Wednesday, May 19, 2010

‘Sweat Equity’ vs. ‘Sweet Equity’ – a Legal Perspective

(In the following post, Rohan Bagai analyzes the regulations relating to ‘sweat equity’ under Indian company law in the light of recent events surrounding the Indian Premier League. Rohan is a corporate lawyer at one of the leading law firms in India. He holds a Master of Laws (LL.M.) degree from New York University School of Law (NYU), New York with a specialization in corporate laws)

The recent Indian Premier League (IPL) brouhaha has triggered off an avalanche of hype and muckraking. This entire debate sparked off with Mr. Lalit Modi’s tweet, opening up a can of worms, disclosing the stake holdings in the newfangled IPL Kochi franchise led by the consortium of Rendezvous Sports World (RSW), particularly the much publicized sweat equity stake held by Ms. Sunanda Pushkar (although that was subsequently surrendered by her to illustrate her bona fide).

Given the hullabaloo created by this IPL-gate, various legal dimensions have emanated, which are being probed by the Government through its various agencies. However, one aspect in this entire episode, which has not been adequately examined and rather needs a serious debate, is that of “sweat equity” and the legal ramifications thereof. The purpose of this post is to examine the legal regime pertaining to “sweat equity” in the light of facts that have been reported in the media. Of course, several aspects are subject to further investigation, but they nevertheless provide a platform on which to analyze the legal regime.

It is significant to note that Section 79A of the Companies Act, 1956, authorizes a company to issue sweat equity shares, subject to prescribed guidelines drawn by the Department of Company Affairs, i.e. the Unlisted Companies (Issue of Sweat Equity Shares) Rules, 2003 (Sweat Equity Rules). In essence, sweat equity shares are issued by a company to its employees or directors at a discounted rate or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights (IP) or other value additions. In the present context, Ms. Pushkar may well have to justify the sweat equity given to her in terms of her role/contribution to RSW in the form of IP or know how or other value additions. Keeping in mind the aforesaid definition of sweat equity, wherein only an employee or director of the company is entitled to such a stake, her purported role of a sales and marketing consultant with RSW may be a clear question mark. Even the board of RSW will be accountable vis-à-vis issuance of sweat equity.

Apparently, as sweat equity shares were issued for a non-cash consideration, RSW would have ideally engaged auditors or chartered accountants to carry out valuations of the IP or know-how or other value additions in order to justify such issuance of sweat equity in accordance with Rule 9 of the Sweat Equity Rules. This is one aspect which needs to be thoroughly probed, more specifically on compliance of such prescribed statutory requirements.  

Further, Rule 6 bars a company from issuing sweat equity shares of more than 15% of total paid up equity share capital in a year or shares in excess of the value of Rs. 5 crore, whichever is higher. In the event the ceiling is to be exceeded, prior approval of the central government would be required. In the instant case, the reported issue of sweat equity was for Rs. 70 crores, i.e. over and above the ceiling stipulated under the said Sweat Equity Rules and that too without prior Central Government approval. Hence, an aspect which needs to be examined is whether such an important prerequisite for issuing sweat equity under the Companies Act has been flouted.

The Companies Act also stipulates a pre-condition that at least 1 year should have elapsed from the day of commencement of business by the company on the date of issuance of sweat equity. In this regard, RSW reportedly became operational only in March 2010. This fact needs to be verified by the Registrar of Companies (ROC) and the Ministry of Corporate Affairs and if it does come out to be accurate, it may constitute a violation of the Companies Act.

In addition, the Companies Act, 1956 stipulates that sweat equity shares should be of the same class as already issued by the company and such an issuance is required to be authorized by a special resolution passed in the general meeting. This special resolution must specify, inter alia, the number of shares, current market price, and class or classes of directors or employees to whom these equity shares are to be issued. Likewise, Rule 4 of the aforesaid Sweat Equity Rules requires an explanatory statement to be annexed to the notice for the said general meeting, which includes the reasons/justification for the issue, the number of shares, consideration and the person's relationship with the company. Furthermore, a separate resolution for approval of shareholders in the general meeting would be necessary if the sweat equity stake is equal to or more than 1% of the issued capital on the date of such issuance. Given such strict requirements, there is a need for closer scrutiny on whether the due process of law and the relevant provisions of the Companies Act relating to shareholders approval prior to issuing sweat equity were complied with.

What is unique about this contractual arrangement between RSW and Ms. Pushkar is that the sweat equity issued was supposedly ‘undilutable in perpetuity’ and that it had a lock-in period of just 2 years, whereas the Companies Act nowhere provides for “undilutable sweat equity in perpetuity’. Most importantly, Rule 10 of the Sweat Equity Rules prescribes a minimum lock-in period of three years for sweat equity, which means that the equity so issued cannot get cashed out before the expiry of three years from the date of allotment. A detailed inquiry would only reveal as to whether such terms and conditions were duly complied with; if not, the circumstances and consequences thereof.

It remains to be seen what the governmental investigations eventually yield. This blurred imbroglio, once again, has exposed India’s age-old issues on transparency and governance across all spectrums of public life – be it sports, be it politics, be it corporate ethics. This is one lurking menace, which needs to be fixed once & for all and here is one opportunity!

- Rohan Bagai


saurabh said...

Hi Rohan

Nice Article. Clarified some concepts.

I just wanted to know, from where has this value of Rs 70 Crore come ? Was this value mentioned explicitly in some document / agreement or was it some silly speculative calculation done by the media ?

While there can be no justification for giving sweat equity to sunanda pushkar, I believe that this amount of Rs 70 crore was just some weird calculation done on the basis of the auction amount bid by kochi consortium.

If this was the logic, is there a legal basis on which such valuation can be done on the basis of a single bid that a company makes as opposed to sweat equity valuation done on the basis of equity?

Lawman said...

Good Article.

However, I didnt quite get the conclusion part. are you suggesting any changes in the regulations? As I understand, this is a clear instance of violation of laws requiring penal action (and not any overhaul in law).

Kind Regards,

Rahul Bakshi said...

pretty good stuff.. wht i lik bout this article is tht it jus doesnt provide legal jargon but is opinionated and enjoyable as wel..

keep up the good work..

Rahul Bakshi said...

wht i lik the most about this article is tht its not jus a bundle of legal jargon but is opinionated and enjoyable to read. alas transprncy n accountblity r attributes tht r yet to enter the indian sociopolitical fabric..

keep up the good work..

-Rahul Bakshi

Rohan said...

@saurabh: thanks a ton. well, yes. the sweat equity amount is speculative, which merely cropped up as a result of Modi's tweet disclosing Ms.Pushkar's sweat equity stake. However, it may be pertinent to note that the purported amount/percentage has not been contradicted even once by Ms.Pushkar! She has merely justified the issuance, if any.

Rohan said...

@lawman: thanks. at the outset, my post intends to outline the legal issues that evolve from this issuance of sweat equity to Ms. Pushkar. Whether there have been any violations or not, in the present context, can only be determined after the completion of all governmental investigations. with regard to the conclusion, it is my attempt to draw light to the age-old ills of lack of transparency and enforcement, which plague our nation!

Rohan said...

thanks rahul for your kind words!

Shabnam Bhaya said...

Hello Rohan

Read the article.I am aware of the main controversies as I had followed the news when this was the hot topic recently.But it is great to read your views!
Ms Sunanda, as I learn, will soon be Mrs Tharoor and that explains a lot.....!

Meera Kaura said...

Good article Rohan. Indeed, the government has an oppurtunity to deal with tranparency issues. But I bet this is not the first time...

Meera Kaura Patel

Derek Ralet said...

Very interesting article. It clarifies some important issues to open the debate on the matter.

Keep it up,



Rohan said...

thank you all for your words of encouragement!

Anonymous said...

Three Directors of the Company have not drawn salary since last 15 years, now we want issue Sweat Equity Shares to the 3 Directors for serving, guiding and managing the company, equivalent to their salary amount. Is it possible issue Sweat Equity shares to the Directors in this situation? if so, the issual of sweat equity shares falls under which category, whether know how or value additions or any other?

Anonymous said...

Company being a Listed Company, is there any limitation in % of Sweat Equity Shares that can be issued per year?

Anonymous said...

Applicability of Takeover : At present Promoters are holding 41%, including the 3 directors holding of around 4, 4 & 6 % each. Suppose after the issual of Swear Equity Shares to the Directors, promoters holding will goes up to 64% and directors holding goes up to 15+ % each, whether in this situation Takeover code applies only to Promoters or both( ie pormoters and directors).

Rohan said...

Yes, in such a situation, the directors may be issued sweat equity. Considering that these longstanding directors may not be able to justify the IP or know-how requirements, 'value additions' seems to be the most suitable category.

Rohan said...

Please note that the SEBI (Issue of Sweat Equity shares) Regulations, 2002 does not presribe any limitation in the % of sweat equity. However, it is relevant to note that sweat equity being a part of the managerial remuneration, would be subject to the 'ceilings on managerial remuneration' provided under the Companies Act, 1956.

Rohan said...

In such a scenario, the Takeover Code should apply to both the promoters as well as the directors, given the fact that the shareholding of each of the directors now exceeds the trigger point of 15% provided under the Code.

Ritika Ganju said...

Congratulations Rohan!

A great piece of analysis to read and well done with getting all the facts of the story together.

Rohan said...

thanks a lot for your words of encouragement Ritika!

Ankit said...

Issue of Sweat Equity to non-employees:

Definition 2.(v)(b)
(b) monetary consideration payable under any other contract, in the case of non-employee.

Doesn't this mean that sweat equity can also be issued to a non-employee? Also, the remaining text of regulation speaks nothing about "non-employee", so can it be assumed that all other limitations (like lock-in period etc.) do not apply to sweat equity issued to non-employees?

Mohit Sahney said...

Can I have your contact no. Rohan as want to consult you on sweat equity