Friday, December 31, 2010
The enforceability of such agreements under Indian law has been a vexed question. Since these agreements have acquired popularity in the Indian context only over the last two decades or so, courts have not been presented with sufficient opportunities to decide upon the enforceability of their provisions. Where courts have indeed ruled on such agreements, it has often been a daunting task to draw common strands that present clarity for parties entering into such agreements. While there does exist one landmark decision of the Supreme Court (V.B. Rangaraj v. V.B. Gopalakrishnan, AIR 1992 SC 453,  73 Comp. Cas. 201), oft-cited in the context of shareholders’ agreements, most other decisions have been rendered by the High Courts in various states (although it must be pointed out that an unduly high proportion of them come from the Bombay High Court for obvious reasons, with Mumbai being the financial capital of India). The High Court decisions are limited in their applicability as they are susceptible to disagreements by other High Courts, thereby conferring limited precedential value. Various High Court decisions referred to in the context of enforceability of shareholders agreements are:
1. Mafatlal Industries Ltd. v. Gujarat Gas Co. Ltd.,  97 Comp. Cas. 301 (Gujarat High Court);The Indian courts have generally not favoured complete freedom of contract in the case of shareholders agreements where clauses have gone against the tenor of company legislation. Courts have either refused to recognise clauses in shareholders agreements or, even when consistent with company legislation, enforced such clauses only if they have been incorporated in the articles of association. It is only recently that the Bombay High Court (in the Messer Holdings decision referred to in item 4 above) recognised rights inter se among shareholders in case of restrictions on transfer of shares by providing a more liberal interpretation. This decision provides some succour to the principle of freedom of contract and enables parties to rely on shareholders’ agreements. However, as mentioned earlier, its relevance may be limited to the extent that it is only a High Court decision and the extensiveness of the principle cannot be taken for granted unless the Supreme Court echoes that view.
2. Smt. Pushpa Katoch v. Manu Maharani Hotels Ltd.,  131 Comp. Cas. 42 (Delhi High Court);
3. Western Maharashtra Development Corpn. Ltd. v. Bajaj Auto Limited,  154 Comp. Cas. 593 (Bombay High Court);
4. Messer Holdings Limited v. Shyam Madanmohan Ruia,  159 Comp. Cas. 29 (Bombay High Court);
5. IL and FS Trust Co. Ltd. v. Birla Perucchini Ltd.,  121 Comp. Cas. 335 (Bombay High Court); and
6. Rolta India Ltd. v. Venire Industries Ltd.,  100 Comp. Cas. 19 (Bombay High Court).
Given this background, a useful discussion on the enforceability of shareholders’ agreements in general is contained in a recent report on The Enforceability and Effectiveness of Typical Shareholders Agreement Provisions prepared by the Corporation Law Committee of the Association of the Bar of the City of New York and published in the August 2010 issue of The Business Lawyer. The report contains a listing of the types of clauses included in a shareholders’ agreement, along with drafting considerations. The report, however, contains a discussion on the legal principles embedded in the laws of the states of Delaware and New York. Nevertheless, it is a useful tool for a corporate lawyer in any jurisdiction that can be used as the basis to test the various provisions for enforceability under relevant local law of a company’s jurisdiction of incorporation.
Thursday, December 30, 2010
The Government appears to have taken an about turn now doing away with the mandatory nature of the provision. It instead seeks to regulate CSR through a “comply-or-explain” approach, by requiring companies to disclose their CSR initiatives and thereby inserting pressure through a process of moral suasion. Although this approach seems more appropriate compared to a mandatory provision, it is not free from ambiguities. As this Economic Times editorial notes:
At first glance, the government seems to have done a U-turn on imposing a mandatory 2 per cent expenditure from company profits on corporate social responsibility. The Companies Bill reportedly won't have this provision. Look closer, and it's a case of "mandating without mandating" as an industry voice describes it. The reworked proposal, it's said, asks firms to have a formal CSR policy targeting a 2 per cent spend, and to furnish details of funds going to social causes in annual reports. In other words, while keeping up a technical pretence of not legally arm-twisting India Inc, the Centre seeks to exert heavy moral pressure by stipulating disclosures if not actual expenditure. To quote the corporate affairs minister, CSR spending won't be "voluntary" or "mandatory" but "somewhere in between"! Why this grey area, unless the government wants leeway to play guilt-inducing big brother?The present observations are based on announcements by the MCA. There will be greater clarity only when the text of the provision in the Companies Bill is made available.
SEBI’s move comes close at the heels of its order on another matter involving unlisted companies in the Sahara group who were purportedly raising finances from a wide group of investors without following the process required for a public offering. That order has, however, been stayed for the time being by the Allahabad High Court.
These measures indicate SEBI’s preference for a public offering process, when the situation so warrants, so that the securities are issued through a transparent process using a disclosure document that subjects issuers and related parties to appropriate liabilities for misstatements.
Interestingly, the urge to introduce transparent measures for primary securities issuances and secondary market trades is not unique to SEBI. The SEC in the US is faced with similar concerns with widespread trades involving high-profile companies such as Facebook, Twitter and LinkedIn, which are yet to float their shares widely through IPOs.
Monday, December 27, 2010
There are a number of procedural changes, including requirements regarding reporting of shareholding patterns of listed companies and announcements regarding significant corporate events. More importantly, clause 40A of the listing agreement has been amended to incorporate the public float norms announced in June 2010 (as amended in August 2010), which require listed companies to maintain a public shareholding of 25%.
Saturday, December 25, 2010
The man who restored the pin factory to its rightful place at the heart of economic theory celebrates his 100th birthday on December 29th. The economics profession was slow to recognise Ronald Coase’s genius. He first expounded his thinking about the firm in a lecture in Dundee in 1932, when he was just 21 years old. Nobody much listened. He published “The Nature of the Firm” five years later. It went largely unread.
But Mr Coase laboured on regardless: a second seminal article on “The Problem of Social Cost” laid the intellectual foundations of the deregulation revolution of the 1980s. Eventually, Mr Coase acquired an army of followers, such as Oliver Williamson, who fleshed out his ideas. In 1991, aged 80, he was awarded a Nobel prize. Far from resting on his laurels, Mr Coase will publish a new book in 2011, with Ning Wang of Arizona State University, on “How China Became Capitalist”.
His central insight was that firms exist because going to the market all the time can impose heavy transaction costs. You need to hire workers, negotiate prices and enforce contracts, to name but three time-consuming activities. A firm is essentially a device for creating long-term contracts when short-term contracts are too bothersome. But if markets are so inefficient, why don’t firms go on getting bigger for ever? Mr Coase also pointed out that these little planned societies impose transaction costs of their own, which tend to rise as they grow bigger. The proper balance between hierarchies and markets is constantly recalibrated by the forces of competition: entrepreneurs may choose to lower transaction costs by forming firms but giant firms eventually become sluggish and uncompetitive.
Mr Coase’s theory continues to explain some of the most puzzling problems in modern business. Take the rise of vast and highly diversified business groups in the emerging world, such as India’s Tata group and Turkey’s Koc Holding. Many Western observers dismiss these as relics of a primitive form of capitalism. But they make perfect sense when you consider the transaction costs of going to the market. Where trust in established institutions is scarce, it makes sense for companies to stretch their brands over many industries. And where capital and labour markets are inefficient, it makes equal sense for companies to allocate their own capital and train their own loyalists.
The 2011 edition of Consilience will focus on the theme of privacy and how it affects individuals and organisations. Consilience 2011 thus seeks to explore the interface between privacy and technology, the effect technology has on our understanding of privacy, and how technology shapes the contours of privacy and is in return shaped by privacy. Specific dimensions that the conference will engage with include privacy in the context of e-commerce transactions, social networking sites, upcoming gadgets, its equation with the State (with a special focus on the upcoming Unique Identity number project). Updates regarding the schedule of the conference will be posted on http://www.consilience.in/.
Friday, December 24, 2010
(This post has been contributed by Amit Agrawal, a legal practitioner practicing before Rajasthan High Court, Jaipur and an alumnus of National Law School of India University, Bangalore)In the SEBI-Sahara controversy, SEBI has previously issued an ad-interim order on November 24, 2010 (discussed previously on this Blog) against Sahara entities and their promoters and directors.
The securities regulator had arrived at a prima facie finding that certain specific companies belonging to Sahara group were “rampantly tapping huge amount of money by not disclosing the source of funds by circumventing the applicable framework of law” under the guise of private placement.
The order of SEBI was challenged before the Lucknow bench of the Allahabad High Court which gave its detailed stay order on December 13, 2010 which can be accessed through JUDIS (Misc. Bench No. - 11702 of 2010).
Whilst much of the space in the order has been devoted to whether the case is fit to be entertained under the writ jurisdiction, the conclusion to stay the SEBI order seems to have been reached based on the following findings:
- Prima facie, SEBI has no jurisdiction in the matter as entities concerned are neither listed nor intend to get listed.With respect, it is humbly submitted that the argument regarding the effect of Section 67(3) of the Companies Act, 1956 discussed in sufficient detail in para 14-16 of the SEBI order, being at the centre of the controversy, was not duly deliberated without which the prima facie finding may run the risk of being branded as a mere superfluous finding.
- Central Government is already seized of the matter;
- Order was passed by SEBI in violation of principles of natural justice; sweeping orders affecting civil rights should not have been passed in utter disregard of principles of natural justice;
- Balance of convenience lies in the favour of Sahara as the ‘issue’ has not been closed and irreparable damage will be caused in case SEBI order stays in force.
Further, whether central government is seized of the matter or not should have been considered to be wholly irrelevant to the challenge at hand i.e. whether the regulatory body which had passed the impugned order prima facie had the jurisdiction in the matter or not.
Also, there is no universal rule that an order can never be passed without providing a hearing. Post decisional hearings are held to be valid substitute for pre-decisional hearings from time to time, especially in cases where the statute itself expressly authorises that the hearing need not be granted prior to issuing the interim order.
Section 11 (4) of the SEBI Act states that “.....the Board may, by an order, for reasons to be recorded in writing, in the interests of investors or securities market, take any of the following measures, either pending investigation or inquiry or on completion of such investigation or inquiry, namely....”
The second proviso to section 11(4) also states that “Provided further that the Board shall, either before or after passing such orders, give an opportunity of hearing to such intermediaries or persons concerned.”
The above position has been endorsed by the Supreme Court in a number of its judgements including in the Maneka Gandhi judgement given in the context of Passports Act, 1967. Judgements of the Supreme Court in the matter of Liberty Oil Mills (1984)3 SCC 465 and Swadeshi Cotton Mills (1981)1 SCC 664, subsequently followed in many other judgements, support the view that where a statute contemplates a post-decisional hearing amounting to a full review of the original order on merits, then such a statute would be construed as excluding the audi alteram partem rule at the pre-decisional stage. Also, it may be noted that in this case merely an interim order was passed by SEBI and the concerned persons were asked to file the objections, if any, within thirty days from the date of the order. An opportunity of personal hearing was also accorded.
Recently, the Tayal group of companies had challenged before the Rajasthan High Court an ad-interim order passed by SEBI by which restrictions were imposed on accessing the securities market and dealing in securities, for the alleged violations of the provisions of the Takeover Regulations and the provisions of FUTP Regulations. It was contended that the order of the SEBI was without jurisdiction and also that Section 11 (4) and 11B are unconstitutional as they permit imposition of penalties without providing procedural safeguards and also amount to violation of Article 19(1)(g). The challenge so made was dismissed by the court and it was inter-alia held that “Interim orders are passed by the Court, Tribunal and Quasi Judicial Authority in given facts and circumstances of the case showing urgency or emergent situation. This cannot be said to be elimination of the principles of natural justice .....”. Copy of the judgement is available here.
In view of the above, the order of SEBI could possibly have been sustained as not being in contravention of the principles of natural justice, even at this interim stage in the court.
As regards the question of imposing wide civil penalties in complete disregard to the principles of natural justice, it may be noted that the judgements from which the support is sought to be derived do not really deviate from the principle that in case the statute expressly authorises or by necessary implication excludes the prior hearing, granting of hearing subsequent to the passing of the order would be sufficient compliance with the principles of natural justice.
The last point on the balance of convenience and irreparable damage too appears to be in the favour of continuing with the prohibition imposed by SEBI though this point is integrally tied to the finding on prima facie case having been made out. Not much discussion exists in the order on this point.
Any business exigency related reason which may possibly have been advanced, it is humbly submitted ,could not possibly have weighed more than the reasoning of SEBI that “...it would be an indefensible failure on the part of SEBI, if it were to allow investors to be imperiled, given the massive scale of fund mobilization as brought out above, prima facie, completely outside the applicable regulatory framework. Taking into account the gravity of this case, I am of the considered opinion that pending the outcome of investigations in the matter, immediate action is called for, in the interest of the investors to prevent these companies from raising further capital from public, which is prima facie in violation of the relevant provisions of the Act and SEBI Act and the relevant regulations made thereunder, as found above in this Order....”
More was the necessity to put on hold the drive of raising funds till the time mist regarding the unlawful methods being deployed in the process was cleared.
Also, it appears that the court, while granting the stay, lost of sight of the principle that the judicial forums should be rather slow to interfere in the matters where an expert body has taken a decision (that too of interim nature) unless the compelling reasons demand interference.
- Amit Agrawal
Friday, December 17, 2010
“The rule is essentially a judge-made rule, almost as old as company law itself, derived from the fundamental principles embodied in the statutes by which Parliament has permitted companies to be incorporated with limited liability.”
So said Lord Walker last week in delivering the judgment of the United Kingdom Supreme Court in Progress Property v Moorgarth. Lord Walker was, of course, referring to the common law prohibition on the unlawful distribution of capital by a company through, inter alia, the sale of its assets to shareholders at an undervalue. The Court has, as expected, affirmed the impugned judgment of the Court of Appeal, which we discussed at length in August.
The principle, sometimes called the rule on maintenance of capital, was authoritatively stated by the House of Lords in Trevor v Whitworth, and has been subsequently applied both by the courts and in statutory provisions. The objective of the rule has always been thought to be the protection of creditors, who are entitled to assume that the risk of a loss of the company’s capital is confined to ordinary commercial activity. The rule is firmly entrenched in both English and Indian law, although its scope varies considerably. Over time, various devices have been employed to circumvent the rule, of which the most prominent is perhaps the sale of corporate assets at an undervalue to (typically) the controlling shareholders. In Aveling Barford v Perion Ltd,  5 BCC 677, Hoffman J. had held that “it is the fact that it was known and intended to be a sale at an undervalue which made it an unlawful distribution.”
Readers interested in a detailed analysis of the facts may refer to ¶¶5-14 of Lord Walker’s judgment, and to the previous post. It will suffice here to recall that Progress Property was a case where the director of a group company procured the sale of the shares of its wholly owned subsidiary to a third party for a sum of around £60,000. It was later shown (or assumed to be shown) that the true and reasonable value of the shares was around £4 million. The particular transaction was part of a wider commercial arrangement whereby a minority shareholder of a company agreed to buy out the majority. It was common ground that the director in question had genuinely believed that that was the fair value of the sale, and it was assumed that he may have acted in breach of his fiduciary duty in so believing. The Court of Appeal declined an invitation to distinguish or overrule Hoffman J.’s emphasis on the role of knowledge in the lawfulness of a sale, and held that an undervalued sale is not contrary to the common law or statutory rule on maintenance of capital, unless it is shown that the director knew that it was undervalued.
In an article commenting on that judgment, Eva Micheler argued that the correct question to ask is whether the transaction between the company and the shareholder was at “arm’s length”. This is a natural step to take, considering that arm’s length is used in transfer pricing disputes to address similar concerns that two parties with a unity of interest may collaborate to impart to a transaction a character it would not have had in normal market conditions. The Supreme Court, however, after noticing this suggestion, has reiterated the traditional approach to the question, which is to ascertain the real “substance” of the transaction. In addition, the Court has emphasised that Hoffman J.’s test is not as much about knowledge itself as it is about an analysis of the “substance” or “legal nature” of the transaction.
In particular, the Court explained the true scope of the rule with reference to two cases – Ridge Securities v IRC  1 WLR 479, and Re Halt Garage  3 All ER 1016. In Ridge Securities, interest payments “grotesquely out of proportion to the principal amounts secured” were made as part of a complex tax avoidance scheme. In dicta, the Court suggested that this payment was contrary to the capital maintenance rule no matter how the transaction is described. In Halt Garage, on the other hand, a small, family-run company paid a modest remuneration to its directors (promoters), which the Court partly upheld, observing that the transaction is illegal only if “the intention is to make a gift out of the capital of the company” and not if it is “genuinely director’s remuneration.” Aveling Barford was far closer to Ridge Securities than to Halt Garage, and Hoffman J. accordingly found that the transaction in that case offended the capital maintenance rule. Approving these decisions, Lord Walker also noted a very common problem in the law of tenancy is similar – whether an agreement to “licence” property in a bid to evade the application of tenancy legislation is so construed by the courts. The locus classicus on this point is, of course, Street v Mountford where Lord Jauncey noted that the question is whether the agreement is “mere dressing up in an endeavour to clothe the agreement with a legal character which it would not otherwise have possessed.”
In short, Lord Walker held, and it is submitted correctly, that the validity of such a transaction does not depend on any brightline test – be it the arm’s length or knowledge – but on an application of the usual principles of construction of documents and transactions, with the objective of ascertaining its true legal nature. In this analysis, the intention/knowledge of the parties is likely to play an extremely significant role, and may in many cases provide sufficient basis for a court to invalidate the transaction. Yet, it is wrong to conclude that knowledge is a necessary condition for invalidity, for if dividend is paid out of capital despite the best of intentions (for example because of a technical error or a misapprehension as to the state of profits), it will nevertheless be invalid. Lord Walker acknowledged that knowledge and intention are likely to be most relevant in the “paradigm example” of a distribution through the sale of an asset, and held that the result depends not on a “retrospective valuation exercise” but on a “realistic assessment of all the relevant facts.”
Lord Mance’s concurring judgment emphasises the caveat noted above – that the test is not always just about an inquiry into the motive or knowledge of the directors, but about ascertaining the “substance of the agreement…whatever the label attached to it by the parties.” Lord Mance was careful to disclaim any general proposition that knowledge is a necessary feature, or that it is essential to prove that a director acted in breach of duty to sustain a challenge to the validity of a sale.
While the Supreme Court’s approach is clearly sensitive to the particular features of individual transactions, it is interesting to contrast it with the Snook approach to “sham” transactions for tax avoidance purposes – in both cases, the courts look to the “legal substance” of a transaction (as opposed to its consequence or economic substance), and yet, it appears that the court is far more likely to attach significance to motive or knowledge and ignore interpositions of artificial devices for capital maintenance purposes.
Monday, December 13, 2010
- Views in the Business Standard;
- Surjit Bhalla in the Indian Express;
- Mobis Philipose in The Mint;
- Nitin Potdar in Money Control;
- Jayanth Varma in the Financial Express; and
- Sandeep Parekh in the Financial Express.
The author, Robert Pozen, lists reasons why boards are ineffective. They are too large (the average size of the top 500 companies in the US was 11 in 2009). Members lack domain expertise (only one of Citigroup’s directors at the time of the subprime crisis had ever worked at a financial services firm). Members are not able to spare enough time for the boards they serve on.Prof. Ram Mohan presents a critique of this idea:
The answers follow. First, have professional directors, that is, people for whom directorship is a primary, not an ancillary, vocation. Secondly, cut the size of boards to seven, the CEO plus six independent directors . Thirdly, of the six directors, make sure four are people with domain expertise. The fifth should have expertise in accounting and the sixth could be a generalist.
Professional directors would not serve on more than two boards. They should spend at least two days a month at the company, apart from board meetings. Since they would be expected to work a lot harder, they should be paid better. Most of the pay should be in the form of long-term stock options.
Since this sort of time commitment would be beyond working professionals, the choice of professional directors would be restricted to retired persons. Pozen thinks this pool is large enough to meet the requirements of companies. Regulators could make professional directors mandatory for banks. Institutional shareholders should push for professional directors in other companies.
But there is a more fundamental fallacy in Pozen’s formulation. The effectiveness of a director is not so much about knowledge of a company. It is more about sincerity and commitment . The questions that need to be asked are often very simple ones. Why are we losing market share? How does the company proposed to reverse the trend in declining profit margins? Which divisions have failed to meet budget targets? Are succession plans in place? Why are star performers leaving?This critique has been echoed in an editorial in today’s Economic Times.
Asking these questions, indicating that one is not satisfied with the answers and demanding accountability for lapses, does not require great insight or ability. It requires commitment and a willingness to rock the boat. These are qualities not commonly found in boards or, for that matter, anywhere else in institutions.
To be sure, the concept of a professional independent director is not novel. It has been the subject matter of debate for over a quarter of a century. Not only has it been considered from a business perspective (Joseph W. Barr, “From the Boardroom: The Role of the Professional Director”, Harvard Business Review, May-June 1976, at 18), but it has also received attention from the legal academy (Ronald J. Gilson & Reinier Kraakman, “Reinventing the Outside Director: An Agenda for Institutional Investors”, 43 Stanford Law Review 863 (1991). More recently, I have had occasion to examine the idea specifically in a short article The Idea of a “Professional” Independent Director.
Apart from the critique mentioned earlier, there is a more fundamental practical question. If the idea of professional independent director is appealing, why have companies (whether in India or elsewhere) not embraced it and appointed such directors on boards. No compelling answer has been forthcoming yet.
However, simply because the idea is yet to take off, it need not necessarily be relegated to the bottom in the list of mechanisms to enhance corporate governance. It may still be superior to existing structure of independent directors, and to that extent it is an idea worth pursuing and sharpening.
Tuesday, December 7, 2010
Monday, December 6, 2010
The complexity of the distinction between penalties and liquidated damages in English law is amply borne out by the fact that even McGregor’s remarkably concise and insightful account is forced to begin with a seventeenth century statute (18th edition, ¶¶13.001 onwards). For an elaborate account of the law, interested readers may refer to Chitty on Contracts (30th edition, ¶ 26-010 onwards), McGregor on Damages (18th edition, Chapter 13), and the leading decisions in Astley v Weldon, Dunlop Pneumatic Tyre v New Garage (especially Lord Dunedin) and Phillips v AG of Hong Kong, (1993) 61 BLR 41. It suffices to note here that in traditional English law, a claimant generally could not recover in excess of actual loss if the sum stipulated in the contract for breach was not a “genuine pre-estimate” of loss and was therefore a “penalty”. This did not bar any action for actual loss, even in the rare circumstances where actual loss exceeded the penalty sum. He was, on the other hand, entitled to liquidated damages without proving actual loss, although in the rare circumstances where actual loss rarely exceeded that sum, he was confined to that sum. Naturally, this made the exercise of distinguishing between a penalty and liquidated damages a crucial one in English law.
The Indian legislature, to quote the Constitution Bench in Fateh Chand, cut across this “web of presumptions” in English law, and enacted a simple rule in s. 74 that a claimant, in the event of breach of contract, is entitled to “reasonable compensation” not exceeding the sum named as penalty or as the sum payable in case of breach. The word “penalty”, which did not originally exist in the section, was added by way of an amendment in 1899, and Sankaran Nair J. explained in 1910 that the object was to make abundantly clear that the provision applied to any stipulation intended to compel the performance of a contract, and not just to the payment of a sum of money in the event of breach. However, Sankaran Nair J. was dealing with the forfeiture of a deposit upon non-completion, which is close in substance to a penalty, and it is not clear whether s. 74 applies to a provision requiring the payment of a sum of money or other performance upon the happening of a certain event that is arguably inconsistent with the putative payer’s primary obligations under the contract, and yet may not constitute a “breach”.
The Supreme Court had an opportunity to clarify whether this is so recently, in BSNL v Reliance. Unfortunately, it has not done so. BSNL v Reliance arose out of the 1997 BSO Interconnect Agreement [“BIA”] and its subsequent amendment that the two companies had entered into, concerning, in layman terms, the sharing of networks. In 2003, the BSO regime was itself replaced in India by the “Unified Access Service Provider” regime, and the BIA was consequently amended in 2006 with retrospective effect from 2003. It provided for charges to be levied by BSNL on Reliance for calls on its network, depending on the nature of the call (local, international etc.). Of importance to this dispute was the “Caller Line Identification” [“CLI”] device, which was not only used by the parties as a means of identifying the caller, but for deciding for billing purposes at what rate a call was to be charged.
In September 2004, BSNL, pursuant to enquiries, discovered that certain CLI numbers were occurring in data more frequently than normal, suggesting either that the CLIs had been tampered with, or, more seriously, that international calls were being “masked” as domestic calls by the manipulation of the CLI. Invoking clause 6.4.6 of the BIA and BIA 2003, which allowed it to invoke a certain method of computing charges and the use of the highest applicable rate for a period of two months before the calls, BSNL levied a charge of about Rs. 9.89 crores on Reliance.
In the Supreme Court, BSNL argued that the court need not even determine whether clause 6.4.6 represents a penalty, because such characterisation is irrelevant to a “sum payable on the happening of an event other than breach.” There is support for this contention in English law. In Export Credits Guarantee Department ( 1 WLR 399), the locus classicus on the point, where the House of Lords rejected an attempt to portray a sum stipulated in the contract as a penalty upon the sole ground that it was payable not in the event of breach of that contract, but on the breach of a contractual obligation the defendant owed to third parties. Whether this is true in India in light of the wide statutory formulation and the Constitution Bench decision in Fateh Chand is an important question of law. Had the Court considered it, it would have been a close point on the facts as well, since clause 6.4.6 was titled “Wrongly Routed Calls” and ostensibly only provided for a different mechanism for computing the charges payable on the happening of a certain event (detection of unauthorised calls).
However, Kapadia C.J. held that the “regulatory regime” must be kept in mind, and that making unauthorised calls destroys the principle of “level playing field” in illegitimately allowing BSNL’s competitors to offer lower rates for international calls. The Court also held that the impossibility of tracing the unauthorised call makes the stipulated method a “reasonable pre-estimate of damage”. Citing Treitel and Chitty on the tests to distinguish between the two, the Court made the following observations:
The nature of the call, be it local or national or international, as indicated by corresponding CLI, is the basis for the levy of IUC (including ADC). If by wrong routing of calls or by masking the cost of providing services is reduced, the concerned operator gets an undue advantage not only in the Indian market over other competing operators but also in the international market. …These time lines is [sic] an indicia showing that clause 6.4.6 is not penal but a pre-estimate of reasonable compensation for the loss foreseen at the time of entering into the agreement. Lastly, it may be noted that liquidated damages serve the useful purpose of avoiding litigation and promoting commercial certainty and, therefore, the court should not be astute to categorize as penalties the clauses described as liquidated damages. This principle is relevant to regulatory regimes… Section 74 of the Contract Act is not violated. Thus, it is not necessary to discuss various judgments of this Court under Section 74 of the Contract Act [emphasis mine].
Two observations may be made. First, if, as BSNL contended, clause 6.4.6 was just one of the many obligations of the parties upon the happening of a certain event (in this case the detection of unauthorised calls), it is not relevant to even consider whether it is a penalty or a genuine pre-estimate of loss. While it was possible for the Court to reach the conclusion that the legal nature of the clause was consistent with a provision regulating the consequences of breach, it is submitted, with great respect, that it could not proceed to the second step without making this finding. Secondly, even assuming clause 6.4.6 engages s. 74, it is difficult to see why it is important to characterise it as a penalty or as a genuine pre-estimate of loss, since in either event the court is required to award “reasonable compensation” not exceeding that sum. The factors relevant to this analysis were discussed by the Constitution Bench in Fateh Chand, and while one could argue that the Court in BSNL v Reliance merely took the view that the named sum, if a genuine pre-estimate, was the best indicator of “reasonable compensation”, the judgment itself does not appear to so limit its use of clause 6.4.6. Thirdly, it is submitted, with respect, that it is in any event irrelevant to consider the “regulatory regime” or the possibility that BSNL’s competitors may offer lower rates, except as an indicator of the likely intention of the parties.
One hopes that the Supreme Court will clarify the true scope of s. 74 in this respect, and engage with the Indian case law on the subject, when the next opportunity arises.
Saturday, December 4, 2010
In Union of India v. Microwave Communication, the Delhi High Court was called on to consider a very important issue relating to the relationship between the Arbitration Act and the Limitation Act. In a remarkably clear decision, involving the interpretation of decisions of the Supreme Court and conflicting dicta from High Courts, the Court concluded that all provisions of Limitation Act, except section 5, apply to applications under section 34 of the Arbitration Act.
Section 34(3) of the Arbitration Act provides that-
An application for setting aside may not be made after three months have elapsed from the date on which die party making that application had received the arbitral award or, if a request had been made under section 33, from the date on which that request had bow disposed of by the arbitral tribunal: Provided that if the Court is satisfied that the applicant was prevented by sufficient cause from making the application within the said period of three months it may entertain the application within a further period of thirty days, but not thereafter. [emphasis supplied]
The Supreme Court in Union of India v. Popular Construction, had held that this provision was absolute, and there was no scope for a further extension of the limitation period under section 5 of the Limitation Act (which allows a Court to extend the limitation period for sufficient causes). In arriving at this decision, the Court observed (¶¶ 12, 14),
As far as the language of Section 34 of the 1996 Act is concerned, the crucial words are 'but not thereafter' used in the proviso to sub-section (3). In our opinion, this phrase would amount to an express exclusion within the meaning of Section 29(2) of the Limitation Act, and would therefore bar the application of section 5 of that Act. Parliament did not need to go further. To hold that the Court could entertain an application to set aside the Award beyond the extended period under the proviso, would render the phrase 'but not thereafter' wholly otiose. No principle of interpretation would justify such a result.
Here by history and scheme of the 1996 Act support the conclusion that the time limit prescribed under Section 34 to challenge an Award is absolute and unextendable by Court under Section 5 of the Limitation Act.
Now, these passages and the rest of the decision make it clear that the Court was dealing only with section 5 of the Limitation Act. It did not deal with other provisions like section 4 (which provides that when the limitation period expires on a day when the Court is closed, the proceedings may be initiated on the day when the Court reopens).
However, several High Courts interpreted the Supreme Court’s dictum and especially the mention of ‘absolute and unextendable’ literally, holding that section 4 could not be invoked even when the limitation period expired during Court holidays. Taking the opposite view was one decision of the Andhra Pradesh High Court in Durga Enterprises v. Union of India, and a couple of decisions of the Supreme Court which had held that Popular Constructions should be read as applying only to section 5 of the Limitation Act.
The Delhi High Court in Microwave Communication concluded, it is submitted rightly, that the stance in Durga Enterprises was to be preferred. They observed (¶ 8),
Section 4 of the Limitation Act has been enacted not to enlarge the period of limitation but on the maxim lex non cogit ad impossibilia. When any party is prevented from doing a thing in Court on a particular day not by his own act but by the act of the Court he/she is entitled to do at the first available opportunity. As stated above, Section 4 does not enlarge the period of limitation but it only enables the party to file any suit, application, etc. on the reopening day of the Court if the Court is closed on a day when limitation expires.
This decision does not permit of any disagreement. However, an additional matter which arose on the facts was not addressed by the Court explicitly, which leaves small question unanswered. The limitation period in question in Microwave Communication, was not the period of three months provided in the body of section 34, but the discretionary period of 30 days mentioned in the proviso. Thus, it was the extended period of limitation that was ending in the Court holidays. Section 4 of the Limitation Act however, applies only for the expiry of the ‘prescribed period’ when the Court is closed. Does ‘prescribed period’ included the period extended for sufficient cause? The language of section 5 suggests that it does not, since it provides that when sufficient cause is shown, the proceedings may be initiated ‘after the prescribed period’. It is true that the marginal heading refers to ‘extension of prescribed period’. Nevertheless, it is atleast arguable that section 4 applies only to an expiry of the original ‘prescribed period’ and not the extended period. This interpretation is also arguably affirmed by the fact that section 4 precedes the extension provision in section 5.
Under the Limitation Act, since there is no limit on the period of extension under section 5, reading section 4 narrowly will not lead to any anomalies. Let us assume that the limitation period in a said action expires on 10.5.2010. The Court vacations can be assumed to date from 28.5.2010 to 3.7.2010. In that situation, if the proceedings are initiated on 3.7.2010, there is no issue of whether section 4 or section 5 applies, since the Court holidays will be considered sufficient cause, so long as the petitioner can show that there was sufficient cause for the period between 10.5.2010 and 28.5.2010. However, let us now assume that this was an application under section 34 of the Arbitration Act. Even if sufficient cause is shown, the limitation period under the proviso to section will not allow an extension of the limitation period beyond 10.6.2010, which will fall within the Court holidays. Hence, in applying section 4, it would be material whether ‘prescribed period’ includes the extended period, or is limited to the original period of limitation.
While this promises to be a fascinating issue of statutory interpretation, it is almost certain that ‘prescribed period’ will be read as referring to the extended period, and not only the original interpretation. It would have been ideal however, if the Delhi High Court had specifically addressed this issue. It is hoped that should this matter go up on appeal to the Apex Court, it affirms the High Court, and also considers the slight anomaly created due to the language of section 4.