Saturday, March 28, 2009

RTI and the Corporate Sector

The Right to Information Act, 2005 has been successful in inducing transparency in the decision-making process of the government. However, it has been reported, quoting the Chief Information Commissioner, that the there is a need for the concept of right to information (RTI) under the Act to be “directly applicable to corporate houses”. The report further states:


“[The Chief Information Commissioner] suggested that there should be different mechanisms for eliciting information from them. He said there was a possibility of the authority denying information related to corporate houses and other business concerns citing section 8(d) of the RTI Act. This section of the Act says that there shall be no obligation to give any citizen information, including commercial confidence trade secrets or intellectual property, the disclosure of which may harm the competitive position of a third party, unless the competent authority is satisfied that larger public interest warrants the disclosure of such information. Habibullah said the CIC plans to submit a proposal to bring corporate houses under the direct purview of the RTI Act.”


It is not entirely clear if, under this proposal, companies will be directly foisted with obligations to release information, but such a move would be wrought with several difficulties:


1. The Act currently applies to information that is “held by or under the control of any public authority”. Hence, companies in the private sector are not bound to release any information under the Act. It appears that any change to this position, as proposed, would require legislative amendment.


2. As the report above states, private information, if released inappropriately, could be subject to misuse, as in the case of confidential information that may harm the competitive position of the company.


3. Finally, from a regulatory perspective, it is not as if companies are devoid of obligations to ensure transparency. There exist fairly elaborate provisions under the Companies Act as well as the securities regulation (comprised in the SEBI Act, Securities Contract (Regulation) Act and the various regulations and guidelines issued under them, as well as the listing agreement with the stock exchanges) that establish a regime for release of information by companies, with careful regard for some of the sensitivities involved in corporate information. Inappropriate releases can result in disruption of stock markets. Considering these sensitivities, it will not augur well for the RTI principles to cover release of information by companies as it could conflict with information rights provided under securities laws. The purpose here is not to advocate opacity in the corporate sector: it is just that the principles that apply to the public sector (such as RTI) cannot be directly used in the private sector.

Thursday, March 26, 2009

A Recent Corporate Governance Survey

Business Standard reports a recent study by Grant Thornton-FICCI of corporate governance practices in Indian companies. The “India 101-500 CGR 2009 was designed to analyze corporate governance practices at ‘mid-market’ listed companies in India. The review methodology was based on a survey to gauge the nature and extent of corporate governance practices and approximately 500 companies across various sectors were targeted to participate in the survey.”


A significant finding of the study relates to the method of appointment of independent directors. The report states:


“A majority of the respondents (56%) felt that an ideal board structure should have between 25% and 50% as independent directors. What appears to have come out strongly is that the bane of the issue relating to the availability of independent directors is in the process adopted by companies to appoint independent directors. A majority of the respondents (56%) disclosed that they did not have a nomination committee to lead the process of appointing independent directors in their companies.”


This study empirically verifies and confirms the assertions we have previously made and covered on this Blog that changes are required to the manner in which independent directors are appointed on Indian companies. While nomination committee is not mandatory in India, one of the items on the reform agenda could be to make them mandatory as they would instill greater independence of those directors from the promoters. However, while reforms are being considered (particularly in the wake of the Satyam episode), it is perhaps not too tall an order to take into account other mechanisms as well, although they may be perceived to be somewhat radical in nature. For example, as noted earlier, corporate governance experts have opined as follows in the context of appointment of independent directors:


“More fundamentally, there needs to be a re-evaluation of who appoints independent directors. Under the current system, they are appointed by the shareholder body as a whole, which is often considerably influenced by the controlling shareholder. What is required is a reform to consider other methods of appointing independent directors. For instance, they can be appointed by a majority of the minority shareholders, whereby the controlling shareholders do not have a say on the matter. Alternatively, there may be proportionate representation on boards of listed company where all shareholders have some level of say in appointment of directors and that the board is not dominated by controlling shareholder nominees. For example, in such a system, the minority shareholders obtain the right to elect such number of directors in proportion to the percentage holding of such minority shareholders. [Note: The system of proportional representation is already available under the Companies Act, in Section 265, but is only optional]”


I have also developed on some of these aspects further in the article A Cautionary Tale of the Transplant Effect on Indian Corporate Governance (pages 17-18, 22-23).

Partnerships and the Effects of Non-Registration: Section 69(2A) declared unconstitutional

In a judgment delivered last week, V. Subramanium v. R. Rao (Civil Appeal 7438/2000; MANU/SC/0417/2009), the Supreme Court declared unconstitutional a significant state amendment to the Partnership Act, 1932.


Section 69 of the Partnership Act reads:

69. Effect of non-registration.

(1) No suit to enforce a right arising from a contract or conferred by this Act shall be instituted in any court by or on behalf of any person suing as a partner in a firm against the firm or any person alleged to be or to have been a partner in the firm unless the firm is registered and the person suing is or has been shown in the Register of Firms as a partner in the firm:

(2) No suit to enforce a right arising from a contract shall be instituted in any court by or on behalf of a firm against any third party unless the firm is registered and the persons suing are or have been shown in the Register of firms as partners in the firms.



Through a state amendment, the State of Maharashtra introduced sub-section (2A). This new sub-section read:

(2A) No suit to enforce any right for the dissolution of a firm or for accounts of a dissolved firm or any right or power to realize the property of a dissolved firm shall be instituted in any court by or on behalf of any person suing as a partner in a firm against the firm or any person alleged to be or have been a partner in the firm, unless the firm is registered and the person suing is or has been shown in the Register of Firms as a partner in the firm:

Provided that the requirement of registration of firm under this Sub-section shall not apply to the suits or proceedings instituted by the heirs or legal representatives of the deceased partner of a firm for accounts of a dissolved firm or to realize the property of a dissolved firm.


Till the introduction of sub-section (2A), a partner in a firm could file a suit for dissolution of an unregistered partnership firm, or for accounts of the dissolved firm, or to recover the properties of the dissolved firm. With the coming into force of the sub-section in 1985, a partner in an unregistered partnership firm in Maharashtra could not file even those types of suits. The question regarding the constitutionality of the sub-section was referred to the Bombay High Court, which upheld the section. An appeal was preferred against this judgment before the Supreme Court.


The Supreme Court (Markandey Katju and G.S. Singhvi JJ.) struck down the impugned sub-section (2A) as violative of Articles 14, 19(1)(g) and 300A of the Constitution.


The Court reasoned that not allowing a partner to file a suit for accounts and recovery of property essentially deprived a partner of an unregistered firm of his right to property in the firm without any compensation. Therefore, the sub-section was in violation of Article 300A of the Constitution (“No person shall be deprived of his property save by authority of law”). Following a line of precedents, it was held that “law” contemplated in Article 300A cannot include a law which is arbitrary in nature. Additionally, the stringency of the law meant that it violated Articles 14 and 19 as well. The reasoning of the Court is seen through the following paragraph from the judgment:


The primary object of registration of a firm is protection of third parties who were subjected to hardship and difficulties in the matter of proving as to who were the partners. Under the earlier law, a third party obtaining a decree was often put to expenses and delay in proving that a particular person was a partner of that firm. The registration of a firm provides protection to the third parties against false denials of partnership and the evasion of liability. Once a firm is registered under the Act the statements recorded in the Register regarding the constitution of the firm are conclusive proof of the fact contained therein as against the partner. A partner whose name appears on the Register cannot deny that he is a partner except under the circumstances provided. Even then registration of a partnership firm is not made compulsory under the Act. A partnership firm can come into existence and function without being registered. However, the Maharashtra Amendment effects such stringent disabilities on a firm as in our opinion are crippling in nature. It lays down that an unregistered firm cannot enforce its claims against third parties. Similarly, a partner who is not registered is unable to enforce his claims against third parties or against his fellow partners. An exception to this disability was a suit for dissolution of a firm or a suit for accounts of a dissolved firm or a suit for recovery of property of a dissolved firm. Thus a partnership firm can come into existence, function as long as there is no problem, and disappear from existence without being registered. This is changed by the 1984 Amendment extending the bar of the proceedings to a suit for dissolution or recovery of property as well. The effect of the Amendment is that a partnership firm is allowed to come into existence and function without registration but it cannot go out of existence (with certain exceptions). This can result into a situation where in case of disputes amongst the partners the relationship of partnership cannot be put an end to by approaching a court of law. A dishonest partner, if in control of the business, or if simply stronger, can successfully deprive the other partner of his dues from the partnership. It could result in extreme hardship and injustice. Might would be right. An aggrieved partner is left without any remedy whatsoever…the restrictions placed (by the impugned section) are arbitrary and of excessive nature and go beyond what is in the public interest. Hence the restrictions cannot be regarded as reasonable.


Accordingly, Section 69(2A) introduced by the Maharashtra state amendment was declared to be unconstitutional.


Wednesday, March 25, 2009

FDI: Compulsorily Convertible Debentures

It is quite common for foreign investors to take up convertible instruments in Indian companies. These instruments are issued as either preference shares or debentures to begin with and are convertible into equity shares of the Indian company at a later date. The conversion may occur in one of two ways: either at the option of the investor, or compulsorily (without any option whatsoever). Such instruments carry characteristics of multiple securities and hence take on nomenclatures such as “hybrids” and “quasi-equity”.

From a legal and regulatory (more specifically, foreign direct investment) standpoint, however, the question is whether such convertible instruments constitute debt, thereby falling within the purview of regulations governing external commercial borrowings (ECBs), or whether they constitute equity, thereby falling under the guidelines pertaining to foreign direct investment (FDI). Previously, all preference shares with an option to convert into equity were treated as FDI, and were counted towards the sectoral caps. As regards convertible debentures, although the policy does not appear to have been entirely clear, there have been instances where convertible debentures have been allowed by the Foreign Investment Promotion Board (FIPB) under the FDI policy. In other words, wherever there was a possibility that the instrument would be converted into equity, that would be treated as equity investment for FDI purposes.

However, the policy was made significantly tighter by the Reserve Bank of India (RBI) in 2007 for preference shares and debentures whereby only fully and mandatorily convertible instruments are now considered to be FDI. All other preference shares and debentures (and including those that are optionally convertible) are considered to be debt and hence governed by the guidelines on ECBs. In its 2007 policy on convertible debentures, the RBI noted the reasons for this:
“It has been noticed that some Indian companies are raising funds under the FDI route through issue of hybrid instruments such as optionally convertible/ partially convertible debentures which are intrinsically debt-like instruments. Routing of debt flows through the FDI route circumvents the framework in place for regulating debt flows into the country. It is clarified that henceforth, only instruments which are fully and mandatorily convertible into equity, within a specified time would be reckoned as part of equity under the FDI Policy and eligible to be issued to persons resident outside India under the Foreign Direct Investment Scheme in terms of Regulation 5 (1) of Foreign Exchange Management (Transfer and Issue of shares by a Person Resident outside India) Regulations, 2000 notified vide Notification No. FEMA 20/2000-RB dated May 3, 2000.”
Subsequent to this policy change, several Indian companies have undertaken issuances of compulsorily convertible debentures to foreign investors. However, a recent news report indicates that a further review by RBI of the working of the policy is under way. The report states:
“The department of industrial policy and promotion (DIPP) has asked the Reserve Bank of India (RBI) to clarify whether compulsory convertible debentures (CCDs) are to be treated as debt or equity, …

Should the RBI decide that CCDs are to be treated as debt, corporate borrowing overseas could be affected. Funds raised through this route would then be included in external commercial borrowing, which is subject to a company-specific ceiling of $500 million. On the other hand, treating CCDs as equity would mean that such investment would have to comply with sectoral FDI limits.”
At the outset, one may wonder why there is a need for a clarification as the policy is quite unambiguous. But, it appears that the confusion arises because of the variations involved in structuring the convertible debentures, particularly the put option. As the news report further notes:
“Confusion has arisen because sometimes CCDs are structured in a way that takes them closer to debt, the official said. For example, at times CCDs have a put option which requires the issuing companies to buy back the shares issues on conversion at a fixed price. This structuring makes it debt like.”
Looking at the basic nature of the instrument, the existence of a put option that requires issuing companies to buyback shares (arising out of conversion) should not alter its character. Compulsorily convertible instruments are nothing but deferred equity; by their very terms they will become equity, albeit at a later point in time. In the interim, they partake the character of preference shares or debentures. Even when converted, the exercise of a put option on the company will be subject to the existing rules on buyback, which carry several restrictions. For instance, there are limitations on the amount that can be expended on a buyback (25% of net worth), amount of share capital that can be bought back (not exceeding 25% each year), solvency certifications from the board of directors and the like. Whether the instruments are convertible in nature or were issued as shares in the first place, there would be no difference to the outcome as these rules will have to be complied with in any case.

It is hoped that these (and other related) issues are considered by RBI while reviewing the existing guidelines or providing clarification on convertible instruments.

Tuesday, March 24, 2009

National Law School of India Review: Symposium on Arbitration

The National Law School of India Review will be holding its 2nd annual Symposium on 18th - 19th April, 2009. The theme of the Symposium is “Towards Unification: Perspectives on Investment and Commercial Arbitration”; and it is intended to cover international commercial arbitration as well as investment treaty arbitration. According to the organizers:


This year, the NLSIR Symposium looks towards a new direction and seeks to address a most crucial issue of private law that can make or break dispute resolution in globalized India – arbitration. The relevance of this issue, of course, holds for the developing countries generally, and the Symposium therefore asks the question whether legal structures in developing countries are conducive to the rapid pace of commercial growth that most concede is now a necessary condition of development and progress. Arbitration has always been significant as a more expeditious vehicle for dispute resolution. However, the importance of arbitration has reached new levels since India has chosen to irreversibly embrace the forces of globalization. The choice to embrace globalization carries a commitment to revamp existing institutional structures to suitably address the infrastructural inadequacies that are antithetical to arbitration. It is crucial, however, to tailor this commitment to India’s unique circumstances and needs, both historical and legal, in the larger context of the unification movement with respect to international commercial arbitration.


The specific sessions of the Symposium are as follows:

· Domestic Arbitration – The Scope of Arbitrability and Applicable Law

· The Expansive Role of the Indian Judiciary and its Implications

· Investment Arbitration and MFN

· The Unification Movement


Some of these issues, particularly those relating to domestic arbitration, have been touched upon here. The issue relating to investment arbitration and MFN is discussed in the article linked here. Speakers at the Symposium include members of the higher judiciary, senior practitioners, and academicians. The list of speaker can be accessed here. Registration details are available here and here.

Monday, March 23, 2009

The AIG Bonus Payments Controversy: Issues of Contract Law

There has been a significant outrage since the controversy over bonus payments to some AIG employees began about a week ago. One of the justifications of the AIG management for pressing on with the payments is that the company is legally obligated to pay their employees failing which it could be liable to suits for breach of contract. Although the controversy has taken a different shape owing to the U.S. Government’s decision to impose a punitive tax on those bonuses, it has given rise to interesting discussions on contract law and bankruptcy law, particularly in the context of employment contracts.


In a New York Times op-ed piece, Lawrence Cunningham, Professor at George Washington University Law School, notes the several possibilities in defence of a denial of payment of such bonuses:


There are numerous issues both sides must contend with to evaluate whether A.I.G. was bound to or excused from its payment duties. First, the specific promises that employees made or conditions stated in their agreements must be examined. Determining what promises exist requires only reading the contracts; identifying conditions (which will likely offer more wiggle room in A.I.G.’s duty to pay) requires both reading the contracts and understanding any negotiations that preceded them.

Apart from specific contractual terms, there are other reasons A.I.G. might rescind these bonuses. They include the nondisclosure of important material information — for instance, if an employee failed to be absolutely candid about the size and risk of trading positions taken on the company’s behalf.

Findings of fraud on the part of an employee would certainly also excuse A.I.G.’s duty to pay. This isn’t to say that any A.I.G. employee engaged in such activity. But given the scale of problems that A.I.G. has confronted, and credible allegations of serious misconduct within the organization, it’s worth investigating.

There is also at least some chance, given A.I.G.’s functional insolvency and the government takeover, that these agreements may be rescinded either on the basis of impracticability or by virtue of unforeseeable and uncontrollable circumstances. A credible fact supporting both excuses is precisely the company’s huge loss last quarter. Courts excuse contract duties when governmental action essentially destroys the original purpose of a contract — and the taxpayers’ 80 percent stake in A.I.G. is a more extreme sort of governmental action than usually appears in such cases.

A final potential legal basis for rescinding these payments is fraudulent conveyance law. This generally limits the right of a financially troubled company to transfer property to favored claimants on sweetheart terms when doing so would hurt the interests of other claimants, like lenders and shareholders — in this case, perhaps even taxpayers. Again, this is not to say that these payments violate this doctrine, but it is a relevant question for the government to probe.

Another debate in the New York Times discusses other issues that could potentially be invoked in a contractual dispute between AIG and its employees over the bonus payments: changed circumstances, frustration of purposes, unconscionable terms, and the like.

Thursday, March 19, 2009

SEBI’s Proposal to Revitalise Rights Issues

Rights issues offer an important avenue for companies to raise capital, especially when bank financing may be difficult owing to a credit crunch as we are currently witnessing. However, in the Indian context, the procedure for carrying out a rights issue has been as onerous as it is for a full-blown public issue. This is because the disclosure requirements and the timing involved in a rights issue have been fairly extensive. In order to encourage companies to undertake rights issues, SEBI earlier announced a reduction in the time period for the entire process, and has now announced less detailed disclosure requirements.


In a Discussion Paper on Rationalisation of Disclosure Norms for Rights Issues, SEBI detailed the rationale for this change:


A listed entity can raise further issue of capital by way of preferential offers, Qualified Institutional Placements (QIPs), Rights Issues (RIs), Further Public Offers (FPOs), American Depository Receipts (ADRs) / Global Depository Receipts (GDRs), etc. Apart from ADRs / GDRs, all other issuances are domestic. While making an issue of capital, several factors guide the issuers in the choice of mode of issuance. These include time, cost, labour involved and disclosure requirements. From our interaction with market participants, it was gathered that quite often, the issuers choose preferential offers or QIP or even ADR / GDR issuances, as these modes require less time, cost and efforts. Such alternate modes of issuances while helping the entities to achieve their capital raising needs, dilute the existing shareholders’ stake in the entity.

“[Rights issues (RIs)] are further issuances of capital made by listed entities to its existing shareholders. Certain information about the entities that are listed and traded on the exchanges is available in the public domain for investors. Hence, for further issuances of capital by such entities, it may not be necessary to mandate exhaustive disclosure requirements. In such cases, it may suffice to have a more restricted set of disclosures about the issue and the entity. Further, rationalization of disclosure norms for RIs would not only make the issuance process faster but also contribute to savings in paper, printing and distribution costs, thereby reducing overall cost of issuances.”


While simplification is a welcome move, there may be practical difficulties in its implementation owing to the wide chasm between primary market disclosures (for public offerings and rights offerings) which are fairly extensive in nature, and secondary market disclosures (i.e. continuing disclosures by companies which are already listed on a stock exchange) which are quite slender. SEBI’s proposal for a revised rights issue regime proceeds on the assumption that information about the company is generally available in the market, which assumption is open for question, as Sandeep Parekh has validly argued on his blog. For a previous discussion of the disparity in the disclosure regime between primary and secondary markets on this Blog, please see here and here.


Furthermore, if the issue of integrated disclosures is addressed, not only will that enable simplified rights offerings, but also simplified follow-on public offerings by public listed companies on the basis of availability of information about the offering company in the markets generally.

Tuesday, March 17, 2009

Differential Voting Rights: Ruling by CLB

Several months ago, we had mentioned that the validity of shares with differential voting rights (DVRs), particularly as a defence against takeovers, was challenged before the Company Law Board (CLB) in the Jagatjit Industries Case. Today’s Economic Times reports that the CLB has passed its order upholding the resolution to allot shares with DVRs to the promoter of the company. A brief background of the facts set out in this report is as follows:


“The two brothers, Anand and Jagatjit, moved the CLB against the company decision in 2004 on preferential allotment of shares with DVRs, giving Karamjit 64% voting rights on his 32% stake in the company.

They had petitioned the court to declare as ‘null and void’ a June 16, 2004, resolution passed at the company EGM, allotting 2.5 million preference shares — each with 20 voting rights — to LP Jaiswal & Sons, a firm-controlled by Karamjit.

The preferential allotment saw Karamjit’s voting rights in the company touch 64% even though his stake, or economic interest, increased to just over 32% from 23.59% earlier.”


It would be interesting to see the reasoning provided by CLB once the order is available. The issue of DVRs has invoked significant discussions in the past (see here and here), and the Companies Bill, 2008 (in its current form) even proposes to do away with DVRs altogether by reverting to the “one-share one-vote” rule, thereby probably making equity shares with DVRs a fairly short-lived instrument.

Monday, March 16, 2009

Regulation of Stock Exchanges

The proposed establishment of a new stock exchange in India has caused a revival of the debate pertaining to regulation of stock exchanges. There are unique issues: stock exchanges are not only profit-making institutions that are companies in form and substance, but they also carry out a regulatory role in respect of companies that are listed on them. This creates an inherent conflict of interest in their operations. As Mobis Philipose notes in The Mint:

“MCX Stock Exchange (MCX-SX) has applied to the Securities and Exchange Board of India, or Sebi, the capital market regulator, to offer trading in equities. If it wins approval, it would be the first greenfield equities exchange in India since the National Stock Exchange (NSE) started about 15 years ago.

The proposed new stock exchange would compete with NSE and the Bombay Stock Exchange (BSE). It would also be the first stock exchange with a common ownership and management in the post-demutualization era.

Globally, when stock markets moved from being broker-owned mutual associations to shareholder-owned entities—a process known as demutualization—concerns arose over the governance of for-profit equity exchanges. In most cases, the regulatory function has been spun off to a different entity to remove any conflict of interest.

A stock exchange’s responsibilities include surveillance of market participants and ensuring that a robust risk management mechanism is in place. It does this by monitoring position limits and collecting adequate margins on time. When the owners of the exchange oversee such regulatory functions, there could be a conflict of interest, some analysts say.”

Although the establishment of this new stock exchange will promote competition in the field and thereby encouraging innovation and better service to clients, there is a genuine concern (expressed by experts in the above Mint article) that this may lead to laxity in regulation of listed companies by stock exchanges (so as to promote listing and trading on them) thereby leading to an overall decline in regulatory standards, this trend being generally known as “the race to the bottom”.

This has been a serious governance issue world over. For example, Professor Allen Ferrell of Harvard Law School lays out the crux of the problem:


“The global movement of traditional stock exchanges to for-profit businesses has put pressure on the self-regulatory function of exchanges. A for-profit stock exchange, burdened with expensive regulatory duties (as a result of being a self-regulatory organization (SRO) under the Exchange Act), and competing with trading platforms that have lower regulatory burdens or no regulatory duties must grow its business to be successful. As with any business, profit growth may come from increased revenues or reduced costs. For a stock exchange, revenue growth must come from increased trading volume, by adding new listings or by acquiring other exchanges or trading platforms. Cost reduction may come from a reduction in regulatory burdens or through economies of scale, such as the consolidation of separate market surveillance units and operating acquired trading platforms on existing surplus IT capacity. This emerging business dynamic may be driving a variety of fundamental changes in global regulation.

There are concerns that this has placed undue strains on the regulatory structure. These issues have included the concern that trading might move to markets with lower regulatory requirements, the existence of inconsistent rules across markets, and that exchanges may reduce the rigor of their regulatory oversight in order to gain market share. There is also the concern that exchanges may be “too soft in regulating themselves and too severe in regulating competitors.” For example, the SEC in its concept release, and in an earlier concept release, discussed the possibility of regulatory arbitrage, whereby, for example, an exchange might reduce its market surveillance function to attract trading volume, or lower listing requirements to attract companies.”

There are a number of methods used in various jurisdictions by which this conflict of interest can be mitigated. These may be employed individually or through a combination of more than one method:

Separate the ownership and management of the exchanges. This can be achieved by imposing a cap on share ownership by a single entity or grouop. This is the model that NSE has been following.

House the regulatory functions in a separate subsidiary company that has a separate board (in other words, create “Chinese walls”). Ferrell notes that the NYSE and NASDAQ followed this approach.

Create a strong independent board that pays adequate attention to the regulatory functions of the stock exchange.

Provide for enhanced governmental supervision of the regulatory function of the exchange rather than by the exchange itself. Ferrell notes that some exchanges follow this: Australian Stock Exchange, the Hong Kong Stock Exchange, the Singapore Exchange and the Stockholm Stock Exchange.

Constitute a separate Regulatory Conflicts Committee of the board to deal with the conflicts between the commercial and regulatory sides of the exchange. The Singapore Stock Exchange follows this model.

At this stage, from the information available, it appears that the new exchange will largely follow the first approach of separation of ownership and management. Although many of these models will dilute the possibility of conflicts, such conflicts cannot be obliterated altogether given the basic feature of a stock exchange that is run on a for-profit basis.

Sunday, March 15, 2009

NCLT and NTT: Questions of "Intrinsic Judicial Functions"


Recently, a Constitution Bench of the Supreme Court (headed by Balakrishnan C.J.) finished hearing arguments on the constitutionality of the proposed National Company Law Tribunal (NCLT), and judgment has been reserved. The matter arose out of an appeal against a Madras High Court decision in R. Gandhi v. Union of India.


The principal challenge to the constitutionality of the NCLT is based on the wholesale transfer of jurisdiction of the High Court in company matters to a quasi-judicial tribunal. It was argued by the petitioners that this transfer resulted in the vesting of intrinsic judicial functions in a quasi-judicial/executive body. Jaisimha Babu J. of the Madras High Court had accepted this contention, holding that the power of the Parliament to create Tribunals does not “extend to rendering such new forums an extension of the legislative or executive branches of the Government, or as forums controlled, or designed to be dominated, or potentially dominated, by the legislative or executive wing of the state…” It was held that the proposed model of the NCLT violated the constitutional principles of separation of powers and independence of the judiciary by vesting essential judicial functions in a non-judicial body.


The challenge to the proposed National Tax Tribunal (NTT) also proceeds on rather similar grounds. This issue is also pending before the Supreme Court. In the case of the NTT, the jurisdiction of the High Courts under sections like Section 260-A of the Income Tax Act (which deals with appeals on “substantial questions of law”) is proposed to be given to the NTT.


The objections to “tribunalisation” are not so much due to the fact that the jurisdiction of the High Courts has been taken away; but because the jurisdiction to decide important legal issues has been given to a quasi-judicial tribunal which does not possess the characteristics of the judiciary in terms of composition, appointment, qualifications etc. Perhaps, the best way to solve problems relating to high pendency of cases in the High Courts would be to transfer the cases to institutions which (whatever they may be labeled as – ‘tribunals’ or ‘Courts’) remain intrinsically and in substance ‘judicial’ in nature. Transferring jurisdiction wholesale to quasi-judicial bodies is only likely to compound the problem.


For instance, the Benches of the ITAT (whose determination of facts in taxation matters is ordinarily conclusive) are composed of one judicial member and one accountant member. An appeal lies from the ITAT to the High Court only on a substantial question of law. In hearing that appeal on the question of law, it is not a fact-finding but an intrinsically judicial function which must be performed. It might be argued on this basis that a body similar to a Bench of the High Court (for instance, two judicial members qualified to be High Court judges; rather than the same structure of one judicial and one accountant member) is required. Additionally, the security of tenure of the members ought to be the same as the security of tenure of High Court judges.


It remains to be seen whether the Constitution Bench is convinced by the arguments and actually strikes down the creation of either the NTT or the NCLT for violation of the doctrines of separation of powers and independence of the judiciary.


Monday, March 9, 2009

Directors are persons in control; failure to disclose their shareholding violates Takeover Regulations

In a far-reaching decision, the Securities and Exchange Board of India has ruled in an adjudication order that members of the board of directors of a listed company (“Target Company”) would be persons having control of the Target Company. Consequently, directors of the Target Company ought to make disclosures of their holdings under the disclosure requirements set out in the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 (“Takeover Regulations”).

Adjudication proceedings had been initiated against members of the board of directors of Matra Realty Limited, the Target Company, for failure to comply with disclosure requirements under Regulation 6(3) in 1997 and Regulation 8(2) of the Takeover Regulations. The noticees took a stance that the Target Company did not have promoters and it was a board-driven company. Moreover, the members of the board of directors did not have a controlling stake in the Target Company, and therefore, they were not in control over the Target Company. Therefore, it was argued that there was no obligation to disclose any promoter shareholding in terms of Regulation 6(3) and Regulation 8(2) of the Takeover Regulations.

Regulation 6(3) of the Takeover Regulations reads as under: -

“A promoter or any person having control over a company
shall within two months of notification of these Regulations disclose the number
and percentage of shares or voting rights held by him and by person(s) acting in
concert with him in that company, to the company.”

(Emphasis Supplied)

Regulation 8(2) of the Takeover Regulations reads as under: -

“A promoter or every person having control over a company shall, within 21
days from the financial year ending March31, as well as the record date of the
company for the purposes of declaration of dividend, disclose the number and
percentage of shares or voting rights held by him and by persons acting in
concert with him, in that company to the company.”

(Emphasis Supplied)

It will be seen that two phrases are used in these provisions – “promoter” and “persons having control over a company”. The term “promoter” is itself defined in Regulation 2(1)(h) of the Takeover Regulations as a any person who is control over the company and any person named in a securities offer document or in a filing with stock exchanges as a “promoter” of the Target Company.

In the order, SEBI has ruled that since the Target Company was a board-managed company, the directors alone could have exercised control over the Target Company. Therefore, their own shareholding ought to have been disclosed since they were “persons having control over a company”.

SEBI took note of the definition of the term “control in Regulation 2(1)(c) of the Takeover Regulations, which is as under:-


“control” shall include the right to appoint majority of the directors
or to control the management or policy decisions exercisable by a person or
persons acting individually or in concert, directly or indirectly, including by
virtue of their shareholding or management rights or shareholders agreements or
voting agreements or in any other matter.

(Emphasis Supplied)

SEBI has also cited the definition of “control” in the Black’s Law Dictionary, 8th Edition, which is as follows: -

“the direct or indirect power to direct the management and policies of a
person or entity, whether through ownership of voting securities, by contract,
or otherwise; the power or authority to manage, direct or oversee”.

(Emphasis Supplied)

The SEBI order notes that “any person who controls the management of a company either individually or collectively with other persons or controls or influences the policy decisions by virtue of his position, can be said to be in ‘control’ over the affairs of the company. In the present case, the Noticee was a part of the Board of Directors which controlled the affairs…..A director is one of the controllers of the company’s affairs. The Board of Directors is the brain and the company is the body. The company can and does act only through the Board. When the brain, i.e., the Board, functions, the company, i.e. the body, is said to function. Thus, the functioning of the company is totally controlled and directed by the Board.”

SEBI noted that the Target Company was a board-managed company, the board had only three directors at the relevant time, and these directors along with persons acting in concert indeed held shares at the relevant time. SEBI has ruled that being “persons having control over” the Target Company, the three directors ought to have made their disclosures under Regulation 6(3) and Regulation 8(2) of the Takeover Regulations. For failure to make such disclosure, monetary penalty has been imposed.

The decision has implications not only for board-managed companies that do not have promoters (for example, ICICI Ltd. and Larsen & Toubro), but also for every listed company in which directors have any shareholding. One is not sure if these companies even aggregate the shareholding of all directors and disclose their shareholding under Regulation 8(2) of the Takeover Regulations.

Now that SEBI has given this ruling, every listed company would have to report the shareholding of its directors under the head “persons having control” – quite distinct from the holding of the “promoters.

Sunday, March 8, 2009

Securitisation and Debt Recovery – A Centre-States Conflict?

The Constitution has devised an elaborate scheme of distribution of legislative powers, and the competence of a legislature to enact a law has normally been challenged by a private citizen to whom the law applies. The latest battleground looks to be the fairly recent structure of securitization, debt recovery and other FI-friendly legislation. The first major decision of the Supreme Court on this point – Central Bank of India v. State of Kerala (C.A. No. 95/2005, decided on 27 February 2009) does not entirely settle the issue.


The issue before the Court was whether recovery mechanisms prescribed in legislations like the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (“RDB Act”), the Securitisation Act, 2002 etc. have primacy over State legislations which provide that the State shall have first charge over assets to enforce any dues that it may be owed. For example, the Bombay Sales Tax Act, 1959 provides that any sum payable to the State under the Act shall be the first charge on the property of the dealer, subject to any provision contained in any Central law regarding first charge. Other State legislations are to the same effect without the rule that it is subject to a provision in a Central law regarding first charge (Kerala General Sales Tax Act, 1963, § 26B). In addition, there are also some Central laws that prescribe first charge independently – the Workmen’s Compensation Act, 1923 (§ 14A), the Employees Provident Fund and Miscellaneous Provisions Act, 1952 (§ 11), the Estate Duty Act, 1953 (§ 74(1)), Mines and Minerals (Development and Regulation) Act, 1957 (§ 25(2)), Companies Act (§ 529A) and so on.


However, the RDB Act (§ 34(1) provides that the provisions of that Act will have effect notwithstanding anything inconsistent contained in any other law. The Securitisation Act contains a similar provision (§ 35). Relying on this, Central Bank of India argued that the Recovery Certificate it had obtained from the DRT in respect of a loan it had granted took precedence over sales tax arrears that the borrower owed to the State Government, and that the first charge provisions of the State legislation were overridden by the Central Acts. The Court examined the contention from three angles. First, it concluded that the doctrine of repugnance had no application, as Article 254 of the Constitution applies only when there are two legislations under the same entry in the Concurrent List. In other words, the Court concluded that the State legislation did not become invalid to the extent it was inconsistent with the Central Act merely because of Art. 254.


Secondly, and more importantly, the Court analysed the scope of the non-obstante clause in the RDB Act and the Securitisation Act. This is likely to be of great importance for future disputes. The Court noted that the provision that the RDB Act and the Securitisation Act would operate notwithstanding anything contained in any other law had to be interpreted in accordance with legislative intent, and that if the legislature intended it to have a limited scope, that had to be given effect to. In determining what the legislature in fact intended with these provisions, the Court observed that the State has for a long time been accorded priority in its debts and first charge over assets. The Court concluded that Parliament, when it enacted the RDB Act and the Securitisation Act, was deemed to be aware of this rule and must be presumed not to have altered it unless it did so specifically. No such specific provision exists in the RDB Act or the Securitisation Act, which allowed the Court to conclude that these legislations operate in a different field, and that there is in fact no conflict between these legislations and the State legislations mentioned above. Such specific provisions exist in Section 529 of the Companies Act, or Section 11(2) of the EPF Act, which prescribe that the creditors secured by those provisions have priority over the first charge that the State traditionally enjoys. The Court observed, “[h]owever, the fact of the matter is that no such provision has been incorporated in either of these enactments despite conferment of extraordinary power upon the secured creditors to take possession and dispose of the secured assets without the intervention of the Court or Tribunal…”. Thirdly, and consequently, the Court held that the sales tax and other arrears owed t the State Government had priority over the decree/Recovery Certificate issued by the DRT in respect of banking debts.


This judgment is likely to be of enormous significance in what is surely going to be the most contentious arena of State-Centre legislative power disputes, with the rapidly increasing number of State legislations that create first charge. For example, ET reports that SEBI has challenged the validity of a Gujarat legislation – Sardar Sarovar Narmada Nigam (Conferment of Power to Redeem Bonds) Act, 2008, claiming that it conflicts with the Companies Act. With the growing penchant for States to enact depositor-protection or other such legislations, this trend looks set to continue in the near future.