Thursday, September 30, 2010

A New Edition of the Consolidated FDI Policy

On April 1 this year, the Government gave effect to a consolidation exercise by locating all policies relating to FDI in a single document known as the Consolidated FDI Policy (as discussed here). That was not meant to be a static policy, but something that was to be reviewed every six months.

Lo and behold, promptly at the end of the first six-month period, the Government today issued a revised FDI policy in the form of the Consolidated FDI Policy: Circular No. 2 of 2010. The policy is usefully accompanied by a press release explaining the key changes. There is no significant change in the direction of the policy, either generally or with respect to any particular industrial sector, although several open issues causing ambiguities in practice have been ironed out in the new circular. Some of the more important clarifications relate to the following (although this list is not exhaustive):
- Clarification that 100% foreign owned NBFCs, with a minimum capitalization of $ 50 million, can set up subsidiaries for specific NBFC activities, without bringing additional capital towards minimum capitalization;

- Introduction of specific provision for downstream investment through internal accruals;

- Clarification of the terms ‘original investment’ and ‘lock-in period’ in case of minimum capitalization of construction development projects;

- Removal of the condition that ‘wholesale trading made to Group companies should be for internal use only’ in the guidelines for Cash & Carry Wholesale Trading;

- Clarification that Minimum Capitalization includes share premium received along with face value of the shares only when it is received by the company upon issue of the shares to the non-resident investors;

- Amendment of Note below the definition of ‘Capital’ to allow for FDI in partly-paid shares and warrants through the Government route;

- Changes in the paragraphs relating to issue price of shares and addition of a paragraph on share-swaps, consistent with extant instructions.
Continuing with the general observations made in my post yesterday regarding the nature of policy making in the FDI arena, the exercise involving consolidation of the FDI policy and its periodic revision (developments that occurred over the last year or so) have certainly streamlined matters. Previously, any attempt at ascertaining a specific rule on foreign investment was like looking for a needle in a haystack. To that extent, the present efforts go a long way in inducing a sense of orderliness to the process, creating a greater level of certainty and comfort for foreign investors as well as Indian companies (who are recipients of the investment). Of course, there will still be areas of ambiguities and confusion, but as long as they are addressed from time to time, progress will be made.

FDI: Shares for Consideration Other than Cash

In another of a series of discussion papers, the Department of Industrial Policy & Promotion (DIPP) has issued one on issue of shares for consideration other than cash.

In the past, foreign investment policy has mandated that shares be issued by Indian companies to foreign investors under the automatic route only against remittances received through normal banking channels. The only exceptions to this are conversion of outstanding amounts on external commercial borrowings or fees payable for technical services. Any attempt by Indian companies to issue shares for non-cash consideration under the approval route has generally been looked down upon by the Foreign Investment Promotion Board (FIPB), although it appears that the FIPB has been taking a more liberal approach lately by allowing such issue of shares in a few cases.

The new discussion paper invites views on whether issue of shares for non-cash consideration should be allowed as a matter of policy and more generally (rather than as a mere exception). The discussion paper considers the following scenarios for issue of shares for consideration other than cash:

- Import of Capital Goods/ Machinery/ Equipment

- Services

- Import of Raw Material/ Trade Payables

- Pre-operative/ Pre-incorporation Expenses

- Share Swaps

- Intangible Assets (including franchisee rights)

- One Time Extraordinary Payments (including arbitration awards).

If implemented, this will provide an array of options for infusion of FDI. For instance, freely allowing share swaps will enhance the use of shares as currency for acquisitions by Indian companies, especially for overseas acquisitions.

However, valuation becomes crucial. In terms of installing checks and balances in the use of non-cash consideration, necessary guidelines must be provided for valuation of the assets or rights being received by the Indian company against which shares are issued to a foreign investor.

Wednesday, September 29, 2010

Proposal for FDI in Limited Liability Partnerships

Limited liability partnerships (LLPs), which are a relatively novel concept to India, have been recognised since April 1, 2009. LLPs are different from general partnerships in several ways, but there are two prominent differences. First, partners in LLPs carry limited liability for acts of the firm. Second, the partnership firm possesses separate legal personality and to that extent it has distinct existence from its owners/partners. In that sense, an LLP is a hybrid entity. While it has the key features of a limited liability company, it has the flexibility of management and operations, small size and tax status similar to a general partnership.

Although LLPs have been in existence for over a year now, the FDI policy has not provided for separate treatment for foreign investment in LLPs. The Consolidated FDI Circular issued on April 1, 2010 permits non-resident Indians and persons of Indian origin to invest in partnership firms and proprietary concerns. Under relevant RBI guidelines, other foreign investors are required to obtain prior approval of the RBI to invest in partnership firms. The absence of specific treatment of LLPs in the FDI policy makes it unsuitable to attract foreign investment in those entities.

In this background, the Government yesterday issued a discussion paper on foreign investment in LLPs. Although the paper does not set out any specific position, it seeks views from the public on various aspects starting from whether FDI should be permitted at all in LLPs to what factors are to be considered while permitting FDI (such as issues of ownership, control, downstream investments, valuation, and the like).

The LLP as a business entity is yet to drum up the impetus it was expected to generate when the LLP Act was passed and later notified in 2009. It appears that the number of LLPs being registered is growing at a slow pace, and the present effort is an additional step to confer benefits on that entity so as to attract more entrepreneurs and professionals to utilise it as a vehicle to carry on their business or profession.

At a more general level, the practice of the Department of Industrial Policy and Promotion (DIPP) in issuing discussion papers on various topics is welcome. It makes the policy-making process transparent and inclusive. The use of policy arguments, the comparative study of position in other similarly situated countries, and in some cases the reference to empirical evidence certainly enhances the quality of policy-making. It is hoped that these discussion papers will be taken to their logical conclusion with a definition pronouncement made one way or the other. Failing this, there is a risk that it will only cause greater ambiguity and confusion in the minds of foreign investors and the Indian recipients of such investment.

Friday, September 24, 2010

SEBI Order on MCX Stock Exchange

SEBI yesterday issued a detailed order rejecting the application of MCX-SX to commence trading in several exchange segments. The background of the case and the gist of SEBI’s order are available at Business Standard and Livemint. SEBI’s conclusion is based on a legal analysis (a fairly intensive one for a regulator) of various issues as well its assessment of whether the applicant is a ‘fit and proper’ for the grant of a licence.

The reasons for SEBI’s conclusion have been summarised in the order as follows:
a. The concentration of economic interest in a recognised stock exchange in the hands of two promoters is not in the interest of a well-regulated securities market.

b. The Applicant is not fully compliant with the MIMPS Regulations as substitution of shares by warrants is an attempt to work around the requirements of Regulation 8 of the same and the same is not a mode recognised as falling within the scope of the said Regulations.

c. The Applicant has been dishonest in withholding material information on arrangements regarding the ownership of shares of its shareholders and therefore has not adhered to fair and reasonable standards of honesty that should be expected of a recognised Stock Exchange.

d. The Applicant has failed to ensure compliance with Regulation 8 of the MIMPS Regulations as its two promoters (FTIL and MCX) are persons acting in concert and cannot hold more than 5% in the equity shares of a recognised stock exchange.

e. The Applicant is instrumental to buyback transactions that are illegal under the SCR Act and cannot be considered to have adhered to fair and reasonable standards of integrity that should be expected of a recognised Stock Exchange.
Questions have been raised regarding certain aspects of SEBI’s ruling, particularly whether the provisions of the Securities Contracts (Regulation) (Manner of Increasing and Maintaining Public Shareholding in Recognised Stock Exchanges) Regulations, 2006 are applicable to MCX-SX’s situation at all (because they have been designed to deal with exchanges that are being demutualised, which MCX-SX is not). The issue is quite likely to go up in appeal.

Beyond the specifics of this case, calls have also been made to reform the regulations for recognition of stock exchanges.

Sunday, September 19, 2010

The Taxation of Sales Preceding Export Transactions - Part II

In the first part, I outlined the conflict between the ‘same goods’ and ‘inextricable connection’ test, witness in applying section 5(3) of the Central Sales Tax Act. The resolution of this conflict, mandated a reference to a Constitution Bench in Azad Coach Builders.

On facts, the seller (Azad Coach Builders) has sold bus bodies to the exporter (TELCO), which were mounted on chassis made by the exported, and exported to a foreign company (Lanka Ashok Leyland). The foreign company had specifically asked the exporter to purchase the bus bodies from the seller, which was supposed to manufacture them according to the instructions of the foreign company. This agreement was also evidenced by the Purchase Order and communication between the parties. Thus, there was clearly a link between the export transaction and the preceding sale. However, since the sale was of bus bodies and the export of buses, the goods were not the same, leading to the conflict between the two tests. The Assessing Officer and the Joint Commissioner of Commercial Taxes (Appeals) applied the ‘same goods’ test and disallowed the exemption. The High Court however, allowed the exemption, applying the ‘inextricable connection’ test. It was the appeal by the State of Karnataka against this decision that brought the case to the Supreme Court.

The Constitution Bench of the Supreme Court reaffirmed the Karnataka High Court, and gave primacy to the ‘inextricable connection’ test over the ‘same goods’ test. Relying on the use of the terms ‘occasions’ and ‘in relation to’ in section 5(3), the Court held that if “each link (of the export transaction) is inextricably connected with the one immediately preceding it”, the sale will be exempt. Placing the burden of showing the link on the assessee, the Court observed, “The assessee in this case has succeeded in showing that the sale of bus bodies have occasioned the export of goods. When the transaction between the assessee and the exporter and the transaction between the exporter and foreign buyer are inextricably connected with each other, in our view, the `same goods' theory has no application”.

However, while the rationale of this dictum is fairly straightforward, and arguably more equitable, it does raise a few questions which merit further attention.

First, this reading of section 5(3) completely nullifies the connection between ‘any goods’ and ‘those goods’, introduced by the initial part of the provision. It may be argued that this is too technical a reading of the provision, but it is nevertheless one which has been accepted by earlier Supreme Court dicta and is not countered by this decision. In fact, a strong case can be made for the proposition that the initial part of the provision narrows the broad language which follows.

Secondly, the Court relies on the Statement of Objects and Reasons; reliance which, it is submitted with due respect, is suspect. While the Statement does mention an ‘inextricable connection’, it merely says that this connection exists when goods are sold to a export canalising agency. It does not say that each case which involves an ‘inextricable connection’ was intended to be exempted. In fact, by mentioning only canalising agencies, which export the goods purchased without any changes whatsoever, the Statement provides more support for the ‘same goods’ test than the ‘inextricable connection’ test.

Finally, the Court hasn’t even gone all the way and given effect to the later part of the provision. We had discussed earlier how the phrase ‘in relation to’ has been given a very wide meaning by the Supreme Court in Doypack Systems Pvt. Ltd. V. Union of India, (1988) 2 SCC 299. In this case, the Court had held that even an indirect connection satisfies the requirement of ‘in relation to’, something which the Constitution Bench in Azad specifically rejects. When choosing a test narrower than Doypack (which was not referred to by the Court) but broader than ‘same goods’, the Court had two options- (a) requiring that the identity of the goods should not have changed between the sale and the export (as argued by Mr. Soli Sorabjee); and (b) requiring that the transaction of sale be inextricably connected to the export (suggested by Mr. Goolam Vahanvati). By choosing the latter, the Court seems to be leaning towards a position that the goods are not relevant for the purposes of determining the scope of the exemption, and all that is needed is some connection between the transactions of sale and export.

In sum, the Court lays down the following propositions for granting an exemption under section 5(3) of the Central Sales Tax Act:

(a) There should be a sale for the purposes of the export;

(b) The purchaser should export;

(c) There should be an inextricable connection (preferably in the form of some degree of privity between the seller and the importer) between the sale and the export, which occasions the export.

The Taxation of Sales Preceding Export Transactions - Part I

Last week, the Supreme Court decided an interesting issue relating to statutory interpretation, very similar to the issue which had arisen in Daga Capital, discussed earlier. The question which the Court in State of Karnataka v. Azad Coach Builders was the extent to which States may tax sales transactions which immediately precede an export/import transaction. The controversy arises because the Constitution places a restriction on the taxing power of States when it comes to taxing sales of purchases of goods ‘in the course of’ import or export.

Article 286(1) of the Indian Constitution reads-

(1) No law of a State shall impose, or authorise the imposition of, a tax on the sale or purchase of goods where such sale or purchase takes place-

(a) outside the State; or

(b) in the course of the import of the goods into, or export of the goods out of, the territory of India. [emphasis supplied]

The question of whether transactions prior to the actual import/export could be said to be ‘in the course of’ export or import was first considered by the Supreme Court in Md. Serajuddin & Others v. State of Orissa (1975) 2 SCC 47; which answered the question in the negative. This prompted the Parliament to change the law by means of a legislative amendment, after which the relevant provision of the Central Sales Tax Act reads-

Section 5: When is a sale or purchase of goods said to take place in the course of import or export.-

(1) A sale or purchase of goods shall be deemed to take place in the course of the export of the goods out of the territory of India only if the sale or purchase either occasions such export or is effected by a transfer of documents of title to the goods after the goods have crossed the customs frontiers of India.


(3) Notwithstanding anything contained in sub-section (1), the last sale or purchase of any goods preceding the sale or purchase occasioning the export of those goods out of the territory of India shall also be deemed to be in the course of such export, if such last sale or purchase took place after, and was for the purpose of complying with, the agreement or order for or in relation to such export. [emphases supplied]

There are two aspects of the amended clause (3) that merit attention.

First, in what seems to be an effort to narrow the scope of the provision, the text provides for an exemption when the ‘sale or purchase of any goods’ occasions ‘the export of those goods’. This connection between the goods being sold (any goods) and those being exported (those goods) suggests that the goods being exported should be the same as those which were sold. This was the ‘same goods’ test, and received judicial approval in Sterling Foods v. State of Karnataka & Another (1986) 3 SCC 469 and Vijayalaxmi Cashew Company & Others v. Deputy Commercial Tax Officer & Another (1996) 1 SCC 468. This interpretation of the provision also draws support from the Statement of Objects and Reasons of the Amending Act 103 of 1976 which added clause (3). The object of section 5(3) was explained as-

... A sale of goods made to an export canalizing agency such as the State Trading Corporation or to an export house to enable such agency or export house to export those goods in compliance with an existing contract or order is inextricably connected with the export of the goods. ... It is, therefore, proposed to amend, with effect from the beginning of the current financial year, Section 5 of the Central Sales Tax Act to provide that the last sale or purchase of any goods preceding the sale or purchase occasioning export of those goods out of the territory of India shall also be deemed to be in the course of such export if such last sale or purchase took place after, and was for the purpose of complying with, the agreement or order, for, or in relation to, such export. [emphases supplied]

However, the last part of clause (3) seems to widen the scope of the exemption by laying down a requirement that the sale or purchase should be ‘for the purpose of complying with, the agreement or order for or in relation to such export’. This ‘inextricable connection’ test also finds limited support in the above Statement of Objects and Reasons, and was stressed on by the Apex Court in K. Gopinathan Nair & Others v. State of Kerala (1997) 10 SCC 1. However, since after applying this test, the Court had concluded that the exemption was not available on facts, there was no need for the Court to consider a conflict between the ‘same goods’ test and the ‘inextricable connection’ test.

It was this conflict that fell for the Court’s consideration in Azad Coach Builders, which I shall discuss in a subsequent post.

Saturday, September 18, 2010

Outbound Acquisitions by Indian Companies

Professor Afra Afsharipour at the University of California, Davis, School of Law has posted an interesting paper “Rising Multinationals: Law and the Evolution of Outbound Acquisitions by Indian Companies”. Although several leading Indian companies have embarked on large overseas acquisitions, the law in this area has not been the subject-matter of serious academic study. To that extent, this paper represents an important contribution to the field. The abstract is as follows:

India is one of the fastest growing economies in the world and is predicted to become the third-largest economy in the world after the United States and China. India‘s economic transformation has allowed Indian firms to gain significant attention in the world economy, particularly as acquirers of non-Indian firms. In the past decade, Indian companies have launched multimillion and multibillion dollar deals to acquire companies around the globe, with a significant concentration of targets in developed economies, in particular the United States and the United Kingdom.

Finance and business scholars have addressed outbound acquisitions by Indian multinationals, emphasizing the business and economic motivations for such transactions. However, there has been little analysis from a legal perspective of the significance of India‘s legal norms and rules, including recent shifts in the country‘s regulatory and legal regimes, in the rapid expansion of Indian multinationals. This Article fills this void by analyzing the role of India‘s post-liberalization legal reforms in outbound acquisitions by Indian companies. This examination presents a more complete picture of the legal environment and legal rules that have facilitated outbound acquisitions by Indian multinationals, but also reveals how limitations in India‘s legal reforms have constrained these deals.

This Article argues that Indian corporate law plays a number of important roles in the emergence of Indian multinationals. First, legal reforms since economic liberalization have set the stage for outbound acquisitions by Indian multinationals. Second, Indian legal reforms and legal history have shaped outbound acquisitions both in terms of transaction structure and transaction size. Third, legal constraints on Indian firms’ mergers and acquisition activity impose substantial restrictions not only on the methods that Indian multinationals use in pursuing outbound acquisitions, but also on the future potential of Indian multinationals.

ECJ on In-house Lawyers and Legal Privilege

On September 14, 2010, the European Court of Justice (ECJ) issued its judgment in the case of Akzo Nobel and Akcros Chemicals on the question whether communication with in-house lawyers is protected by legal professional privilege. The case involved an investigation by European Commission authorities of possible anti-competitive practices wherein officials took copies of a number of documents. The companies involved claimed legal privilege over certain documents, such as “two e-mails, exchanged between Akcros’ … general manager and Mr. S., Akzo’s … coordinator for competition law. The latter is enrolled as an Advocaat of the Netherlands Bar and, at the material time, was a member of Akzo’s … legal department and was therefore employed by that undertaking on a permanent basis.”

The ECJ rejected the claim of legal privilege relying on its previous judgment in AM & S Europe v. Commission [1982] ECR 1575. The following extracts from the Akzo judgment are self-explanatory as to the reasoning adopted by the court:

40. … in AM & S Europe v Commission, … 41. the Court stated that the protection [of legal privilege] was subject to two cumulative conditions. … first, that the exchange with the lawyer must be connected to ‘the client’s rights of defence’ and, second, that the exchange must emanate from ‘independent lawyers’, that is to say ‘lawyers who are not bound to the client by a relationship of employment’.

42. … the requirement as to the position and status as an independent lawyer, which must be fulfilled by the legal adviser from whom the written communications which may be protected emanate, is based on a conception of the lawyer’s role as collaborating in the administration of justice and as being required to provide, in full independence and in the overriding interests of that cause, such legal assistance as the client needs. The counterpart to that protection lies in the rules of professional ethics and discipline which are laid down and enforced in the general interest.

44. It follows that the requirement of independence means the absence of any employment relationship between the lawyer and his client, so that legal professional privilege does not cover exchanges within a company or group with in-house lawyers.

45. … An in-house lawyer, despite his enrolment with a Bar or Law Society and the professional ethical obligations to which he is, as a result, subject, does not enjoy the same degree of independence from his employer as a lawyer working in an external law firm does in relation to his client. Consequently, an in-house lawyer is less able to deal effectively with any conflicts between his professional obligations and the aims of his client.

47. Notwithstanding the professional regime applicable in the present case in accordance with the specific provisions of Dutch law, an in-house lawyer cannot, whatever guarantees he has in the exercise of his profession, be treated in the same way as an external lawyer, because he occupies the position of an employee which, by its very nature, does not allow him to ignore the commercial strategies pursued by his employer, and thereby affects his ability to exercise professional independence.

49 It follows, both from the in-house lawyer’s economic dependence and the close ties with his employer, that he does not enjoy a level of professional independence comparable to that of an external lawyer.

50 Therefore, the General Court correctly applied the second condition for legal professional privilege laid down in the judgment in AM & S Europe v Commission.
In deciding the question of legal privilege, the ECJ has taken up the opportunity to expound on the role of an in-house lawyer and distinguish it from the role of an external lawyer.

The direct effect of the ruling in Akzo Nobel is likely to felt by companies operating in the EU and it is unlikely to affect the law in jurisdictions where domestic law confers legal privilege on in-house lawyers. However, in jurisdictions where such privilege is not conferred expressly by domestic law on in-house lawyers, the Akzo Nobel judgment could have some persuasive value.

Under Indian law, the Bar Council of India Rules require any lawyer taking up full-time salaried employment to “intimate the fact to the Bar Council on whose roll his name appears and shall thereupon cease to practise as an advocate so long as he continues in such employment” (Rule 49, Section VII, Chapter II, Part VI). Hence, the reasoning of ECJ in the Akzo Nobel judgment ought to apply with greater force in such circumstances, ceteris paribus (i.e. without taking into consideration other procedural and evidentiary aspects of domestic Indian law, if any, that may operate to the contrary).

Friday, September 17, 2010

More on Independent Directors

Can Independent Directors Appoint Alternates?

Despite closely following developments in the law relating to independent directors (IDs) in the recent past, this question took me by surprise. Considering the special position of an ID, it seemed to me that an individual occupying that position is incapable of being substituted, even if that were temporary in nature. However, a debate generated during the past week or so in Singapore suggests that the concept of alternates for IDs does, after all, exist. This has given rise to calls for greater clarity on whether the practice should be allowed and, if so, what safeguards need to be embedded to ensure that there is no dilution of corporate governance in those companies.

An alternate director is appointed where an original director is unable to attend board meetings for a period of time. Under Section 313 of the Indian Companies Act, an alternate director can be appointed during the absence of the original director “for a period of not less than three months from the State in which meetings of the Board are ordinarily held”. When the original director returns, the position of the alternate director stands vacated.

This concept is likely to create difficulties when applied to an ID. First, director independence is an essential element of an enhanced corporate governance framework. The identity of the ID is crucial to independence, and hence any ability to appoint alternate IDs will defeat this purpose. Second, while IDs are to be appointed (or at least subsequently approved) by the shareholders in general meeting, alternate directors can be appointed by the board, thereby considerably diluting the appointments process. This is the case even under Section 313 so long as the articles provide for that. Third, corporate governance norms do not usually provide for qualities that alternate directors ought to possess. For instance, it is not clear if alternate directors need to satisfy the requirements of independence that apply to the original IDs, even though they should logically apply.

Thus far, appointment of alternates for IDs does not seem to have captured much attention in India. To my knowledge, not many Indian companies have gone down the route of appointing alternates for IDs – but I would welcome correction if that is not the case. Considering that the concept of ID is being fine-tuned under the Companies Bill, it might make eminent sense to plug this point to avoid any ambiguity.

Takeovers and Independent Directors

In several jurisdictions, whenever a takeover offer is launched the board of directors of the target company must generally consider whether the offer is in the interests of its minority shareholders. In this behalf, courts attach importance to the views of an independent board while determining whether a takeover offer should be allowed to proceed. This practice is now embedded in corporate legal systems such as Delaware.

In India, the SEBI Takeover Regulations provide in Reg. 24(4) that the directors of the target company may, if they so desire, send their comments to shareholders after seeking the opinion of a committee of independent directors. Since the consideration of a takeover offer by the target company’s board is an optional matter, it is for the board (or a committee) to take a view on the offer. The offer therefore largely tends to be an affair between the acquirer and the controlling shareholders who are exiting the company, which leaves minority shareholders in the lurch if they are unhappy with the terms of the offer. One such scenario has played out in Vedanta’s offer for Cairn where the controlling shareholder is availing of non-compete fees which are not available to the minority shareholders. Due to resistance from the minority shareholders, the board of Cairn Energy has sought to deviate from the usual practice, and to appoint a committee of independent directors to look into the interests of the minority shareholders. While this is welcome, the desirability of the final outcome of the committee’s review would depend on process it follows to arrive at its decision, and also level of transparency in that process.

For the longer term, the Takeover Regulations Advisory Committee (TRAC) has noted that it is only optional under the present Takeover Regulations for the board (or independent committee) to make recommendations to the shareholders, and has recommended that this be made mandatory. See paragraph 13.0 of the Report and Reg. 26(6) of the proposed draft Regulations.

Thursday, September 16, 2010

“Subject to contract” agreements and Good Faith

On the issue of when a contract is formed in the case of "subject to contract" agreements, the leading Indian contract law textbook notes that what needs to be determined is, "… whether the formal document is of such a nature that it was the very condition of the contract or whether it was commemorative of the evidence on the point…" (Pollock & Mulla, 12th edn., page 213). While on the face of it the test might appear to be clear, applying this in particular facts can be a cumbersome exercise. Niranjan had previously discussed in detail the judgment of the UK supreme Court in RTS Flexible, on issues related to contract formation. The principles in that case have been discussed and applied in a judgment by the England & Wales High Court, in Benourad v. Compass Group. The law on the point as arising from that judgment may be summarized thus:
1. The fact that a draft contractual document contemplates that a party would obtain legal advice before signing, are indicative of the fact that the parties do not intend to be bound until the document is signed.
2. While parties may have intended at the initial stage that an oral agreement was not legally binding until a formal written document was executed, if "it can be objectively ascertained that the continuing intention of the parties changed", then the requirement for a written document does not matter. The parties will be bound nonetheless.
3. Where the case is not of a "subject to contract" agreement, the fact that services have been performed is a particularly important factor in determining whether the contract has been formed. Where the agreement is "subject to contract", the issue will turn on whether "all the essential or important terms" have been agreed. If they have, and if services are rendered, a Court is likely to find that there is a contract without the necessity for a formal written agreement.
4. Where certain terms of commercial/economic significance have not been agreed, the parties may be held to have agreed "to be bound now while deferring important matters to be agreed later". The more important the un-agreed term, "the less likely it is that the parties will have left it for future decision"
In this connection, a recent decision of the ICSID – Azpetrol International Holdings v. The Republic of Azerbaijan – may be interesting. Prof Andrew Newcombe has posted a note on the decision here; and he says:
"The question before the tribunal in Azpetrol was whether an exchange of emails between counsel for the parties resulted in a binding settlement agreement. Applying English contract law principles, the tribunal found that there was a binding settlement agreement. As a result, the tribunal held that it lacked jurisdiction under Article 25(1), ICSID Convention, because there was no longer a legal dispute between the parties. The award serves as a cautionary tale for counsel negotiating settlement agreements." The decision is available here; and the relevant analysis of the Tribunal is found from page 24 (paragraph 67) onwards. The Tribunal noted:
"(The Tribunal) is not persuaded that the term "agreement in principle" is inevitably used in English law and in the practice of English lawyers to refer to a non-binding agreement. The Claimants did not produce any authority which went that far. The authorities on which they relied (Attorney-General of Hong Kong v. Humphreys Estate, [1987] AC 114; Cobbe v Yeoman Management Ltd., [2008] UKHL 55) show that the term can be used in that way but those cases concerned agreements for the sale of land, one of the rare cases in which English law provides that a contract must be evidenced in writing in order to be binding, and they do not suggest that the term is invariably used in that way. Similarly, the leading commentary (Chitty on Contracts) does not, in the Tribunal's view, sustain the broad principle advanced by the Claimants."
A connected issue in this regard pertains to pre-contractual liability in general. What liability arises in pre-contractual negotiations? Is there a duty in common law to negotiate in good faith? The Harvard Law Review recently published an article in this regard authored by Professors Alan Schwartz and Robert Scott – "Precontractual Liability and Preliminary Agreements". in an extreme form, the contents of this duty might be expressed thus:
"A party who manifests a willingness to enter into a contract at given terms should not be able to freely retract from her manifestation. The opposing party, even if he did not manifest assent, and unless he rejected the terms, acquires an option to bind his counterpart to her representation or charge her with some liability in case she retracts…" (Omri Bin-Shahar, Contracts without Consent: Exploring a New Basis for Contractual Liability, 152 U. Penn. L. Rev 1829)
Common law is unlikely to recognise such a broad formulation of the duty. Indeed, since Routledge v. Grant (1828), it is settled law that a party is free to withdraw its offer, unless there is a consideration for the offer being kept open. Further, in Watford v. Miles [1992] 1 All ER 453, specifically, the House of Lords held that there could be no duty to negotiate in good faith for an undefined amount of time. This position is distinct from the position in many civil law countries – under civilian systems, offers cannot easily be revoked, unless they are made expressly subject to revocation. Civilian systems are, then, more likely to impose an obligation to conduct negotiations in good faith (this is covered within the civilian doctrine of 'culpa in contrahendo'). The Convention on the International Sale of Goods (CISG) – born out of a compromise between common law and civil law systems – also recognizes such a 'good faith' obligation in Article 7. On the role of good faith in international sales transactions under the CISG, see John Klein, Good Faith in International Transactions.
Nonetheless, it may not be entirely true that common law refuses to recognise any good faith obligation whatsoever. For instance, an Australian case – Renard Constructions v. Minister for Public Works (1992) 26 NSWLR 234 – suggests that a duty to negotiate in good faith can be imposed on grounds of reasonableness. Restitutionary remedies may also arise. The England & Wales High Court noted on this point that restitutionary obligations are likely to be imposed where the defendant has received an "incontrovertible benefit" as a result of the plaintiff's services; or where the defendant "has requested the claimant to provide services or accepted them (having the ability to refuse them) when offered…" For restitutionary claims to arise in this latter instance, the defendant must have acted with the knowledge that the services were not intended to be given freely. No restitutionary remedies will be possible if the plaintiff took a risk that he or she would only be reimbursed for his expenditure if there was a concluded contract.
Broadly, the Court appears to have taken a view that while the formation of a contract is to be ascertained objectively, the permissibility of a restitutionary remedy is to be ascertained subjectively. This appears to broadly fit into the common law understanding of the role of good faith as well.




Independent Directors under the Companies Bill, 2009

The report of the Parliamentary Standing Committee on Finance (SCF) pays significant attention to the role of independent directors on Indian companies (particularly the listed ones). While it is not doubted that the existing system of independent directors requires further review and strengthening, the SCF’s recommendations seem to go the other extreme in advocating a process which amounts to regulatory micromanagement of corporate boards. Unsurprisingly, the SCF’s views have generated a great deal of debate, and set out below are a few columns that discuss the issue in greater detail:

- Pratip Kar in the Business Standard;

- Omkar Goswami in the Business Standard; and

- Bibek Debroy in the Financial Express.

Sunday, September 12, 2010

Depreciation on Intangible Assets

A year ago (almost to the date), we had discussed the decision of the Bombay High Court in CIT v. Techno Shares, observing that it appeared at odds with section 32 of the Income Tax Act. Last week, the Supreme Court overruled the Bombay High Court. However, while the conclusion arrived at by the Court seems appropriate on the facts of the case, it is slightly disappointing that the basis on which the Bombay High Court had arrived at its conclusion has gone unaddressed by the Apex Court.

The issue which fell for the Court’s consideration was whether deprecation could be allowed on the membership card of a member of the Bombay Stock Exchange. The Indian law on depreciation is governed by section 32 of the Income Tax Act, the relevant part of which provides for depreciation ‘know-how, patents, copyrights, trademarks, licenses, franchises or any other business or commercial right of similar nature’. Thus, the Court was asked whether the membership card could be said to be a ‘license’ or a ‘business or commercial right of a similar nature’.

The Bombay High Court, in deciding this issue had held that the card was neither a license nor a business or commercial right covered by the provision. The rationale adopted by the Court was that, applying the principle of noscitur a sociis and ejusdem generis (broadly meaning words in a statute should take colour from their context), the overriding requirement for allowing depreciation on intangibles under section 32 was that they be related to intellectual property rights [“IPR”]. Since the membership card had no relation to any IPR, the Bombay High Court refused to allow depreciation.

The Supreme Court however, has arrived at a different conclusion. The Court examined in detail the provision and the Rules and Bye-Laws of the Bombay Stock Exchange, to come to the conclusion that it is a business/commercial right, and that its terms make it clear that this right is in the form of a license. The Court observes that membership of the stock exchange enables a person to trade on the floor of the exchange, to participate in trading sessions and to access the market. This “right to participate in the market has an economic and money value. It is an expense incurred by the assessee which satisfies the test of being a ‘licence’ or ‘any other business or commercial right of similar nature’ in terms of Section 32(1)(ii)” (¶ 19).

Thus, the Court concluded that membership granted business/commercial rights in the nature of a license, and hence was clearly covered by the scope of the provision. However, in so doing, the Court does not explicitly express its view the reasoning adopted by the Bombay High Court- in its reading into the provision an IPR requirement, and in its reading ‘license’ narrowly. Obviously, by allowing depreciation on the membership card, the Court has impliedly rejected the argument on an IPR requirement being read into section 32. However, the reading down of ‘license’, which was also an important part of the Bombay High Court’s reasoning, has not got special attention from the Apex Court. In fact, the Court seems to be at pains to emphasise that the decision is not applicable beyond the specific confines of the facts at hand. In the words of the Court,

We hold that the said right of membership is a “business or commercial right” which gives a non-defaulting continuing member a right to access the Exchange and to participate therein and in that sense it is a licence or akin to licence in terms of Section 32(1)(ii) of the 1961 Act. That, such a right vests in the Exchange only on default/demise in terms of the Rules and Bye-laws of BSE, as they stood at the relevant time. Our judgment should not be understood to mean that every business or commercial right would constitute a “licence” or a “franchise” in terms of Section 32(1)(ii) of the 1961 Act. [emphasis supplied]

In sum, the Court has impliedly dismissed the IPR requirement read in by the Bombay High Court, while leaving the field open for further curbs being read into the interpretation of ‘any other business or commercial right of similar nature’.

Saturday, September 11, 2010

Movement Towards Mandatory CSR

A few weeks ago, we discussed the Government’s proposal to introduce mandatory provisions regarding corporate social responsibility (CSR). A press release issued yesterday by the Ministry of Corporate Affairs suggests mandatory provisions for CSR will be included in the new company legislation. The release states:
In response to the overwhelming concerns shown by the Standing Committee of Parliament on Finance (SCF), which thoroughly examined The Companies Bill, 2009, on the extent of Corporate Social Responsibility (CSR) being undertaken by corporates and the need for a comprehensive CSR policy, the Ministry of Corporate Affairs have agreed that the Bill may now include provisions to mandate that every company having [(net worth of Rs.500 crore or more, or turnover of Rs.1000 crore or more)] or [a net profit of Rs.5 crore or more during a year] shall be required to formulate a CSR Policy to ensure that every year at least 2% of its average net profits during the three immediately preceding financial years shall be spent on CSR activities as may be approved and specified by the company. The Directors shall be required to make suitable disclosures in this regard in their report to members.

In case any such company does not have adequate profits or is not in a position to spend prescribed amount on CSR activities, the directors would be required to give suitable disclosure/reasons in their report to the members.

While welcoming the Ministry’s acceptance of the Committee’s suggestion to bring Corporate Social Responsibility (CSR) in the statue itself, the Committee feels that separate disclosures required to be made by companies in their Annual Report by way of CSR statement indicating the company policy as well as the specific steps taken thereunder will be a sufficient check on non-compliance.
If effected, this would not only be a significant change under Indian law, but would also make Indian corporate law somewhat unique regarding the manner in which CSR is treated. Most other jurisdictions treat CSR either through broad exhortations of policy under company or other legislation or by specifically requiring corporate actors, primarily boards of directors, to take into account the interests of non-shareholder constituencies and broader stakeholders while making corporate decisions. In that sense, no absolute obligations are imposed on companies under the law in other jurisdictions to carry out CSR activities.

The only other example of mandatory CSR we are aware of is Saudi Arabia where companies are required to pay amounts “equal to 2.5% of income and capital” to the revenue department, which will then distribute the amounts to the needy around the country. While this operates more like a government levy on corporate profits, in India the proposal at least leaves it to the discretion of individual companies to determine the manner in which the amounts are deployed.

The new mandatory regime for CSR is likely to attract its share of detractors. However, the success (or otherwise) of such a requirement will lie in its actual functioning. For example, there could be questions on the manner in which companies would decide the precise uses for which they would spend the monies, how they would resolve conflicting demands among stakeholders, what checks and balance would be employed to ensure that the funds are not misused, and how incentives may be created such that the funds are deployed for the most appropriate circumstances.

(Update – September 13, 2010: Our guest contributor, Somasekhar Sundaresan, has expressed similar views in this Business Standard column)

Possible Relaxation for Foreign Investors with “Existing Ventures”

Since 1998, the Indian Government’s policy has required foreign investors to obtain approval of the Foreign Investment Promotion Board (FIPB) while investing in a field where they have or had a previous joint venture in India. In other words, such investors are ineligible from investing under the automatic route. In considering a foreign investor’s application, FIPB usually seeks no-objection letter from the previous joint venture partner. This policy was designed with a view to ensure that the interests of domestic industry were not jeopardized and hence attempted to discourage foreign investors from terminating ventures with Indian partners so as to go solo.

This policy was the subject-matter of a major review in January 2005. It was then decided to apply the policy only to “existing ventures” as of January 12, 2005 (the date of the policy revision) and to exempt all future ventures from this requirement. While this represented a significant dilution of the rule, it nevertheless covered all previous ventures up to that date and hence restricted the ability of various investors who had existing ventures then from investing in India under the automatic route.

Considering that 5 years have elapsed since, the Government is now reviewing the policy. In a discussion paper issued yesterday, the Department of Industrial Policy and Promotion is considering abolition of this rule. The discussion paper notes the altered economic circumstances that govern Indian businesses today (compared to those that existed at the time of introduction of the rule) and the several difficulties in its implementation. The paper also takes cognizance of the fact that such a restriction does not exist in the foreign investment rules of other emerging economies such as Brazil and China.

The discussion paper is timely as the rule regarding “existing ventures” has been a source of consternation for foreign investors foraying into India. Moreover, the abolition of the rule would also make the foreign investment regime in India consistent with principles of contract law that discourage instruments that act in restraint of trade, as I have previously argued.

Friday, September 10, 2010

Supreme Court on Powers of the Competition Appellate Tribunal: SAIL v. Jindal Steel

The Supreme Court of India has decided on the scope of the powers of the Competition Appellate Tribunal, in SAIL v. Jindal Steel. Reports of the decision are available on Legally India and Bar and Bench. We will carry a detailed analysis of the decision shortly.

UPDATE: The judgment is now available on the JUDIS website - it can be downloaded through a date-wise search. The judgment is: Competition Commission of India v. SAIL and another, Civil Appeal No. 7779 of 2010 [D.No.12247 OF 2010], judgment dated September 9, 2010 (per Swatanter Kumar J.).

Thursday, September 9, 2010

Some Thoughts on the Vodafone Judgment: A Case for Reconsideration?

The blog has discussed the Vodafone controversy in some detail, and commented on important extracts from the Bombay High Court’s judgment yesterday. This post discusses parts of the judgment in more detail, and suggests, with respect, that the judgment is incorrect. For the convenience of our readers, the paragraph number in question is indicated in brackets where appropriate.

Chandrachud J. begins by noting the exact nature of the transaction and the corporate entities involved in it (¶¶ 2 – 52). It is important to appreciate that, as a matter of law, there were two avenues open to the Revenue to charge the Vodafone transaction [“the Transaction”] to tax – under s. 5(2) r/w s. 45 of the Income Tax Act, 1961, or under s. 9(1)(i) r/w with s. 45. S. 5(2) provides that income that “accrues or arises in India” is chargeable, while s. 9(1)(i) covers all income arising through or from any business connection in India” or through the transfer of a capital asset situate in India”. The difference between the two provisions is that s. 5 pertains to actual receipt (or accrual) of income, while s. 9 is a deeming provision that, by legal fiction, determines that income is deemed to accrue or arise in India. In addition, the Revenue relied on s. 195 to engage withholding tax provisions, and on s. 201 to prove that Vodafone is an “assessee-in-default”.

To succeed under the first limb of chargeability, the Revenue needed to show that Vodafone acquired a “right to receive” income in India, for this is what the term “accrues or arises in India” means. Presumably, Chandrachud J. rejected this submission, for ¶ 78 moves swiftly to consider the law on the scope of the deeming provision – s. 9(1)(i). This is not surprising, for the Transaction involved the sale by a non-resident to a non-resident the share of a non-resident company, through an agreement executed outside India, subject to the laws of England, and for which payment was made outside India.

To succeed under the second limb, the Revenue was required to demonstrate that a “capital asset” was transferred, and that it was “situate” in India. Its case began with the interesting proposition that, in addition to shares, a “controlling interest” constitutes an independent capital asset. This, if true, would have concluded the case, for it is undeniable that Vodafone acquired an indirect “controlling interest” in Hutchison Essar Ltd. [“HEL”]. However, it is not, and a long line of cases has established that “controlling interest” is merely incidental to the ownership of shares. In ¶70, Chandrachud J. accepts this position and holds that “a controlling interest does not for the purpose of the Income Tax Act 1961 constitute a distinct capital asset”.

Thus, one avenue remained – that although the “share” sold was not situate in India, it in “reality” represented the transfer of capital assets situate in India. Chandrachud J. begins this part of the judgment with a comprehensive analysis of the scope of the deeming provision in s. 9 of the ITA, and refers with approval to one of the more important decisions on the point – CIT v. Qantas Airways. In Qantas, the assessee, an Australian airline, sold aircrafts outside India. Notably, the Revenue had not even suggested in that case that this was an indirect transfer of a capital asset “situate in India” but rather argued that the proceeds of the sale constituted income “from a business connection in India”. S.B. Sinha J. rejected this submission, noting that the intention of Parliament was to exclude “any any income derived out of sale or purchase of a capital asset effected outside India [emphasis mine].

In ¶63, Chandrachud J. summarises the position of law in India, noting that a “sham” is a transaction in which the parties “while ostensibly seeking to clothe the transaction with a legal form, actually engage in a different transaction altogether”. As we shall see, this point is of vital importance to the conclusion the Court draws later.

With this background, and after an analysis of extra-territoriality in taxation, Chandrachud J. applies these principles to the facts (¶ 120), and begins by noting that “the case of the Petitioner is that the transaction was only in respect of one share of CGP in Cayman Islands … this being a capital asset situate outside India…” To test this submission, Chandrachud J. looks to two types of facts– (a) the conduct of the parties and (b) the documents. The conduct of the parties revealed that both Vodafone and Hutchison had construed the transaction as a sale of telecom interests in India. For example, Vodafone and Hutchison had stated to the FIPB that the object of the transaction was the acquisition of a controlling interest in HEL, and the companies’ officers had made statements to this effect to the Stock Exchange and to the Press. Similarly, the documents in the Transaction were clearly designed to facilitate the transfer of control over HEL to Vodafone – for example, Framework Agreements entered into with companies holding a stake in HEL, a non-compete agreement with Hutchison vis a vis HEL and the sale deed itself (which referred to “Company interests” as a 66.9848 % stake in the issued share capital of HEL). Based on these factors, Chandrachud J. concluded that:

… it would be simplistic to assume that the entire transaction between HTIL and VIH BV was fulfilled merely upon the transfer of a single share of CGP in the Cayman Islands. The commercial and business understanding between the parties postulated that what was being transferred from HTIL to VIH BV was the controlling interest in HEL.

It is submitted that this is an unfortunate conclusion. As Chandrachud J. had himself observed in ¶63, a transaction is something other than what its legal form suggests it is only if that is the true intention of the parties themselves. In this case, Vodafone and Hutchison entered into a transaction that involved the sale of a share of a non-resident company, for a consideration of about $ 11 billion. Was the objective of the transaction the transfer of control over the Indian entity? Of course it was. But does it follow that the legal nature of the transaction was the transfer of shares in HEL? It is submitted, with great respect, that it does not.

The “legal nature” of a transaction is a manifestation of the intention of the parties. For example, if a transaction is termed a “sale” but in fact confers extremely limited rights on the buyer, it may be considered a “licence” notwithstanding the nomenclature, because that is the legal substance of the transaction. But if it is in “legal” reality a sale, it cannot be considered a “licence” because, for example, the “economic consequences” of the transaction are akin to a licence. For this reason, it is also submitted that the conduct of the parties, the submission to the FIPB, the statements to the Stock Exchange are of very limited relevance in determining the legal nature of the Agreement of 11 February 2007. Thus, the petitioner’s case was that the Transaction, in law, is the transfer of a single share of a non-resident company.

The point was put very well by Lord Diplock in Snook v. London and West Riding Investments:

I apprehend that, if it has any meaning in law, it means acts done or documents executed by the parties to the "sham" which are intended by them to give to third parties or to the court the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create … for acts or documents to be a "sham," with whatever legal consequences follow from this, all the parties thereto must have a common intention that the acts or documents are not to create the legal rights and obligations which they give the appearance of creating. No unexpressed intentions of a "sham" affect the rights of a party whom he deceived [emphasis mine].”

Many find this somewhat inequitable – after all, why should India permit companies to take advantage of the corporate form and low-tax jurisdictions to avoid what would otherwise be payable on a simple transfer of HEL shares? The answer is that while nothing prevents the Indian legislature from enacting a General Anti Avoidance Rule, such as the one proposed in the Direct Taxes Code, courts cannot do so. As Lord Cairns observed, “if the Crown cannot bring the subject within the letter of the law, the subject is free, however apparently within the spirit of the law the case might otherwise appear to be” [emphasis mine]. Despite ambiguous observations in McDowell, the Supreme Court has clarified in Azadi Bachao Andolan that Indian law adheres to this rule. What makes yesterday’s judgment even more ironic is that Chandrachud J. himself notes that an assessee who engages in such tax avoidance “does not tread upon a moral dilemma or risk a legal invalidation” (¶ 56).

Finally, the Court rejected the Samsung approach to s. 195, which has been independently confirmed by the Supreme Court today, and also held that it is open to the assessee to raise the plea of apportionment before the Assessing Officer. However, it is submitted with respect that this judgment is an unfortunate one, for it conflates “legal substance” with “objective of the transaction”. One hopes that the Supreme Court will take a different view.

Confidentiality = Non-compete?

In India, there is a fair amount of debate regarding the enforceability of non-compete agreements given Section 27 of the Contract Act that invalidates contracts in restraint of trade. Recent developments in California may throw some further light on the issue.

Oracle’s appointment of former HP-CEO Mark Hurd has given rise to litigation by HP. This report in the Wall Street Journal notes that while Hurd entered into a confidentiality agreement with HP, he was not bound by any non-compete obligation:
One sticking point in Mr. Hurd's move could be the terms of his severance package from H-P. That package, which could be worth more than $35 million depending on H-P's stock price, doesn't contain a noncompete clause as those are typically difficult to enforce in California. However, Mr. Hurd did agree to a 24-month confidentiality agreement, which prevents him from disclosing sensitive information related to H-P.
The question then is whether the confidentiality clause may be enforced by preventing an employee from working for a competitor such that it would effectively operate as a non-compete. Professor Bainbridge outlines his view of the legal position:
Count me a skeptic. Courts are often reluctant to let trade secret law impose prior restraints on free movement of labor. If HP had wanted to put restraints on Hurd's post-HP employment, it could have done so in the employment agreement. Given that courts construe those agreements narrowly so as to prevent unreasonable restraint of trade, moreover, HP should not get by a legal back door what it did [n]ot bargain for in the first instance. If Hurd reveals trad[e] secrets or other protected information, HP can always sue him ex post.
At a broad level, this seems similar to the position under Indian law.