Thursday, December 31, 2009

The Year That Was: A Round-up of 2009

The year began amid serious efforts by governments across the world to battle the fallout of the financial crisis. Although India escaped relatively unscathed from the direct effects of the crisis, it had experienced flight of capital from the country. While 2009 saw investors flocking back and aiding the recovery of the stock markets, India experienced its own crisis of sorts in the form of the financial fraud at Satyam. That required a swift response from the Government not only in terms of protecting the interests of the affected stakeholders, but also in occasioning regulatory reforms.

In this post, we recapitulate some of the key developments of the year in the corporate law sphere and related areas of interest, and ponder over what lies in store for the year ahead.

Business Entities

A new business vehicle in the form of the limited liability partnership took shape. The Limited Liability Partnership Act came into effect on April 1, 2009. It has been met with tepid success thus far, and its wider acceptance by the business community is likely to take some more time.

Moving to companies, significant regulatory reforms are underway. The Companies Bill, 2009 has been presented in Parliament, and is under active consideration. It was somewhat disconcerting that the Bill was presented in the same form it was in 2008 without taking into account the intervening developments surrounding Satyam. However, it appears that the Government is in the process of considering an overwhelming set of comments and suggestions received from various quarters, and one can expect changes to the Bill before it is finally passed. The progress of the Bill and the form the legislation is likely to finally take are significant developments to anticipate in the next year.

Reforms pertaining to company law administration have been hanging in balance for some time now. Although the Companies Act was amended in 2002 to herald the establishment of the National Company Law Tribunal (NCLT) to exclusively deal with corporate law matters thereby easing the burden of the regular stream of courts, this move has been mired in litigation. The Supreme Court, which completed its hearings earlier this year on the matter, is likely to pass its verdict on the constitutionality of the NCLT, which is still awaited - a development one can look forward to next year.

On a more optimistic note, the Competition Commission of India - whose establishment too was earlier ensnared in similar controversy – became active during the year.

Corporate Governance

The events in January 2009 surrounding Satyam captured the attention of the regulators, corporates, investors and observers for most part of the year. Due to what has been billed as the largest corporate fraud in India, the Government acted with great alacrity in rescuing the company and in protecting the interests of the investors, employees, creditors and customers. The board of the company was substituted by a Government-nominated panel of directors, who have been credited with the efforts that succeeded in keeping the company afloat. The company itself was finally sold to another Indian technology company. All of this was carried out under the aegis of the Company Law Board, which too displayed tremendous agility that was commanded by the situation.

As the magnitude of this episode possessed the capacity to tarnish the reputation of India as an investment destination and also its bellwether IT industry, a series of regulatory reforms were unleashed. Some of them immediately followed: mandatory disclosure of share pledges by promoters and amendments to the SEBI Takeover Code to exempt potential acquirers of Satyam from making an open offer.

On the corporate governance front, despite clarion calls being sounded for a complete overhaul of the existing norms, there was little progress towards reforms. However, the last few months of the year witnessed a flurry of activity on this count. While SEBI proposed changes to financial disclosures and audit norms, industry and professional bodies such as the Confederation of Indian Industry (through a separate Task Force) and the Institute of Company Secretaries of India have made detailed recommendations for strengthening corporate governance norms. These efforts have culminated in the publication of voluntary guidelines by the Ministry of Company Affairs that cover not only corporate governance, but also corporate social responsibility (this being the first concrete regulatory step as regards social responsibility).

Securities Regulation

The year witnessed significant changes on the primary markets front, consistent with SEBI’s continuing efforts to strengthen the markets. A mid-year round of reforms ushered the introduction of anchor investors in the Indian markets to whom shares can be allotted on a discretionary basis, along with continued improvements to the rights issue process. Subsequent reforms saw focus on the SME segment as well as on greater flexibility in pricing for follow-on public offerings. SEBI has also taken the opportunity to streamline primary market regulations by issuing the comprehensive SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009.

In other areas, SEBI’s approach has been more restrictive in nature. Although the Companies Act permits issue of shares with differential voting rights, SEBI decided to prohibit the issue of shares with “superior” voting rights. SEBI also decided to place further restrictions on the use of warrants in listed companies. It appears that SEBI has taken these steps to prevent the misuse of these equity or equity-linked instruments by promoters who may obtain undue advantage relative to other shareholders.

SEBI has also made significant changes in the mutual fund sector. These pertain to entry loads and the terms of distribution of units.

Mergers & Acquisitions

SEBI took a significant step this year by commissioning a review of the Takeover Code by a newly appointed Takeover Regulations Advisory Committee (TRAC) in order to overhaul the oft-amended and unduly complex set of norms that govern takeovers of Indian listed companies. TRAC has been receiving suggestions on the changes required, and it is expected that the existing Code will be revamped during the next year.

At the same time, the existing version of the Code was again subjected to strict scrutiny on at least a couple of matters. While SEBI provided informal guidance in the case of Bharti Airtel advising that depository receipts such as ADRs/GDRs will not attract the open offer requirements, the Code itself was somewhat unexpectedly amended shortly thereafter to clarify that holders of ADRs/GDRs will be obligated to make an open offer if they are entitled to voting rights under the depository agreement. An issue that is frequently the subject-matter of litigation under the Code is indirect acquisitions, and it did not disappoint this year either. The ruling of the Securities Appellate Tribunal in the Zenotech case has evoked considerable debate (please see 1, 2 and 3).

Separately, the complexity of the new regulations on delisting has been a source of consternation, and the failure of Bharti and MTN to consummate their merger talks also brought into limelight the issue of dual listings and the regulatory hurdles that exist currently.

Exchange Controls

Foreign investment through Indian holding companies has historically eluded clarity. In an effort to streamline the rules, the Government issued guidelines in the form of Press Notes 2 & 3 of 2009 that provided the mechanism for calculating foreign ownership in Indian companies, particularly when such foreign investment is indirectly through other Indian companies. In order to obviate any unintended consequences arising from these press notes, the government had to clarify the matter through issuance of a further Press Note 4. Nevertheless, matters appear not to have been fully resolved yet as there have been calls for further clarification of these rules. One measure of liberalisation though has been to eliminate caps on payment of royalties in foreign collaborations under the automatic route.

Since the law and policy on foreign investment has been scattered across various guidelines and press notes, the Government has recently undertaken a consolidation exercise by proposing a Master Press Note which will be periodically reviewed.

On the debt front, there has been a flip flop in terms of policy-making, but it is hard to criticise such an approach as that is dependent on prevailing market conditions from time to time. While the policy on external commercial borrowings were considerably liberalised at the beginning of the year, they have been subjected to some amount of tightening at the end of the year.


2009 has been an eventful year for India’s tax regime, both international and domestic. The controversy over the taxation of non-residents continued, with courts taking conflicting positions on the scope of the Supreme Court’s judgment in Ishikawajima-Harima. It is certain that the last word has not been said on this issue, and the taxation of non-residents for services that are “rendered” abroad but “utilized” in India remains a possibility. Fortunately, there is less disagreement about India’s conception of a “permanent establishment” for the purposes of tax treaties. Indian courts, over the past year, have taken a broad, commercial view of “auxiliary activities”, with the result that a liaison office in India assisting the operations of a non-resident may not constitute a permanent establishment. However, the recent decision of the Karnataka High Court on the withholding tax obligations of non-residents has generated substantial comment.

On the domestic front, the controversy over the scope of penalty proceedings for furnishing inaccurate particulars has been settled, by and large, in favour of the Revenue. With the Supreme Court expressly overruling judgments that had imposed a mens rea requirement for levying penalties under the Income Tax Act, it seems unlikely that this contention will succeed in the future, although it is not entirely free from doubt.

A lot has been said in 2009 about the permissibility of tax avoidance in India, and whether the distinction between tax avoidance and tax evasion persists. The Direct Taxes Code, if passed in its current form, will end this debate, for it contains specific “anti-avoidance” provisions.

2010 is likely to be an important year for taxation: India may witness a consolidation of its indirect tax regime, and there may be clarity on the fate of the DTC.

Commercial Dispute Resolution

There have been substantial developments in two important areas of dispute resolution: arbitration, and the role of the Debt Recovery Tribunal. In a series of judgments in 2009, the Supreme Court has reaffirmed its landmark, although much criticised, judgment in Bhatia International on the applicability of Part I of the Arbitration Act to international commercial arbitrations whose seat is outside India.

The Debt Recovery Tribunal’s role was not entirely clear, until the Supreme Court’s comprehensive judgment in August 2009. It is settled now that the exclusive jurisdiction that the DRT has over suits filed by banks cannot bar the jurisdiction of the civil court with respect to an “independent suit” filed by the borrower.

In all, there have been significant developments this year, and we do have a lot to look forward to in the coming year.

We wish all our readers a happy and prosperous 2010.

(With inputs from V. Niranjan on taxation and commercial dispute resolution)

Voluntary Guidelines on Governance and Social Responsibility

Corporate Governance

Earlier this month, we had highlighted the recommendations of the CII Task Force and the Institute of Companies Secretaries of India seeking reforms to the existing regime for corporate governance in India. Shortly thereafter, and based on various other suggestions received, the Ministry of Corporate Affairs has published the Corporate Governance Voluntary Guidelines 2009. The preamble sets the tone:

These guidelines provide for a set of good practices which may be voluntarily adopted by the Public companies. Private companies, particularly the bigger ones, may also like to adopt these guidelines. The guidelines are not intended to be a substitute for or addition to the existing laws but are recommendatory in nature.

While it is expected that more and more corporates should make sincere efforts to consider adoption of the guidelines, there may be genuine reasons for some companies in not being able to do so completely. In such a case it is expected that such companies should inform their shareholders about the reasons for not adopting these guidelines either fully or partially. It is hoped that “India Inc” would respond to these guidelines with keen interest. It is also hoped that by following good governance practices, the Indian corporate sector would be in a better position to enhance not only the economic value of enterprise but also the value for every stakeholder who has contributed in the success of the enterprise, and while doing so, it would be setting the global benchmarks for good corporate governance.

After taking into account the experience of voluntary adoption of these guidelines by the corporates and consideration of relevant feedback, the Government would initiate the exercise for review of these guidelines for further improvement after one year.
This is similar to the ‘comply-or-explain’ approach followed in the U.K. Substantively the guidelines cover areas such as board of directors, responsibilities of the board, the audit committee, auditors, secretarial audit and the institution of a mechanism for whistle blowing.

Corporate Social Responsibility

Almost simultaneously, the Ministry of Corporate Affairs has issued the Corporate Social Responsibility Voluntary Guidelines 2009. The preamble sets out the background:

CSR is not philanthropy and CSR activities are purely voluntary- what companies will like to do beyond any statutory requirement or obligation. To provide companies with guidance in dealing with the abovementioned expectations, while working closely within the framework of national aspirations and policies, following Voluntary Guidelines for Corporate Social Responsibility have been developed. While the guidelines have been prepared for the Indian context, enterprises that have a trans-national presence would benefit from using these guidelines for their overseas operations as well. Since the guidelines are voluntary and not prepared in the nature of a prescriptive road-map, they are not intended for regulatory or contractual use.

While it is expected that more and more companies would make sincere efforts to consider compliance with these Guidelines, there may be genuine reasons for some companies in not being able to adopt them completely. In such a case, it is expected that such companies may inform their stakeholders about the guidelines which the companies have not been able to follow either fully or partially. It is hoped that “India Inc.” would respond to these Guidelines with keen interest.

After considering the experience of adoption of these guidelines by Indian Corporate Sector and consideration of relevant feedback and other related issues, the Government may initiate the exercise for review of these Guidelines for further improvement after one year.
These guidelines cover the core elements of CSR and also provide guidance for their implementation.

In some sense, these guidelines represent a path-breaking step. It is true that several Indian corporate groups have been well-known for decades for their socially responsible behaviour, which has often received recognition in business and related literature. There have been efforts amongst the industry, professional associations and academia to engender a greater sense of social responsibility among companies. However, this step is unique as it represents the first concrete step regulatory standpoint that recognises the need for observance of CSR as a separate matter. Although this is only by way of exhortation rather than a mandatory requirement, it does send perceptible signals to corporate India.

We hope to blog more in due course about the detailed provisions of both sets of voluntary guidelines.

Compensating Investors: IPO Irregularities

SEBI has recently published a report by the Justice D.P. Wadhwa Committee in connection with irregularities in various IPOs in 2005. The report itself was, however, submitted by the Committee to SEBI as early as December 2007. In those IPOs, certain applications were made by certain persons using fictitious demat and bank accounts in the retail quota “so as to corner shares by using the favourable allotment chances for retail investors”.

While various legal proceedings and investigations have been initiated in the wake of these irregularities, the Wadhwa Committee was entrusted with the task of recommending the procedure for identifying persons who may have been deprived due to such irregularities so that they may be appropriately compensated through reallocation of shares.

After deliberation, the Committee established 3 principles for this purpose:

“a. To quantify the amount of unjust enrichment that has taken place, and which is the subject of reallocation.

b. To identify the genuine applicants who may be considered “deprived”.

c. To decide a basis on which the unjust enrichment is to be reallocated amongst the “deprived” applicants.”

As for the compensation amount through reallocation, the Committee felt that “the amount which is the difference of closing price of shares on the first day of listing / trading at NSE and the IPO price will be considered. These applicants will not be entitled for the market price movements subsequent to the listing.”

As regards the method of reallocation, the Committee recommends a “spillover” method. It notes:

Under this method, totally unsuccessful applicants shall be reallocated shares equally from the afferent pool, till they each receive the minimum shares allotted to the lowest category in the IPO. Once that number is reached, any afferent shares left over shall “spill over” and be reallocated to the partly successful applicants in the firm category and thereafter to the partly successful applicants in drawal of lots categories.
There are questions about the practicality of such an approach. The observations in an Economic Times editorial bear some merit:

[Compensating retail investors] is a long and convoluted process that will usurp regulatory time and attention at a time when there are graver issues that deserve its attention. The effort to compensate individual applicants who were not allotted shares because of the scam is simply not worth the trade-off in terms of time and money spent.

This is not to say perpetrators of the scam should be allowed to go scot free. Most certainly not! They should be made to disgorge their ill-gotten gains of close to Rs 100 crore and should be criminally prosecuted as well. But the money obtained will be better spent beefing up the Investor Protection Fund — and used to educate investors, the vast majority of whom are sorely in need of financial literacy — than going on a wild goose chase trying to identify losers in the IPO scam.
There are also some issues pertaining to the methodology for computing the amount: “Again, the Wadhwa committee arrives at the notional loss as the difference between the issue price and the closing price of the shares on listing. Why assume investors would have sold their shares on listing?”
In some respects, the report lacks a sense of finality as many factors, including the quantum of compensation, are dependent on the outcome of various proceedings pending before different fora that relate to the IPO irregularities.

Thursday, December 24, 2009

DIPP issues draft "Master Press Note"

The Department of Industrial Policy and Promotion has issued a draft Press Note dated 24th December 2010 ("PN") that is similar to the Master Circulars that we have on FEMA issued by the Reserve Bank of India. This 66 page Press Note is only a draft and comments are invited by 31st January 2010 after which a final Press Note would be issued. A couple of quick and preliminary comments.

  1. It is not wholly clear whether this PN will replace all earlier PNs or is merely intended to be a "manual" for guidance. At one place, it is stated that the PN " This Press Note consolidates into one document all the prior regulations on FDI and reflects the current ‘regulatory framework’ on FDI. It is clarified that this is a consolidation/compilation and comprehensive listing of most matters on FDI and is not intended to make changes in the extant regulations. While attempt has been made to deal with the subject comprehensively, if some aspect(s) has been left out then that will continue to be dealt in the current way where it is listed.". At another place, the PN says " All earlier Press Notes on FDI issued by Department of Industrial Policy and Promotion, Government of India stand rescinded.". To me, the intention appears to be that this PN, when finally issued, will replace all earlier Press Notes.
  2. Just as Master Circulars, this "Master" Press Note will have a sunset clause but unlike Master Circulars, the period is six months. The PN will be reviewed every six months in April and September.

More on this draft PN later.

- Jayant Thakur