Sunday, May 30, 2010

Insurance policies and the tax/fee distinction

Recently, the Bombay High Court had occasion to consider an important issue regarding the transferability of life insurance policies, and the restrictions that the LIC has the powers to place on such transferability.

The background to the facts of this case is provided by another decision of the Bombay High Court in Insure Policy Plus Services v. LIC, decided in 2007. The petitioners in this case were companies engaged in the business of assignment life insurance policies. The business model involved acquiring a policy from the policy holder for consideration, and then transferring it to a third party for consideration. A life insurance policy being personal movable property, such a business has existed in India, and the world over, and has not been tainted with any illegality or irregularity. In fact, section 38 of the Insurance Act specifically provides for the assignment and transfer of insurance policies. However, in late 2003, LIC issued a circular prohibiting the transfer/assignment of life insurance policies in favour of companies trading in the policies. This circular was challenged by the companies by way of a writ petition. LIC contended that the companies had no insurable interest, rendering the transfer a wagering agreement and hence, in violation of public policy. Further, while section 38 allowed the transfer of policies, it was merely procedural, and there was nothing in the provision to suggest that such transferability was mandatory. Rejecting these contentions, the Court held that a policy holder has complete rights over the policy, including the right to transfer the policy, so long as the requirements of section 38 are satisfied. Further, the mere fact that such transfer left the original policyholder remediless in the event of his/her death, the Court held that this concern was insufficient to invalidate a transfer which was otherwise valid in law.

An SLP was filed by LIC against this decision, but no stay was granted by the Supreme Court. In response, LIC issued a circular in May 2007, imposing a charge of Rs. 250/- on the transfer of life insurance policies to financial companies. It was this circular was challenged in Dravya Finance v. LIC, as restricting the transfer/assignment of life insurance policies which had held to be legal. [Interestingly, Justice Rebello, who had delivered the decision in Insurance Policy Plus Services was also on the Bench, although the decision here was delivered by Justice Bhatia]. Further, this amounted to a tax without the authority of law, rendering it unconstitutional. However, LIC defended the imposition on the grounds that it was not a measure directed at the prevention of transfers, but merely due to the expenses which were incurred by it on account of allowing such transfers. Viewed this way, it was more in the nature of a fee, and could not held to be unconstitutional. Thus, the issue here was the distinction between a tax and a fee, and whether the fact that the levy is compensatory necessarily makes it a fee. This issue was conclusively decided by the Supreme Court in 2006 in Jindal Stainless v. Haryana. The Court there held that even if both are compensatory, there is a fundamental distinction between a compensatory tax and a fee. The former is compensatory vis-a-vis a class of people, while the latter is compensatory vis-a-vis an individual. [A case note by Niranjan is available here. Further, as Mihir discusses here, in April this year, a Constitution Bench of the Supreme Court has referred this issue to a larger bench.]

Relying on the Supreme Court’s decision in Jindal, the Court observed,

If the amount of Rs. 250/- charged by the respondent No. 1 for registration of every assignment of a policy is in the nature of administrative charges for general services being rendered by the LIC to its policy holders or assignees, it would amount to tax. Similarly, if it is a fee, which has no co-relation with the service being rendered to the particular customer, it will also amount to a tax and cannot be charged without the authority of law. However, if it is a fee in the nature of charges for the services rendered to the particular customer and is not for recovery of general administrative expenses of the LIC, it may be treated as a fee or service charges. Therefore, the question arises as to whether the amount being charged by the respondent No. 1 is a fee in the nature of service charges or it is in the nature of recovery of administrative expenses akin to tax.

The Court then examined the data provided by LIC, to conclude that its expenses had indeed increased on account of the transferability of the policies. Now, given the decision in Jindal, and the paragraph extracted above, mere correlation between the levy and the expenses would be insufficient to render the levy a fee, unless it was compensatory vis-a-vis each individual policy holder. However, the Court seems to ignore this point, in observing,

From this, it is clear that the cost of transaction of assignment of policies has considerably increased and therefore the Corporation has decided to levy service charges. As noted by the Supreme Court ... a fee is paid for performing a function and fee is not ordinarily considered to be a tax. If the fee is levied merely to compensate an authority for the services rendered, it cannot be called a tax . Taking into consideration the legal position and the explanation given by the respondent No. 1 for levying service charges, we have no doubt that by the impugned Circular, the respondent No. 1 has levied service charge or a fee for the services to be rendered to the person requesting for registration of assignment and therefore the said charges cannot be treated as tax.

As is apparent from this extract, the Court seems to have bypassed the distinction between a compensatory tax and a fee which Jindal seems to have affirmed. However, although the levy was a held to be a fee, the Court held that under section 48(2)(k), the power to levy a fee was with the Central Government, and could not be delegated to LIC without a specific provision in the Act. Such a levy, without the authority of law, would violate the petitioners’ right to carry on business under Art. 19(1)(g), as also Art. 300-A of the Constitution. Also, since the circular permitted transfers in favour of family members, LIC of India & LIC Housing Finance Ltd. and in favour of the Government bodies, it was also held to be violative of Art. 14 on grounds of unfair discrimination.

Thus, while the Court seems to have reached the right conclusion on the facts of the case, the reasoning employed in distinguishing between compensatory taxes and fees seems dubious. It is hoped that the reference to the higher bench, and the SLP in Insure Policy Plus Services, will conclusively clarify these controversies.

Wednesday, May 26, 2010

Depository Receipts and Voting Rights

SEBI has written to the Ministry of Finance and the Reserve Bank of India to curb the practice whereby holders of ADRs/GDRs pass on their voting rights to boards or managements of the companies in which they hold these instruments. As the Economic Times reports:

The Securities & Exchange Board of India (Sebi) has recommended a change in current rules to allow holders of American Depository Receipts or Global Depository Receipts issued by Indian corporates to exercise their voting rights, raising the possibility of increased shareholder activism in future.

Depository receipts, or DRs, are securities issued to overseas investors by Indian companies. In September 2009, the capital market regulator had brought holders of such securities under the takeover code. Investors or holders of ADRs/GDRs are entitled to vote on the shares underlying or representing the receipts, but their rights are restricted by the clauses in the ‘terms of issue’ or agreements between the holders of these instruments and the issuers. In reality, their voting rights are as good as having none.

The regulator now wants to prevent Indian firms issuing ADRs/GDRs from incorporating provisions which curtail the voting rights of depository receipt holders and which empower the management to exercise voting rights on their behalf. The finance ministry and the Reserve Bank of India will need to amend the rules to bring into force the proposed changes.

The issue that this proposal seeks to address is outlined below:

Most companies have issued ADRs/GDRs featuring clauses where the voting rights are in favour of the management. In some cases, the boards of issuer companies instruct the custodian bank—which holds the actual shares on behalf of ADR/GDR holders—to vote for them. In other cases, the right is vested with depository holders. However, in the event of their failure to exercise their voting right, it is deemed to have vested with the board of the issuer company. These instructions are incorporated in the agreement or ‘terms of issue’.

This proposal is expected to enhance corporate governance among companied that have issued DRs and to stimulate investor activism, and has generally been lauded. However, it leaves certain questions unanswered, particularly given the lack of strong empirical evidence on exercise of available voting rights by ADR/GDR holders.

1. The typical ADR/GDR investor is a financial institution with a certain measure of sophistication to determine whether or not to invest in the ADRs/GDRs which do not carry voting rights. In such circumstances, is there a need for the regulator to intervene and insist on conferring voting rights upon investors?

2. Such institutional investors may likely be interested in the economic return on the investment rather than control rights, due to which they may be indifferent to the availability of voting rights. Even when crisis situations emerge, such investors are likely to vote with their feet (as we witnessed in the massive ADR sell-off in Satyam) rather than in a general meeting.

3. Even when voting rights are available (e.g. generally in a company), there is no compulsion to exercise those rights. On the contrary, shareholders are free to pass on those rights to others on a discretionary basis, such as through a proxy. In the case of a depository agreement of the nature sought to be curbed by SEBI, it just so happens that the ADR/GDR holder passes on those rights up front without seeking to exercise them at each general meeting.

4. In case voting rights become crucial to any ADR/GDR investors, it is always open to them to convert those securities into underlying shares and exercise all concomitant rights, including to directly vote at a meeting.

Although SEBI’s previous decision to make ADRs/GDRs with voting rights subject to the open offer requirements under the Takeover Regulations is understandable, it is not clear whether a strong case has been made out for a wholesale ban on the ability of holders to confer voting rights on the board, management, depository or any other person.

Enforcement of Corporate Governance Norms: Anecdotal Evidence

A constant quibble with corporate governance in India is that while the body of substantive norms has been ballooning over time, the enforcement of those norms has not kept pace. In a somewhat unusual measure, the National Stock Exchange (NSE) has threatened to suspend trading of a listed company for failure to file governance reports as required under the listing agreement. As the Business Standard notes:

There are some 1,300 listed companies on exchanges, according to information available on the public domain, that have not complied with the listing agreement or on corporate governance issues and they have been suspended.

It may be noted Clause 49 of the listing agreement, which is an umbrella regulation on corporate governance norms, mandates companies to submit a quarterly report, signed either by the compliance officer or the CEO, to the stock exchange within 15 days from the close of a quarter.

According to the Exchange public announcement, the company failed to respond to its notice for non-compliance with provisions of listing agreement.

While such ultimatums may exert pressure on companies to comply with corporate governance norms, it is the public shareholders who are likely to suffer if the stock exchange indeed carries them out. Any suspension of trading or delisting will cause equal harm to those shareholders as their holdings will instantly become illiquid.

Other measures targeted at the company have been made available in Section 23E of the Securities Contracts (Regulation) Act, 1956, which reads: “If a company … fails to comply with the listing conditions or delisting conditions or grounds or commits a breach thereof, it or he shall be liable to a penalty not exceeding twenty-five crore rupees.” Perhaps the use of such targeted enforcement measures may like generate greater compliance without directly affecting the interests of the public shareholders. It is not clear if enforcement pertaining to violation of corporate governance norms has been initiated yet against any company under Section 23E.

Tuesday, May 25, 2010

Interpretive Guidance: Differential Rights on Shares

Section 86(a)(ii) of the Companies Act, 1956 as well as the Companies (Issue of Share Capital and Differential Voting Rights) Rules, 2001 permit the issue of shares with differential rights as to voting and dividend (DVRs) by companies, subject to certain conditions. Such issue of shares with DVRs has also been implicitly blessed by the Company Law Tribunal in Anand Pershad Jaiswal v. Jagatjit Industries Limited, MANU/CL/0002/2009. Based on this, a limited number of companies, Tata Motors including, had issued shares with DVRs, which have been listed on stock exchanges.

Subsequently, in July 2009, SEBI amended the listing agreement to state that listed companies are prohibited from issuing shares with “superior” voting rights. Clause 28A was inserted in the listing agreement, which states: “The company agrees that it shall not issue shares in any manner which may confer on any person, superior rights as to voting or dividend vis-à-vis the rights on equity shares that are already listed.” This further circumscribed the ability of companies to issue shares with DVRs under the pre-existing legal regime, and the consequences emanating from this change have been the subject matter of previous discussion on this Blog (here and here).

Apparently confounded by this development, Tata Motors, which had issued ‘A’ Ordinary Shares that carried 5% greater dividend than ordinary shares, but only 1/10th of voting rights compared to ordinary shares, approached SEBI for informal guidance. This was to ensure that their existing listed shares with DVRs were not impacted, and furthermore that any fresh issue of similar shares by Tata Motors not only through rights issue, bonus issue or conversion of other instruments but also through public issue, preferential allotment or qualified institutional placement (QIP) was permitted. SEBI issued its informal guidance on April 23, 2010:

i. The existing listed ‘A’ Ordinary Shares will continue to have all their existing rights.

ii. The company may make a fresh issue of ‘A’ Ordinary Shares on the same terms as the existing listed ‘A’ Ordinary Shares by way of a bonus or rights issue.

iii. The company may make a fresh issue of ‘A’ Ordinary Shares by way of a follow on public issue, preferential allotment of ‘A’ Ordinary Shares and QIP of ‘A’ Ordinary Shares, subject to compliance with the SEBI (ICDR) Regulations.

iv. The company may issue ‘A’ Ordinary Shares on exercise of conversion option by holders of Convertible Alternative Reference Securities (CARS) subject to terms and condition[s] of the convertible instrument and fulfillment of other guidelines, regulations and any other applicable laws.

v. The company may issue employee stock options (“ESOPs”) in accordance with the SEBI (Employee Stock Option and Employee Stock Purchase Scheme) Guidelines, 1999 where the options can be converted into ‘A’ Shares on the same terms as the existing ‘A’ Ordinary Shares.

There are possibly three different sets of implications from the guidance.

First, item i. ensures “grandfathering” of the existing shares with DVRs already issued by Tata Motors (prior to the changes brought about by SEBI in July 2009) as they are not affected in any matter.

Second, items ii. and iv. relate to issue of further shares with DVRs arising out of pre-existing obligations, such as conversion of CARS and even possible rights issue or bonus issue where the existing holders cannot be prejudiced merely because they are holding shares with DVRs.

Third, item iii. (and perhaps item v.) whereby Tata Motors is allowed to issue new shares with DVRs (similar to the existing shares) by way of a further offering either to the public or on a private basis.

While the exceptions made for grandfathering the existing shares and for pre-existing obligations arising from those is understandable, there is a question on whether SEBI’s permission to Tata Motors to issue fresh shares with DVRs falls within the overall scheme of SEBI’s guidelines. Whether the ability of Tata Motors to issue such fresh shares arises on account of its specific fact situation (as it has already issued the ‘A’ Ordinary Shares) or whether other companies too would be entitled to avail of this route is an open question. However, it appears more likely that the dispensation is limited to Tata Motors (which is the recipient of the informal guidance, granted on the basis of specific facts and circumstances) and other companies may not be able to rely on it.

For an analysis on these and other issues, please see this discussion on CNBC-TV18 where our guest contributor Somasekhar Sundaresan elaborates.

Sunday, May 23, 2010

The Impact of Tightening Financial Regulation

The last week has witnessed tighter financial regulations emerging out of the U.S. and European markets. While some of the reforms are expected to result in migration of investments into more liberal markets in Asia (including India), others represent introduction of stringent measures that are already in place in India.

Possible Regulatory Arbitrage

First, the European Union finance ministers have approved more stringent regulation of hedge funds. Objections have already been registered to this move, particularly by the U.K.:

The proposal, which would impose transparency standards on hedge-fund managers based outside of the EU, was endorsed by a majority of ministers over U.K. objections at a meeting in Brussels today. Osborne told reporters he was “very pleased” that his counterparts had listened to his concerns that the provisions could harm U.K. interests.

Britain is home to 80 percent of European hedge-fund and 60 percent of private-equity managers, according to a report last year from the Financial Services Authority. It’s also a hub for non-EU funds looking to market in Europe. The U.K. didn’t have enough support among ministers to stop the law from taking another step toward being implemented.

The proposals have been subject to critical review by the financial press. As the Economist notes:

On May 17th and 18th the two committees agreed to proposals that are intended to govern “alternative investment funds”, a long-winded name for hedge funds and private-equity funds, two sectors that in the eyes of many exemplify the ugly face of free-market capitalism. Confusingly the drafts contradict each other in some important respects; both differ, too, from a draft law proposed by the European Commission, Europe’s executive branch.

Other areas of concern include proposals to impose bank-like limits on the pay of fund managers—ostensibly to limit risk-taking even though the risks they take are anything but bank-like—as well as constraints on how much funds can borrow. Investors are also worried by measures to increase the liability that custodian banks have for the assets they look after. Pension funds and others fear they will be charged a higher premium by custodians as a result.

Not all these proposals will survive the reconciliation process. What seems likely to emerge is a messy compromise that will not drive the industry out of business or out of Europe, but will do little to improve financial stability either.

The Financial Times considers these measures a response to a non-existent problem:

German politicians have long complained about the destabilising effects of hedge fund and private equity "locusts" in financial markets. Now they and other European Union legislators are using the subprime mortgage and Greek debt crises to justify a crackdown.

This might be fair if hedge funds had caused either event, but they did not. Banks such as IKB, which went on a collateralised debt obligation bender with its "Rhineland" structured investment vehicle before collapsing, were more to blame. I have not, however, heard Germany call for European oversight of its industrial and regional banks.

The French and German governments have often wanted to subdue Anglo-Saxon finance and now have other EU members behind them, including Spain, holder of the current EU presidency. But the Alternative Investment Fund Managers Directive that was this week thrust on George Osborne, Britain's new chancellor of the exchequer, is protectionist, prescriptive and perverse.

As far as the Asian region is concerned, the key question is whether all this will result in a migration of hedge funds from Europe to the Asian markets, a phenomenon that the Economic Times examines. It remains to be seen whether hedge funds are likely to flood the Indian stock market in particular.

Currently, hedge funds may come in through the “front door” and invest directly by registering themselves with SEBI as foreign institutional investors (FIIs). Alternatively, they can invest in an indirect fashion through offshore derivative instruments (ODIs) (such as participatory notes) issued by other registered FIIs. Although the ODI route was restricted by SEBI in 2007, that decision was reversed in 2008, thereby permitting ODI investments by entities such as hedge funds, subject of course to relevant KYC (know-your-client) and disclosure norms (discussed here and here). Arguably, the persistence of the ODI route in the Indian markets provides a more liberal framework compared to the strengthening regimes in markets such as the European Union.

Tighter Controls Already in Existence in India

Second, there are two sets of changes introducing stringent measures that are already an integral part of financial market regulation in India.

In the U.S., the Securities and Exchange Commission (SEC) has proposed stock-by-stock circuit breaker rules “under which [the authorities] would pause trading in certain individual stocks if the price moves 10 percent or more in a five-minute period.” This is in response to the disruption caused to the markets on May 6 whereby “the market dropped significantly and after approximately 30 S&P 500 Index stocks fell at least 10 percent in a five-minute period.” As Sandeep Parekh points out, circuit breakers in individual stocks have been operational in India for over a decade.

Moving to Germany, it banned “naked short sales of euro-denominated government bonds, credit default swaps based on those bonds, and shares in Germany's 10 leading financial institutions.” This is similar to the ban on naked short sales imposed by the SEC in the U.S. in the wake of the financial crisis, which has thereafter been continued on a more enduring basis. Again, the Indian regulators appear to have acted with foresight in prohibiting naked short sales in the first place when short selling was introduced into the Indian markets in a structured fashion.

Framework for SME Exchange

After making a proposal nearly two years ago for the establishment of a separate stock exchange for small and medium enterprises (SMEs) to enable them to access the capital markets, SEBI has recently established the legal framework for achieving the same either through promotion of dedicated exchanges and/or dedicated platforms of the exchanges for listing and trading of securities issued by SME. SEBI has taken the following steps:
1. Introduced Chapter XA in the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 which deals with issue of specified securities by SMEs;
2. Prescribed a format of the listing agreement to be entered into between the SME issuer and the concerned stock exchange. As the SEBI circular issuing the model listing agreement states, there are certain relaxations provided to SME issuers in comparison with main board listed companies, which are as follows:
a. Companies listed on the SME exchange may send to their shareholders, a statement containing the salient features of all the documents, as prescribed in sub-clause (iv) of clause (b) of proviso to section 219 of the Companies Act, 1956, instead of sending a full Annual Report;
b. Periodical financial results may be submitted on “half yearly basis”, instead of “quarterly basis” and
c. SMEs need not publish their financial results, as required in the Main Board and can make it available on their website.
3. Amended the policy framework for SME listing through a circular that is in addition to the framework previously announced by SEBI.
As I had previously noted:
Overall, this is a welcome move as it could potentially create financing avenues for SMEs and also a separate market for investors keen to target that segment of the economy. This is also in tune with the international trend as we have seen earlier. However, it also calls for some caution and pessimism, particularly in view of past attempts which have failed. The prime attempt relates to the establishment of the OTC Exchange of India (OTCEI), which has not garnered the attention of the SME segment as it was expected to. Recent reports and commentaries have pointed to the need to ensure that this is not repeated with the current attempt (see, LiveMint and Mostly Economics blog).

From a legal and regulatory standpoint, it is likely to be more difficult to control the activities of SMEs as they may not have adequate infrastructure to meet with the required audit, reporting and compliance procedures as compared to the larger more established corporates. The reputation incentives of SMEs to comply with listing requirements and corporate governance may not be as high as their larger counterparts. …
In essence, there is a need to guard against a “race to the bottom”.

Friday, May 21, 2010

The Corporate Veil and Arbitration Clauses

With the rapid growth of group companies in India over the past decade, it has become commonplace for a commercial transaction to be routed through several entities in one group. In cases where some of those entities have entered into agreements containing an arbitration clause, and others have not, the question arises as to whether the non-signatories are bound by the arbitration clause.

In answering this question, two considerations are relevant. The first is one of arbitration law, and in particular, s. 7 of the Indian Arbitration and Conciliation Act. The second, however, is the contention that is often made in these circumstances that the corporate veil may be lifted in cases where one of the companies has a limited economic role in the transaction. This contention has met with varying degrees of success in the United States and England, but has been accepted on occasion in France. On April 27, the Supreme Court had an opportunity to consider these questions, in Indowind Energy Ltd. v. Wescare Ltd., available here. A two-judge Bench of the Supreme Court, comprising Justices Raveendran and Radhakrishnan, decided the matter.

Indowind and Wescare, the Respondent, are companies incorporated under the Companies Act, 1956. Subuthi Finance Ltd., another incorporated company, is the promoter of Indowind. In February 2006, Subuthi and Wescare entered into an agreement by which Wescare agreed to sell certain Wind Electric Generators to Subuthi for Rs. 98 crores, part of which was to be paid through the issue of shares. While Indowind was not a party to this Agreement, the Agreement provided that it was “subject” to the approval of the Board of Directors of Wescare, Subuthi and Indowind, and that the Agreement would be null and void in the absence of approval. This Agreement contained an arbitration clause, which Wescare invoked when disputes arose, following the failure of the Indowind Board to approve the Agreement. Wescare filed an injunction application under s. 9 of the Arbitration Act, requesting the High Court to restrain Indowind from proceeding with its IPO, and from using the assets sold by Wescare. That application was dismissed by a single judge on the basis, inter alia, that Indowind was not a party to the Agreement, and had not signed or ratified the Agreement. Subsequently, Wescare once again approached the High Court, under s. 11(6) of the Act, seeking the appointment of an arbitrator. The Chief Justice allowed the application, holding that the case was a fit one for lifting the corporate veil, and that Subuthi and Indowind are “one and the same party”. In addition, the Chief Justice relied on several factual circumstances that established a close connection between Subuthi and Indowind.

The Supreme Court rejected this approach, and made several important observations on the sanctity of the corporate form. It began by noting that s. 7 of the Act requires that the arbitration clause is contained in a document “signed by the parties”, or in an exchange of letters, telex etc. Alternatively, the clause must be “incorporated by reference”. The Court firmly rejected the possibility of lifting the corporate veil, in the following terms:

It is not in dispute that Subuthi and Indowind are two independent companies incorporated under the Companies Act, 1956. Each company is a separate and distinct legal entity and the mere fact that two companies have common shareholders or common Board of Directors, will not make the two companies a single entity. Nor will existence of common shareholders or Directors lead to an inference that one company will be bound by the acts of the other. If the Director who signed on behalf of Subuthi was also a Director of Indowind and if the intention of the parties was that Indowind should be bound by the agreement, nothing prevented Wescare insisting that Indowind should be made a party to the agreement and requesting the Director who signed for Subuthi also to sign on behalf of Indowind. The very fact that parties carefully avoided making Indowind a party and the fact that the Director of Subuthi though a Director of Indowind, was careful not to sign the agreement as on behalf of Indowind, shows that the parties did not intend that Indowind should be a party to the agreement.

The Court rejected the contention that a non-signatory may be bound by an arbitration clause by virtue of its “conduct”, holding that the requirement in s. 7 that the agreement be in “writing” is mandatory. In addition, the Court held that the Chief Justice or his designate under s. 11(6) is not the appropriate forum to inquire into the conduct of the parties, and must merely consider whether there is an arbitration agreement or not.

The Court did not entirely foreclose the possibility that a non-signatory in India may bind himself to an arbitration clause through conduct, but noted that this would have to be through “incorporation by reference” or under the provisions of s. 7(4)(b) of the Arbitration Act. It declined to follow American decisions binding non-signatories for the reason that the underlying statutory provision in question was substantially different to s. 7.

It will be interesting to observe whether the Supreme Court confines its observations on the corporate form to the particular context of arbitration agreements, or chooses to apply it more generally.

Wednesday, May 19, 2010

Proposal for Streamlining Stamp Duty on Mergers, etc.

The issue of applicability of stamp duty to a scheme of arrangement (merger/ amalgamation, demerger, reconstruction or otherwise) effected with the sanction of the High Court under sections 391 to 394 of the Companies Act, 1956 has always been a vexed one. As regards stamp duty legislation more generally, several states have enacted their own stamp duty laws while the remaining states are governed by the Indian Stamp Act, 1899.

Stamp duty is usually levied on various instruments, including a “conveyance”. Although various states may define the expression differently, one example is contained in the Indian Stamp Act, 1899, which defines “conveyance” in Section 2 Sub-section (10) as including “a conveyance on sale and every instrument by which property, whether movable or immovable is transferred inter vivos …”.

The definition of “conveyance” in stamp duty laws did not historically include the order of a High Court under a scheme of arrangement in an express manner, and as a matter of practice court orders sanctioning schemes of arrangement were never liable for payment of stamp duty. In the last two decades, however, several states began amending their stamp laws to expressly include orders of the court approving a scheme of amalgamation under section 394 of the Companies Act within the definition of “conveyance”. Consequently, at present, the seven states of Maharashtra, Gujarat, Karnataka, Rajasthan, Chattisgarh, Madhya Pradesh and Andhra Pradesh have included a High Court order (approving a scheme of amalgamation under section 394 of the Companies Act) within the definition of “conveyance” in their stamp laws. As far as these states are concerned, the position regarding liability of stamp duty on arrangements is somewhat clear, although the rates of stamp duty as well as the basis of computation differ even among those states. To that extent, while there is little doubt regarding computation of stamp duty on schemes of arrangement among companies within a single such state, the issue can be somewhat compounded if the companies involved are registered in different such states.

Matters become further complicated when we examine other states that do not expressly include High Court orders on amalgamation within the definition of “conveyance”. The Indian Stamp Act, 1899, which applies to several states in India (other than those discussed in the preceding paragraph) is one such legislation without an express inclusion for a scheme of arrangement. Predictably, that has resulted in a great amount of uncertainty in cases that involve amalgamation of companies registered in states governed by the Indian Stamp Act. Multiplicity of High Court rulings pointing in different directions has only added to the confusion.

In order to briefly set out the lay of the land (without in any way attempting to be exhaustive), it would be useful to examine some of the leading cases. The Bombay High Court was first confounded with this issue in Li Taka Pharmaceuticals Ltd. v. State of Maharashtra, AIR 1997 Bom 7, wherein it held that “even prior to the amendment [in the Bombay Stamp Act expressly including an order of amalgamation], a conveyance would include every instrument by which the property is transferred to or vested in another person inter vivos” and that the amendment was only with a view to set to rest any doubts and to clarify and explicitly state that an order of amalgamation was already included in the definition of conveyance by implication.

The development of case law in West Bengal has been somewhat mixed. A single judge of the Calcutta High Court held in Gemini Silk Limited v. Gemini Overseas Limited, 2003 53 CLA 328, that an order sanctioning a scheme of amalgamation under section 394 is covered by the definition of “conveyance” under the Indian Stamp Act and therefore liable to stamp duty. That was the case even though “conveyance” was not defined to expressly include an order of amalgamation. Subsequently though, a Division Bench of the Calcutta High Court adopted a contrary view in Madhu Intra Limited v. Registrar of Companies, (2006) 130 Comp. Cas. 510, where it was held that an order of amalgamation was not subject to stamp duty, because it did not fall within the definition of a “conveyance”; moreover even if such an order were to be taken as a “conveyance” or an “instrument” the transfer of assets and liabilities effected thereby is purely by operation of law. The Division Bench even went to the extent of expressly setting aside the order and judgment of the single judge in the Gemini Silk case.

More recently, the Delhi High Court in Delhi Towers Ltd. v. G.N.C.T. of Delhi, MANU/DE/3152/2009, was not persuaded by the Division Bench ruling in Madhu Intra. The Delhi High Court instead adopted the previous reasoning in Li Taka Pharmaceuticals and Gemini Silk, and in a comprehensive judgment held that an order of the High Court approving a scheme of amalgamation would be liable to stamp duty even in the absence of an express inclusion of such orders within the definition of “conveyance”. Moreover, the court also noted that stamp duty should be computed on the basis of the consideration paid for the amalgamation, which is reflected in the value of the shares allotted by the amalgamated company in exchange for the amalgamation. Hence, the value of the individual properties being transferred is immaterial to the computation of the stamp duty.

All of these go to demonstrate the lack of uniformity in the applicability of stamp duty on schemes of arrangement in states where the Indian Stamp Act, 1899 operates. In order to remedy this situation, the Union Ministry of Finance has decided to follow the path adopted by the seven states and to amend Section 2(10) to include the following within the definition of “conveyance”: “(iii) every order made by the High Court/Tribunal under Section 394 of the Companies Act, 1956 in respect of the amalgamation or reconstruction of companies; and every order made by the Reserve Bank of India under section 44 A of the Banking Regulation Act, 1949 in respect of amalgamation or reconstruction of Banking Companies;” This has been set out in draft amendments to the Indian Stamp Act that have been approved by the Ministry of Finance.

Such an amendment is welcome as it will put to rest the differing views expressed by the Delhi and Calcutta High Courts and introduce a greater level of certainty, although it would increase the cost of implementing mergers and other forms of reconstruction (which would have to be factored in by parties at the planning stage). If enacted, these amendments would ensure that stamp duty is applicable on schemes of arrangement (such as mergers and other forms of restructuring) in almost all states. However, elements of uncertainty and disparity are set to continue. Although the proposed amendments will only make orders of courts on schemes of arrangement chargeable to stamp duty, the actual rates of stamp duty (and the modes of computation thereof) are still left to individual states to determine. To that extent, the exercise of determining and factoring in stamp duty as a cost element in a merger transaction would continue to be cumbersome, especially in transactions involving companies whose registrations span different states.

‘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

Bombay HC on the Binding Nature of AAR Ruling

(The following post has been contributed by Ravichandra S. Hegde of J. Sagar Associates)

The Bombay High Court on April 29, 2010, while allowing a Writ Petition against the Income Tax Department has ruled on the binding nature of the decision rendered by the Authority for Advance Rulings (“AAR”). The Court has clarified that the decision given by the AAR would be binding on the applicant, the Commissioner and the Income Tax authorities subordinate to him in respect of the applicant’s transactions.

The Petition was filed by the Prudential Assurance Company Ltd, a registered sub-account of a Foreign Institutional Investor (“FII”) against the Director of Income Tax (International Taxation) (“DIT”) being aggrieved by the notice issued by the Commissioner. The matter pertains to the year 2001 when AAR was called upon to determine the incidence of taxation for the purchase and sale of shares by the Petitioner in its ordinary course of business. In April 2001, the AAR had decided that the purchase and sale of shares by the Petitioner was in the ordinary course of its business and the income which resulted from such transactions would constitute business profits and not capital gains. It was also held that the gains arising from the realization of portfolio investments in India would also be treated as part of the company’s business profits. The AAR had made it clear that the amount receivable by the Petitioner from share transactions in India would not be taxable in India as the Petitioner did not have a permanent establishment in India. The Petitioner relied upon this ruling of the AAR in all its assessments till 2008. 

The dispute arose between the parties when DIT purported to set aside the earlier assessments of the Petitioner by issuing a notice to the Petitioner inter alia calling upon the former to show cause as to why the previous assessments should not be set aside as erroneous and prejudicial to the interest of the revenue. The basis for such a notice was that the AAR, in its ruling in the case of Fidelity Northstar Fund (AAR No. 678/ 2006) held that the profits derived on account of purchase and sale of equities would constitute capital gains and would be chargeable to tax accordingly.

The Court interpreted the provisions of Section 245S of the Income Tax Act, 1961 and observed that the ruling pronounced by the AAR shall be binding on the Applicant who had sought it and on the Commissioner along with his subordinates only in relation to the transaction which is the subject matter of the said Application. The Court further stated that the ruling shall not be binding if there is a change in law or facts on the basis of which the ruling was pronounced by the AAR. Once a ruling has been pronounced by the authority, the binding effect of the ruling can only be displaced in accordance with the procedure which is stipulated under law. It was in this backdrop that the High Court came to a conclusion that the subsequent ruling of the AAR which clarified the position on the subject as to the taxability issue would not amount to a “change in law” to erode the binding effect of the ruling given earlier in similar case. The High Court hence held that the Commissioner had exceeded his jurisdiction in relying upon the ruling of AAR in Fidelity Northstar Fund as a ruling which would apply to the Petitioner.  

As a matter of fact, there has been no conclusive ruling on this issue. In my earlier post I had written on the taxation of derivative transactions by FII, where AAR in the case of Royal Bank of Canada had granted the benefit of exemption from taxation to the FII stating that the profits derived from the derivative transactions would amount to business income and not capital gains. While deciding such issue, the AAR had referred to its earlier decisions in the matter of Morgan Stanley and Co and Fidelity North Star Fund, though some reservations over the decisions were expressed by the Chairman. Now pursuant to the decision of the High Court it can be said that till the decision of the AAR is not set aside as provided in the statute, the ruling will be a law for the subject transactions and binding on the Commissioners for all further assessments years.

- Ravichandra S. Hegde

Wednesday, May 12, 2010

Further Comments on the NCLT judgment

In an earlier post, I had noted that a Constitution Bench of the Supreme Court has upheld the establishment of the National Company Law Tribunal and the National Company Law Appellate Tribunal, in an appeal filed by the Union of India against a judgment of the Madras High Court. The judgment of the Constitution Bench (Union of India v. R. Gandhi / Madras Bar Association) is now available on JUDIS (Civil Appeal No. 3067 of 2004 with Civil Appeal No. 3717 of 2005, unanimous, judgment dated May 11, 2010, per Justice Raveendran)

What the Court held:

While it is true that the competence of Parliament to establish the NCLT and the NCLAT has been upheld, the judgment effectively approves of the principles laid down in the impugned judgment of the Madras High Court. What the Constitution Bench has held is that “the creation of National Company Law Tribunal and National Company Law Appellate Tribunal and vesting in them, the powers and jurisdiction exercised by the High Court in regard to company law matters, are not unconstitutional…” However, “We declare that Parts 1B and 1C of the Act as presently structured, are unconstitutional (and) may be made operational by making suitable amendments, as indicated above, in addition to what the Union Government has already agreed in pursuance of the impugned order of the High Court…” In sum, the legislative competence of Parliament to create the NCLT and the NCLAT has been upheld, but the particular structure of the NCLT and NCLAT presently being proposed has been held unconstitutional. Thus, in order for the NCLT and the NCLAT to come into existence, the Union of India will have to carry out several amendments beyond what was mandated in Chapters 1A and 1B of the Companies Act, 1956 inserted by the Companies (Second Amendment) Act, 2002. The decision does not decide on the constitutionality of the National Tax Tribunal (although the matter as heard together, it appears to have been de-linked).

The contentions and the controversy:

The contentions against the creation of the NCLT and NCLAT were as follows:

1. Parliament does not have any legislative competence whatsoever to vest intrinsic judicial functions, particularly those which have been traditionally performed by the High Courts for a long time, in any Tribunal outside of the Judiciary.

2. The constitution of the NCLT and transferring the entire company jurisdiction of the High Courts to the Tribunal was violative of the doctrine of separation of powers and independence of the Judiciary, particularly having regard to the proposed qualifications of membership of the NCLT.

The real controversy was with respect to the second of these contentions. At issue were Sections 10(FD)(3) and 10(FX). Section 10(FD)(3) deals with the appointment of technical members (as opposed to judicial members), while Section 10(FX) deals with the selection process for the Chairperson of the Tribunal.

Competence of Parliament:

The Union of India contended that Parliament had legislative competence under the Constitution, and that being the case, the manner of exercise of its legislative power was not subject to challenge. On the other hand, it was contended by the respondents that legislative competence to create Tribunals existed only under Articles 323-A and 323-B of the Constitution. Those two Articles deal with the creation of tribunals in respect of some specific matters and it was contended that the NCLT was not limited to those matters listed in the two Articles. This contention was rejected – it was held that legislative competence can be exercised in respect of all matters in List I of the Seventh Schedule; and Article 323-A and 323-B is not a limiting provision. The subject-matters specifically listed in those articles are not exhaustive.

Concerns over membership:

The stronger challenge, and also the ground which was pressed more strongly, was on the membership of the Tribunal. On this, the Court takes a severe view of the Union’s argument that once competence was established, there could be no further test. The Court observes:

… when we say that Legislature has the competence to make laws providing which disputes will be decided by courts and which disputes will be decided by Tribunals, it is subject to constitutional limitations, without encroaching upon the independence of judiciary and keeping in view the principles of Rule of Law and separation of powers. If Tribunals are to be vested with judicial power hitherto vested in or exercised by courts, such Tribunals should possess the independence, security and capacity associated with courts. If the Tribunals are intended to serve an area which requires specialized knowledge or expertise, no doubt there can be Technical Members in addition to Judicial Members. Where however jurisdiction to try certain category of cases are transferred from Courts to Tribunals only to expedite the hearing and disposal or relieve from the rigours of the Evidence Act and procedural laws, there is obviously no need to have any non-judicial Technical Member. In respect of such Tribunals, only members of the Judiciary should be the Presiding Officers/members of such Tribunals… Therefore, when transferring the jurisdiction exercised by Courts to Tribunals, which does not involve any specialized knowledge or expertise in any field and expediting the disposal and relaxing the procedure is the only object, a provision for technical members in addition to or in substitution of judicial members would clearly be a case of dilution of and encroachment upon the independence of the Judiciary and Rule of Law and would be unconstitutional…

The present model does NOT pass the constitutional threshold:

In applying these principles to the NCLT/NCLAT, the Court states, capturing most of the concerns against the NCLT/NCLAT, “The issue is not whether judicial functions can be transferred from courts to Tribunals. The issue is whether judicial functions can be transferred to Tribunals manned by persons who are not suitable or qualified or competent to discharge such judicial powers or whose independence is suspect…” Further, the Court holds that when Parliament proposes to substitute a Tribunal for the High Court to exercise jurisdiction on company matters which the High Court is currently exercising, the standards expected from Judicial Members and the standards for appointing Judicial members should be as nearly as possible the same as those applicable for appointment of High Court judges. The Court recognizes that Technical members may be necessary for proper functioning of the NCLT/NCLAT. In appointing Technical members, the Government should keep in mind that “A lifetime of experience in administration may make a member of the civil services a good and able administrator, but not a necessarily good, able and impartial adjudicator…” It prescribes that only an officer of Secretary level in the appropriate civil service with specialized skills can be appointed as a Technical member of the tribunal. Again, the mere fact of being a civil servant is not enough – the person appointed must have expertise in company law and allied subjects. Furthermore, no such member can be allowed to “retain a lien over his retain his lien over his post with the parent cadre or ministry or department in the civil service for his entire period of service as member of the Tribunal…

The conclusions of the Court are as follows:

1. Who can be appointed as a Judicial member?

Only Judges and Advocates can be considered for appointment as Judicial Members. Furthermore, only High Court Judges, or Judges who have served in the rank of a District Judge for at least five years, or a lawyer who has practiced for ten years, can be considered for appointment as a Judicial Member.

2. Who cannot be appointed as a Judicial member?

Persons who have held a Group A or equivalent post under Central or State Governments with experience in the services such as the Indian Company Law Service (Legal Branch) and Indian Legal Service (Grade-1) cannot be considered for appointment as judicial members. Their expertise in these services can at best mean that they can be considered for appointment as technical members. In sum, a judicial member must closely approximate a High Court Judge.

3. Who can be appointed as a Technical member?

Only officers holding the ranks of Secretary/Additional Secretary can be considered for appointment as Technical members.

4. Who cannot be appointed as a Technical member?

A `Technical Member' presupposes experience in the specific field to which the Tribunal relates. A member of Indian Company Law Service who has worked with Accounts Branch of that service, or officers in other departments who might have incidentally dealt with some aspect of Company Law, cannot be considered as ‘experts’ and cannot be considered as being qualified for appointment as Technical members.

5. What is the Selection Committee for appointment?

The Selection Committee must be headed by the Chief Justice of India or his nominee, who shall also have the casting vote. Besides this, there is to be a senior Judge of the High Court or the Supreme Court. The other two members can be the secretaries of some government department (such as finance & company affairs, and law & justice).

6. What is the term of office of the members?

The term of office must be seven years, or at the very least, five years. This is because the presently proposed three-year term was too short to result in development of additional expertise, and because the “said term of three years with the retirement age of 65 years is perceived as having been tailor-made for persons who have retired or shortly to retire and encourages these Tribunals to be treated as post-retirement havens. If these Tribunals are to function effectively and efficiently they should be able to attract younger members who will have a reasonable period of service…” Members cannot retain a lien over there parent cadre for a period of more than one year from joining the Tribunal. Members can be removed/suspended prior to ending of their term only with the concurrence of the Chief Justice of India.

7. How shall Benches be constituted?

Two-Member Benches must have a Judicial member. Whenever any larger bench or any special bench is constituted, the number of Technical Members cannot exceed the Judicial Members.


Now, of course, some of these conclusions are rather broad – the Court is only laying down the shortcomings in the presently proposed model, and it is for the Government to take note of these principles and pass an appropriate law establishing the NCLT. Thus, the judgment has upheld the competence of the Parliament to set up the NCLT, but it has not upheld the actual establishment of the NCLT itself. Only after the Parliament modifies the present law will an actually existing and functional Tribunal be possible. It is perhaps in everyone’s interest that Parliament sticks to the Court’s views as closely as possible in enacting the new law, else another constitutional challenge would be in the offing. The ball is now back in the Parliament’s court.