Friday, October 30, 2009

United States Supreme Court considers a corporation's 'principal place of business'

An important question, with significant implications for contemporary corporate law theory will be heard by the United States Supreme Court on November 10. The matter in question is Hertz Corp. V. Friend (08-1107), which poses the question of which State can be considered to be a corporation’s ‘principal place of business’.

The issue has arisen against the backdrop of a class action against the company, for the violation of state wage and labour laws. The suit was filed in a California State Court, in response to which Hertz Corp. removed the action to Federal district court. Before the Federal district Court, the respondents argued that Hertz’s principal place of business was California, hence it was a Californian citizen, and not different from any other plaintiff. On this basis, it was contended that the matter be remanded back to the State Court. The district court, relying on the ‘place of operations’ test, considered several factors like ‘the location of employees, tangible property, production activities, sources of income, and where the sales take place’, and concluded that since Hertz Corp.’s business in California was ‘significantly larger than any other state in which the corporation conducts business’, California was its ‘principal place of business’ in the United States. This decision was affirmed on appeal by the Ninth Circuit, whose decision is available here.

In its petition for certiorari before the Ninth Circuit Court of Appeal, and now before the United States Supreme Court, Hertz contends that the different circuits in the country are applying four different tests to determine the ‘principal place of business’, necessitating some clarity from the Supreme Court about the appropriate test to be used. The Seventh Circuit uses a ‘nerve center’ test focussed on the location of the ‘corporate brain’ or the corporate headquarters; the third circuit looks at the corporation’s center of activity, while some other circuits rely on the totality of the corporation’s activities (the Fifth, Sixth, Eighth, Tenth, and Eleventh Circuits). Of these, for a wide range of reasons, Hertz advocates the use of the ‘nerve center’ approach, according to which, its principal place of business would be New Jersey and not California. It is also supported in this view by the United States Chamber of Commerce. The respondents contend that though the tests being used are different in nomenclature, they result in very similar conclusions. Further, the Congress has specifically preferred the use of ‘principal place of business’ over ‘place of incorporation’ in §1332 of the Class Action Fairness Act of 2005 (“CAFA”). The ‘principal place of business’ being a term of art borrowed from bankruptcy law, it must be decided the way it is in bankruptcy law, i.e., by considering a wide range of factors, and not only the place of incorporation.

This has given rise to issues of whether corporations having a presence in more than one State should be allowed to chose which jurisdiction they can be sued in, and to what extent the theoretical headquarters of a corporation can be given precedence over the practical headquarters of its operations. Thus, the issue is of great significance, not only in the specific context of the CAFA, but also in corporate law theory in general. Particularly, given the similar controversy that has arisen around tax avoidance and multi-national corporations, the hearing on November 10, and the subsequent decision is of great interest. A more detailed discussion of the issues involved is available here, and copies of the briefs in the matter are available here.

Thursday, October 29, 2009

Changing Advertising Practices in India - The End of "Puffery"?

The Government's proposed “Advertising Code” for food and health products is an interesting development , particularly in light of developments in India over the past three years or so on the subject. This blog has discussed emerging trends in India on the norms governing advertising practices.

To briefly recapitulate, the law does not proscribe comparative advertising, which is a near-ubiquitous practice in today’s commercial world. It does not even require that the advertisement be true and accurate in every respect. English law for a long time was that an advertisement that was mere “puffery” could not form the basis for any action in law. This was based on the belief that an advertisement that is so exaggerated as to be clearly untrue is unlikely to cause any reliance on the part of the consumer who sees it, and consequently does not have to be regulated as strictly as advertisements that purport to be factual but are not. For example, an advertisement claiming that drinking a particular soft drink is the route to becoming a millionaire is clearly “puff”, and is less misleading than claiming that the soft drink is superior on account of the fact that competing drinks contain pesticides. This principle was accepted in India as well, until 2008, when the Madras High Court held that the peculiar circumstances of the Indian consumer make the doctrine inappropriate in Indian law. The Supreme Court and the majority of the High Courts had held otherwise, and the only real restriction on comparative advertising was that it could not "disparage" the goods of a competitor.

In this context, it is interesting to note that the Government’s proposal to introduce an Advertising Code appears to primarily tackle misleading and “puffed” advertisements in food and health products. The proposal has emerged under the framework of the Food Safety & Standards Act, 2006 [“the FSSA Act”], under which the Food Safety and Standards Authority of India has been set up [FSSAI]. The FSSA Act prohibits unfair trade practices and “misleading and deceiving advertisements”. The FSSAI notes although commercial advertising is a protected activity Art. 19(1)(a) of the Constitution of India, no law governs it, except guidelines drafted by the Advertising Standards Council of India [“ASCI”]. Those guidelines, however, have no binding force and are intended to function as self-regulation guidelines.

The Code proposes radical changes to existing commercial practices. The restrictions are that advertisements cannot disparage “good dietary practice”, encourage “excessive consumption”, suggest “portion sizes” that may be appropriately consumed and so on. The Code practically makes puffery illegal by prescribing that “advertisements should not mislead consumers…to believe that the consumption of the product advertised will result directly in personal changes in intelligence, physical ability or exceptional recognition, unless supported with adequate scientific evidence”. It also requires that “celebrities or prominent” people not promote food in such a way as to “undermine a healthy diet”. A copy of the entire Code is available here.

The merits of the regulation apart, it is important to consider a few serious questions of enforcement. For one, since the Code, as will inevitably be the case, is phrased in broad terms, it seems more appropriate that this be part of a self-regulation model. If, on the other hand, the FSSAI decides to enforce it, it may have to evolve suitable institutional support to be able to assess not only what advertisements offend the Code, but also whether there is parity in treatment. For example, s. 5(a)(1) of the Federal Trade Commission Act in the United States empowers the FTC to prevent advertisements that are inconsistent with the Act, in addition to the normal remedy of seeking an injunction from a civil court. Similarly, the United Kingdom in 1962 set up the Advertising Standards Authority to regulate advertising. When the ASA finds a particular advertisement to be inconsistent with the guidelines in the UK, the normal practice is for the owner of the advertisement to remove it, thus establishing a model of self-regulation.

Thus, the Madras High Court’s opinion of 2008 appears to have anticipated these developments. After noticing the law in England and the USA, the Court had observed then that “it is doubtful if false claims by traders, about the superiority of their products, either simplicitor or in comparison with the products of their rivals, is permissible in law. In other words, the law as it stands today, does not appear to tolerate puffery anymore. I do not know if "Puffing" which is only a twin sister of "bluffing", permitted by English courts in the past, still has the sanction of law even in England, after the advent of 'legacy regulators' such as CAP, Oftel, Ofcom, Clearcast etc…

If the Code becomes law, the interesting question for Indian law will be whether its principles ought to be extended to other areas of commerce as well. Comments on the Code are available here and here.

Powers of SEBI and SEC Compared

In his column in the Business Standard this week, our guest contributor Somasekhar Sundaresan argues that, if one were to go by the rule book, SEBI has greater powers than the SEC. He lists out several significant powers of SEBI that can be exercised without intervention of the court. Here are some excerpts:

Take the Raj Rajaratnam case itself. The SEC has had to file a complaint before a court (see litigation/complaints/2009/comp21255.pdf) asking the court to pass orders to disgorge the alleged gains earned by way of insider trading, to restrain the accused from acting as officers or directors of any issuer of securities, and to pay civil monetary penalties under the US securities laws.In India, SEBI itself is armed with powers to take each of the aforesaid actions in absolute terms — not just as interim measures.

On an almost daily basis, SEBI issues directions under Sections 11 and 11B of the SEBI Act asking people not to deal in securities or to access capital markets or to be associated with capital markets. SEBI has wide powers to issue “such directions as it deems fit” with the only touchstone of rationale being the “interests of the securities market”.

Chapter VIA of the SEBI Act, 1992 empowers SEBI to inflict monetary penalties directly without the intervention of any court. Adjudicat-ing Officers, who are employees of SEBI, acting as quasi-judicial officers have the power to impose civil monetary penalties. These penalties can be as high as Rs 25 crore or three times the benefit gained due to the violation.

SEBI has also written subordinate legislation in the form of regulations governing market intermediaries registered with it to impose disciplinary penalties ranging from censure to cancellation of registration.

The only area where SEBI does not have powers for direct action without an intervention of a court is the ability to send people to jail. Section 24 of the SEBI Act requires SEBI to file a complaint before a criminal court to get an accused convicted and jailed for contravention of any provision of the SEBI Act, or rules or regulations made under it.

'Business connection', 'Attribution' and the withdrawal of Circular 23 of 1969

Through Circular No. 7 of 2009, the CBDT has withdrawn Circular No. 23 of 1969 (“Circular 23”). Circular 23 explained the position relating to ‘business connection’ under Section 9 of the Income Tax Act, 1961.

The Circular was relied upon in the arguments in the Morgan Stanley case before the Supreme Court; as also by the Bombay High Court in SET Satellite. These decisions had laid down the broad proposition that in an international transaction, if the non-resident compensates its permanent establishment (“PE”) at arms-length price, no further profits of the non-resident would be attributable to the PE in India.

With the SET Satellite decision set to come up before the Supreme Court, concerns have been raised as to the implications of the withdrawal of this circular. In particular, does the view in Morgan Stanley or SET Satellite need to be reconsidered in light of the withdrawal of the Circulars? Furthermore, what is the extent to which income from a business connection is taxable in India, after the withdrawal of the Circular?

The principle of Morgan Stanley:

The principle enunciated by the Supreme Court in Morgan Stanley on the question of attribution of income to India is as follows:
The impugned ruling (of the AAR) is correct in principle insofar as an associated enterprise, that also constitutes a PE, has been remunerated on an arms-length basis taking into account all the risk-taking functions of the enterprise. In such cases, nothing further would be left to be attributed to the PE…

This was followed by the Bombay High Court in SET Satellite:

In our opinion considering the judgment, if the correct arm’s length price is applied and paid then nothing further would be left to be taxed in the hands of the foreign enterprise…

In both these cases, Circular 23 was cited before the Court; yet it did not for part of the Court’s reasoning. In SET Satellite, on this issue, the Bombay High Court directly followed Morgan Stanley (the decision has been previously discussed here). In Morgan Stanley itself, Circular 23 is mentioned in the Supreme Court judgment only when the Supreme Court notes that the AAR placed reliance on the Circular. No reliance is placed on the Circular in the reasoning/conclusion of the Supreme Court itself. The reasoning of the Court is premised on the conceptual relation (and not a relation introduced solely by Circular 23) between a correct transfer pricing analysis and attribution of profits. This relation has been discussed in the previous post on SET Satellite.

Now, if Circular 23 played no part in the actual reasoning of the Court, then the withdrawal of that Circular cannot in any manner require that the principle laid down by the Court be reconsidered. Accordingly, while fears have been expressed that the withdrawal of the Circular will strengthen the Department’s case against SET Satellite in the Supreme Court, it is arguable that those fears are misplaced.

The extent to which income from a business connection can be taxed in India:

Circular 23 stated that “Section 9 does not seek to bring into the tax net the profits of a non-resident which cannot reasonably be attributed to operations carried out in India.” Concerns might be raised as to whether the withdrawal of the Circular changes this basic position.

Circular 23 discussed issues related to extent of taxable income under Section 9. The relevant part of Section 9 provides that all income accruing or arising “directly or indirectly, through or from a business connection in India” is deemed to accrue or arise in India. According to the relevant Explanation 1 to the Section:
in the case of a business of which all the operations are not carried out in India, the income of the business deemed under this clause to accrue or arise in India shall be only such part of the income as is reasonably attributable to the operations carried out in India…

Thus, the position that only that income which is reasonably attributed to India is covered under Section 9, is clarified in the Section itself. This position is thus due to the Explanation to the Section and not due to Circular 23. Circular 23 only clarified how this would apply in practice – it did not, indeed it could not have, deviated from the principle of attribution which is mandated by the Section itself.

Circular 23, in paragraph 1, itself states that it is a consolidation and restatement of previous clarifications (or the scope of the corresponding Section in the 1922 Act). Paragraph 3 of the Circular again clarifies that “The following clarifications would be found useful in deciding questions regarding the applicability of the provisions of section 9 in certain specific situations…” From this, it is evident that the Circular does not even purport to lay down any specific legal principle; it only discusses the application of the principle in Section 9 to various fact situations.


There is at least an arguable case that the withdrawal of the Circular makes no difference to the legal position – either on attribution to PEs or on extent of income taxable under Section 9. What, then, was the need to ‘withdraw’ the Circular? The CBDT claimed that there was misuse of the Circular which resulted in assessees claiming relief not in accordance with the provisions of Section 9. Perhaps, the CBDT wanted to give the Revenue wider scope for ingenuity in argument; however, in my view, the legal position would remain unchanged.