Wednesday, March 31, 2010

The Supreme Court on Penalty

Earlier posts had discussed the decision of the Supreme Court in Dharmendra Textiles, and its subsequent interpretation by the High Courts and Tax Tribunals. One of the most important reading downs was seen in the decision of Mumbai Bench of the ITAT, in ACIT v. VIP Industries. The Tribunal there considered a case where penalty was levied because of an increase in taxable income resulting from a deduction claimed by the assessee being disallowed by the Assessing Officer. The Tribunal held that in such a case, since there is no ‘undisclosed’ income, the decision in Dharmendra Textiles could not be interpreted to require the imposition of a penalty. Now, the Supreme Court, in Reliance Petroproducts has affirmed this interpretation.

Section 271(1)(c) provides for the imposition of penalty in cases where the assessee ‘has concealed the particulars of his income or furnished inaccurate particulars of such income’. On the facts of the case before the Supreme Court, there was no question of concealment, and the same was not contended by the Revenue either. However, the Revenue argued that the incorrect claim for a deduction made in the return amounted to furnishing ‘inaccurate particulars of income’. The Court unceremoniously rejected this contention, holding, “By any stretch of imagination, making an incorrect claim in law cannot tantamount to furnishing inaccurate particulars”.

The Court then examined the decisions in Dilip Shroff and Dharmendra Textiles, observing that the latter had only overruled Dilip Shroff on the limited question of whether mens rea was essential for penalty to be levied under section 271(1)(c). In the opinion of the Court, the meaning of ‘inaccurate particulars’ provided in Dilip Shroff continued to be good law. Before the Court in Reliance Petroproducts, there was no question of mens rea, with the controversy being limited to whether an incorrect claim amounts to the furnishing inaccurate particulars. On this issue, the Court followed Dilip Shroff and held that unless there was error, falsehood, or inaccuracy in the returns filed, “A mere making of the claim, which is not sustainable in law, by itself, will not amount to furnishing inaccurate particulars regarding the income of the assessee. Such claim made in the Return cannot amount to the inaccurate particulars”.

IDR Offering Document

Here is the draft red herring prospectus for the first ever offering of Indian depository receipts (IDRs) proposed by Standard Chartered Bank. Particularly interesting is the section titled “Frequently Asked Questions on the IDR Facility” on pages 42-51 that provides details of operation of the IDR mechanism.

Governance Norms for Central PSUs

In 2007, the Central Government issued the Guidelines on Corporate Governance for Central Public Sector Enterprises (CPSEs). This was a measure introduced to bring corporate governance norms in CPSEs on par with the private sector. However, it was only a voluntary measure.

On March 25, 2010, the Government announced that the Guidelines would now be continued on a mandatory basis. Hence, all CPSEs will now be bound by requirements such as the composition of the board of CPSEs, audit committee, subsidiary companies, disclosures, code of conduct and ethics, risk management and reporting”.

This is a significant measure as public sector companies have often been found to be lacking in compliance with the corporate governance norms for all listed companies prescribed by Clause 49 of the listing agreement. The mandatory nature of the new guidelines may compel CPSEs to comply with higher standards of governance.

However, even with the new announcement, there could be continuing obstacles in ensuring full compliance with norms.

First, these guidelines are applicable only to CPSEs, being held by the Central Government, which constitute only a small proportion of public sector undertakings (PSUs). Those PSUs that are within the ambit of state governments’ authority do not require compliance with these guidelines.

Second, there are differences between the corporate governance norms for CPSEs introduced by these guidelines and the norms for listed companies generally under Clause 49. For instance, and just to take a minor example, the CPSE guidelines require listed CPSEs to have at least 50% of the board as independent directors, while Clause 49 has two thresholds at 33.33% and 50% depending on the identity of the chairperson. It is not clear as to which of the requirements are applicable to CPSEs or whether they are simply to comply with the more onerous of the two requirements.

Third, and as this column in the Financial Express notes, the mandatory guidelines may be of no avail if they continue to perpetuate the dominance of the controlling shareholder, being the Government. Rather, it is argued, that the interests of the public minority shareholders need to be specifically protected.

Thursday, March 25, 2010

E*Trade Mauritius: Reaffirming legal form over economic substance

The Authority of Advance Rulings has issued its ruling in the matter of E*Trade Mauritius; and the Ruling essentially follows the decision of the Supreme Court in Azadi Bachao Andolan. The facts before the Authority were that the Applicant was a company incorporated in the Mauritius, and had been issued a Tax Residency Certificate by the Mauritius income tax authorities. The Applicant was a subsidiary of a company incorporated in the United States of America. The Applicant held shares in an Indian company, IL&FS Investsmart Ltd. It transferred its shares in the Indian company to another Mauritius company. Under domestic law, the gains from this transfer (gains arising through the transfer of a capital asset situate in India) would be chargeable under Section 9 of the Income Tax Act. Having a tax residency certificate in Mauritius, the applicant claimed the benefit of Article 13(4) of the Indo-Mauritius DTAA. Under Azadi Bachao, the applicant would clearly be entitled to the benefit of the DTAA; and the gains would be taxable only in the residence country, Mauritius.

The Revenue however contended before the AAR, that “there is scope and sufficient reason to infer that the capital gain from the transaction arises in the hands of the US entity which holds the applicant company. In other words, the beneficial ownership vests with the US company which according to the department has played a crucial role in the entire transaction. Though the legal ownership ostensibly resides with the applicant, the real and beneficial owner of the capital gains is the US Company which controls the applicant and the applicant company is merely a fa├žade made use of by the US holding Company to avoid capital gains tax in India.” According to the Revenue, considering that the ‘real’ beneficiary was the US parent of the Mauritius applicant, the gains must be held to accrue to the US company. Under the relevant provision of the Indo-US treaty, the gains would be taxable in India. Contrary to this argument, the applicant contended that beneficial ownership is irrelevant in the context of Article 13 of the Indo-Mauritius treaty. Strong reliance was placed on Azadi Bachao.

The AAR analysed the decision in Azadi Bachao, and ruled, “…the Supreme Court found no legal taboo against ‘treaty shopping’ … if a resident of a third country, in order to take advantage of the tax reliefs and economic benefits arising from the operation of a Treaty between other countries through a conduit entity set up by it, the legal transactions entered into by that conduit entity cannot be declared invalid. The motive behind setting up such conduit companies and doing business through them in a country having beneficial tax treaty provisions was held to be not material to judge the legality or validity of the transactions.

The Revenue contended that where the incorporation of a Mauritius entity is merely a device or a sham, the ratio of Azadi cannot be applied. Again, the AAR clarified, once again on the basis of Azadi, that “… the word ‘device’ cannot be used ‘in any sinister sense’ and the design of tax avoidance by itself is not objectionable if it is within the framework of law and not prohibited by law. However, a transaction which is ‘sham’ in the sense that “the documents are not bona fide in order to intend to be acted upon but are only used as a cloak to conceal a different transaction” (per Lord Tomlin in Duke of West Minister) would stand on a different footing ….

In an earlier post discussing a recent English decision on lifting the corporate veil, Niranjan had stated that ‘sham’ is a legal concept which requires Courts to see what the legal substance of the relationship between the parties is. Courts are, however, not entitled to look at alleged ‘economic realities’ in deciding on the basis of allegations of sham. The AAR has held that the law in India after Azadi is the same, saying that “for acts or documents to be a ‘sham’, the parties thereto must have a common intention that they are not to create the legal rights and obligations which they give the appearance of creating…” Consequently, it was held that the Mauritius treaty would apply and the gains would not be taxable in India

While the decision does not contain any broad proposition of law beyond that which was already laid down in Azadi, it is significant for once again emphasizing that the ‘sham’ doctrine is a legal concept and not an economic concept. Further, the AAR has once again foiled the attempts of the Revenue to circumvent the ruling in Azadi by relying on McDowell’s case. Undoubtedly, McDowell’s case was decided by a larger Bench of the Supreme Court – that cannot be reason enough to supersede Azadi, which has elaborated on the true effect of McDowell. As the Bombay High Court had stated in Akshay Textiles, 308 ITR 401, and as once more clarified by the AAR, McDowell as interpreted and understood in Azadi is the law in India.

Wednesday, March 24, 2010

The Delhi High Court Departs from Samsung Electronics

One of the most pressing issues pending consideration of the Supreme Court is the appeal from the decision of the Karnataka High Court in Samsung Electronics. Earlier posts have considered whether the interpretation of section 195 proposed by the High Court is appropriate, and also the admission of the appeal by the Supreme Court. However, while the hearing before the Apex Court is due only in August this year, the Delhi High Court has delivered a telling blow, though not putting the issue beyond doubt.

The issue in Van Oord ACZ, India v. CIT, decided by the Delhi High Court last week, was whether the assessee, an Indian subsidiary of a foreign company, was required to deduct taxes on amounts paid as reimbursement to its parent company. In the proceedings before the Delhi Bench of the Income-tax Appellate Tribunal, the assessee had contended that the said amount was not taxable, and hence there was no obligation on the assessee to deduct tax at source on the amount. The Tribunal, however, held that it could not examine the chargeability of the amount, and since the assessee had failed to deduct tax at source, it would directly be considered ‘in default’, and would suffer the consequences of non-deduction provided under the Income Tax Act. On appeal, the Delhi High Court reversed this decision of the Tribunal.

The issue concerning non-deduction of tax on payments under section 195 is two-pronged: (i) whether chargeability is essential for deduction; and (ii) whether the assessee can make the determination of chargeability or has to make an application to the Assessing Officer under section 195(2) for making the determination. The Karnataka High Court, in Samsung Electronics, had decided both these questions against the assessee, holding that chargeability was irrelevant to the obligation to deduct, and that there must be an application under section 195(2). While the Delhi High Court has specifically departed from Samsung Electronics on the first issue, the stand taken on the second issue is ambiguous.

To begin with, the Delhi High Court is emphatic that deduction at source under section 195 is required only when the sum paid is chargeable under the Act. Relying on observations in the Supreme Court’s decision in Transmission Corporation, the Court holds that the Act does not impose an obligation to deduct tax on all payments made to a non-resident, irrespective of their chargeability. An earlier post on Samsung Electronics discussed how that decision led to this cumbersome conclusion. By categorically laying down chargeability as a prerequisite for deduction, the Delhi High Court has departed from this highly questionable interpretation of the provision.

However, on the issue of who is to make the determination of chargeability, the Delhi High Court leaves the issue curiously poised. The Court observes,

If the parties feel that either the deduction of tax at source by the payer is required to be at a rate lower than the prescribed rate or no deduction is required to be made they are required to file an application before the ITO for obtaining such certificate. In case no such application is filed before Assessing Officer for obtaining such certificate or such application is rejected by Assessing Officer and direction is issued by the Assessing Officer to deduct such tax at a particular rate the payer is duty bound to deduct tax as per the directions of Assessing Officer and in case no such application for obtaining the certificate was filed before the Assessing Officer then the payer is duty bound to deduct tax as per the prescribed rates in force at the relevant time.

The highlighted parts suggest that the Delhi High Court is in agreement with its counterpart in Karnataka that the appropriate authority to make the determination of chargeability is the Assessing Officer, and if no application is made under section 195(2), the assessee is bound to deduct tax at source. This conclusion is bolstered by the fact that the Court does not categorically disagree with Samsung, choosing instead to distinguish it on facts. The only extent to which it chose to depart from Samsung was on the question of whether chargeability is required for the obligation to deduct. Thus, looking at the cautious approach adopted by the Delhi High Court to Samsung, and the extract reproduced above, it would appear that Samsung remains untouched insofar as the obligation to apply to the Assessing Officer under section 195(2) is concerned.

However, this conclusion seems suspect due to two other observations made by the Delhi High Court:

First, the primary basis on which the Court comes to the conclusion that chargeability is a prerequisite for deduction is the inclusion of the phrase ‘chargeable under the provisions of this Act’ in section 195(1). However, this same phrase is also contained in section 195(2), clearly suggesting that there is no obligation to apply under section 195(2) for a sum which is not chargeable under the Act. This may be the reason why the Court, in the extract reproduced above, speaks of an obligation to apply when ‘no deduction is required to be made’, as opposed to when ‘the sum paid is not chargeable’. This distinction is important, since there may reasons other than chargeability, which result in deduction being unnecessary. For instance, if the entity to which the sum is paid (deductee) is a loss-making entity, there would be no tax levied on that entity even if the amount paid is chargeable. In such a case, the assessee (deductor) could possibly argue that since there is no tax liability on the deductor, there is no obligation to deduct on the Indian assessee. What the Delhi High Court does is to provide that in such a scenario, the assessee must deduct. It does not necessarily mean that there is an obligation to deduct even of the amount is not chargeable.

Secondly, even if the decision is read as meaning that there is always an obligation on an assessee to apply under section 195(2) irrespective of chargeability, the decision of the Court on the requirement of chargeability for deduction under section 195(1) denudes this supposed obligation under section 195(2) of all practical effect. This is because the Court specifically holds that if there is non-deduction, and it is subsequently discovered that the sum paid was not chargeable, the consequences of non-deduction do not attach to the assessee. In the words of the Court,

However, in case in the assessment proceedings relating to the recipient, it is ultimately held that the sum received by the recipient was not chargeable to tax, the effect of that would be that it was no obligation on the assessee to deduct tax at source on the sum paid to the said non-resident and in that eventuality, the assessee will not be treated as in default and would be absolved of any consequences for not deduction the tax at source.

Let us assume that an assessee chooses to take the risk and does not apply to an Assessing Officer under section 195(2), on the firm belief that the sum paid is not chargeable. In such a case, even if it is held that there was an obligation to so apply, a subsequent finding that the sum was not chargeable would absolve him of all liability for non-deduction.

Tuesday, March 23, 2010

Air Travel, International Airlines and Liabilities

(The following post comes to us from Sumit Agrawal, who is an alumnus of the National Law University, Jodhpur and associated with the Securities and Exchange Board of India (SEBI) as Legal Officer in its Integrated Surveillance Department. Views expressed herein are his own. Email:

Losing luggage on foreign land is a life-time experience, especially when you are about to start a journey to 3 countries and you are told by an airline that everything (from your shoes to fancy hat, digital camera to mobile charger) you packed to enjoy a 2-week tour is not available. One will wonder that with all sorts of baggage check-ins, bar-coding, scanning, baggage-tickets, and security exit-checks, how an airline could separate you from your bag. Believe it or not, you will consider yourself unlucky and the airline a deficient service provider.

In that situation, you will be reminded of a law called the Consumer Protection Act, 1986 which defines "deficiency" broadly as instances of fault, imperfection, or any inadequacy in services. In such cases, Consumer Disputes Redressal Fora and Commissions have the authority and jurisdiction to award compensation for delayed, lost or damaged baggage, including legal costs, compensation for mental trauma and interest. There is another law in such cases on which customers should fall back and that is the Carriage by Air (Amendment) Act, 2009, a newly passed law but hardly known to 'aam aadmi'.

It is interesting to note that India recently became 91st country to have ratified the Montreal Convention 1999 which does away with the archaic system of "compensating by weight" and adopts the more progressive, more consumer friendly and internationally recognized "compensate by passenger" system in cases of delayed, lost, damaged or destructed baggage. The Director General of Civil Aviation (India) had deposited with International Civil Aviation Organization (ICAO) on 1 May 2009, the Instrument of Accession by India to the Convention for Unification of Certain Rules for International Carriage by Air done at Montreal.

Under Article 253, entries 13 and 14 of Union List as provided under Constitution of India, Parliament is competent to make a law for implementing “any treaty, agreement or convention with any other country or countries or any decision made at any international conference, association or other body.” Quickly enough, the Carriage by Air (Amendment) Act, 2009, which incorporates the provisions of this Convention, came into force from 1 July, 2009. Under the Third Schedule to the Act, the liability of the carrier (airline) in case of destruction, loss, damage or delay can go up to 1000 Special Drawing Rights (SDRs) for each passenger and in case the passenger has made special declaration of higher value at the time of check-in then the liability can go up to such declared sum. SDRs are a currency conversion measure available on the website of International Monetary Fund (here and here), where 1 SDR values around Rs. 75. Hence, the airlines’ liability stands up to Rs. 75,000 per passenger for lost baggage if the values of items lost are within this limit and are allowed to be carried by law, say non-alcoholic, legitimate items, etc.

The new law also states that any provision tending to relieve the airlines of liability or to fix a lower limit than that which is laid down in statutory rules shall be null and void. In terms of rule 22, a court in addition to these limits can provide litigation costs and other expenses including interest. It is also interesting to note that this is applicable to airlines irrespective of nationality of aircraft provided the airline has a presence in India.

Therefore, gone are the days when airlines could escape their obligations under the pretext of their kilo-based iron-clad legally drafted policy compensating 20 US dollars for a kilo or by including some other hidden conditions. By bringing such an amendment, Parliament of India has not only brought Indian carriage law in line with international regime but has also imposed a sort of strict liability on airlines while dealing with customers belongings which they entrust to airlines with a duty to care.

Hopefully, the new law would act as a breather for harassed passengers from various tactics of airlines trying to bring compensation to the absolutely insignificant sum.

Parliament Has Done Its Duty, Now Let Airlines Do Theirs.

- Sumit Agrawal

Wednesday, March 17, 2010

Mutual Funds as Activist Investors

On several occasions, discussions on this Blog have pointed to the inadequacy of shareholder activism (spearheaded by institutional investors) in India, and have therefore called for greater participation of institutional investors in governance processes. A circular issued by SEBI on March 15, 2010 addressed to mutual funds and asset management companies represents an important step towards greater institutional investor participation in corporate governance of Indian listed companies.

Here are some extracts:

i. The issue of the role of Mutual Funds in Corporate Governance of listed companies was considered by the Mutual Fund Advisory Committee. It was felt that mutual funds should play an active role in ensuring better corporate governance of listed companies.

ii. It has been decided that henceforth, [asset management companies (AMCs)] shall disclose their general policies and procedures for exercising the voting rights in respect of shares held by them on the website of the respective AMC as well as in the annual report distributed to the unit holders from the financial year 2010-11.
In addition, mutual funds are required to disclose on their website as well as in their annual report the actual exercise of votes as general meetings of their portfolio companies on certain specified matters. The circular even prescribes a format for this purpose.

By imposing mandatory disclosure obligations and thereby enhancing transparency, this compels mutual funds to take a more active and considered role while exercising their voting rights on companies. It may no longer be possible for mutual funds to either abstain from voting or to grant proxies in favour of managements or promoters without following a reasoned decision-making process. This is particularly relevant because institutional investors such as mutual funds possess significant shareholding (at least in the aggregate, if not individually) with the power to tip the scales on key voting matters such as merger, change in control, preferential allotment of securities and the like.

Another aspect which is noteworthy is that one of the items which require disclosure of exercise of voting rights pertains to “social and corporate responsibility issues”. Coming a few months after the issuance of the Corporate Social Responsibility Voluntary Guidelines issued by the Ministry of Corporate Affairs, this represents an emerging trend whereby regulators and policy-makers in India are being increasingly sensitised towards matters of corporate social responsibility (CSR), socially responsible investing (SRI) and ethical investing. Naysayers may claim this is nothing but rhetoric; nevertheless, it will require mutual funds to disclose their policies and voting patterns on these matters that will compel such institutions to sit up and take note of these issues.

While the circular applies from a purely legal standpoint only to mutual funds, its broader message could well pave the way for greater shareholder activism in India led by institutional investors.

Monday, March 15, 2010

Stamp Duty on Amalgamations

The Mint has a column by Heena Singhvi that discusses the often contentious issue of whether stamp duty is payable on an order the High Court sanctioning a scheme of amalgamation between two or more companies. Of greater relevance is the discussion of the Delhi High Court decision in Delhi Towers Ltd. v. G.N.C.T. of Delhi (MANU/DE/3152/2009), delivered on 4 December 2009, where the court held that an order of the High Court sanctioning a scheme of amalgamation would fall within the definition of “conveyance” under the Indian Stamp Act, 1899 thereby requiring payment of stamp duty. That is so even where the definition does not expressly include such order of the High Court.

Although the court’s reasoning is not entirely unusual (having been adopted in the past by the Bombay High Court in Li Taka Pharmaceuticals Ltd. v. State of Maharashtra in 1997), it does clarify the position in Delhi. Moreover, greater acceptability of such interpretation may embolden stamp authorities in other states with similar definition of “conveyance” in their stamp duty legislation to levy duty in relation to schemes of amalgamation or even other forms of arrangement such as demergers.

Lehman Bankruptcy Examiner’s Report

The Report of the Examiner in the Chapter 11 proceedings of Lehman Brothers Holdings Inc. provides details about certain transactions that were carried out in the company and the manner in which they were accounted for in its books. The key transaction is question is referred to as “Repo 105”, and the New York Times Dealbook’s White Collar Watch has a nice summary:

The examiner’s report gives us a new term for hiding problems on a corporate balance sheet that may become common parlance: “Repo 105.” Starting in 2001, Lehman Brothers engaged in repurchase agreements, called “repos,” which were described by DealBook as “what amounts to a short-term loan, exchanging collateral for cash up front, and then unwinding the trade as soon as overnight.” Repos are a common method for investment banks to finance their operations and are neither illegal nor questionable, at least when clearly accounted for.

Lehman Brothers went a step further by having the collateral exchange under the agreement worth 105 percent of the cash it received — hence, the “105” in the firm’s nomenclature. By doing so, that turned it into a sale for accounting purposes, so that the firm could move the assets it exchanged in the deal off of its balance sheet, at least for a short while.

As explained by DealBook, “That meant that for a few days — and by the fourth quarter of 2007 that meant end-of-quarter — Lehman could shuffle off tens of billions of dollars in assets to appear more financially healthy than it really was.” By timing Repo 105 transactions to the end of a quarter, the reports filed with the S.E.C. and reviewed by investors looked much better than what was going to be the case just a short time later. Enron did much the same thing with some of its assets, such as its notorious Nigerian barge deal.
There is discussion about similarities with Enron, as Ideoblog too notes. As commentators expect a flurry of litigation against Lehman’s former officers and outside advisors, the existing corporate governance norms including the Sarbanes-Oxley Act of 2002 are likely to be put to intense testing. This would be particularly so with regard to the provisions pertaining to certification of financial statements and internal controls by the CEO and CFO.

Friday, March 12, 2010

Regulating Credit Rating Agencies

The RBI recently put out two documents, (i) the Report of the Committee on Comprehensive Regulation of Credit Rating Agencies prepared “in response to the direction given by the High Level Coordination Committee on Financial Markets to reflect on the inter regulatory issues emanating from the activities of Credit Rating Agencies”, and (ii) the Assessment of Long Term Performance of Credit Rating prepared by the National Institute of Securities Market. The NISM study complements the committee report.

The committee report reviews the role of credit rating agencies (CRAs) in India, the regulations governing the industry and makes certain recommendations. Its key findings are summarized as follows:

The committee feels that prima facie there is no immediate concern about the operations and activities of CRAs in India even in the context of the recent financial crisis. However there is a need to strengthen the existing regulations by learning the appropriate lessons from the current crisis. The committee has taken note of international action in this regard and inter alia recommend that there may be greater disclosures regarding materially significant revenues received from a particular issuer/ non rating business like advisory services. A lead regulator model for CRAs may also be explored. The committee has also strongly recommended voluntary compliance with existing and emerging regulations like IOSCO Code.
Both the committee report as well as the NISM study are quite extensive. In his blog, Professor J.R. Varma notes, however, that the terms of reference of the committee could have include at least two more important questions that currently continue to be unanswered. These are the reduction in the use of CRAs by regulatory authorities and the introduction of competition in the CRA sector in India.

Thursday, March 11, 2010

FIPB Website

I chanced upon a website dedicated solely to the Foreign Investment Promotion Board (FIPB). It is not clear as to how long this website has been in existence. Today’s Business Standard reports that the FIPB will soon commence receiving electronic applications, and that the e-filing facility will be formally launched tomorrow (March 12). This is a welcome development and will certainly go a long way in easing the application process for foreign investment under the approval route. In one sense, this may be seen a belated move, considering that other regulators such as the Ministry of Corporate Affairs had migrated to electronic filing systems a few years ago.

SEBI Order on Shareholding Disclosures

On March 8, 2010, SEBI passed an order in the case of Bank of Rajasthan (BoR).

SEBI commenced investigation into the shareholding pattern of BoR following a reference received from the Reserve Bank of India (RBI). Pursuant to the RBI Guidelines on Ownership and Governance in Private Sector Banks dated February 28, 2005, the promoters of BoR were required to reduce their shareholding in the company. SEBI’s order finds that while the promoters did in fact reduce their stake in the company, certain other companies fronting for the promoter group were acquiring BoR shares in parallel, and no disclosures were made regarding those acquisitions either under the listing agreement or the SEBI Takeover Regulations. SEBI’s order details a complex web of transactions through which inter-firm transfers of funds were made to the accounts of corporate bodies who purchased BoR shares; such purchaser entities had contact details similar to that of BoR’s promoters; and there were common directorships between the promoter group and the acquiring entities.

The SEBI order contains a summary of the transactions and their outcome:

18. The promoters of BoR have by way of their continuous disclosure publicly announced that their stake has been coming down from 44.18% as at quarter ending June 2007 to 28.61% as at quarter ending December 2009 which was clearly false. This evidently conveyed a misleading picture to investors, stock exchanges and to SEBI. While the promoters apparently conveyed the impression that they were reducing their shareholding, they did not in fact dilute their controlling stake in BoR. Indeed on the contrary they had actually increased their shareholding in a deceptive and fraudulent manner with the active connivance of others. It was planned in such a way that on paper their holding seems to have reduced but in reality, the holding of the promoters (controlled by the Tayal group) along with their front entities, had actually increased from 44.71% as at quarter-ending June 2007 to 60% as at quarter-ending March 2008 and stood at 55.01% as at quarter-ending December 2009. No disclosures related to acquisition were made to the stock exchanges by any of the acquiring groups or by BoR at any time over this extended period thereby providing misleading information to the investors in the scrip. In fact, the promoters of BoR and their connected entities have been trading in the shares of BoR without any disclosure to this effect to either the public or the stock exchanges.

19. The promoters and Tayal group entities had made fund transfers to the entities in the Yadav group so that these entities could purchase the shares of BoR from the open market. Later on, the Yadav group entities made off-market transfers to the promoter related Silvassa group entities. These Silvassa entities are located at addresses that are offices and manufacturing facilities of various other Tayal group companies. Thus, the Yadav group and Silvassa group were acting in concert with the promoters of BoR to disguise the actual stake of the Tayal Group in BoR. The artifice outlined above of disguising the ownership structure apparently also seems to have superficially resulted in compliance with the guidelines issued by RBI on ownership and shareholding. However, this has to be referred to RBI for further action as they may deem fit.
For these reasons, SEBI invoked the Takeover Regulations (in view of acquisition of substantial acquisition of shares by persons acting in concert without making disclosures or an open offer) and the Prohibition of Fraudulent and Unfair Trade Practices Regulations (stating that the transactions were prima facie fraudulent). In exercise of powers under the SEBI Act (including Section 11B), SEBI passed an far-reaching order restraining over 100 entities from accessing the securities markets and prohibiting them from buying, selling or dealing in securities in any manner whatsoever, until further directions.

The following are some quick thoughts:

1. It is heartening to note coordination and collaboration between regulatory bodies. SEBI’s investigation, culminating in its order, was initiated through a reference by the RBI. It is not known if such inter-regulatory body references to SEBI have occurred frequently, if at all, but it sets an interesting trend.

2. SEBI’s order is based on an analysis of fund flows and stock purchases. It relies on a determination of relevant facts, which represent several interconnected transactions, much of which is also arguably circumstantial. However, that usually tends to be the case in investigations concerning share transactions such as unfair trade practices or insider trading.

3. In the BoR case, SEBI has invoked its powers under Section 11B of the SEBI Act to debar several entities from dealing in the securities markets. That provision confers wide powers on SEBI to pass orders “in the interest of investors, or orderly development of securities market” and to rein in intermediaries. While the usage of this legal provision by SEBI has become quite widespread, the Supreme Court has recently provided some guidance on the nature and usage of the powers by SEBI. The Initial Private Opinion blog refers to a judgment of the Supreme Court of India in SEBI v. Ajay Agarwal, which holds that Section 11B is procedural in nature and can therefore be applied retrospectively, and that an order of SEBI under that section is not in the nature of penalty. There is also some general discussion about the nature and purpose of SEBI’s powers under Section 11B. (Update – March 16, 2010: Somasekhar Sundaresan reviews the Supreme Court judgment in his Business Standard column)

Tuesday, March 9, 2010

Voluntary Nature of Corporate Governance Norms

For the last ten years, corporate governance norms in India have been a mandatory requirement for large listed companies, through Clause 49 of the listing agreement. However, in the recent round of reforms, the Ministry of Corporate Affairs has deviated from that path to set out voluntary guidelines for corporate governance (discussed earlier here). Even though these guidelines come in the wake of the Satyam episode, there seems to have been a conscious departure from the mandatory approach adopted by way of Sarbanes-Oxley Act in the U.S. in the aftermath of Enron and other scandals. The present step is more akin to the “comply or explain” approach followed by the Combined Code of Corporate Governance in the U.K.

A paper titled Corporate Governance in the UK: Is the Comply or Explain Approach Working? observes as follows:

We find that the Code fostered compliance, especially in the areas not covered by its forerunner, the Cadbury Code. In an encouraging sign, more than half of the non financial constituents of the FTSE350 were fully compliant with all provisions of the Code at the end of 2004. In addition, we found that on average less than 10% of all firms were not compliant with a given single provision.

However the picture is not so rosy when analyzing those firms that did not comply with the provisions of the Combined Code. We find that the firms that did not comply with the Code often did a very poor job of providing explanations. Even worse, in almost one in five cases, firms did not provide any explanations for their non-compliances at all. Further, even when an explanation is provided, most of the time it fails to identify specific circumstances that could justify such a deviation from the rule. Companies that do not comply tend to stick with the same (poor) explanation until they directly jump to compliance. Once compliant, either a company remains compliant or if it stops complying, does not provide convincing explanations as to why this is the case.
It is too early to judge whether similar results will emerge in India. The Voluntary Guidelines are quite recent and will have to be worked for sometime before they can be empirically verified.

Monday, March 8, 2010

Board Diversity and Women Directors

On the occasion of the International Women’s Day, it is apt to consider the role of board diversity, particularly the participation of women directors, in corporate governance. A discussion in the Hindu Business Line finds that women in corporate boardrooms continue to be an exception rather than the norm. Some countries have addressed this concern by imposing specific requirements for women directors in their corporate governance norms. Several European countries have taken the lead in this direction. For example, Norway imposes a mandatory requirement to appoint women directors on its companies, and is the first country to do so – the Financial Times has an extensive report titled Skirting the Board, which analyzes Norway’s experience. Other countries that have taken (or are in the process of taking) similar steps are France, Germany and Spain.

There is also some empirical evidence that supports the role of board diversity. One study finds “significant positive relationships between the fraction of women or minorities on the board and firm value”. Another study by Renee B. Adams and Daniel Ferreira establishes other benefits of women directors, but raises some doubts as to their contribution towards firm value; the abstract states:

We show that female directors have a significant impact on board inputs and firm outcomes. In a sample of US firms, we find that female directors have better attendance records than male directors, male directors have fewer attendance problems the more gender-diverse the board is, and women are more likely to join monitoring committees. These results suggest that gender-diverse boards allocate more effort to monitoring. Accordingly, we find that CEO turnover is more sensitive to stock performance and directors receive more equity-based compensation in firms with more gender-diverse boards. However, the average effect of gender diversity on firm performance is negative. This negative effect is driven by companies with fewer takeover defenses. Our results suggest that mandating gender quotas for directors can reduce firm value for well-governed firms.
As far as Indian corporate governance is concerned, the issue of board diversity is yet to gain sufficient recognition. There has been very little discourse on this topic, including as to the requirement for women directors. Existing norms and proposals on corporate governance do not provide any coverage of this topic. Since board diversity does have some benefits, it is perhaps worth considering the issue at a policy level. Such consideration should keep in mind the relevant factors that are in operation in India, including the availability of types of individuals who would be suitable to occupy board positions, as well as various economic and cultural factors. It appears premature at this stage to impose a mandatory requirement of appointing minimum number of women directors in India, especially because the available empirical evidence is not clear, but it is certainly worthwhile for companies and their nomination committees to lay down parameters regarding board and gender diversity that may be applied while making board appointments. It is possible that a handful of blue-chip companies are already following such an approach, but that needs to be reflected in a widespread fashion.

Sunday, March 7, 2010

SEBI Decisions on Public Offers and Derivatives

SEBI has made some regulatory pronouncements at its board meeting yesterday that concern public offerings of securities and the derivatives markets.

As regards public offerings:

(i) SEBI has decided that all investors in public offerings (including retail investors) “would be required to bring in 100% of the application money as margin along with the application for securities”. This creates a level playing-field and makes demands more realistic, by removing the disparity between retail investors and institutional investors as the latter are only required to bring in 10% of the application money under the current regulations. The change is to take effect from May 1, 2010.

For a further detailed analysis of this change, please see an editorial and a column in the Financial Express.

(ii) Reservation for employees in public/rights issues would be available to employees of subsidiaries and material associates of the issuer whose financial statements are consolidated with the issuer’s financial statements. This change seems to have been long overdue, because the current scheme of things presented some form of inconsistency. While employees of subsidiaries were eligible to be issued stock options in the parent company, they were unable to participate in a public offering of the parent through reservations. This was the case both under the erstwhile SEBI (Disclosure and Investor Protection) Guidelines, 2000 and the SEBI (Issue of Capital and Disclosure) Regulations, 2009, which inconsistency has now been removed.

(In an earlier move relating to securities offerings, SEBI has called for certain details of qualified institutional placements (QIPs) to be filed with the stock exchanges for display on their website. These include details such as “allottes in QIP who have been allotted more than 5% of the securities offered in the QIP, viz names of the allottees and number of securities allotted to each of them [and] pre and post issue shareholding pattern of the issuer”. This is expected to enhance transparency in the QIP process.)

As regards, derivatives, SEBI’s board meeting decided as follows:

The Board further decided in principle to allow the Stock Exchanges to introduce:

a. equity derivatives contracts with tenures upto 5 years;

b. derivative contracts on volatility indexes which have suitable track record, and

c. physical settlement of equity derivatives.
The last aspect of physical settlement bears importance. When stock derivatives were introduced in India about a decade ago, the strategy was to follow a phased process. Initially, trades were to be settled in cash (in the form of contracts for differences) and, after necessary systems were put in place, the settlement of derivative contracts were to be allowed through physical settlement (i.e. through delivery of securities). Until now, derivatives on the exchange have been cash-settled and SEBI’s decision is recognition of the transition to the next phase of derivatives trading in the Indian markets.