Tuesday, August 31, 2010

Fraud and the amendment of a section 34 application

In an important fallout of the Satyam controversy, the Supreme Court, earlier this month, reiterated the law on the amendment of section 34 applications, and also clarified the kinds of fraud that would justify the setting aside of arbitral awards on grounds of public policy. After the fraud perpetrated Mr. Raju, Venture Global sought to amend its section 34 and bring the facts about the fraudulent conduct on record. Before the AP High Court, Satyam successfully contended that the amendment of the pleadings was hit by the limitation period prescribed under section 34, and could not be allowed. Venture’s appeal against this decision fell for the Supreme Court’s consideration.

Section 34 of the Act, in its relevant part, reads-

34. Application for setting aside arbitral award.

(1) xxx

(2) xxx

(a) xxx

(b) the Court finds that-

(i) the subject-matter of the dispute is not capable of settlement by arbitration under the law for the time being in force, or

(ii) the arbitral award is in conflict with the public policy of India.

Explanation.-Without prejudice to the generality of sub-clause (ii) it is hereby declared, for the avoidance of any doubt, that an award is in conflict with the public policy of India if the making of the award was induced or affected by fraud or corruption or was in violation of section 75 or section 81.

(3) An application for setting aside may not be made after three months have elapsed from the date on which the party making that application had received the arbitral award or, if a request had been made under section 33, from the date on which that request had been disposed of by the arbitral tribunal:

Provided that if the court is satisfied that the applicant was prevented by sufficient cause from making the application within the said period of three months it may entertain the application within a further period of thirty days, but not thereafter. [emphasis supplied]

Based on the language of the provision, there were two arguments available to the Satyam- (a) that the extended period of 30 days, contained in the proviso to clause (3), had expired and it was not open to the Court to allow any further extension; and (b) that the fraud in question had not induced or affected the award, and was not relevant for the purposes of section 34. The first of these arguments had been considered and rejected by the Supreme Court in State of Maharashtra v. Hindustan Construction Company. In this case, the Apex Court had been called on to consider whether the limitation period applied only to fresh applications for setting aside awards, or also to amendments to existing section 34 applications. The Court held that amendments to existing applications, if necessary in the interests of justice, and not amounting to a fresh application, would not be barred by the proviso to section 34(3). (A more detailed discussion of the decision is available here).

That then left only the question of whether the fraud perpetrated by Mr. Raju could be said to have induced or affected the impugned award. Mr. Salve contended for Satyam that the phrase ‘making of the award’ had to be read narrowly, and that events subsequent to the award had no bearing on a section 34 application. Mr. Venugopal, for Venture Global, contended that since the facts were not revealed by Mr. Raju until after the award, there was no way they could have been made part of the original section 34 application. Also, since the concealment had materially affected the passing of an award in Satyam’s favour, it was material for the purposes of setting aside the award. Accepting the Respondent’s contentions, the Supreme Court overturned the decision of High Court and allowed the amendment of the application. The Court observed that the phrase ‘making of the award’ could not be read narrowly, especially since the scope of the provision was widened by the phrase ‘induced or affected’. Further, the Court went on to elucidate on its conception of public policy in the following words-

The concept of public policy in ABC, 1996 as given in the explanation has virtually adopted the aforesaid international standard, namely if anything is found in excess of jurisdiction and depicts a lack of due process, it will be opposed to public policy of India. When an award is induced or affected by fraud or corruption, the same will fall within the aforesaid grounds of excess of jurisdiction and a lack of due process. Therefore, if we may say so, the explanation to Section 34 of ABC is like `a stable man in the saddle' on the unruly horse of public policy. [emphasis supplied]

Thus, the Court concluded that the amendment of the section 34 application could not be barred by limitation in the interests of justice, and that the fraud alleged was such as to fall within the scope of fraud which had ‘induced or affected the making of the award’. On this basis, the decision of the High Court was overturned. (Another exhaustive discussion of the decision is available here).

On a concluding note, one issue discussed earlier seems to be interesting in the context of the discussion above. In Moore Stephens, the House of Lords had held that fraud by the ‘directing mind and will’ of a company will be attributable to the company is all cases, except when the company itself is a victim (as opposed to a vehicle) of the fraud. In the case of Satyam, whether the company was a vehicle or a victim of the fraud is open to argument. Hence, in a case like this, it may be possible to argue that the fraud perpetrated by Mr. Raju is not attributable to Satyam. However, on the text of section 34, there is no requirement that the fraud which ‘induced or affected the making of the award’ be attributable to a party to the arbitration proceedings. It is probably for this reason that the question of attribution was not argued before or considered by the Court. It is instructive to contrast the Indian language with that of the English Arbitration Act, 1996, which talks of an award ‘being obtained by fraud’. The use of the word obtained (as opposed to influenced or affected) can be taken to signify that under English law, the fraud in question should be attributable to a party.

On this reading of the provision, it seems that the question of attributability of the fraud is not relevant for the purposes of section 34(3). However, on a closer examination of the decision of the Supreme Court, there are a couple of observations which can be taken to be assumptions by the Court that fraud under section 34 is fraud attributable to a party. First, the Court cites and approves the provision in the English Arbitration Act, which, as seen above, can be interpreted as containing the requirement of attribution. Secondly, there is the observation of the Court that “If the argument advanced by the learned counsel for the respondents is accepted, then a party, who has suffered an award against another party who has concealed facts and obtained an award, cannot rely on facts which have surfaced subsequently even if those facts have a bearing on the facts constituting the award ... Such a construction would defeat the principle of due process and would be opposed to the concept of public policy incorporated in the explanation” [emphasis supplied]. Admittedly, neither of these instances are authority for the proposition that attribution of the fraud to a party has been read into section 34 by the Court. This is especially so given broad observations like “if the concealed facts, disclosed after the passing of the award, have a causative link with the facts constituting or inducing the award, such facts are relevant in a setting aside proceeding and award may be set aside as affected or induced by fraud”. However, since the Court only decided that the application may be amended to make fraud a ground, and did not dispose of the question of whether the award may be set aside on grounds of fraud (which being a question on merits, is still to be decided by the lower courts), there is always the possibility that this question comes up for consideration in future.

Monday, August 30, 2010

Direct Taxes Code Bill, 2010

The Direct Taxes Code Bill, 2010 was introduced in Parliament earlier today. A copy of the Bill can be downloaded from here. Over the next few days, we will discuss some of the provisions of the Bill in greater detail. For now, some news reports on the DTC are linked below:

Corporate India Cautious in welcoming DTC (Economic Times)

DTC may boost investment flow into capital markets: Analysts (Economic Times)

Direct Tax Code tabled: What do experts make of it? (Moneycontrol)

Saturday, August 28, 2010

Nomination of Directors by Shareholders

Earlier this week, the U.S. Securities and Exchange Commission (SEC) adopted the much anticipated proxy access rule which allows shareholders to nominate candidates for directorship. The essence of the new rules is as follows:

The new rules require companies to include the nominees of significant, long-term shareholders in their proxy materials, alongside the nominees of management. This "proxy access" is designed to facilitate the ability of shareholders to exercise their traditional rights under state law to nominate and elect members to company boards of directors.

Under the rules, shareholders will be eligible to have their nominees included in the proxy materials if they own at least 3 percent of the company's shares continuously for at least the prior three years.
This has generated an extensive debate (e.g. on the Conglomerate Blog) as to whether such proxy access to shareholders has merit when it comes to nomination and appointment of directors.

All of this might seem like “much-ado-about-nothing” in parts of the Commonwealth where shareholder rights to nominate directors have been available traditionally within law. For example, in India, shareholders have extensive rights under the Companies Act, 1956 to determine the composition of the board (Sec. 257: propose candidates for directorship; Sec. 263: vote for appointment of directors; Sec. 284: vote for removal of directors). To that extent, the developments under U.S. federal law continue to trail behind the position in many parts of the Commonwealth such as India as regards shareholder democracy under corporate law. Even though proxy access has enhanced rights of shareholders in U.S. companies, those additional rights come along with stringent conditions (such as the requirement to own 3% over 3 continuous years).

Friday, August 27, 2010

SEBI’s Domain Over Auditors of Listed Companies

Earlier this month, the Bombay High Court issued its judgment in the case of Price Waterhouse & Co. v. Securities and Exchange Board of India. The court ruled that SEBI possesses necessary powers to initiate investigations against an auditor of a listed company for alleged wrongdoing.

Facts: A writ petition was filed before the Bombay High Court by Price Waterhouse & Co. (PWC) and some of its partners and affiliates challenging a show cause notice issued to them by SEBI. This pertains to PWC’s audit of Satyam Computers and their alleged failure to detect financial wrongdoing within the company of significant magnitude that in turn resulted in severe losses to Satyam shareholders. The financial wrongdoing included overstatement of cash and bank balances, non-existent accrued interest, overstated debtor position and the like. SEBI’s show cause notice sought to initiate action against PWC under Sections 11, 11B and 11(4) of the SEBI Act and Regulation 11 of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Markets) Regulations, 2003. Although PWC raise objections regarding jurisdiction of SEBI before its member, no order was passed on jurisdiction, which then prompted PWC to file the writ petition before the Bombay High Court for quashing the pending proceedings before SEBI.

Arguments: The principal arguments raised by PWC are that SEBI does not have the requisite jurisdiction to initiate action against auditors who are discharging their duties as professionals. SEBI can only regulate the securities markets and that auditors can never be considered to be associated directly with the securities markets. Moreover, PWC argued that there is already an established legal regime in the form of the Chartered Accountants Act, 1949 (and the Institute of Chartered Accountants of India (ICAI) established therein) that governs the accounting profession and hence any restrictions on the practice of that profession can be imposed only by the ICAI. Only the ICAI can determine whether there has been a violation of applicable auditing norms. Failing this, SEBI would be seen as encroaching upon the powers of the ICAI.

On the other hand, SEBI argued that the investigation pertains to a corporate scam that had a cascading effect on the price of Satyam’s shares and consequently on the securities markets as a whole. Since the auditor’s role is to certify the books of accounts of the company, persons dealing in the securities markets are likely to place reliance upon those accounts while making investment decisions. Consequently, it is argued that SEBI has jurisdiction to take appropriate steps in relation to auditors of listed companies.

Issues: The key questions before the court were (i) whether the show cause notice issued by SEBI was without jurisdiction so as to require quashing of such proceedings; and (ii) whether the proceedings initiated by SEBI amount to an encroachment of the powers of the ICAI under the Chartered Accountants Act.

Decision: The court analyzed the powers of SEBI under various provisions of the SEBI Act. It found various measures were available to SEBI that could be employed in regulating the securities markets. Those powers were of wide amplitude which would “take within its sweep a chartered accountant if his activities are detrimental to the interest of the investors or the securities market”. The court found that by taking remedial measures to protect the securities markets, it cannot be said that SEBI is regulating the accounting profession. SEBI’s general domain extends to protecting investors of listed companies and the securities markets. In exercise of such powers, there is no reason why SEBI cannot prevent any person from auditing a public listed company. Even though the auditors are not directly involved in the securities markets, the court found that since investors rely heavily on the audited accounts of the company, the statutory duty of the auditors and discharge thereof “may have a direct bearing in connection with the interest of the investors and the stability of the securities markets”. The court finally ruled that the powers of SEBI are independent of those held by the ICAI and hence SEBI cannot be said to encroach upon the powers of the ICAI under the Chartered Accountants Act.

Analysis: The judgment is important as it establishes the regulatory domain of SEBI over auditors of listed companies. The court largely arrives at its conclusions based on an analysis of SEBI’s powers to regulate the securities market, which is then contrasted with ICAI’s powers to regulate the accounting profession.

A greater significance of this judgment is that it establishes the role of an auditor to be closely linked with the functioning of the securities markets. Inherent in this analysis is the fact that proper performance of audit role in listed companies is a prerequisite for investor protection which is crucial to maintain robust securities markets. If audit and investor protection are said to be interconnected, it then takes us to a fundamental legal question: do auditors owe a duty to shareholders/investors? The Bombay High Court, in this case, appears to answer in the affirmative: “The auditors in the company are functioning as statutory auditors. They have been appointed by the shareholders by majority. They owe a duty to the shareholders and are required to give a correct picture of the financial affairs of the company.” [emphasis added]. Although the court cites to Institute of Chartered Accountants of India v. P.K. Mukherjee to state that auditors owe duties to shareholders in a company, that case had largely to do with a provident fund and its beneficiaries and it is not clear whether the ruling has any direct application to the present situation.

More importantly, the fact that auditors owe duties to shareholders seems to move away from conventional wisdom. In cases involving civil liability, the general position appears to be that the duty of reasonable care in carrying out audit of the company’s accounts is owed to the company in the interests of its shareholders, and that no duty is owed directly to individual shareholders. This has been solidified ever since the House of Lords pronounced its decision in Caparo Industries Plc v. Dickman [1990] 2 A.C. 605 (H.L.). The Bombay High Court’s judgment in the PWC steers clear of any detailed discussion regarding this jurisprudence. At one level, it may be argued that this discussion is not necessary in view of SEBI’s wide powers under the SEBI Act, but since those powers are derived from the investor protection mandate of SEBI, those powers may not be available if auditors do not have duties to individual shareholders in the first place. It is not clear if the discussion of auditors’ civil liability to individual shareholders can be divorced from auditors’ subjection to powers of a securities regulator acting to protect the investor community.

Although the judgment is confined to auditors, it remains to be seen whether third parties such as other advisors involved in securities markets activity (generally referred to as “gatekeepers”) could be drawn into the ambit of SEBI’s powers. Even here, courts in other jurisdictions have been slow to impose civil liability on such third parties. E.g. the U.S. Supreme Court decision in Stoneridge v. Scientific Atlanta. As far as certain gatekeepers such as investment/bankers and credit rating agencies are concerned, they are subject to SEBI's domain by virtue of registration under relevant SEBI regulations that apply to them.

The last word is yet to be spoken in the matter, since the judgment itself indicates that PWC has sought to file a special leave petition before the Supreme Court.

Thursday, August 26, 2010

Bits of Interest

1. SEBI and Auditors: It was reported a few days ago that the Bombay High Court has allowed SEBI to proceed with its enquiry against the auditors in connection with the Satyam scam. The judgment is now available on the Bombay High Court website.

2. Satyam Saga: With all the accused persons now having been released on bail, questions are being raised regarding the investigative and prosecutorial processes in India. On the other hand, the current state of affairs may be viewed as resulting from the undue complexity of the case. See Shyamal Majumdar in the Business Standard and this discussion on CNBC.

3. Foreign Investment in Pharma: The Department of Industrial Policy and Promotion has released a discussion paper titled “Compulsory Licensing” that seeks to ensure the “availability and affordability of pharmaceutical products” to Indian consumers. Noting the several recent instances of takeovers of Indian pharma companies by multinationals, it seeks to restrict the foreign investment regime in the pharma industry. One of the options proposed is as follows:

Presently, investment up to 100% in the pharmaceutical sector is on the automatic route. This could be shifted to the government route so that proposals for mergers and acquisitions in this important sector could be scrutinized by the FIPB. This could be a way of monitoring whether new technology is being brought in by a foreign company while taking over an Indian company.
4. CSR: Mandatory or Voluntary: We had earlier discussed the merits and demerits of imposing mandatory CSR requirements among companies. In this Wall Street Journal column, Aneel Karnani is agnostic about managers’ ability and their motivation to pursue CSR. He notes:

Very simply, in cases where private profits and public interests are aligned, the idea of corporate social responsibility is irrelevant: Companies that simply do everything they can to boost profits will end up increasing social welfare. In circumstances in which profits and social welfare are in direct opposition, an appeal to corporate social responsibility will almost always be ineffective, because executives are unlikely to act voluntarily in the public interest and against shareholder interests.

Executives are hired to maximize profits; that is their responsibility to their company's shareholders. Even if executives wanted to forgo some profit to benefit society, they could expect to lose their jobs if they tried—and be replaced by managers who would restore profit as the top priority. The movement for corporate social responsibility is in direct opposition, in such cases, to the movement for better corporate governance, which demands that managers fulfill their fiduciary duty to act in the shareholders' interest or be relieved of their responsibilities. That's one reason so many companies talk a great deal about social responsibility but do nothing—a tactic known as greenwashing.

Managers who sacrifice profit for the common good also are in effect imposing a tax on their shareholders and arbitrarily deciding how that money should be spent. In that sense they are usurping the role of elected government officials, if only on a small scale.
Karnani then discusses the role of various players such as the government/regulators and civil society as well as of self-regulation by companies, and then concludes:

In the end, social responsibility is a financial calculation for executives, just like any other aspect of their business. The only sure way to influence corporate decision making is to impose an unacceptable cost—regulatory mandates, taxes, punitive fines, public embarrassment—on socially unacceptable behavior.

Pleas for corporate social responsibility will be truly embraced only by those executives who are smart enough to see that doing the right thing is a byproduct of their pursuit of profit. And that renders such pleas pointless.
Such arguments, often adopted by opponents of the social responsibility movement, tend to take a pure economic approach. That approach does not call for voluntary CSR, let alone mandatory CSR. Such an extreme stance may not be beyond question, because both regulation and practice are beginning to recognize the existence of interests other than shareholders that corporate managers must cater to. In India, the Corporate Social Responsibility Voluntary Guidelines 2009 exhort companies to act in a socially responsible manner, while there are plenty of instances where reputable Indian companies have already embarked on serious CSR initiatives.

Wednesday, August 25, 2010

Deal-making and a Changing Legal Regime

Vedanta’s takeover offer for Cairn Energy has raised some questions because it comes in the wake of impending changes to the SEBI Takeover Regulations that may make it potentially difficult for acquirers to structure transactions. Commentators have argued that the timing of the acquisition would help the acquirer take advantage of two beneficial provisions under the current regime (that may not be available following the overhaul): (i) the ability to make a 20% open offer to public shareholders (as opposed to a full 100% offer); and (ii) the ability to pay non-compete amounts to the selling controlling shareholder up to 25% without paying the same to public shareholders (as opposed to parity of payments under the proposed regime). For details, please see S. Murlidharan in the Business Line and a discussion on CNBC.

Separately, Sandeep Parekh has an interesting analysis in the Business Standard about the interplay between non-compete fees under the Takeover Regulations and the more basic question of whether non-compete agreements are even valid given Section 27 of the Indian Contract Act, 1872 (which makes agreements in restraint of trade void). Sandeep notes:

… on a correct interpretation of the Indian Contract Act, the Sebi regulation allowing non-compete payments itself stands on weak legs. If the law made by Parliament disallows non-compete payments, it is clear that a regulation by Sebi cannot possibly allow it and be the basis of discriminating between shareholders. This fine legal issue will no doubt be resolved by the Supreme Court in due course.
Another factor that may be added to Sandeep’s analysis is the possibility that non-compete agreements may be permissible if there is a sale of business along with goodwill. This is due to an exception to Section 27 of the Contract Act:

Exception 1.-One who sells the good-will of a business may agree with the buyer to refrain from carrying on a similar business, within specified local limits, so long as the buyer, or any person deriving title to the good-will from him, carries on a like business therein, provided that such limits appear to the Court reasonable, regard being had to the nature of the business.
In case of a sale of a company, non-compete payments may be justified by buyers on the ground that they are obtaining the goodwill from the sellers. However, courts do have the discretion to determine whether limits of restraint are reasonable. Whether this exception will apply in the context of sale of shares in a public listed company that is followed by a takeover offer is another matter. But, whether this exception will apply when the seller does not completely exit the company (but continues to retain a partial stake) is a matter that introduces even greater complexity because it may raise a doubt as to whether there has been a sale of goodwill at all in order for the exception to apply. As Sandeep too observes, many of these questions merit no easy answers.

Saturday, August 21, 2010

Call for Submissions: Indian Journal of Law and Technology

(We have received the following Call for Submissions from the Indian Journal of Law and Technology)
The Indian Journal of Law and Technology (IJLT) is an annual law journal published by the Law and Technology Committee of the Student Bar Association, at the National Law School of India University, Bangalore, India. IJLT is the first and only law journal in India specifically devoted to the field of technology law. The previous issues of IJLT have featured articles by distinguished authors such as Christoph Antons, Yochai Benkler, Donald S. Chisum, Raymond T. Nimmer, John Frow, Jonathan Zittrain, Lawrence Liang and Shamnad Basheer.

The submissions to the Journal are selected for publication on the basis of a peer-review mechanism conducted through an external Article Review Board consisting of academicians and experts in the field of technology law. The Journal is edited by an Editorial Board consisting of students from the National Law School of India University selected on an annual basis through a selection process that tests them on their editing skills and knowledge in the concerned areas of law.

The Journal accepts academic submissions in the form of articles, notes, comments or book reviews on a host of legal issues regarding the interface between law and technology, including e-commerce, cyber crime, biotechnology, bioethics, competition law, outsourcing, intellectual property, related public policy, and law and society issues posed by new technology. The Journal is also oriented towards publishing academic work that considers the aforementioned issues from a comparative perspective and/or the perspective of the developing world.

The Editorial Board invites submissions for Volume No. 7 of 2011. The Journal follows a rolling submissions policy and the deadline for the forthcoming volume is 15 November 2010. The submissions received after this date shall be considered for the next volume. The submissions must relate to any of the broad themes mentioned above or any other law and technology-related theme.


1. All manuscripts (in hard copy or e-mail) must be accompanied by:

a. A covering letter with the name(s) of the author(s), institution/affiliation, the title of the manuscript and contact information (email, phone, etc.)

b. An abstract of not more than 200 words describing the submission
2. Electronic submissions (on website or email) should ideally be made in Word Format (.doc)/(.docx), although (.pdf) is also acceptable.

3. Text and citations should ideally conform to the rules in THE BLUEBOOK: A UNIFORM SYSTEM OF CITATION (19th edition). However, any uniform system of citation is also acceptable. The system of citation used (if not THE BLUEBOOK) must be specified in the covering letter. The Journal employs footnotes as the method of citation.

4. No biographical information or references, including the name(s) of the author (s), affiliation(s) and acknowledgements should be included in the text of the manuscript, file name or document properties. All such information may be incorporated in the covering letter accompanying the manuscripts.

5. The Journal encourages gender neutrality in its submissions.

6. The articles in the Journal will be edited and published according to the orthographical and grammatical rules of Indian English, which is based on British English; thus, submissions in American English will be modified accordingly.

7. To facilitate the publication of concise and relevant legal scholarship, the Journal strongly encourages authors not to exceed 30000 words (inclusive of text and footnotes). However, this word limit is not binding and can be waived in appropriate circumstances.

8. Authors are required to obtain written permission for the use of any copyrighted material in the manuscript and must communicate the same to the Journal. Such material may include tables, charts etc.

9. Authors are also required to inform the Editorial Board if they have submitted their manuscript to another law journal and if they have received an offer of publication. Authors may request an expedited review on this basis. It shall be within the discretion of the Editorial Board to grant an expedited review.

10. Either electronic or hard copies of the manuscripts may be submitted although electronic submissions are strongly encouraged.

Please send the submissions to:

a. editorialboard@ijlt.in

b. Address hard copies to

The Chief Editor,
Indian Journal of Law and Technology
National Law School of India University,
Bangalore – 560242.

c. Submissions can also be made on our website – http://www.ijlt.in.
11. Upon selection for publication, the authors shall grant a licence to the Editorial Board/Law and Technology Committee to edit and publish the manuscript as part of the Journal. Authors shall retain copyright over their submissions but must acknowledge first publication in the Journal. Unless otherwise agreed upon, such a license shall be as per the standard terms and conditions provided by the Journal to the authors upon acceptance.

Friday, August 20, 2010

Section 100 revisited: In Re Organon

We have discussed the law on reduction of share capital under Section 100 of the Companies Act previously. A recent decision of a Single Judge of the Bombay High Court has an interesting observation in this regard. In Re Organon (India) Limited [2010] 101 SCL 270 (Bom), Kathawalla J. observes after discussing the previous cases (including British & American Trustees [1894] AC 399, Re Panruti AIR 1960 Mad 537, Miheer Mafatlal [1996] 11 SCL 70, Sandvik Asia [2009] 92 SCL 272):

“This Court is bound by the decision of the learned Division bench (in Sandvik) and cannot withhold sanction to the special resolution for reduction of capital, unless there is some patent unfairness regarding the fair value of the shares or there is lack of an overwhelming majority of non-promoter shareholders who vote in favour of the resolution…” [emphasis added]

It is unclear whether Sandvik is actually an authority for the underlined portion above – it seems that the Court in Organon has read in an additional requirement of an “overwhelming majority” of “non-promoter shareholders” to vote in favour of the resolution.

In an earlier article, Mr. Somashekhar Sundaresan had noted that the effect of Sandvik was that, “Private equity investors holding small stakes without serious rights could easily be thrown out by management using such resolutions. In family-run companies, a segment of the family that holds a minority stake could get thrown by the rest of the family. All that one would need is a special resolution…” Now, if the observation in Organon is to be read as laying down the law on the point, the effect of Sandvik could easily be watered down. A mere special resolution would not be enough – that special resolution would need an overwhelming majority of non-promoter shareholders backing it. This is almost tantamount to giving a veto power to the non-promoter minority shareholders. Interestingly, on the facts of the case, this had no effect on reduction of share capital – of the more than thousand non-promoter shareholders, only one had objected. Nonetheless, the observation (in the form of the statement of law which the Court states it was applying) would perhaps require reconsideration by a larger Bench.

RBI: Regulatory Framework on Core Investment Companies

An earlier post had discussed a Reserve Bank of India (RBI) proposal on regulation of Core Investment Companies; and had discussed the draft guidelines which the RBI had proposed. The RBI has now released the ‘Regulatory Framework for Core Investment Companies’. A Core Investment Company (CIC) is defined as being an NBFC carrying on the business of acquisition of shares and securities which satisfies the following conditions:

i. it holds not less than 90% of its Total Assets (total assets also being defined in a separate clause) in the form of investment in equity shares, preference shares, debt or loans in group companies.

ii. its investments in the equity shares (including instruments compulsorily convertible into equity shares within a period not exceeding 10 years from the date of issue) in group companies constitutes not less than 60% of its Total Assets.

iii. it does not trade in its investments in shares, debt or loans in group companies except through block sale for the purpose of dilution or disinvestment.

iv. it does not carry on any other financial activity referred to in Section 45I(c) and 45I(f) of the Reserve Bank of India Act, 1934 except investment in bank deposits, money market instruments, government securities, loans to and investments in debt issuances of group companies or guarantees issued on behalf of group companies.

Among other things, all CICs with an asset size of less than Rs.100 crores would be exempted from the requirements of registration with RBI. For this purpose all CICs belonging to a Group will be aggregated. CICs with an asset size of Rs 100 crores or more will be considered as Systemically Important Core Investment Companies (CICs-ND-SI) and would be required to obtain Certificate of Registration (COR) from RBI under Section 45-IA of the Reserve Bank of India Act, 1934. Minimum Capital Ratios and Leverage Ratios have been prescribed for CICs-ND-SI. The notification (dated August 12, 2010) is available here.

Governments as Issuers of Securities

As we have been constantly focusing on this Blog (here, here and here), public sector enterprises (PSEs) in India that are substantially owned by the Government often take advantage of relaxations and special dispensations from the applicability of securities laws and corporate governance norms that otherwise apply in their entirety to their private sector counterparts. Even where actions have been initiated by regulators, they have been dropped. For instance, about two years ago when SEBI required PSEs to comply with minimum requirements for appointment of independent directors, the action was not pursued because the PSEs argued that the appointment was beyond their control as it required (under their respective articles of association) the approval of the President of India, which was not forthcoming.

An interesting contrast emerges from a recent U.S. experience where the SEC has charged the State of New Jersey for violating federal securities laws by not disclosing in various state bond offerings that two of its public employee pension funds were underfunded. The Conglomerate Blog observes that this might be the beginning of a wave of legal actions against state and municipal authorities that may have violated securities laws. More interestingly, it points to several political compulsions that may drive state agencies away from ensuring full compliance with securities laws, such as fair disclosure.

For a start, if even a single instance of non-compliance by governments or public enterprises is pursued to its logical conclusion, it may at least motivate others to move towards greater compliance.

Thursday, August 19, 2010

Unlawful Distribution of Capital: The Question of Intent

Five judges of the United Kingdom Supreme Court are scheduled to hear an exceedingly interesting case on October 5 and 6, 2010, on what the Court of Appeal describes in the impugned judgment as a “short, but quite basic company law point”. The judgment of the Court of Appeal in the case - Progress Property v. Moorgarth Group, [2009] EWCA Civ 629 - is available here, and the point of company law that arises is the extent to which the knowledge or intent/motive of a director is relevant in judging whether the sale of an asset amounts to an unlawful distribution of capital. The prohibition on such distribution is codified under the Indian Companies Act, 1956, as well, and is of some importance today, considering the increasingly popular device of intra-group asset transfers.

As background, it is appropriate to recall that the House of Lords held in 1887 (Trevor v. Whitworth) that a corporation cannot return any part of its capital, for it is to the capital of a company that creditors look in the event of liquidation, and are entitled to assume that capital is lost only in the normal course of business. The effect of the rule was to prevent the return by a company of assets to its majority shareholder, the payment of dividend except out of distributable profit, buy-back of shares etc. It was recognised that this is necessary in some circumstances – such as an unexpected loss in assets – and statutory intervention in England through the 1980 and 1985 Companies Act specified these exceptions. The common law doctrine continued to have force outside of the statutory exceptions. The Indian Companies Act, 1956, functions on the same premise, providing in s. 205(1) that dividend may be paid only out of “profits of the company for that year”, and creating specific exceptions for buy-back of shares, reduction of capital etc.

Attempts were made to evade the rule in Trevor v. Whitworth by resorting to more ingenious methods of returning capital – payment of dividend on unrealized profit, payment without accounting unrealized losses and so on. These methods were declared illegal, either by case law or by statute, and could not be ratified by the shareholders, as it was ultra vires the company. The most prominent device to avoid the rule then came to be the sale of assets at an undervalue. This has the effect of returning capital – for example, a company that sells assets worth Rs. 1 crore at Rs. 10 lakh to its majority shareholder does no more than return capital to him. However, it is easy to disagree about valuation, and consequently harder to conclude in these circumstances that the transaction is in fact a disguised return of capital. The locus classicus on this subject is a decision of Hoffman J. in Aveling Barford v. Perion Ltd., [1989] 5 BCC 677. Faced with the sale of a valuable company asset to a company that was controlled by the majority shareholder of the vendor, Hoffman J. held that courts look at “the substance rather than the outward appearance”, and further found that “it was the fact that it was known and intended to be a sale at an undervalue which made it an unlawful distribution [emphasis mine].” The words “known and intended” suggest that the company selling an asset must do so for the purpose of selling at undervalue or returning capital, and it is this question of intent that is set to be heard by the Supreme Court in Progress Property.

The facts of Progress Property are similar to Aveling Barford, with one crucial difference. In 2003, Progress Property Co. Ltd. [“PPC”] and Moorgarth Group Ltd. [“Moorgarth”] were both controlled by Tradegro (UK) Ltd. [“Tradegro”]. PPC held shares in its subsidiary, known as YMS Properties (No. 1) Ltd. [“YMS1”]. Tradegro entered into an agreement with a minority shareholder in PPC to transfer its majority shareholding in that company to him, and as part of this agreement, was required to transfer PPC’s shares in YMS1 to Moorgarth, before completion. In short, the minority shareholder acquiring PPC required Tradegro to divest PPC of its shareholding in YMS1 prior to acquisition. In pursuance of this agreement, PPC sold its stake in YMS1 to Moorgarth in October 2003, for a price of around £ 64,000. This figure was arrived at after making a deduction of £ 4 million for an indemnity which could be enforced against PPC. It later transpired that there was no such indemnity liability, but it was accepted by all parties that this mistake was a genuine one, and that the parties were under the impression that the shares had been sold at market value.

After the takeover was completed, PPC brought an action to declare the sale to Moorgarth invalid and ultra vires, and relied heavily on Aveling Barford for the proposition that a sale at less than full value is ultra vires regardless of whether the sale was effected in ignorance of the true value. The Court of Appeal was quick to reject this “optimistic submission”, pointing out that it is the sale of an asset for the purpose of paying less than full value that makes it ultra vires, and not the mere fact of sale. An important reason for this rule is that it otherwise puts directors at the peril of having every sale questioned, if it subsequently turns out the property had been wrongly valued, even if the directors acted reasonably and in the best interests of the company. PPC also argued that the director “ought” to have known of the valuation error, but the Court of Appeal held that this is of no relevance in determining whether the transaction is ultra vires – for, courts invalidate a return of capital that is “disguised” as a transfer by assigning it an unnaturally low sale price, and not a sale that coincidentally has such a price, whether through the ignorance of the vendor or otherwise.

Interestingly, the rule in Aveling Barford, based on s. 263 of the 1985 English Companies Act, was thought to greatly inconvenience intra-group transfers of assets, or restructuring assets for legitimate business reasons. S. 845 of the 2006 English Companies Act partially modifies the strict rule in Aveling Barford, and an excellent discussion of the reasons for the move is available in the Explanatory Note to the Act (¶¶1151-5). Although these statutory developments predate the events in Progress Property, it is expected that the Supreme Court will affirm the Court of Appeal’s decision, for knowledge and intention are significant factors in assessing the genuineness of a transaction for return of capital purposes.

Event Announcement: Mr. Soli Dastur's Lecture on the DTC

Mr. S.E. Dastur, Senior Advocate, will be delivering the 1st K.A. Sathe Memorial Lecture at Symbiosis Institute of Management, Range Hills, Khadki, Pune on Sunday, August 22, 2010 at 9.45 a.m. Mr. Dastur, the country’s foremost tax expert, will be speaking on the Direct Taxes Code.

The lecture is being organized by the Pune Income Tax Appellate Tribunal Bar Association. Readers who are in (or can be in) Pune over the weekend may find the lecture extremely interesting.

Saturday, August 14, 2010

NLSIR: Call for Submissions

I have received the following call for submissions from the National Law School of India Review, which may be of interest to readers.

"The National Law School of India Review (NLSIR) is the flagship law journal of the National Law School of India University, Bangalore, India. The NLSIR is a bi-annual, peer-reviewed law journal providing incisive legal scholarship about issues that are at the forefront of contemporary legal discourse. Over the past 20 years, the NLSIR has regularly featured pieces authored by judges of the Indian Supreme Court, Senior Counsels practicing at the Indian bar, and several renowned academics. 
The most recent issue of the NLSIR, Volume 22(1), featured contributions by former Chief Justice of India, Justice K. G. Balakrishnan, Professor James B. Jacobs of New York University, and Justice Michael Kirby, former Judge, High Court of Australia. More details are available here.

The NLSIR is now accepting submissions for its upcoming issue - Volume 23(1). The issue will be published in early 2010; and the deadline for submissions is October 15, 2010. Papers may be submitted as Articles (approximately 8000 words), Essays (approximately 5000 words) or Comments (approximately 2500 words). Submissions may be made to mail.nlsir@gmail.com, and queries regarding submission may be made at the same email address."

Friday, August 13, 2010

Bombay High Court Upholds Section 14A and Rule 8D - Part II

In a previous post, the outline of the propositions in Godrej & Boyce v. DCIT was provided, followed by a discussion of the first issue before the Court. The other two issues, and the Court’s conclusions are discussed below.

Section 14A(2) and (3) and Rule 8D are Constitutionally valid

The next question posed by the case was whether the discretion granted to the AO by section 14A(2) and (3) and Rule 8D falls foul of Article 14 of the Constitution. Under section 14A(2), the Assessing Officer, if not satisfied with the correctness of the assessee’s claim, may determine the amount of expenditure incurred in relation to such income. Such determination is to be done in accordance with the method prescribed under the Income Tax Rules, i.e., Rule 8D. Section 14A(3) is a clarificatory provision that even if an assessee claims that no expenditure has been incurred in relation to the income, it shall not curtail the AO’s powers under sub-section (2). Rule 8D reads-

(1) Where the Assessing Officer, having regard to the accounts of the assessee of a previous year, is not satisfied with:

(a) the correctness of the claim of expenditure made by the assessee; or

­(b) the claim made by the assessee that no expenditure as been incurred, in relation to income which does not form part of the total income under the Act for such previous year, he shall determine the amount of expenditure in relation to such income in accordance with the provisions of sub­rule (2).

(2) The expenditure in relation to income which does not form part of the total income shall be the aggregate of following amounts, namely:­

(i) the amount of expenditure directly relating to income which does not form part of total income;

(ii) in a case where the assessee has incurred expenditure by way of interest during the previous year which is not directly attributable to any particular income or receipt, an amount computed in accordance with the following formula, namely:­ A x B



A = amount of expenditure by way of interest other than the amount of interest included in clause (i) incurred during the previous year;

B = the average of value of investment, income from which does not or shall not form part of the total income, as appearing in the balance sheet of the assessee, on the first day and the last day of the previous year;

C = the average of total assets as appearing in the balance sheet of the assessee, on the first day and last day of the previous year;

(iii) an amount equal to one­half per cent of the average of the value of investment, income

from which does not or shall not form part of the total income, as appearing in the balance sheet of the assessee, on the first day and the last day of the previous year.

Based on these provisions, the assessee contended that section 14A(2) provided an undue license to the AO to disallow expenditure incurred by an assessee. Further, Rule 8D did not make a distinction between different types of businesses, applying a uniform rule for the determination of expenditure to be disallowed. The import of Article 14 is that equals be treated equally, and also that unequals be treated unequally. By treating all businesses on par, the assessee contended that Rule 8D violated Article 14, and should be struck down as unconstitutional. However, in an act of judicial deference, the Bombay High Court rejected this contention. The Court cites several decisions of the Supreme Court to the effect that the presumption of constitutionality enjoys an exalted status, particularly in the case of tax statutes. Article 14, although requiring classification having a rational nexus to the object of the law, had to be applied cautiously to tax statutes. “Only if there is perversity or capriciousness in the method adopted by the Legislature” would a tax statute violate Article 14. Here, there was no such perversity or capriciousness, since the mechanism laid down by section 14A(2) and Rule 8D had a nexus with the determination of the expenditure to be disallowed. The Court also observed that Rule 8D(2)(iii), though laying down a blanket rule, would in most cases lead to a determination much lower than that would follow from an application of sub-clause (ii). On the basis of the requirement of judicial deference, and the supposed reasonability of the provision, the Court held that Rule 8D and section 14A(2) and (3) were constitutionally valid.

While the Courts observations on judicial deference to the Parliament’s tax policy cannot be faulted, the application to the facts at hand and are not free from doubt. The Court cited several provisions to the effect that the principle of rational classification under Article 14 should be applied cautiously to tax laws. However, it is submitted that when the dicta cited by the Court referr to classification, they refer to the Legislature being given “a free hand to devise classes – whom to tax or not to tax, whom to exempt and whom not to exempt” (State of U.P. v. Kamla Palace, (2000) 1 SCC 557). It is not clear whether once the types of tax and the persons on whom it is to be levied, the judicial deference extends to allowing legislative mechanisms to deem certain incomes or expenditures in whatever way they deem fit. Admittedly, the Supreme Court in Gujarat Ambuja Cement v. Union of India, AIR 2005 SC 3020, held that legislative discretion extends to determining what should be taxed, and also “the manner in which the tax may be imposed”. However, I am not sure if this can be taken to allow the use of mechanisms which have little or no rational nexus with concepts such as income and expenditure. It seems from a perusal of the decision that the Court anticipates and answers this contention, when it observes that that primary basis of the assessee’s challenge is the equal treatment of unequals, which does not hold water in light of the Supreme Court decisions cited. That leaves only the question of arbitrary discretion. In response to that, the Court holds that the discretion granted by section 14A(2) is not uncanalised- it is only on an objective assessment of the accounts of the assessee, and after giving him/her a fair hearing, that the AO may use Rule 8D to make an independent determination of the disallowed expenditure.

Thus, in the Court’s view, the arguments on neither irrational classification nor arbitrariness held water, and section 14A(2) and (3) and Rule 8D were held constitutionally valid.

Rule 8D may not be applied retrospectively

After failing in its first two contentions, the assessee did manage to convince the Court to see weight in its third contention- challenging the retrospective application of Rule 8D. The Revenue contended that since Rule 8D was merely procedural, it should be given retrospective effect. The Court admitted that the legislature had the power to enact both prospective and retrospective provisions, and that there was a presumption that procedural provisions were intended to have retrospective effect. However, noting that this presumption could be rebutted by the language of the amending statute, the Court held that Rule 8D could not be given retrospective effect.

For starters, it is submitted that the detailed examination of the principles of retrospective legislation was not relevant, as was pointed out by the Court itself. Section 295(4) of the Act provides that while there is the power to make retrospective rules, this power cannot be employed to prejudicially affect the interests of assessees. Given this provision, noted by the Court, the discussion of the law on the presumption of retrospectivity seems to be little more than obiter. In any event, the Court, relying on the Supreme Court’s dictum in CWT v. Shravan Kumar Swarup, 210 ITR 886 (1994), held that since Rule 8D was not a “well known, well settled or well accepted method”, but was an “artificial method of determining expenditure”, it should not be given retrospective effect. Further, the legislative history of section 14A, and the introduction of Rule 8D clearly suggested that the legislature did not intend the provision to have retrospective effect.


In sum, the Bombay High Court laid down the following propositions-

(a) Dividend income was ‘income not included in total income’ for the purpose of section 14A (In an interestingly timed development, the Kerala High Court has also upheld this position in CIT v. Leena Ramachandran)

(b) Rule 8D is not unconstitutional, since there is irrational classification

(c) Section 14A(2) and (3) are not unconstitutional on grounds of arbitrariness, since the satisfaction of the AO has to be objective, based on the accounts of the assessee, and after providing a fair hearing

(d) Rule 8D cannot be given retrospective effect.

Bombay High Court Upholds Section 14A and Rule 8D - Part I

Earlier posts discussed the decision of the Mumbai Special Bench of the ITAT in Daga Capital, and exceptions to the seemingly assessee-adverse ruling that had been carved by other tribunals and courts. The issue was then heard by the Bombay High Court, which finally pronounced judgment yesterday. The decision in Godrej & Boyce v. DCIT, has not provided as much of a reprieve to assessees as would have been hoped- only holding that the dubious Rule 8D of the Income Tax Rules is to be applied prospectively, while upholding its constitutionality and that of section 14A of the Income Tax Act.

The case before the Court involved a typical scenario in which section 14A is usually invoked. Section 14A provides that in computing the total income of an assessee, no deduction shall be allowed in respect of expenditure incurred in relation to income which does not form a part of the total income under the Act. This expenditure can be that claimed by the assessee; or if the Assessing Officer is not satisfied with the claim made, such expenditure as the AO may compute in accordance with Rule 8D of the Rules (introduced w.e.f. March 2008). The assessee here had earned dividend income, which is exempt under the Act; and contended that no expenditure had been incurred in relation to that income. However, the AO differed and held made a disallowance of `6.92 crore, which was overturned in appeal by the Commissioner (Appeals). However, on appeal by the Revenue before the ITAT, it was held following Daga Capital, that Rule 8D had retrospective effect, and also applied to assessment year 2002-03, which was under consideration. On this ground, the matter was remanded back to the AO for a fresh consideration in light of section 14A(2) and Rule 8D. It was against this remand that the assessee appealed to the High Court, which clubbed with it a writ petition challenging the vires of section 14A and Rule 8D.

The Court formulated three questions for its consideration, answering two of them in favour of the Revenue, and the third in favour of the assessee-

(a) Can dividend income be considered to be income ‘not includible in total income’, for the purposes of section 14A?

(b) Do section 14A(2) and (3), and Rule 8D pass Constitutional muster?

(c) Can Rule 8D be applied with retrospective effect?

Of these, I shall discuss the first question in this post, and the other two questions in a subsequent post.

Dividend income is covered by section 14A

After a detailed discussion of the object of section 14A, and in particular sections 142A(2) and (3), Justice Chandrachud moves to examine the first issue regarding the inclusion of dividend income under the provision. Under section 115-O, income tax is levied on any amount ‘declared, distributed or paid ... by way of dividends’. Section 115R levies a tax on income distributed by a Mutual Fund to its unit-holders. The assessee contended that although dividend income is exempt from taxation under section 10(34) of the Act, it is still taxable in the hands of the company under the abovementioned provisions. Hence, far from being a provision which excludes dividend income from total income, section 10(34) is only a provision that prevents double taxation of dividend income.

However, following the Supreme Court’s dictum in CIT v. Indian Bank Ltd. (AIR 1965 SC 1473), that “it is income that is taxed but it is not taxed in vacuo. It is taxed in the hands of a person”, Justice Chandrachud dismissed this contention. The Court clarified that the tax paid by a company under section 115-O or 115R is not a tax paid on behalf of the shareholders, neither is it a tax on dividend. The tax paid by the company is a tax on the profits of the company, which means that the dividend earned by the shareholder is exempt from tax. Thus, as far as the shareholder is concerned, the dividend income being earned is not includible in the total income, and comes under the purview of section 14A.

The issue of constitutionality and the retrospectivity of Rule 8D will be discussed in a subsequent post.