Sunday, November 22, 2009
Friday, November 20, 2009
Thursday, November 19, 2009
The recent decision of the SEBI to set aside as ultra vires two orders passed by a Special Committee set up by it has led to a huge furore in commercial and legal circles. The origin of the controversy was the appointment of CB Bhave as the Chairperson of the SEBI at a time when SEBI was investigating the propriety of the actions of the National Securities Depositary Limited (“NSDL”), in relation to several past events. The fact that CB Bhave had been the CMD of NSDL prior to his appointment as Chairman of SEBI, lead to an obvious conflict of interest. In order to avoid this conflict, it was decided that the investigation be carried out by an independent Committee. The investigation was completed and an order delivered in December 2008. In a departure from usual practice, the SEBI did not disclose the findings till November this year, when it also declared that the two orders were ultra vires and hence void. The basis of this conclusion was that
a. The Board had delegated its authority to the committee to dispose of three quasi-judicial proceedings pending against NSDL.
b. The committee, however, entered findings that the Board failed as a regulator, while disposing of two matters relating to IPO Irregularities and DSQ Software Ltd.
c. These findings against the Board are outside the confines of delegation and therefore, these are without the authority of law.
d. These findings, which have vitiated these two orders, cannot be severed from the rest of the orders. Hence these orders are null and void and are non est.
e. The third order (in the matter of Rajnarayan Capital Market Services Limited) is in order since it does not have similar findings.
Much has been said about the effect of such a decision on the accountability of the SEBI, and the real suspicion that the decision is in bad faith. However, there are also two important legal issues that arise from this decision of the SEBI, which is what I focus on here. These are:
First, does the SEBI have the power to declare an order of the Special Committee as ultra vires? Secondly, even if it has this power, was the order here in fact ultra vires and liable to be declared void?
On the first issue of the powers of the SEBI, they are comprehensively covered by Chapter IV of the SEBI Act (these powers have also been discussed earlier). The structure of the Act broadly envisages action of two types- taken by the SEBI itself (ss. 11, 11A and 11B), or by an Investigating Authority appointed by the SEBI (s. 11C). The decisions taken by either of these are appealable only to the Securities Appellate Tribunal (ss. 15T, 15Y and 20A). Besides this appeal mechanism, the Central Government can also be appealed to (s. 20), and it can also take other action against the decision of the Board or the Investigating Authority (ss. 16 and 17). This schema suggests that the SEBI has no review power over the actions of the Investigating Authority, which is what has led some to argue that the decision in the NSDL case was also incorrect. However, it is important to appreciate that the nature of the Committee and the Investigating Authority is fundamentally different. The Committee was exercising the powers of the SEBI under ss. 11 and 11B, which were delegated to it under section 19. There is nothing in the Act to suggest how the exercise of this delegated power can be controlled. Admittedly, such a power has arguably never before been exercised by SEBI (there is a dispute over whether it was exercised on 2006). However, given that the Special Committee was the first body of its sort under the SEBI framework, there is limited value that can be garnered from past precedent. This necessitates reliance on general administrative law principles on sub-delegation. Usually, the controversy over sub-delegation is focussed on whether the delegate has the power to sub-delegate. Given section 19, this isn’t in issue here. The other issue is the extent to which the delegate can exercise control over the sub-delegate. While this has been a point of serious contention, the more supported view seems to be that the delegate continues to retain authority over the matter that has been sub-delegated. Though some decisions like the UK Court of Appeals in Blackpool Corporation v. Locker,  1 KB 349) and the Employment Appeal Tribunal in Department For Environment Food & Rural Affairs v. Robertson,  ICR 1289 (affirmed on a different point in Robertson v. Department For Environment Food & Rural Affairs,  EWCA Civ. 138, para. 41), have departed from this view, they have been criticised as proceeding on a mistaken understanding of ‘sub-delegation’ (Jackson, 66 LQR 363, 376). In any event, these decisions also only restrict the rights of the delegate during the delegation, and do not prevent it from revoking the delegation. Thus, there seems to be nothing to prevent SEBI from reviewing the exercise of the delegated powers by the Special Committee, especially when what it purported to review was not the decision per se, but the scope of the decision.
This is not to say that the exercise of this power was appropriate on the circumstances here. In fact, while I believe that SEBI has the power to revoke the authority granted to the Special Committee or to declare it void, there is no doubt that the power was incorrectly used here, for two reasons-
First, the very reason for the constitution of the Special Committee was to avoid all conflicts of interest resulting from Mr. CB Bhave’s previous position on NSDL. The fact that independent and not existing members were chosen for the Committee clearly shows that the mere recusal by Mr. Bhave was considered insufficient to counter the conflict of interest. Subjecting the decision of this independent body to the review of the very body that may be influenced by a conflict of interest seems incorrect and undesirable. In these special circumstances, I think the review by the SEBI was inappropriate, and could not be remedied only by Mr. Bhave’s recusal.
Secondly, the SEBI declared the orders of the Special Committee ultra vires because they consider the role of the SEBI instead of focussing only on NSDL. Further, these observations on the functioning of the SEBI are considered to be so fundamental as to constitute an integral part of the decision. However, a reading of the orders suggests nothing of the sort. In fact, after a few passing mentions during the text of the order dealing with the IPO scam, in the penultimate paragraph 94, the members specifically state, “It would not be appropriate for us to leave this matter without expressing our concern about the failure of SEBI to carry out its regulatory role adequately”. This shows that the observations were ancillary to the other findings of the members, far from being integral and inseparable from their other findings. Further, of the three orders, only the ones pertaining to the IPO scam and DSQ Software were annulled. The third order regarding Rajnarayan Capital Market Services Ltd. was affirmed on the basis that the Committee had made no such observations outside the scope of its mandate. However, as rightly pointed by one of the several discussions of this issue, this distinction is incorrect. Even the RCMSL order contains a recommendation to the SEBI, in paragraph 35. The only difference is that there are no general observations or strictures against the SEBI. This lends force to the argument that the other orders were held ultra vires not due to the consideration of SEBI’s conduct, but because of what they said about SEBI’s conduct. This conclusion also finds support in the fact that the SEBI refused to disclose the orders for about 11 months.
In sum, SEBI’s decision to declare ultra vires the decisions of the Special Committee appointed to look into the NSDL matter is incorrect. However, the problem with the decision is less the lack of competence of the SEBI to take the decision, but more the propriety of the decision on its merits. Hence, while the apprehension over the decision and its implications is justified, doubting the competence of the SEBI to make such a determination would be directing the disapprobation at the wrong target.
Monday, November 16, 2009
Professor Balasubramanian of IIM Bangalore has posted two interesting papers.
In the first paper, Addressing Some Inherent Challenges to Good Corporate Governance, he examines certain specific issues arising due to the concentrated ownership in Indian listed companies. Specifically, he notes:
While the objectives of good governance, namely creation, protection and equitable distribution of shareholder value, have long been recognized, their full achievement in practice has been dogged by challenges emanating from various sources like dominant shareholders, autocratic executive managements, inefficient independent auditors, inefficient enforcement mechanisms, and so on. Standing out prominently among these challenges is the potential for controlling shareholder dominance often abetted, unwittingly or otherwise, by inefficient board surveillance over the executive.He then considers two specific issues, both involving corporate decision-making, one at the board level and the other at the shareholder level.
Although Indian listed companies are mandated to have independent directors, Professor Balasubramanian notes that independent directors have not been conferred significant powers. For instance, independent directors are to vote on the board like any other directors, which means that they can be outvoted (unless, of course, independents constitute a majority on the board, which is almost a rarity). Furthermore, quorum requirements do not require the presence of independent directors. The solution he proffers is that independent directors should be given affirmative votes or veto powers on specific matters, particularly those that involved conflict of interest or self-dealing transactions. While this will certainly empower independent directors, it will also impose significant responsibility and accountability that such individuals have to property discharge.
At the shareholder level, he advocates the concept of interested shareholders, whereby those who are interested in a resolution (e.g. controlling shareholders in a self-dealing transaction) ought not to participate in the voting process. Current law does not impose any duties on shareholders to abstain from voting at a general meeting, except in certain limited circumstances imposed by SEBI, as discussed earlier on this blog.
In sum, Professor Balasubramian’s recommendations are in furtherance of the recognition that corporate governance norms in India ought to be tailored to suit the structures and environment that operate in the Indian business context.
The second paper, Governing the Socially Responsible Corporation - A Gandhian Perspective, explores the linkages between corporate governance and Gandhian philosophy. The paper considers Gandhian traits relating to trusteeship, truth, non-violence, and the like, in the corporate context. For example, the element of trusteeship is inherent in directors’ fiduciary duties (e.g., loyalty) towards a company; truth is the basis for corporate disclosures and securities regulation; non-violence carries with it principles of social responsibility whereby the activities of corporations ought not to cause harm to its larger group of stakeholders. The paper also has a useful set of dos and don’ts in corporate governance viewed in this light.
Sunday, November 15, 2009
An earlier post had discussed the issue in Hertz v. Friend, which calls upon the United States Supreme Court to determine what is the ‘principal place of business’ of a corporation having operations in more than one State. The Court heard the matter on 10th November, and the transcript is available here. Unfortunately, while it makes interesting read, the potential the case seemed to have for a discussion on general corporate law theory remains unrealised. A majority of the arguments focussed only on the policy behind the Class Action Fairness Act, with a very limited discussion of concepts like ‘headquarters’ or ‘gaming the system’.
The idea of ‘headquarters’ formed a substantial portion of the petitioner’s arguments, where he was required to discuss the effect of following a headquarter-rule for determining the principal place of business. The headquarter was defined as the place from which the corporation is ‘directed and controlled’. The ultimate test the petitioners seemed to be advocating is that there is a strong presumption in favour of the headquarters being the principal place of business, which can be rebutted if it is proved to be a sham. As to the defendants contention that ‘principal place of business’ was a term of art borrowed from bankruptcy laws, the petitioner argued that they are two terms referring to the same thing.
The defendants focussed more on the policy behind the CAFA, and suggesting that the Congressional intent clearly sought to depart from the headquarters being considered the principal place of business. It was contended that following the headquarters test would allow corporations to ‘game the system’, and should not be allowed. Justice Scalia responded by suggesting that ‘gaming the system’ should not really be a concern since it wasn’t much of a concern in determining the citizenship of individuals. In conclusion, the respondents submitted that the ‘principal place of business’ has to be determined with reference ‘first to the location of employees, tangible properties and production activities, and then second to income earned, purchases made and where sales take place’.
Thus, the oral arguments failed to churn up the discussions on corporate law that could have been expected, and barring the few issues mentioned above, focussed entirely on the policy behind the CAFA and diversity jurisdiction in the US in general. It now remains to be seen what the Court finally chooses as the primary basis of its decision.
Saturday, November 14, 2009
2. Shantanu Surpure and Rashi Saraf compare and contrast the regulations in the US and India regarding insider trading, and point to the difficulties in successful investigation and prosecution of violations;
3. Sandeep Parekh critiques SEBI’s approach in the IPO scam cases;
4. T.T. Ram Mohan views Government disinvestment in public sector undertakings from a governance perspective;
5. The Reserve Bank of India (RBI) announces draft guidelines with a view to liberalising the regime governing derivatives in foreign currency by permitting certain types of put and call options, while prohibiting others;
6. The Economist analyzes the acquittal of two Bear Stearns hedge fund managers who were prosecuted for lying to investors about the state of their funds. They are said to have exchanged e-mails that “showed the two panicking behind the scenes while reassuring investors in public.” The collapse of the two Bear Stearns hedge funds in 2007 exhibited the first signals of the financial crisis. This case has some similarities with that of a stock analyst at Merrill Lynch during the Internet bubble years, but the latter case resulted in a different outcome;
7. Noted economist Dani Rodrik disfavours the removal of capital controls. He notes: “Prudential control on capital flows makes a lot of sense. Short-term flows not only wreak havoc with domestic macro-economic management, but also aggravate adversary exchange-rate movements”. He adds: “You can oppose capital controls because you believe financial markets are on the whole a force for good, and that any interference will therefore generate efficiency losses. Or you can oppose controls because you think that they can be easily evaded and are therefore doomed to remain ineffective. What you can’t do is oppose capital controls because they are both costly and ineffective.” All of this is surely music to RBI’s ears.
8. Finally, the Harvard Law School Forum has some lessons for M&A advisors in drafting their engagement letter to protect themselves from third-party liability, at least as a matter of New York Law.
Earlier posts here had discussed the decision of a Special Bench of the Bombay ITAT in Daga Capital and the possible inequities that could result from its interpretation of section 14A. The most significant one was that expenditure could be disallowed even if no nexus was established between the expenditure and tax-free investment income. To quote from an earlier post explaining the inequity,
Section 14(A)(2) provides that if the Assessing Officer (AO) ‘is not satisfied’ with the assessee’s claim as to the amount of expenditure relatable to exempt income, he shall determine the amount of expenditure ‘in accordance with such method as may be prescribed’. This prescribed method in provided in Rule 8D of the Income Tax Rules, according to which the amount of expenditure disallowed is proportionate to the amount of tax-free investments made, irrespective of the source of the investment. Thus, the mode of computation uses the proportion of the investment vis-a-vis the total assets of the company, to determine what proportion of the total expenditure should be disallowed. Further, section 14A(3) provides that this mode of computation applies also when the assessee claims that no expenditure has been incurred by him in earning the tax-free income. An archetypical case would be when an enterprise has sufficient reserves of interest-free funds to make a tax-free investment. In such a case, there is no question of there being any expenditure in relation to earning tax-free income, since the funds invested in the earning of the income have been internally provided. In such a case, ideally, there should be no disallowance of deductions for expenditures that may have been incurred in other activities of the business. Prior to the decision in Daga Capital, there were a few decisions, specifically in the context of section 14A, stating that the burden was on the Revenue to show the link between the expenditure incurred and the tax-free income earned. However, after the broad interpretation of the provision and the retrospective application of the computation provisions vide Daga Capital, the position seems to have undergone a change. This means that even if an enterprise has not, in fact, borrowed for the purposes of making tax-free investment, but borrowed for other purposes, it still would be denied deductions to the extent worked out by Rule 8D.
Two decisions of the ITAT had sought to alleviate the inequity of the position, by creating a presumption in favour of the assessee in certain cases or by holding that the extent of disallowance cannot be increased on an application of Rule 8D.
However, the Punjab and Haryana High Court in CIT v. Hero Cycles has finally done that which the Tribunal could not do due to rules of precedent- it has held that notwithstanding the application of Rule 8D, the establishment of a nexus between the expenditure incurred and the tax-free income has to be established by the Revenue. On facts, one of the units of the assessee had incurred interest expenditure, and the assessee as a whole had earned some tax free dividend income. The Revenue sought to connect these two together, and apply Rule 8D to disallow the expenditure. However, the CIT(A) found on facts that the interest expenditure had been set off elsewhere, and the dividend income was earned from the investment of tax free money. Based on this finding of fact, the CIT(A) upheld the assessee’s contention.
This decision was appealed against by the revenue to the High Court. Relying on its August 2009 decision in CIT v. Winsom Textile Industries Ltd., the Court affirmed the order of the CIT(A), opining that “[d]isallowance under Section 14A requires finding of incurring of expenditure where it is found that for earning exempted income no expenditure has been incurred, disallowance under Section 14A cannot stand”. While the decision doesn’t seem remarkable in itself, given the concerns expressed after Daga Capital, it serves as an assurance to assessees incurring expenditure and earning tax-free income through different parts of their business.
However, another twist to the issue is provided by the recent order of a Third Member of the Ahmedabad ITAT in Kanel Oil v. JCIT. Discussing the hierarchy between a Special Bench decision and the decision of a non-jurisdictional High Court, the Third Member held that the High Court would override only if there was no other conflicting High Court decision on the issue, and if the High Court decision was not per incuriam. On facts there, the Third member held that the High Court had ignored certain statutory provisions, rendering it per incuriam. On this basis, he held that the Special Bench decision would override the High Court. The merits of this decision, and the competence of a lower court to determine whether the decision of a higher court is per incuriam can be the subject of much independent debate. However, what is relevant here is to note that if Kanel Oil is to be followed, the position may be unsettled even after Hero Cycles. The computation scheme under Rule 8D(2)(ii) and (iii) specifically provides for disallowance even if there no nexus between the expenditure and the income. On this basis, it may be possible to argue that Hero Cycles ignores the text of Rule 8D, and being the decision of a non-jurisdictional High Court, need not be followed in Bombay, where Daga Capital’s Special Bench order would continue to hold fort.
In sum, Hero Cycles seemed to have provided a certain panacea to assessees concerned about the precise scope of Rule 8D and the decision in Daga Capital. However, the degree of relief afforded has been lessened by the uncertain implications of Kanel Oil.