Friday, August 28, 2009

SEBI and Corporate Law

Some of the previous posts on this Blog (SEBI prohibits issue of shares with "superior" rights and Shareholders and Their Duties under Indian Law) have generated reactions from readers on a significant issue, which is the role that SEBI has recently been playing in altering provisions of basic company law as far as listed companies are concerned. It may be worthwhile to ponder whether this approach by SEBI is appropriate in the overall regulatory set up in India regarding corporate law.

Historically, the Companies Act, 1956 did not envisage any direct role either for SEBI or its predecessor (the Controller of Capital Issues). Since the establishment of SEBI in 1992 and until 2000, SEBI’s role was confined to the SEBI Act and regulations thereunder without any specific role under the Companies Act. It is only with the Companies (Amendment) Act, 2000 that SEBI was granted a role in the Companies Act. Section 55A of the Companies Act states:
Powers of Securities and Exchange Board of India.-The provisions contained in sections 55 to 58, 59 to 81 (including sections 68A, 77A and 80A) , 108, 109, 110, 112, 113, 116, 117, 118, 119, 120, 121, 122, 206, 206A and 207, so far as they relate t issue and transfer of securities and non-payment of dividend shall,-

(a) in case of listed public companies;

(b) in case of those public companies which intend to get their securities listed on any recognized stock exchange in India, be administered by the Securities and Exchange Board of India; and

(c) in any other case, be administered by the Central Government.
SEBI was made responsible for administering provisions regarding securities regulation under the Companies Act in relation to listed companies or companies which were going to be listed on stock exchanges. In these circumstances, SEBI’s role was expected to be one of “administering” the provisions rather than altering the fundamental basis of companies law (or in other words to exercise any legislative functions).

However, in recent practice, it has been found that several of SEBI’s regulatory powers are being exercised in a manner that dilutes (or even sometimes supersedes) basic provisions of company law. Of course, SEBI’s powers extend only to listed companies (or those that are being listed), but those companies are required to comply with requirements that are at variance with provisions of company law.

Just to take a few illustrations (discussed at some length in the posts referred to above), while the Companies Act permits shares with differential rights as to voting and dividend, SEBI has proscribed the issue of shares with “superior” voting rights. While the Companies Act does not prevent shareholders from exercising voting rights even if they are interested in a resolution, SEBI has required promoters (controlling shareholders) to abstain from resolutions involving delisting of shares of a company, and has also proposed to extend such abstention requirements to other resolutions generally. Such anomalies continue even in relation to the Companies Bill, 2009. It is not necessary for our present purposes to list these out in detail.

This approach creates certain difficulties. First, it creates uncertainty in interpretation due to inconsistencies in various provisions of law governing companies and securities. It also leads to multiplicity of regulators. Second, and more importantly, it gives short shrift to the process of lawmaking. For instance, provisions the Companies Act that contain basic principles and concepts can be amended only through statute that requires approval of the Parliament and assent of the President. However, any dilution of those provisions through SEBI regulation, which is only subordinate legislation, entirely bypasses that process. Although SEBI has also begun the practice of issuing concept papers and draft regulations on various matters and obtaining public comment before promulgating regulations, it is not the same as following the extensive legislative process through elected members of Parliament as required by the Constitution.

Similar, but not identical, debates have been witnessed in other prominent jurisdictions. For instance, although corporate law is a state subject in the U.S., it has been subject to constant encroachment more recently by way of federal legislation. The Sarbanes-Oxley Act of 2002 and more recent proposals on shareholder bill of rights in the wake of the global financial crisis are instances on point, although they have occurred much to the consternation of several corporate law academics and commentators who denounce the “creeping federalization of corporate law” and argue for preservation of separation of lawmaking at the state and federal levels.

Returning to the Indian scenario, the point is not to undermine SEBI’s efforts on substance regarding several initiatives it has taken and is proposing to take (such as requiring interested shareholders to abstain from voting) with a view to protection of the interests of minority shareholder. These are precisely matters that some of us having been advocating on this Blog too. But, what is in question is the exact process to be adopted. On aspects involving foundations of company law, it is necessary for SEBI to initiate the proper legislative process, rather than resort to its own rule-making powers on an ongoing basis. What is in question here is the means and not the end.

Corporate Frauds; Earnings Management

One question that does not seems to have been fully answered in the last few months is whether the Satyam episode is truly an aberration or whether it is just the tip of the iceberg (thereby signalling a systemic problem generally in several Indian companies).

The Economic Times has an interesting report on various types of frauds that are practised in Indian companies and the role of various agencies (such as forensic auditors, investigators and the like) in trying to curb fraudulent activity in businesses. This seems to suggest the existence of a deeper malaise within the system. As regards timing, the possibility of such frauds are not only higher in times of downturns (as currently being witnessed), but the chances of detection are high during such times too. The famous quote by Warren Buffet in this behalf has been repeated too often in recent months: “Only when the tide goes out do you discover who's been swimming naked.”

At a broad level, there could be two types of incentives for persons involving in fraudulent activity, one which relates to the motives of individual employees towards personal aggrandizement at the cost of the company (and other stakeholders) involved, which amounts to pure fraud or cheating. The other is a larger issue, which revolves around the concept of earnings management where companies are under pressure to meet earnings estimates, especially where quarterly reporting is involved (as in the case of public listed companies in India), and may hence fail to truly represent the state of affairs of the company. These incentives get somewhat further distorted where performance-based pay and stock options are used to remunerate senior managers, thereby inducing companies to maintain their stock price.

While the pure-fraud cases are to be dealt with through criminal law, issues such as earnings management are also to be dealt with through stringent provisions securities regulation and corporate governance norms. The current evidence indicates a greater incidence of the former type of cases rather than the latter, but beyond a point the distinction between the two gets somewhat blurred (as in Satyam’s case) and hence caution must be exercised to prevent both types of occurrences.

Thursday, August 27, 2009

The Revival of Housing Derivatives

An article in the latest issue of the Economist discusses the revival of housing derivatives, and its close connection with the recent financial meltdown. The idea first surfaced in 2006, when housing derivatives were available as futures contracts on the Chicago Mercantile Exchange. However, the housing bubble, and the fact that these were available only for sophisticated investors, reduced their popularity (detailed news reports available here and here). In June this year, two leading American economists in the area of American house-price movements have opened up the market to retail investors with the launch of a product called MacroShares. With the blow that the recent financial crisis has dealt to the belief that housing prices always increase, the time seems ripe for this idea to generate significant interest.

The Economist reports-

Derivatives have a bad name at the moment, but this sort is tame enough. MacroShares are securities that reflect the value of the S&P/Case-Shiller home-price index in ten large urban centres. The securities are issued in pairs, one for investors who wish to bet on the upward movement of house prices, and one for those who think prices will fall. That means every bet has an offsetting investment. Investors must also pay for their interest upfront, eliminating counterparty risks. And unlike actual homes, MacroShares are traded on public exchanges and are therefore liquid.


The next step is to tie derivatives more tightly to the interests of individual homeowners. MacroShares is already mulling a product tied to specific locations, rather than national house-price movements. A homebuyer in Miami, say, could offset the risk of price decline in the local area with a housing derivative. Lenders could end up wrapping these derivatives into mortgage contracts as a form of home-equity insurance.

Wednesday, August 26, 2009

Swiss Accounts and Banking Secrecy: Contrasting Outcomes

After prolonged discussions, the US and Swiss authorities came to an agreement earlier this month whereby UBS would disclose details of certain US account holders who are suspected of evading US taxes. The Time Magazine outlines the terms:

Under the terms of the new agreement, the IRS will submit a request to Swiss tax authorities to divulge within one year the names of clients suspected of stashing money in UBS to evade U.S. taxes. Account holders will be notified before their names are disclosed and will be able to appeal the decision in Switzerland's Federal Administrative Court. This approach, the Swiss government says, is in line with the existing law allowing the exchange of account information in cases of suspected criminal activity and also complies with the newly signed double-taxation treaty between the two countries, which stipulates that Switzerland will cooperate with the U.S. in investigating suspected cases of tax evasion.
However, as far as similar requests by the Indian government are concerned, the outcome has not been promising. The Swiss authorities are reported to have declined India’s request on accounts of its broad nature. Professor Vaidyanathan of IIM Bangalore has some interesting thoughts and suggestions on India’s approach, including a comparison with the US strategy.

The Resurgence of Securitization and CDS

The concepts of securitization and credit default swaps (CDS) have acquired a negative connotation over the last couple of years since they were said to have triggered the global financial crisis during the second half of 2007. More, importantly, the assets involved were sub-prime loans that underwent a process of disintermediation due to which risk perceptions on the underlying assets were altered.

Now, there appears to be a resurgence of these instruments. Copious arguments are being made that it was not the concepts of securitization and CDS themselves that triggered the crisis, but it was the manner in which they were operated. In a column today in the Financial Express, K. Vaidya Nathan extols the virtue of securitization, if done properly.

Prof. Jayanth Varma of IIM Ahmedabad goes a step further and questions the notion that securitiation was responsible for triggering the crisis in the first place. He notes:
In 2007, we thought that the problem was about subprime mortgages, that it was about securitisation and that it was about CDOs (collateralised debt obligations). Now we know that these initial hasty judgments were mistaken. Defaults are rising in prime mortgages, huge losses are showing up in unsecuritised loans, and several banks have needed a bailout.

Over the last two years, our understanding of securitisation has also changed significantly. As global banks released their results for the last quarter, it became clear that bank losses are now coming not from securitised assets but from unsecuritised loans or whole loans.

He posits that securitization may have highlighted the problem early on due to accounting requirements:

It is becoming clear that what the US is witnessing is an old-fashioned banking crisis in which loans go bad and therefore banks become insolvent and need to be bailed out. The whole focus on securitisation was a red herring. The main reason why securitisation hogged the limelight in the early stages was because the stringent accounting requirements for securities made losses there visible early.
Similarly, as far as CDSs are concerned, K. Vaidya Nathan points out in another column in the Financial Express that RBI has undertaken an initiative to assess the possibility of introducing a CDS market. At the same time, he advocates transparency by introducing exchange-traded products, and states that even where there are over-the-counter products there should be a central registry.

Overall, it appears that there are significant economic advantages through securitization and CDS. They are important mechanisms for hedging and risk-mitigation. However, they can be subject to abuse, as we have seen from the sub-prime crisis. The key role of regulation would be to engender the use of these instruments (albeit with some caution) so that parties are able to obtain the attendant advantages. At the same time, care should be taken to ensure that these instruments are used purely for hedging purposes rather than as a matter of speculation.

Financial Crisis, Economics and Regulation

There is a recent assortment of interesting columns regarding the financial crisis, the role that regulation (or the lack thereof) has played in the exacerbation of the crisis, and the various economic instruments utilized by policy makers to rein in the crisis. The following is a list of these readings:

1. Beyond the crisis by Subir Gokarn in the Business Standard.
2. Financial Regulation - I by A.V. Rajwade in the Business Standard.
3. Now’s the time to remember economics by Meghnad Desai in the Financial Express.
4. Hubris, risk and regulation by Nirvikar Singh in the Mint.

Friday, August 21, 2009

Scope of Deductions under the Income Tax Act

Two recent decisions of the Income tax Appellate Tribunals have provided important guidelines on the scope of the deductions under the Income Tax Act. One deal with what expenditures cannot be deducted on grounds of being ‘prohibited by law’, and the other dealt with the extent to which foreseeable losses could be allowed as deductions prior to their crystallisation.

The first of these was a decision of the Nagpur Bench of the ITAT in Western Coalfields Ltd. v. ACIT. The assessee here was a colliery company, which transported coal in wagons to customers. In the case of under-loading of the railway wagons, reimbursement had to be provided to the customers who had paid on the basis of the weight of a standard wagon. In case of over-loading, extra charges had to be paid to the Railways. These overloading charges were referred to as a ‘penalty’ in the rules of the Railways. Hence, the issue before the Court was whether these over-loading charges could be claimed as business expenditures by the assessee, and deducted from its taxable income. The Department relied on the Explanation to section 37, which states-

... any expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law shall not be deemed to have been incurred for the purpose of business or profession and no deduction of allowance shall be made in respect of such expenditure.

The Tribunal began by dismissing the Department’s contention on the under-loading charges since they were merely in the nature of a contractual agreement, and could not be considered a penalty. The only real issue before it was whether the over-loading charges, referred to as a ‘penalty’ in the Railway Rules, were in the form of expenditure incurred for a purpose ‘prohibited by law’. The Tribunal answered this question in the negative for three reasons:

First, the Court relied on a decision of the Punjab and Haryana High Court in CIT v. Hero Cycles, where it was held that if the illegality was not a result of a deliberate violation of law, the expenditure could not be disallowed. On facts here, the Tribunal concluded that the over-loading was not due to any deliberate act on the part of the assessee, but due to poor infrastructural facilities and the nature of the commodity in question (coal). Due to the lack of any deliberate intent, the Tribunal held that the Explanation to section 37 was not attracted.

Secondly, the Tribunal looked at the object of the provision, observing that it was meant to disallow illegal/unlawful expenditure in the nature of protection money, extortion, bribes, and the like. Thus, it had limited application to cases like the one at hand.

Finally, and most significantly, the Tribunal emphasised the commercial nature of the expenditure. Assuming the Railways were to be replaced by a private carrier, the over-loading charges would clearly have been in the nature of a business expenditure. In that case, the Tribunal held that, the mere fact that the Railways was a Government entity would not affect the nature of the expenditure.

It is this third basis that is of the most significance in future cases of a similar nature, since it seems to relies on the nature of the transaction in the course of which the expenditure was incurred, as opposed to the entity with whom the transaction was entered into. This interpretation would be useful for all expenditures incurred for breaches or modifications of contracts entered into with Government entities, which otherwise may have been considered as expenditure incurred for a purpose ‘prohibited by law’.

The other decision was one by the Bombay Bench of the ITAT in Jacobs Engineering v. ACIT. The issue here was whether deductions made on account of foreseeable losses could be allowed before the losses actually crystallised. The assessee relied on paragraph 13.1 of Accounting Standard-7, which allowed a provision to be made for the entire amount of the loss when the current estimate of total contract cost and revenue indicated a loss. The Department pointed out that this Accounting Standard had not been notified by the Government and could not be used in assessment proceedings. Also, it placed reliance on the well-accepted ‘matching principle’ for the contention that only so much of the loss that had actually crystallised could be allowed in the current year.

Deciding the issue in favour of the assessee, the Tribunal held that the non-notification of AS-7 did not necessarily mean that it could not be used for the purposes of assessment. It also observed that a couple of earlier decisions had placed reliance on AS-7, and hence it allowed the amount of foreseeable losses to be deducted. While this decision may seem to proceed on the narrow basis of the provisions of AS-7, it is of considerable significance in the current economic climate. As pointed out by an article carried by the Economic Times on this case,

Typically, when a contract is planned, an estimate is made based on various factors of production involved such as steel, cement, labour. These are subject to changes in the external economic environment that aren’t under the control of the company. The costs could, hence, increase while the revenue or business estimated from such a contract may not see a corresponding increase.

Given the large number of incomplete or remodelled projects due to the recent economic downturn, this decision could provide considerable respite to assessees.

Norms on Minimum Public Float Set to Become Reality

In a post over a year ago, we had discussed that several companies were listed with differing minimum public shareholding in the past due to varying rules regarding minimum public float. These discrepancies continue to date. In order to obviate them, the Ministry of Finance had proposed imposing a uniform public float of 25%. This was also alluded to in the Budget this year.

The Economic Times reports that this proposal has received the assent from the Finance Minister and is expected to take effect soon. It states:

The finance minister has put his seal of approval on a proposal that could willy-nilly lead to disinvestment in many of India’s biggest listed public sector companies starting as early as April 2010. Pranab Mukherjee has okayed a plan that will make it compulsory for at least a quarter of the shares in all listed companies to be owned by the public, including investment and financial institutions. Government-owned and private companies in which the founders own more than three-fourths of the shares will be required to increase the public float by 5% annually until at least 25% of the shareholding is in the hands of the public.

This may help set right some of the past discrepancies in listing requirements, particularly because several leading listed companies in India still have promoters (or controlling shareholders) holding a substantial stake thereby having complete control over such companies. Not only does this provide limited liquidity to public shareholders, but it also reduces the ability of minority shareholders to exercise meaningful rights in these companies. As the Economic Times notes:

The new rules will affect public sector companies like Steel Authority of India Ltd (government stake of 85.82%), Minerals and Metals Trading Corp (99.33%) National Mineral Development Corp (98.38%) and State Bank of Mysore (92.33%). Private companies in which the founders own over three-fourths of shares include Puravankara Projects (89.50%), Ackruti City (89.96%), Wipro (79.22%), Jet Airways (80%), Nirma (77.17%) and Novartis (76.42%).

There are 150 big firms where promoters own more than 75%, including 25 state-owned enterprises. If they issue shares to meet the planned regulatory requirement, these firms could together raise nearly Rs 1.5 lakh crore at current market prices, including about Rs 1.2 lakh crore by the 25 government-run firms.

However, there are bound to be difficulties in implementation as it is not clear if the markets have the wherewithal to absorb such large-scale public offerings within a limited period of time. As regards companies themselves, they would have concerns regarding valuation given the current state of the financial markets, and may not wish to dilute at sub-par valuations.

Thursday, August 20, 2009

Amendments to DIP Guidelines: Rights Issues and IDRs

SEBI today issued amendments to the SEBI (Disclosure and Investor Protection) Guidelines, 2000 with a view to simplifying the process for a rights issue. Since listed companies embarking on a rights issue are already subject to the disclosure norms under the listing agreement, substantial information regarding such companies are already available in the public domain, and hence SEBI has decided to streamline the disclosures. This addresses a long-standing complaint that rights issues are cumbersome and costly, thereby putting off several companies from accessing capital through this route. In addition, SEBI has also confirmed the use of the Applications Supported by Blocked Amount (ASBA) process for rights issues. Speed is also of the essence, as the time period taken for finalisation of basis of allotment has been reduced to 15 days from the earlier period of 42 days from the close of the issue.

In an earlier development (on July 31, 2009), SEBI effected amendments to the Guidelines, mainly with a view to specify financial disclosures for Indian Depository Receipts (IDRs). Since companies from various jurisdictions (with differing financial disclosure requirements) could list in India, there is a need to introduce some level of uniformity. The new disclosures require financial statements to be in accordance with Indian GAAP, IFRS or US GAAP. The amendments also take into account incidental matters such as audit report, corporate governance requirements, etc. The curious aspect regarding IDRs is that despite a number of changes (and further relaxations) in rules and guidelines by the Ministry of Company Affairs and SEBI progressively over the last few years, the instrument appears to have received tepid response and does not seem to have been lapped by industry at all.

Monday, August 17, 2009

Merits of a Financial Services Appellate Tribunal

(The following column by Somasekhar Sundaresan appeared in today’s Business Standard)

Newspapers have recently reported that a proposal has been mooted in government to convert the Securities Appellate Tribunal (SAT) into a “Financial Services Appellate Tribunal” to hear grievances against orders passed by various sub-sectoral regulators. Currently, the SAT hears appeals only against orders passed by the Securities and Exchange Board of India ('SEBI').

India has not opted for a single integrated regulatory approach unlike the United Kingdom, which has the Financial Services Authority as the sole regulator. We do not even have a “twin-peak” model where regulatory oversight is divided between the role of market development and safety and the role of conduct-of-business regulation. We have a combination of a functional approach (where you are regulated on the basis of the function you carry out) and an institutional approach (where you are regulated by a regulator depending on the nature of your institution).

While there may be no single “correct” approach, in India, the ground reality is that individual institutions are regulated by multiple regulators. For example, a firm or group of firms (all consolidated as far as balance sheet strength is concerned) may be a member of stock exchanges, commodity exchanges, provide advisory or distribution services for mutual funds and insurance companies, investment banking services and also be an intermediary in the money markets. We have numerous cases of commercial banks regulated by the Reserve Bank of India (RBI) also carrying on depository participant business, regulated by SEBI. Each function played by an institution has a regulator and the same compliance team ends up having to be conversant with the idiosyncrasies and peculiarities of multiple regulators.

Each of these sub-sectors in the financial system may have its own raison de etre and therefore each regul-ator may have its own turf. However, the persons who are regulated are one and the same. A financial disaster affecting one role can impact the risks faced by the other role. While there are numerous argum-ents for and against having different regulators for different roles, an important feature of any good regulatory system having an effective check and balance on the regulator’s role in the form of an appellate process as a matter of right. An appellate mechanism keeps regulators on their toes and improves regulation.

Presently, SEBI is the only regulator that is subjected to a statutory right to appeal against its orders. The SAT is a creature formed by the SEBI Act, 1992, with powers to hear appeals against any decision of SEBI by which any person is aggrieved. The SAT was set up in 1995 with a far more limited role. A parallel appellate body then sat in the Ministry of Finance, taking decisions but failing to contribute to well-articulated jurisprudence. However, over time, the SAT has developed into a robust institution – truly one of the best specialised tribunals in the country.

The RBI, which administers banking regulations and exchange controls does not have any regulator overseeing its functioning. Indeed, the scope of an appellate oversight of the RBI ought not to include appeals against its decisions to raise or lower interest rates, or its decisions on whether to support the Indian Rupee or to let it depreciate. However, the RBI increasingly takes decisions that affect a significantly wider band of people with every passing year.

In the antiquated days of the Foreign Exchange Regulation Act (FERA), excha-nge controls had a very narrow constituency – not many bought foreign excha-nge, not many set up shop outside India, and in fact, not many even travelled outside India. Today, the picture is completely different.Any person can remit $200,000 abroad. Indian tourists visit the rest of the globe. Indian companies are liberally up shop abroad. Foreign investors freely set up shop in India. The sheer number of people whose lives are affected by RBI’s decisions has expanded exponentially.

The RBI does a number of things that SEBI does – it writes regulations on its own, issues circulars, issues show cause notices, initiates enforcement action, and even has powers to compound offences. Yet, there is no appellate oversight over such regulatory functions of the RBI. Therefore, the only recourse for anyone affected by a wrong decision of the RBI is to file a writ petition. Writ courts, by definition, are not expected to consider merits in detail but would only examine if due process has been followed. For example, recently some banks have been penalised by the RBI for breach of know-your-client norms through terse and inarticulate ord-ers from the RBI, with no appellate recourse, and yet the same bank’s depository participant business, when penalised by SEBI, is subject to the important safeguard of an appeal.

The RBI is but an example. The Insurance Regulatory and Development Authority (IRDA), which regulates the insurance sector has a Parliamentary mandate identical to that of SEBI – to protect the interests of pol-icyholders and to promote the orderly development of the insurance sector. Commodity exchanges, once the preserve of commodity merch-ants is now a wide market with numerous investors trading in commodity derivatives. The Forward Markets Commission (FMC) takes a number of decisions that impact members of commodity exchanges and even the exchanges themselves. Yet, the IRDA and FMC are not subject to appellate oversight.

There may be a compelling case to have different horses run different course for the primary regulation of various sub-sectors. However, the appellate process and the factors that would weigh with an appellate body in judging a decision would be very similar, and primarily a function of well established principles of administrative law. Therefore, consolidating all the potential appellate powers in one single tribunal without creating multiple tribunals would be a very welcome measure.

Sunday, August 16, 2009

Moore Stephens: Extending Protection for Auditors

Moore Stephens v. Stone & Rolls might well be the most important case on auditors' liability since Caparo v. Dickman . The House of Lords, by a narrow majority, extended the protection which Caparo offers to auditors even further.
The facts, as detailed by Lord Phillips, were that the sole “directing mind” of a company used the company as a vehicle for defrauding certain banks. The fraud was discovered and the company was successfully sued for deceit by the principal victims (a bank). Moore Stephens were the company’s auditors. The auditors accepted for the sake of argument that they were in breach of their duty to the company. They also accepted that, but for their breach, the fraud would have ended earlier, meaning that the company’s liability for deceit would have been lesser. The company (now in liquidation) sought to recover its losses from the auditors. The auditors contended that the claim could not succeed because it was founded on the company’s fraud and was barred by the maxim of ex turpi causa non oritur actio. Essentially two issues arose. First, as a matter of law, what is the correct test to apply in deciding whether a fraud of the “directing mind and will” will be attributed to the company? Secondly, assuming that the directing mind’s fraud is in law attributed to the company, does the ex turpi causa principle bar all claims – including claims against auditors who were appointed to do the very thing of detecting the fraud?
The first issue turns on principles of attribution developed since Lennard’s Carrying Co. v. Asiatic; the second on the absoluteness of the ex turpi causa rule as expressed in Tinsley v. Milligan. It was held that a directing mind’s fraud will be attributed to the company in all cases, except where the fraud was played directly on the company. If the company is a vehicle of the fraud, as opposed to the victim of the fraud, the directing mind’s fraud will be attributed to the company. This would mean that the fraud of the directing mind is, in law, the fraud of the company. Once such attribution occurs, the principle of ex turpi causa would apply. The auditors were appointed for the very thing of detecting the fraud. Yet, when the company brings a claim against them for negligence in failing to detect the fraud, they can rely on the ex turpi causa rule to prevent the company from pursuing the claim. The only exception to this is if the company shows that it was the direct and primary victim of the fraud. In other words, if a company’s directing mind has committed a fraud using the company as a vehicle, then the company cannot bring a claim in negligence against the auditors for failing to detect the fraud.
Caparo v. Dickman had ruled out auditors' liability in cases of claims by third parties, unless the third party could show the existence of a “special relationship”. Moore Stephens has restricted liability even further. Auditors will be liable only if the directing mind’s fraud is targeted at the company; and not in other cases. Even the fact that the company has appointed an auditor for the very purpose of detecting such frauds would not allow the company to bring a claim against the auditors.
Courts have been hesitant in enforcing auditors’ liability – the policy reason typically is that Courts will not (in Justice Cardozo’s words) put auditors under a liability “in an indeterminate amount to an indeterminate class for an indeterminate time”. Caparo’s foundations were in this policy reason. But Moore Stephens – by refusing to draw exceptions to the ex turpi causa rule – goes even further; in certain cases, auditors will not be liable even to the company which appoints them.

Wednesday, August 12, 2009

Direct Taxes Code 2009: Draconian "Anti-Avoidance" Measures?

The draft Direct Taxes Code Bill and a Discussion Paper on the subject have been made available by the Government, in keeping with the Finance Minister’s promise in the budget speech. Initial reports suggest that experts have welcomed the proposed Bill. Here are the links to a CNBC report, and ET report, and a Mint report. The general tenor of these reports is positive, though the Mint mentions that “The scope and extent of what is sought to be considered as tax avoidance is wide and can be a cause of concern as it could place significant onus on taxpayers to defend the bona fides of a suspect transaction.” That the provisions are a “cause of concern” appears to be a massive understatement.

Typically, tax avoidance is considered to be legal; tax evasion is illegal (Azadi Bachao Andolan v. Union of India). The draft Bill radically changes this position. The Discussion Paper released by the Government echoes the philosophy that “Tax avoidance, like tax evasion, seriously undermines the achievements of the public finance objective of collecting revenues…” The philosophy has been sought to be put in practice by the draft Section 112. The fact that it might actually be desirable in policy to maintain the avoidance-evasion distinction appears to be a point which is lost on the Government. Here is what the proposed Section says:

112. (1) Any arrangement entered into by a person may be declared as an impermissible avoidance arrangement and the consequences, under this Code, of the arrangement may be determined by,-
(a) disregarding, combining or re-characterising any step in, or a part or whole of, the impermissible avoidance arrangement;
(b) treating the impermissible avoidance arrangement-
(i) as if it had not been entered into or carried out; or
(ii) in such other manner as in the circumstances of the case the Commissioner deems appropriate for the prevention or diminution of the relevant tax benefit.
(c) treating parties who are connected persons in relation to each other as one and the same person; or
(d) disregarding any accommodating party or treating any accommodating party and any other party as one and the same person;
(e) deeming persons who are connected persons in relation to each other to be one and the same person;
(f) re-allocating, amongst the parties to the arrangement,-
(i) any accrual, or receipt, of a capital or revenue nature; or
(ii) any expenditure, deduction, relief or rebate;
(g) re-characterising-
(i) any equity into debt or vice-versa;
(ii) any accrual, or receipt, of a capital or revenue nature; or
(iii) any expenditure, deduction, relief or rebate

So what exactly does the Section mean? Any arrangement can be treated as an impermissible avoidance arrangement. In so treating the arrangement, the Revenue can practically do whatever it wants to do. Effectively, the Government can lift the corporate veil as and when it wants to. It can look at the “substance” of the transaction as and when it wants to. The only guideline is provided in the fact that “impermissible avoidance arrangement” is defined in Section 113, clause 14:

impermissible avoidance arrangement means a step in, or a part or whole of, an arrangement, whose main purpose is to obtain a tax benefit and it,-
(a) creates rights, or obligations, which would not normally be created between persons dealing at arm's length;
b) results, directly or indirectly, in the misuse, or abuse, of the provisions of this Code;
(c) lacks commercial substance, in whole or in part; or
(d) is entered into, or carried out, by means, or in a manner, which would not
normally be employed for bonafide purposes;

First, if “impermissible avoidance arrangement” is defined, how can Section 112 possibly say that “any arrangement” may be declared as an impermissible one? Let us assume for a moment that “any arrangement” in Section 112 only refers to those covered by the definition in Section 113. The definition in Section 113 is, nonetheless, extremely broad. To take just one instance, what does “lacks commercial substance” mean? Again, the Discussion Paper provides some guidance; as does clause 17 of Section 113:

The lack of commercial substance, in the context of an arrangement, shall be determined, but not limited to, by the following indicators:
(i) The arrangement results in a significant tax benefit for a party but does not have a significant effect upon either the business risks or the net cash flows of that party other than the effect attributable to the tax benefit.
(ii) The substance or effect of the arrangement as a whole differs from the legal form of its individual steps .
(iii) The arrangement includes or involves:
(a) round trip financing;
(b) an 'accommodating party', as defined;
(c) elements that have the effect of offsetting or cancelling each other;
(d) a transaction which is conducted through one or more persons and disguises the nature, location, source, ownership or control of funds; or
(e) an expectation of pre-tax profit which is insignificant in comparison to the amount of the expected tax benefit.

The Government seems to be labouring under the illusion that commerce is carried on solely to increase the government’s revenue. For, if there is something which confers a tax benefit, that – according to the Government – lacks commercial substance…

The Government might as well have enacted a law saying “Whatever the Revenue demands, the assessee must pay.” The General Anti-Avoidance Rule in Section 112 is bound – if enacted – to result in great uncertainty. It will be impossible for businesses to know what their tax liability is; what legal transactions are impermissible. It is based on the premise that any legal means to reduce tax liability is unconscionable. Undoubtedly, it is for legislative policy to provide the lead in looking at the substance over the form – this particular legislative policy, however, seems to render form totally redundant.

This much is bad; but the worst is yet to come. Here is what Section 114, clause 1 says:

An arrangement shall be presumed to have been entered into, or carried out, for the main purpose of obtaining a tax benefit unless the person obtaining the tax benefit proves that obtaining the tax benefit was not the main purpose of the arrangement.

So not only is an assessee not allowed to reduce his tax burden, he is also expected to prove that he is not reducing his tax burden. The Discussion Paper also suggests that the provisions are in line with international trends. Soviet Russia seems to be a prime example.

Contracts of Sale, Works Contracts, and TDS

Tax deducted at source (TDS) has proved to be a controversial area of law for quite some time now. One issue that has most recently come to light is likely to have enormous commercial significance – under what circumstances is a company obliged to treat an ordinary transaction as a “works contract” and not a “sale of goods” with the consequent liability to deduct TDS?

The governing provision is s. 194C of the Income Tax Act, 1961. It provides that any person responsible for paying any sum to any resident for carrying out any work in pursuance of a specified contract shall be liable to provide for TDS on that payment. The crucial question, therefore, is the meaning of the expression “carrying out any work”. In 1972, the Supreme Court, in a landmark judgment (State of Punjab v. Associated Hotels, AIR 1972 SC 1131, answered this question as follows:

…where the principal objective of work undertaken by the payee of the price is not the transfer of a chattel qua chattel the contract is of work and labour. The test is whether or not the work and labour bestowed end in anything that can properly become the subject of sale…neither the ownership of the materials nor the value of skill and labour as compared with the value of the materials is conclusive although such matters may be taken into consideration in determining in the circumstances of a particular case, whether the contract is, in substance, one of work and labour or one for the sale of a chattel. A building contract or a contract under which a movable is fixed to another chattel or on the land where the intention plainly is not to sell the article but to improve the land or the chattel and the consideration is not for the transfer of the chattel, but for the labour and work done and the material furnished, the contract will be one of work and labour…”

This was in contrast to the requirements under the traditional law of the sale of goods, particularly before the 46th Constitutional amendment, that the existence of “goods”, the intention to transfer title to those goods and actual transfer of title are necessary to consider the transaction a sale (State of Madras v. Gannon Dunkerley, AIR 1958 SC 560). However, disagreement still persisted, and in an attempt to resolve it, the CBDT issued a circular in 1994 stating expressly that s. 194C does not apply to a “sale of goods”. Following this, attempts to extend the reach of s. 194C to professional services, commission agents etc. were struck down by the Bombay and Delhi High Courts. In 2005, the Supreme Court once again affirmed the test laid down in Associated Hotels, and added that any determination of the nature of a transaction had to take commercial reality and the intention of the parties into account (State of Andhra Pradesh v. Kone Elevators, (2005) 3 SCC 389).

Applying these principles, a transaction where the customer supplied the plans and specifications and had the right to trial runs before delivery was still considered a sale. Similarly, a transaction where the Orissa Government agreed to supply a chassis to a contractor who was to build a bus was considered a contract for the sale of the bus to the Orissa Government. In both cases, the parties intended to buy the article in question. On the other hand, making photostat copies of a document and delivering it to the customer is not a contract for the “sale of paper” because the object of the transaction, in the minds of the parties, is the provision of photocopying services, and not the supply of paper. In other words, the passing of title must be “ancillary” to the contract for performance of work for it to constitute a contract for work (Hindustan Aeronautics v. State of Karnataka, AIR 1984 SC 744).

The reason this issue has become relevant now is that the Supreme Court has issued notice last week to Samsung India on its liability to provide for TDS. Samsung outsources the manufacture of certain goods to other manufacturers, and the IT Department has argued in its written submissions that the other manufacturers are not at liberty to dispose of the goods, to use a different process of manufacture etc., and that the contract in substance is one for works. This is a question of fact that is likely to be closely contested, for the transaction does appear, at first sight, to resemble a contract for works. The Delhi High Court had found in favour of Samsung. A Business Standard report is available here.

The Supreme Court’s verdict is likely to be of great interest to several companies, given the difference it makes to TDS liability. For example, if the Department prevails in the Supreme Court, Samsung faces a TDS bill of about Rs. 1.7 crore for one assessment year.