. The question was whether the High Court had jurisdiction over the matter.

The relevant provision is Section 42 of the Arbitration and Conciliation Act. Section 42 of the Act provides for jurisdiction of Court to deal with arbitral proceedings. It states that only the Court to which an application has been previously made with respect to an arbitration agreement, will have jurisdiction over subsequent matters arising from the arbitration agreement and arbitral proceedings. The issue raised in the instant case was whether the appointment of the Arbitrator by the Delhi High Court clothed the High Court with the jurisdiction to deal with the execution proceedings following the arbitral award.

The decree-holder contended that since the High Court had appointed the arbitrator, it is vested with the jurisdiction to deal with subsequent matters by virtue of Section 42 of the Act. The judgment debtor raised the contention that the mere appointment of the arbitrator under Section 11, Arbitration & Conciliation Act, 1996 should not endow the Delhi High Court with the jurisdiction to deal with the execution petition. Relying on precedents, the judgment debtor contended that the execution petition can only be entertained by the Civil Court and not the High Court.

In this light, it is pertinent to cast a look at Section 2 (e) of the Arbitration Act. It states that for the purposes of the Arbitration Act, the word “Court” includes the principal Civil Court of original jurisdiction and the High Court in exercise of its original jurisdiction. The only precondition is that the Courts should have been of competent jurisdiction to deal with the subject-matter of the arbitration if the same would have arisen in a suit.

In the instant case, the decree-holder contended that the word “Court” under Section 2(e) of the Act refers to High Court. Rejecting this submission, the Court remarked that as has been well-established through precedents, ‘Chief Justice’ under Section 11 of the Act is not equivalent to “Court” under Section 2(e) of the Act. Therefore, the mere appointment of the Arbitrator does not vest the Delhi High Court with the jurisdiction to deal with execution proceedings. The Delhi High Court asserted that the meaning of the term “Court” under Section 42 must be read in conformity with Section 2(e).

It was also contended that by filing an application under Section 34 for setting aside the award, the judgment debtor had acquiesced to the jurisdiction of the Delhi High Court, and was therefore now barred from making a challenge about the same. However, the Court rejected this contention, and noted that acquiescence could not confer jurisdiction where none had existed.

In the instant case, the Court found that the Court lacked jurisdiction because of the pecuniary limits that had been placed upon it by a 1996 amendment to the Delhi High Court Act, which enhanced the ordinary civil jurisdiction of the Court from five lakhs to twenty lakhs. As no action on the part of the judgment debtor could confer jurisdiction upon the Court where it was clearly lacking, the Court held that it lacked the pecuniary jurisdiction to entertain the present execution petition. This judgment is especially relevant for clarifying doubts as to the jurisdiction of the High Court over execution matters, and also settles a controversial debate about the correct construction of Sections 11 and 42 of the Arbitration Act.

Gautam Bhatia & Venugopal Mahapatra

LLP Bill Passed in Parliament

Media reports (here and here) indicate that the Limited Liability Partnership Bill, 2008 has been passed by Parliament. It was passed in the Lok Sabha on December 12, 2008, while the Rajya Sabha had already approved the Bill on October 24, 2008.

The Ministry of Company Affairs has also published on its website two sets of draft rules relating to LLP for comments from the public:

1. The Limited Liability Partnership (Concept) Rules & Forms: comments due on December 31, 2008; and

2. Concept LLP (Winding up and Dissolution) Rules: comments due on January 12, 2009.

This is an important step under Indian law as it creates a new business vehicle with the flexibility of a partnership structure, but with the protections of separate legal personality and limited liability of a corporate structure. However, before it is successfully implemented, changes will be required to the Income Tax Act to define the tax liability of an LLP and its partners.

Shares and Stocks: India and Delaware

India has largely followed the scheme of the erstwhile British company law in enacting the Companies Act, 1956. This is true even in the case of share capital structures that companies can have, such as only two types of shares, preference shares and equity shares for public limited companies, and also restrictions on companies dealing with their shares, such as rules against trading by a company in its own shares and prohibitions on “financial assistance” (section 77 of the Companies Act). Although the Companies Act has undergone amendments over the years, India has retained most of the original restrictions regarding share capital of companies, with some relaxations made from time to time (e.g. permitting equity shares with differential voting rights and buyback of shares, albeit with several restrictions). The U.S. (Delaware in particular), on the other hand adopts a liberal regime when it comes to share capital structures and permitting a company to deal with its own shares.

In this context, I recently came across an interesting paper by P.M. Vasudev titled Capital Stock, Its Shares and Their Holders: A Comparison of India and Delaware that compares the law governing share capital in India and Delaware. The abstract from SSRN is as follows:

The paper explores the origin of “shareholder supremacy” in Anglo-American corporate law and the present legal position of corporate capital stock, its shares and their holders. The study is comparative, and the statutes of India and Delaware are selected for comparison. The paper argues that Indian company law, which is based on English law, adopts the “business model” of corporations that gives at least as much importance to the business of companies as it does to their finances. But American corporate law, as it has evolved over the last two hundred years and exemplified by the Delaware statute, creates a “financial model” in which corporations are treated mostly as issuers of securities, and the statute treats the securities as commodities in which corporations deal. The Delaware statute has a bias in favour of the stock market and adopts the policy of encouraging trade in the securities.

The paper traces the process of development of corporate law in the two jurisdictions, and attempts to explain the divergence in their philosophies in the context of the respective developmental processes. The implications of the two philosophies for corporate behavior and governance are also examined. The comparison also illustrates how Indian company law is converging towards the American financial model, since the government of India adopted the policy of economic liberalization and globalization in the 1990s.
While it is true that Indian law is now moving in the direction of a liberalised share capital regime, particularly since the late 1990s, several restrictions continue to operate, and the pace of reform is considerably slow. Public companies can still carry only two types of shares, preference and equity (with the exception of equity shares with differential voting rights, which are also subject to several conditions). All shares need to carry “par” value; companies need to have an authorised share capital and a minimum share capital (Rs. 0.1 million for private companies and Rs. 0.5 million for public companies) - while these concept are being considered restrictive and hence progressively abolished in several jurisdictions.

Further, under Indian company law, there are stringent conditions under which a company can deal in its own shares. Previously, a company was unable to buyback its shares. However, in 1999, the Companies Act was amended to allow companies to buyback their shares, subject to certain conditions. Such conditions include the following: (A) a company can expend no more than 25% of its net worth to buy back its shares; (B) the total number of shares bought back each year cannot exceed 25% of the total paid-up share capital; (C) the debt-to-equity ratio of the company following the buyback should be no more than 2:1; and (iv) the directors are required to provide a solvency statement on oath (that the company would not be rendered insolvent within a period of one year).

There is another possible avenue for companies to repurchase its shares without complying with these restrictions, but that requires the company to obtain the approval of the High Court (section 100 of the Companies Act).

Indian company law also carries prohibitions against “financial assistance” by companies in relation to acquisitions of its own shares. The term “financial assistance” has been given wide interpretation, and this imposes significant hurdles on the ability of acquirers to borrow money for their acquisitions on the strength of the target company’s own assets, through the classic “leveraged buyout” (LBO) structure.

Most countries in the Commonwealth are moving towards a “solvency” approach to capital maintenance, whereby companies are free to deal with, or finance the acquisition of, their own shares as they please, if the companies continue to remain solvent after that (thereby protecting the interests of the creditors). So long as solvency is assured, the law does not intervene. However, the progress of Indian law towards such a solvency approach is considerably slow, with the regulations still imposing stringent conditions.

My purpose here is not to advocate for an unrestricted regime in India that may allow companies to freely deal with their capital, but to highlight the need for a comprehensive review of the share capital provisions of the Indian company law in the context of modern business needs. That opportunity is currently available in the form of the Companies Bill, 2008; but, sadly, the Bill does not make much headway on these issues.

Sunday, December 14, 2008

The Fallout of Daga Capital

An earlier post had noted that a recent decision of the Bombay ITAT could significantly affect the taxation of shares and securities, and group companies generally. To briefly summarise, it was a case involving a company dealing in shares and securities. It claimed that the interest it incurred on loans taken to finance the purchase of shares was deductible, although its dividend income was entirely exempt under the Act. The Tribunal held by a majority that s. 14A of the Act, which provides that expenditure incurred in relation to exempt income is not deductible, applied, and that ‘in relation to’ must be construed widely. Significantly for other disputes, the Tribunal observed that a ‘but-for’ test must be employed in this respect, so that any expenditure but for which the exempt income would not have been generated will be considered to be have been incurred ‘in relation’ to that income, and consequently not deductible.


Following this decision, Business Standard reports that the CBDT has asked its field formations to reopen all cases where similar claims are likely to have been allowed, such as a group company claiming deduction on expenses like interest on loans taken to invest in subsidiaries. The Department has been asked to review cases all the way back to 1997, which is when s. 14A was inserted into the Act. Further, in accordance with a change introduced by the 2008 Finance Act, cases can be reopened with retrospective effect from 1962.


This proposal is likely to affect all companies that invest in their group entities or in mutual funds, shares etc. It is expected to net the Department upto Rs. 20,000 crore. It is likely that the move will be challenged, but the law today appears to impose no bar on the enactment of retrospective tax legislation.


The Business Standard report is available here.





Saturday, December 13, 2008

A different perspective on the six-month ban on contra transaction under Insider Trading Regulations

On December 5, 2008, a comment on the recent amendments to the SEBI (Prohibition of Insider Trading) Regulations, 1992 ("Insider Trading Regulations") was made here. I have a different perspective on the issue.

Every listed company is required under Regulation 12 of the Insider Trading Regulations to formulate a code of internal procedures. Such a code is required to be modeled on the Model Code set out in Schedule I to the Insider Trading Regulations (“Model Code”). The recent amendments have inserted a mandate that such an internal code ought not to dilute the terms of the Model Code, and the listed company ought to “ensure compliance” with the such an internal code.

The recent amendments also included a prohibition, inserted in the Model Code, on directors, officers and employees of listed companies from effecting a transaction contrary to the nature executed by them within a period of six months. To put it simply, if a person covered by the internal code were to buy shares of his company, he ought not to effect a sale transaction within a period of six months.

Prior to the amendment, Para 4.2 of the Model Code entailed a position that if a person covered by the internal code were to effect a contra transaction within a period of 30 days, his original investment would not be considered to have been made “for investment purposes”. In other words, such an investment could be considered to have been made for speculative purposes. Speculative transactions by an insider would be a strong circumstance when considering a larger charge of insider trading. Demonstration of guilt of insider trading will necessarily be an inferential exercise.

The recent amendment has done away with this position and has in fact inserted a provision in the internal code that an employee ought not to effect a contrary transaction within six months. This provision is a good practice requirement that companies have been asked to implement.

A contrary transaction within six months does not necessarily mean an act of insider trading has taken place. Insider trading, in simple terms, has been defined as an act of trading while in possession of unpublished price sensitive information. The very execution of a contra trade within six months does not necessarily mean that a violative transaction has been effected. However, it is a good practice to ensure that employees are not found actively buying and selling securities of their own employer-company.

Therefore, there is indeed no need to envisage an imposition of the severest penalty of Rs. 250 million for a breach of such a “good practice” measure. Such a breach is best left to the listed employer company to punish. If the employer company does not take action, the company would be guilty of breaching Regulation 12, which now requires the company to ensure compliance with the internal code.

The scheme of good securities regulation is for the statutory regulator to be a regulator of last resort. If the market regulates itself and each unit of the market regulates its constituents (as indeed would listed companies have to regulate their employees) most of the job would be well done. Therefore, there ought not to be any concern of such a scheme of regulation laying bare a loophole, or that an unintentional lapse has occurred in formulating the regulatory scheme.

There is another aspect of the matter that should be borne in mind. When the Insider Trading Regulations mandate a listed company to formulate an internal code to govern its employees, it would follow that the regulatory mandate is that employees adhere to such an internal code. If the employee breaches the code, the employee would have breached a statutory code, which although internal, is nevertheless statutory in character.

It is settled law that regulatory legislation ought to be purposively construed, as opposed to the rule for interpreting fiscal statute, which should be strictly construed. In the event of an ambiguity in interpreting fiscal statute, the view that would favour the taxpayer ought to be adopted. However, with regulatory legislation, the view that would further the remedy and suppress the mischief ought to be adopted.

Therefore, the purpose of Regulation 12 of the Insider Trading Regulations being to provide for a framework that would entail all directors, officers and employees adhering to the internal code of conduct that is of a standard not lower than the Model Code, a breach of the internal code would arguably be a breach of the Insider Trading Regulations.

The sanction for such a breach is manifold. While a simple breach in the form of effecting a contra transaction within six months ought not to attract severe penalties, which are reserved for the specific violations listed in Section 15G of the SEBI Act, 1992 (“the Act”), the residuary penalty provision in Section 15HB of the Act which enables imposition of Rs. 10 million could arguably be invoked.

Similarly, any breach of any provision of the Act, or any of the rules and regulations made under the Act is punishable with imprisonment or fine or both. Of course, the standard of proof and the rules for sentencing in a criminal trial are far more stringent than an action for imposition of civil penalty under Section 15HB of the Act.

However, as stated earlier, if there has been a simple breach of a contra transaction within a span of six months, without any offence of insider trading (trading while in possession of unpublished price sensitive information) capable of being inferred, there would in fact be no ground to impose a penalty. Indeed, even the listed company may warn an employee against such a breach that falls short of an offence of insider trading.

More importantly, Sections 11 and 11B of the Act clothe the regulator with sweeping powers to issue directions in the interest of the capital market. Any insider found to have been repeatedly breaching even the internal code could face a direction not to act in any particular manner (perhaps even not to deal in securities of his employer company for a prescribed period), and attendant with such a direction is severe stigma, loss of reputation, and of course, a bad tarnishing of regulatory track record.

Every breach of every provision of law need not necessarily have a stringent penalty. Even where imposition of penalty is provided for, it is not necessary that penalty ought to be imposed. In Hindustan Steel Ltd. vs. State of Orissa (AIR 1970 SC 253), the Supreme Court said:-

"A penalty will ordinarily be imposed in cases where the party acts deliberately in defiance of law, or is guilty of contumacious or dishonest conduct, or acts in conscious disregard of its obligation; but not, in cases where there is a technical or venal breach of the provisions of the Act…

The Supreme Court somewhat disturbed this position in Chairman, SEBI vs. Shriram Mutual Fund & Another by stating in an ex-parte decision that once there is a breach, civil penalty has to necessarily follow, and there is no need for existence of a guilty mind.

In the circumstances, the requirement not to execute a contra transaction within six months could in fact have severe consequences. Contra trading within the six-month timeframe on the comfort that there is no real sanction, could prove perilous.

Friday, December 12, 2008

Self Regulation for Directors on SEBI's Board

I recently blogged about the transparency measures that SEBI has initiated by deciding to make its agenda papers and minutes of proceedings public.

Under the first such disclosure, it is now learnt that on December 4, 2008, the Board of Directors of SEBI adopted a Code on Conflict of Interests for its members. You can get it on the hyperlink above.

In a nutshell, the Code requires every director to make disclosures of his conflict of interests, and enjoins a duty on the director to "ensure" that any conflict of interest does not affect any decisions of SEBI. An express bar not to exploit any personal or professional relationship with regulated entities or employees of such entities has also been brought in.

Every director of SEBI now has to declare his holdings and his family's holdings in shares. At the end of every financial year, within 15 days, the disclosures are required to be updated. Wholetime Members of SEBI are required to make disclosures within 15 days of every transaction.

Once agenda papers are circulated, a director is required to disclosure the nature of interest in any item on the agenda, and obviously, refrain from deliberations on the agenda item. Even if a director of SEBI has a dispute in relation to any service availed of from any market intermediary, that would have to be disclosed.

The Code also introduces a gift policy and discourages gifts altogether. Any gift that could have a value of above Rs. 1,000 has to be handed over to SEBI.

Every director of SEBI has to disclose any post, employment or fiduciary position which he holds or has held in the preceding five years. Every other significant relationship, whether financial, professional, personal or family relationship with any regulated entity has to be disclosed. Honorary positions too have to be disclosed.

The potential conflict of interest has to be disclosed. The SEBI Chairman may determine any doubt in this regard. If the Chairman has a doubt, he would seek a determination from the SEBI Board of Directors.

Interestingly, any person who has reasonable ground to believe there is a conflict of interest may bring the matter to the attention of the "Secretary to the Board", who would place the complaint before the Chairman.

The Code provides that the information disclosed would be kept confidential except where disclosure is necessary for managing conflicts, or for disciplinary action, or under requirements of law. Therefore, the Right to Information Act would indeed be applicable and such information can be accessed.

I don't want to sound boring laudatory, but this is another step towards institutionalizing the functioning of the apex regulator in India's capital markets, and bringing in transparency. There has been some debate on the blog about the introduction of new amendments to the regulations prohibiting insider trading. By turning the spotlight inwards, any governmental authority would only prove that projecting one's performance is better achieved by discharging one's statutory mandate transparently than by holding press briefings.

Wednesday, December 10, 2008

Thoughts on the ASBA process – Part II

(The following post is contributed jointly by Prerak Ved of Crawford Bayley & Co. and Yogesh Chande of Platinum Partners.)

In continuation of the thoughts/concerns raised in Part I posted earlier, stated below are some further thoughts/concerns on the ASBA process, including those arising out of SEBI’s press release dated December 04, 2008 bearing PR No.283/2008 (the “Press Release”):

(1) As per the list of recognised SCSB’s available on the SEBI website, there are fifteen (15) SCSB’s recognised as on date. As per this list, there are 57 banks registered with SEBI as bankers to the issue, and all of them are eligible to be registered as SCSB’s; so the number of SCSB’s has the potential to increase. Typical small ticket issues had maybe one to two bankers, while mid-size and larger issues had between three and five, or maybe more (but never upto fifteen!!). Clause 16.1.7 read with Clause 16.1.5 of the DIP Guidelines requires certain details regarding SCSB’s SEBI registration status, as also whether any communication has been received from SEBI prohibiting from acting as an SCSB/banker, and any inquiry/investigation being conducted by SEBI. While obtaining such information may be easy if a few banks are involved, it would be cumbersome to obtain the relevant confirmations from all SCSBs. It would practically be difficult to obtain this information in case of fifteen SCSBs, and even more difficult if the number of SCSB’s reaches 25-30 or more. This is also given the fact that ASBA is currently is only for retail investors, and not for QIB and other non-retail investors. It may be noted that appointment of SCSBs is deemed in nature, irrespective of whether an applicant in the issue has an account with that bank or not. The responsibility lies on the merchant banker(s), and issue timelines may be adversely impacted if any SCSB does not furnish timely information in this regard for whatever reasons. An alternative suggestion in this area would be that SCSBs furnish this information to SEBI on a periodical basis, rather than handing the co-ordination for obtaining data for multiple SCSB’s to the merchant banker(s).

(2) In continuation of (1) above, the number of SCSB’s does not depend on the ticket size of the issue. We have seen some public and rights issues with minimal ticket size (even less than 50 crores, and 25 crores in some cases), which typically have a single lead manger and a single banker. The cost issues and co-ordination logistics for co-ordination with multiple SCSBs in case of these smaller issues may be too much to handle, and may end up discouraging issues with very small ticket size. In this regard, it may be desirable to set a threshold limit (let’s say, issue size of Rs. 25 crores) above which ASBA mechanism may be applicable.

(3) The scheme of DIP Guidelines seems to suggest that the issuer company has to pay the SCSB’s fees. While appointment is deemed by law, fees are left to the discretion of the parties. What happens if the issuer company and the concerned SCSB are unable to agree on the commercial aspects? There is a potential for disputes in this area, and a standardised fee schedule/fee calculation mechanism, even as a suggestion from SEBI, may help to mitigate potential disputes in this area, even though it may not be strictly within SEBI’s purview to do so.

(4) In case the SCSB does not unblock the funds from the applicant’s bank account for transfer to the issuer’s account for whatever reasons (even though beyond its control), would the underwriting obligations of the lead manager(s) get triggered? Hence the Underwriting agreement should be carefully drafted.

(5) In the Press Release, it has been decided to extend ASBA to rights issues also. While the initiative is laudable investor interest, it is difficult to understand as to if ASBA can be introduced in rights issues, why it cannot be introduced for fixed price public issues as well, and why it has been restricted only to book-built issues.
By Prerak Ved and Yogesh Chande

Monday, December 8, 2008

Decision in the Vodafone Tax Case

An earlier post mentioned that the decision of the Bombay High Court in the Vodafone case had gone against the petitioners, i.e. Vodafone. However, the text of the judgment which was not available as on the date of that post has become available since, and throws up some interesting issues for discussion.

The issues before the Court were (a) the constitutionality of the certain amendments introduced by the 2008 Finance Act, and (b) the validity of the show-cause notice issued by the Department to the petitioner. On the constitutionality, the Court held that constitutional validity cannot be challenged in abstracto and has to be assessed in the context of specific facts. Here, the petitioner had not presented before Court the agreement between the parties to the transaction, and in the absence of such basic facts, the Court drew an adverse inference and refused to examine constitutional validity. On the challenge to the show-cause notices, the Court relied on a series of Supreme Court and High Court decisions decided in the last couple of years for the proposition that “Unless, the High Court is satisfied that the show cause notice was totally non est in the eye of law for absolute want of jurisdiction of the authority to even investigate into facts, writ petitions should not be entertained for the mere asking and as a matter of routine and the writ petitioner should invariably be directed to respond to the show cause notice and take all stands highlighted in the writ petition. Whether the show cause notice was founded on any legal premises is a jurisdictional issue which can even be urged by the recipient of the notice and such issues also can be adjudicated by the authority issuing the very notice initially, before the aggrieved could approach the Court.” Thus, the threshold required to be established by the Department was only a prima facie existence of jurisdiction and nothing more. Since a decision on these two matters were theoretically sufficient for the Court to decide the issue before it, following the strict rules of judicial precedent, this decision should not be of great relevance in the litigation on the merits of the dispute that is bound to follow.

However, what makes the decision one of possible significance is the fact that the Court spent considerable time discussing the merits of the dispute and in arriving at conclusions that would be of persuasive value in any subsequent litigation. For one, the Court repeatedly asserted that the transfer was not of the shares of a Cayman Islands situated company, but of assets situated in India. For arriving at this conclusion, they relied on prior statements by officials of the company indicating the intent to take over the Indian part of Hutchison’s business, the fact that the approval of the FIPB had been sought before the transaction, and other circumstances (renaming of the new entity, sharing of the license to carry on business etc.). All these make it a clear case of lifting the corporate veil, and determining the nature of the transaction by giving precedence to substance over form.

In light of the issues discussed in a number of earlier posts, on recent trends in this area, in both the Indian and English law, this decision of the Court to apparently lift the veil is one of the enormous significance.

The Court also discussed and relied on the ‘effects doctrine’, which is a principle of international law granting a State jurisdiction over actions which, although carried out outside its territory, have effects within. Following the application of this principle in few recent decisions on the scope of the MRTP Act, the Court held that since the “very purpose of entering into agreements between the two foreigners is to acquire the controlling interest which one foreign company held in the Indian company, by other foreign company”, it would be taxable in India. The fact that this principle was used independent of the decision on lifting the veil seems to suggest that even if the veil were not to be lifted, the mere existence of this effect would be a sufficient basis of taxation. The use of this principle in this manner seems to mark a significant departure from the principle of strict interpretation of charging provisions in tax statutes, and also from the attitude that seemed to form the basis of prior decisions of the Apex Court in cases like Azadi Bachao Andolan.


For extracts of relevant parts of the decision and another take on it, see http://legaldevelopments.blogspot.com/2008/12/bombay-high-court-decision-in-vodafone.html.

Friday, December 5, 2008

Transparency Measures in SEBI

The Securities and Exchange Board of India ("SEBI") is taking significant and material steps towards bringing in transparency in its own workings.

First, the status of offer documents being processed by SEBI is now online. After repeated complaints about delays in clearing offer documents, SEBI now publishes every week, the status of the offer document under process. Therefore, the public gets to know what the status is. For an Indian regulator, this is a great start. One could say that the status can easily be obfuscated in verbiage that is not decipherable, but even to put that up and invite attention from the public is a big first.

Second, and more far-reaching move has been yesterday's decision to make all the agenda papers and the minutes of the proceedings of the SEBI board meetings public. This is a very significant measure because for the first time, people would get to know what is the regulatory thinking that went behind the provisions and the law formulated by SEBI. To my mind, this is a major step towards implementing a principle-based system. Courts can see what precisely SEBI had in mind. Now, of course, the minutes could be drafted in a very guarded manner, reveaing little, but putting those minutes in the public domain will also invite to how the regulator runs its shop.

If you want to read the very language that ushered in this change, here it is:-

In order to bring transparency in the working of the Board it was decided that the agenda papers submitted to the Board on all policy issues will be made available in the public domain by putting them up on the SEBI website after the Board has taken a decision on the issue. The minutes of the meeting relating to such items will also be made available on the SEBI website after the Board has approved the minutes. Accordingly the agenda papers for today’s Board meeting will be made available on the SEBI website by December 15, 2008.

Hopefully, other government agencies will build up courage to take this leap.

No penal consequences for violating the new trading restrictions on Insiders?!

Poor drafting of the recent amendments to the SEBI Insider Trading Regulations has made the bar on six month reverse trading/ derivatives substantively ineffective.

The SEBI Insider Trading Regulations were amended vide notification dated 19th November 2008 available here and some issues relating to these amendments were discussed by me here.

The Model Code relating to procedures, etc. to prevent Insider Trading has been amended to introduce two major bars. Firstly, directors, etc. are now barred from carrying out an opposite transaction for six months. Thus, if such person buys even one share, he cannot sell any shares and if he sells one share, he cannot sell any shares for the next six months. Further, another clause absolutely barred such persons from taking any positions in derivatives. Let us call these two sets of transactions as “Specified Transactions”.

The question is what are the consequences of violation of these two restrictions?

The SEBI Act provides for severe punishment for Insider Trading. Under Section 15G, the specified acts by an Insider attract a penalty of Rs. 25 crores or 3 times the profits made from Insider Trading, whichever is higher. Under Section 24, violation of the Regulations could result in imprisonment upto 10 years or a fine of upto Rs. 25 crores or both. There can be other consequences also.

Would any of such consequences be attracted for violating the bar on carrying out such Specified Transactions i.e, such opposite transactions or derivatives? The answer seems to be No.

Violations of the Code are to be punished by the Company internally and the Model Code suggests that they “may be penalised and appropriate action may be taken by the company”. The violators shall also be “subject to disciplinary action by the company, which may include wage freeze, suspension, ineligible for future participation in employee stock option plans, etc..

Beyond this, it appears that SEBI cannot levy the said penalties of Rs. 25 crores, etc. or prosecute and get such person imprisoned, etc. The reason is the peculiar placement of the amendments. The bar on Specified Transactions is contained in the Model Code. Regulation 12 merely requires listed companies and other entities to “frame” and “enforce” a Code in the lines of the Model Code. There is no requirement in the Act or the Regulations that the Code so made should be followed. While an obligation and enforcement relation has been created between the Company, etc. and such persons, no such obligation or enforcement relation has been created between SEBI and such persons.

If, e.g., the Company does not frame such Code as prescribed, SEBI can levy the said penalties, etc. and take other penal and other action. Further, if the Company does not enforce this Code, then also such penal consequences would follow. But the Regulations do not go further and require that the Code so framed should also be complied with by the directors, etc.

Is this intentional or is it an unintentional drafting lapse? On first impression, one could be tempted to consider that this is intentional. The Consultative Paper on proposed amendments to Insider Trading of March 2008 did consider the requirements of the Model Code to be akin to corporate governance requirements. In fact, it discussed that disclosure of non-compliance was perhaps a better way to punish the Company economically through the markets. It also recommended dilution of the punitive requirements. Effectively, it appeared to suggest a change in approach. However, even considering these original thoughts, it still appears to me that it is not intended by SEBI that such violations should not attract penal consequences.

I think it is not only an unintentional lapse and this also arises on account of an improper appreciation of the structure of the Regulations. SEBI has all along assumed that violations of the Code as framed by the Company are not only punishable with monetary penalties and directions but also subject to prosecution. In the aforesaid Consultative Paper of March 2008, SEBI recommended that the violations of the Code should not result in imprisonment. It further said that “other powers of monetary penalties and directions should be continued”. Thus, SEBI assumed that the violations already attracted all these penal consequences.

On this erroneous presumption, perhaps, SEBI placed the bar on the Specified Transactions in the Model Code.

But where is the provision, in the Act or the Regulations, saying that violations of the Code will attract such penal consequences? Nowhere, I think.

Thus, by possibly an unintentional drafting lapse, the bar on the Specified Transactions will not attract the penalties, prosecution, etc. Taking this further, even violation of the 30 day lock in for shares acquired in IPO or, for that matter, violation of any other provision of the Code, would not attract such punishment.

Of course, this does not mean that such persons can merrily carry out Insider Trading as defined i.e., trade in shares on the basis of unpublished price sensitive information or communicate such information, etc. Also, persons violating the bars on Specified Transactions would also face, as discussed above, action by the Company for violation of the Code.

-       Jayant Thakur

Key Decisions at SEBI Board Meeting

SEBI’s recent board meeting has resulted in certain significant decisions impacting capital markets activity in India as well as SEBI’s own decision-making process.

Public/Rights Offerings: Observation Letter

When a draft offer document is filed with SEBI, either in a public offering (initial public offering (IPO) or follow-on public offering (FPO)) or in a rights offering, SEBI reviews the draft offer document and issue its comments in an observation letter. In the past, this observation letter was valid for a period of three months. If the issuer did not undertake the offering within the three-month period, a fresh filing process had to be commenced. In its recent decision, SEBI has increased the three-month validity period for its observation to one year.

Clearly, this decision is another in the series of moves by SEBI to boost the sagging capital markets in India, particularly the primary markets. As the Economic Times notes, in the recent downturn, several companies that had filed draft documents and received observation letters from SEBI had to let them lapse because the market conditions were not conducive to accessing the public capital markets. The extension of the time period is expected to provide more flexibility to companies to time the launch of their offerings.

However, some practical difficulties could still persist in fully utilising this facility. Rahul Guptan, an experienced Indian capital markets lawyer and now a partner with Clifford Chance in Singapore, notes in his email to me:

“While this is an interesting development from SEBI, it raises issues from a disclosure perspective. Any company issuing a prospectus one year after the original was filed and cleared with SEBI would require the financials to be updated. This would be a material change. Further, the Book Running Lead Managers and the lawyers would obviously have to undertake further diligence to check whether there have been updates and changes in the business. There will definitely be a need for the auditors as well to review the financial position of the company. Therefore, all companies would necessarily have to file a document with material changes. What the SEBI announcement does not clarify is how it will treat such an updated document? Would it be subject to review once again? If it is subject to review then in how much time will the review be completed? SEBI should review all documents that are filed with it after such a prolonged period from the issue of the original observations. What perhaps the SEBI move really addresses is a waiver for issuers from having to pay the filing fees once again. Whilst this is a welcome gesture, I do not think the requirement to re-file and also the SEBI powers to review should be curtailed in any manner.”
There is still opportunity for SEBI to consider these issues and address them while amending to Disclosure and Investor Protection Guidelines to reflect this change.

Transparency in the SEBI Process

SEBI’s press release states:

In order to bring transparency in the working of the Board it was decided that the agenda papers submitted to the Board on all policy issues will be made available in the public domain by putting them up on the SEBI website after the Board has taken a decision on the issue. The minutes of the meeting relating to such items will also be made available on the SEBI website after the Board has approved the minutes. Accordingly the agenda papers for today’s Board meeting will be made available on the SEBI website by December 15, 2008.
SEBI has, over the years, been introducing transparency in its regulatory process. For instance, it has been following the practice of issuing policy papers on key changes to regulations and seeking comments before the actual regulations are enacted. This current measure is a further step in that direction, and has received a favourable response generally (Ajay Shah and Sandeep Parekh). Perhaps this may also provide a suitable model for other Indian regulators to emulate.

Another related decision (on stock exchanges and the use of RTI to seek information) bolsters the element of transparency. The Economic Times reports:

Gaining access to information relating to the securities market will now be easier, with the Securities and Exchange Board of India (Sebi) taking the view that it has the authority to seek information from stock exchanges for providing it to the public under the Right to Information Act (RTI).

India’s main stock exchanges such as the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE) were reluctant to provide information saying they are not a public authority under RTI. A recent ruling by the appellate authority of the market regulator has stated that stock exchanges are bound to furnish information sought by the regulator even if it is for the RTI purpose.