Thursday, December 29, 2011

The Court of Appeal on the illegality defence

The role of illegality as a defence to a claim for damages has always been the subject of much debate. There are two principal rationales that can be proposed for illegality being a defence: (a) that the claimant cannot be allowed to rely on his illegal conduct (reliance-based rationale); and (b) that allowing the claim will result in stultifying the law which rendered the claimant’s conduct illegal (stultification/policy rationale). To take a concrete example, let’s assume that A pays B on the assumption that B has it in his power to ‘arrange’ a knighthood for A. If B subsequently fails to deliver, or if A discovers that B never could have arranged such a knighthood, can A claim damages from B? The English High Court in Parkinson v College of Ambulance held not, and seems clearly right. However, what is debatable is whether the claim is denied because A, in making the claim, necessarily must rely on his being party to an illegal act; or because allowing A to recover the amount would stultify the law rendering the procurement of knighthoods illegal. Over the last few years, English courts appear to have moved from the reliance-based rationale to the policy rationale for illegality as a defence. This was also recognized and affirmed by the latest report of the Law Commission of England on illegality, where it observed that legislative reform was not necessary since the policy rationale was gaining judicial ground.*

A recent decision of the Court of Appeal in Delaney v Pickett again revisited the issue of illegality as a defence to a civil claim. The claim was by the passenger of a car against the driver, for damages caused by negligent driving. However, since the purpose of the journey in this case was the collection and transportation of illegal drugs for subsequent re-sale, the High Court denied recovery. The High Court judge held that since the negligent driving occurred during the course of an illegal activity, it arose ‘directly ex turpi causa’, and hence no claim could lie. The judge also observed that “the conduct upon which the Claimant was engaged in concert with the first Defendant was sufficiently anti-social that public policy prevents him from pursuing a claim arising out of it”.

On appeal, the Court of Appeal considers two important cases on the meaning of ‘directly’ when used in conjunction with ex turpi causa. In Pitts v Hunt, the claim was by the injured pillion passenger on a motorcycle being driven by his friend, both of them drunk, and deliberately driving in a manner designed to frighten others. The Court held that since the pillion passenger was party to, and encouraged the negligent and reckless driving, he could not claim damages for injuries suffered by him from such driving. Dillon LJ observed that what was important was not the seriousness of the illegality, but the connection between the illegality and the injury sought to be compensated. In his words, “Where the plaintiff's action in truth arises directly ex turpi causa, he is likely to fail … Where the plaintiff has suffered a genuine wrong, to which allegedly unlawful conduct is incidental, he is likely to succeed”. This causal view of the ex turpi causa rule was further explained by Lord Hoffman in Gray v Thames Trains Limited, where he observed:

It might be better to avoid metaphors like "inextricably linked" or "integral part" and to treat the question as simply one of causation. Can one say that, although the damage would not have happened but for the tortious conduct of the defendant, it was caused by the criminal act of the claimant? Or is the position that although the damage would not have happened without the criminal act of the claimant, it was caused by the tortious act of the defendant?

Lord Hoffman held that if the criminal act of the claimant caused the injury, no claim would lie. But if the tortuous act caused the injury, even if the tortuous conduct was occasioned by the criminal activity, a claim would still lie.

Relying on this passage from Gray, Ward LJ in Delaney v Pickett holds that,

We are not concerned with the integrity of the legal system. We do not need to ask whether the claim would be an affront to the public conscience. There is no need for an analysis of the pleadings to establish whether or not the claimant is relying on his illegality to found his claim. It is not a question of the claimant profiting from his own wrongdoing. Here the crucial question is whether, on the one hand the criminal activity merely gave occasion for the tortious act of the defendant to be committed or whether, even though the accident would never have happened had they not made the journey which at some point involved their obtaining and/or transporting drugs with the intention to supply or on the other hand whether the immediate cause of the claimant's damage was the negligent driving. The answer to that question is in my judgment quite clear. Viewed as a matter of causation, the damage suffered by the claimant was not caused by his or their criminal activity. It was caused by the tortious act of the defendant in the negligent way in which he drove his motor car. In those circumstances the illegal acts are incidental and the claimant is entitled to recover his loss. (emphasis supplied)

The underlined lines from the passage are clear support for the growing body of judicial and academic opinion that reliance by the claimant on his illegal act is immaterial to the applicability of the illegality defence. However, the passage is unclear as to whether the policy-based rationale is always applicable. The suggestion appears to be that the only question to be asked on the facts of this case was one of causation. While that is certainly one of the important questions to be answered, it is doubtful whether it can be conclusive. In Gray, the claimant, who had suffered post-traumatic stress disorder caused by a train accident, killed a person due to the disorder and was convicted of manslaughter. In a claim against the train operator, he also sought damages for loss of earnings after his detention and for loss of his liberty and damage to reputation and for his feelings of guilt and remorse consequent on the killing. It was denying this claim that Lord Hoffman held that since the detention and damage to reputation was caused by his illegal act and not the train accident, no damages would be recoverable. However, that does not suggest that the causal test is determinative of the illegality question. Undoubtedly, it is possible to ‘explain’ the decision in Delaney on policy grounds, given that it is not inconsistent with the stultification rationale. However, the absence of a specific mention of the rationale, and the emphasis placed on the causal view of the ex turpi causa principle suggests that the case was actually not decided on the policy-basis either.

In sum, the role of illegality as a defence to civil claims is still unclear. While the stultification/policy-based rationale appears to have the most appeal, and does explain several of the cases, it does not seem easy to apply and is not universally followed. Delaney is another example where on facts, causation or some other test may be conclusively applied, without reference to the underlying rationale of the illegality defence.

*The only exception is the landmark decision in Tinsley v Milligan, where the majority held that in the context of presumed resulting trusts, as long as the claimant does not need to rely in his pleadings on the illegality, the claim will succeed. Although Lord Millet in Tribe v Tribe does appear to have narrowed Tinsley to its facts, this narrowing is not very convincing, and is arguably obiter.

Tuesday, December 27, 2011

Companies Bill, 2011: Layering of Subsidiaries

It is quite common for companies to be structured in the form of groups. Apart from various operational advantages of separating businesses into distinct entities, it also has the effect of enabling promoters to maintain control over separate aspects of the business. Group structures are prominent in countries where shareholding is concentrated, and the corporate structures in many Asian jurisdictions typify group holdings. Group structures also have certain incidental effects: the possibility of limiting liability to separate entities that may be thinly capitalized so as to adversely affect the interests of third parties dealing with such entities (especially its unsecured creditors such as tortious creditors) and also provide greater scope for related-party transactions that may not be on arm’s length basis thereby enabling promoters to extract greater value from the company to the detriment of the minority shareholders. These are usually addressed by different principles of law: lifting of the corporate veil in order to deal with the unintended consequences of limited liability, and stricter controls on related-party transactions. The Companies Bill, 2011 goes to the extreme of imposing severe restrictions of the ability of companies to operate as groups.
First, the Bill confers powers on the Central Government to prescribe the number of layers of subsidiaries that a specific class of company may have. Second, in terms of making investments, clause 186 of the Bill states that a company cannot make investments through more than two layers of investment companies. An “investment company” is defined as “a company whose principal business is the acquisition of shares, debentures or other securities”. Of course, the Central Government may make exceptions to this rule. Moreover, investments in subsidiaries outside India are excluded from this limit so long as multiple layers of subsidiaries are permitted in the relevant jurisdictions where the subsidiaries are located.
Although there can be no argument against the need for controlling the use of group company structures as they can be subject to abuses, the present proposal for limiting its use altogether goes too far. It is unusual for jurisdictions to impose such absolute curbs on the use of investment vehicles, and this provision in the Bill appears to be somewhat unique even in the international context. This seems to have emanated again from specific episodes witnessed in the past, in this case the stock market scam involving the use of investment vehicles for routing funds back and forth from companies and their promoters, which was the subject matter of a Joint Parliamentary Committee report nearly a decade ago. Again, the severity of these restrictions is arguably a result of individual experiences in specific cases, and a need for legislative reaction to plug gaps identified through those. However, the downside of such legislative approach is that with a view to ensnaring specific abuses it also has the effect of capturing genuine business transactions and corporate structures within its scope thereby curbing the ability of companies to organize themselves more efficiently. This provision, if implemented, is likely to affect investments and acquisitions using layers of subsidiaries, which may otherwise be optimal from various perspectives, including taxation. Although existing corporate group structures are likely to be grandfathered as clause 186 is likely to be implemented only prospectively, it would affect any further changes to existing structure and to the creation of new structures.
These curbs also far exceed the existing method of dealing with group structures, which are generally considered acceptable. The checks and balances currently employed by the law is through lifting the corporate veil, which is possible only in exceptional circumstances, and with the existence of specific grounds that have been established by case law. At a broader level, even the landmark case of Adams v. Cape Industries plc, [1990] Ch. 433, generally recognizes the utility of these structures and does not proscribe them at the outset. Even when it comes to issues of round-tripping of investments and abusive related-party transactions, it is more advantageous to deal with them through existing (or proposed) governance structures such as an independent board or audit committee, obtaining independent shareholder approval, requiring a transfer pricing report by an external gatekeeper, and the like. These principles-based approaches ensure that while genuine transactions are allowed, the abusive ones are reined in. The Bill, however, deals with both genuine and abusive transactions alike, and paints them with the same brush by restricting them. The saving grace, however, is that these are default provisions, and are capable of being moderated by Central Government through rules, and it is hoped that the rule-making process would consider some of these commercial realities and ensure the required flexibility.

Friday, December 23, 2011

Companies Bill: Stalled in Parliament?

Newspaper reports (here, here and here) suggest that the Companies Bill has run into some rough weather, with indications that it might be referred to the Standing Committee for further review. This is surprising as well as disconcerting, as it comes within a week of the Government presenting the Bill in Parliament.

It represents further delay in the corporate law reform process, which has been taking place in fits and starts for a decade now, with a logical conclusion still being elusive. Granted that there are areas in the Bill that may require fine-tuning, but the approach of holding back the reform process itself is not desirable. Based on the experience with the Standing Committee’s review of the Companies Bill, 2009, it is possible that there could be a significant reconsideration on fundamental issues in case it goes up for review, which could delay the process much further.

In the meanwhile, a corrigendum to the Companies Bill, 2011 has been issued that apparently contains some changes of a substantive nature as well.

In any event, we hope to continue our periodic analysis of the Bill with a touch of optimism.

Wednesday, December 21, 2011

Guest Post: Arbitration Update

(In the following post, Ms Renu Gupta, Advocate, discusses recent developments in Indian arbitration law)

This post provides brief updates about some decisions of the Supreme Court of India in the year 2011 (this excludes cases which have already been discussed on this blog such as Yograj case here, and P.R Shah case here), which have made significant contribution to the field of arbitration.

In a dispute between the parties, Praveen Enterprises invoked arbitration through proceedings under Section 11 of the Arbitration and Conciliation Act, 1996 (hereinafter, “A&C Act”). State of Goa filed counterclaims against Praveen Enterprises.
Praveen Enterprises argued that these counterclaims were not raised by State of Goa, by way of objection to Section 11 proceedings or at any stage prior to filing its counterclaims (pleadings) before the arbitrator. Therefore, these counterclaims were beyond the scope of reference of disputes to arbitration and State of Goa was barred from raising these counterclaims.
The question before the Supreme Court was, “[W]hether the respondent in an arbitration proceedings is precluded from making a counter-claim, unless a) it had served a notice upon the claimant requesting that the disputes relating to that counter-claim be referred to arbitration and the claimant had concurred in referring the counter claim to the same arbitrator; and/or b) it had set out the said counter claim in its reply statement to the application under section 11 of the Act and the Chief Justice or his designate refers such counter claim also to arbitration.
The Supreme Court held that (a) in an arbitration where the tribunal has been constituted by the court, under Section 11 of the A&C Act, the Chief Justice or the designate is not required to draw up the list of disputes and refer them to arbitration; and (b) where the arbitration agreement provides for referring all disputes between the parties to arbitration, the arbitrator will have jurisdiction to entertain all disputes, even though any such dispute was not raised at a stage earlier to the stage of filing pleadings before the arbitrator.
Judicial precedents show that there has been much litigation on this question. The position was different under the Arbitration Act, 1940, where the Court infact “referred” disputes to arbitration. Accordingly, if a party tried to raise a dispute, which was not covered in the reference made by the Court under the old Act, it was considered to be outside the scope of arbitration
Under A&C Act, there is no “reference” of disputes by the Court to arbitration. Therefore, the position under the two legislations is different. In several arbitrations under the A&C Act, lawyers often tried to use the analysis under the old Act to seek ouster of the adversary’s counterclaims. However, this decision finally lays down an unambiguous position, thus closing doors for the erstwhile famous litigation strategy used in arbitration.
[Disclosure – I have participated in an arbitration where the lawyers for the opponents adopted this strategy]

This is an interesting case in which despite existence of an arbitration clause in the agreement between the parties, Tantia Constructions went to Court to seek relief under its writ jurisdiction, which relief was granted by the High Court.
The Supreme Court held that an alternative remedy (arbitration in this case) is not an absolute bar to invocation of writ jurisdiction.
In my view, this decision increases the scope for interference by courts, in cases where the parties have agreed to resolve their disputes by arbitration, beyond the scope of interference warranted by A&C Act. In a situation where arbitration proceedings have already commenced, this decision could enable a party to seek interim relief in the form of a writ, from a Court, even though the A&C Act clearly provides for provisions for seeking interim relief from Court under Section 9 and from the tribunal itself under Section 17.

3. Booz Allen Hamilton Inc. v. SBI Home Finance Ltd., (2011) 5 SCC 532
In this case SBI Home Finance had filed a suit for enforcement of a mortgage made in its favour. An application was filed by one of the parties under Section 8 of A&C Act, for reference of disputes to arbitration, since there was an arbitration clause agreed to by the parties. The question before the Court was, whether the dispute relating to enforcement of mortgage was covered within the arbitration clause.
The Supreme Court observed that there are three facets of arbitrability, relating to the jurisdiction of the arbitral tribunal, (i) whether the disputes are capable of adjudication and settlement by arbitration, i.e., whether the disputes, having regard to their nature, could be resolved by an arbitral tribunal or whether they would exclusively fall within the domain of Courts, (ii) whether the disputes are covered by the arbitration agreement, and (iii) whether the parties have referred the disputes to arbitration.
We are only concerned with (i) here.
The Court observed that an agreement to sell or an agreement to mortgage does not involve any transfer of right in rem but create only a personal obligation. Therefore if specific performance is sought either in regard to an agreement to sell or an agreement to mortgage, the claim for specific performance will be arbitrable. On the other hand, a mortgage is a transfer of a right in rem. A mortgage suit for sale of the mortgaged property is an action in rem, for enforcement of a right in rem. A decree for sale of a mortgaged property requires the Court to protect the interests of persons other than the parties to the suit and empowers the Court to entertain and adjudicate upon rights and liabilities of third parties (other than those who are parties to the arbitration agreement). Therefore, a suit for enforcement of a mortgage being the enforcement of a right in rem will have to be decided by Courts of law and not by arbitral tribunals.
The Court held that the scheme relating to adjudication of mortgage suits contained in Code of Civil Procedure, 1908, provides for the procedure prescribed for adjudication of the mortgage suits, the rights of mortgagees and mortgagors, the parties to a mortgage suit, and the powers of a Court adjudicating a mortgage suit. This scheme makes it clear that such suits are intended to be decided by public fora and therefore, impliedly barred from being referred to or decided by private fora, namely an arbitral tribunal.

In a dispute arising between the parties, from an unregistered lease deed (which was required to be compulsory registered under the Registration Act, 1908), the question before the Court was whether the parties could rely on such unregistered instrument, as evidence before the arbitral tribunal. The Court also discussed the implications, on the arbitration proceedings, of not stamping the main agreement, which contains the arbitration clause.
The Supreme Court held that an arbitration agreement, forming a part of an instrument, which is required to be stamped under the applicable laws, if not sufficiently stamped, has no legal effect. Although, such deficiency can be cured upon payment of insufficient stamp duty and penalty, as may be applicable.
Such an instrument when required to be compulsorily registered under the Registration Act, 1908, and not so registered, can be received as evidence by an arbitrator only for the limited purpose of (i) evidence of a contract in a suit for specific performance, and (ii) evidence of collateral transaction not required to be effected by a registered instrument.
This is an important development, which should caution parties to adequately stamp and register their agreements, as and when required by law, in order to not face a situation where the agreement itself cannot be received in evidence before an arbitral tribunal.

Amendments to Preferential Allotment Rules

(I would like to thank my colleague, Mr. Saiyam Chaturvedi for his invaluable research.)

The Sahara case has led to certain amendments being made to the Unlisted Public Companies (Preferential Allotment) Rules, 2003 (the "Rules"). While the Sahara case itself has seen itself being argued and debated across various judicial fora over the last couple of years, the Government of India has tried to close some of the potential loop-holes through these amendments.

Firstly, the definition of “preferential allotment” under Rule 3(1) of the Rules has been amended. Earlier,  the definition of “preferential allotment” included the issue of shares on preferential basis and/or through private placement made by a company and issue of shares to the promoters and their relatives either in public issue or otherwise. This definition has now been amended to mean allotment of shares or any other instrument convertible into shares including hybrid instruments convertible into shares on preferential basis made pursuant to Section 81(1A) of the Companies Act, 1956 (the “Act”). Further, allotment of shares shall not be made to more than 49 persons as per the first proviso to Section 67(3) of the Act. These amendments are clearly inspired by the Sahara case, as (a) there was an issue of Optionally Fully Convertible Debentures in that case, which was adjudged by the judiciary to be 'hybrid instruments', and (b) the SEBI order in the Sahara case held that allotment of such debentures to more than 49 persons ‘on private placement’ basis would be considered a public issue.

Secondly, Rule 4 (Special Resolution) of the Rules has been amended in light of the new definition of “preferential allotment”. Earlier the said Rule 4 stated that no issue of shares on a preferential basis can be made by a company unless  authorized by its articles of association and unless a special resolution is passed by the members in a general meeting authorizing the board of directors to make such issue. The amended Rule 4 also encompasses issue of any other instrument convertible into shares including hybrids convertible into shares on a preferential basis.

Finally, a new Rule 8 (Invitation and allotment of securities) has now been incorporated, which sets out a number of conditions which will now apply to preferential allotments. A few key conditions are:

(a) Any offer or invitation not in compliance with section 81(1A) read with Section 67(3) of the Act, will be treated as a public offer and the provisions of the Securities Contracts (Regulation) Act, 1956 and the Securities and Exchange Board of India Act, 1992, will have to be complied with.

(b) No company offering securities will release any public advertisements or utilize any media, marketing or distribution channels or agents to inform the public at large about such an offer [It is pertinent to note that Sahara, through its marketing agents, advertised its issue leading to around 6.3 million subscribers for the debentures].

Companies Bill, 2011: Amalgamation and Corporate Restructuring

The provisions of the Companies Act, 1956, specifically sections 391 to 394, contain an elaborate framework that enable companies to give effect to arrangements and compromises with their shareholders and creditors. The expression “arrangement” has interpreted to include a wide range of transactions, such as mergers, demergers and other forms of corporate restructuring (including debt restructuring). This framework has largely functioned well, and in fact these provisions have been extensively used by the corporate sector in India, much more so than similar provisions contained in statutes in other countries. The judiciary has also clearly laid out the parameters within which such schemes of arrangement may be initiated, approved by shareholders and creditors and then accorded the sanction of the court. Miheer Mafatlal and Hindustan Lever are landmark decisions of the Supreme Court in that behalf.

The Companies Bill, 2011 seeks to make a number of changes to this framework that are likely to have an impact on mergers and acquisitions (M&A) transactions involving Indian companies. While some of the proposals are intended to make it easier for companies to implement schemes of arrangement, others impose checks and balance to prevent possible abuse of these provisions by companies. Ernst & Young has a nice comparison of the provisions in the Companies Act and the 2011 Bill on matters relating to M&A. In this post I propose to touch upon only some of the key issues.


Under the Companies Act, schemes of arrangement are to be approved by the High Court that has jurisdiction over the companies involved. While this ensures an oversight of the scheme and its fairness, there have been concerns regarding possible delays. For example, the average time taken for a scheme to be implemented from start to finish is no less than 6 months, and in several cases the schemes have taken a couple of years to be approved by the High Court. To that extent, the proposal to move the jurisdiction of the High Court in such matters to the National Company Law Tribunal (NCLT) is welcome as that would be a specialized body dealing only with cases under company and related laws thereby introducing elements of timeliness and efficiency. This is not a new proposal, but its introduction had been mired in litigation (R. Gandhi v. Union of India), and the provisions in the Bill appear to be a result of the resolution that emerged from the Supreme Court in the R. Gandhi case.

Objection to the scheme

Currently, any shareholder, creditor or other “interested person” may object to the scheme of arrangement before a court if such person’s interests are adversely affected under it. However, the Companies Bill, 2011 imposes some onerous requirements such that only persons holding at least 10% shares or at least 5% of the total debt outstanding in the company can object to the scheme. While it is understandable that there must be restrictions against frivolous litigation, the current provision operates against minority shareholders and creditors. One of the reasons that the scheme of arrangement route is adopted by companies is that, once approved, schemes can be implemented in a wide manner as it is binding on all affected parties. The binding nature of the scheme is premised on the fact that the court will adjudge on the interests of all parties that may be affected by the scheme. By substantially eroding the power of minority shareholders and creditors to object, that basic premise has been destroyed. This provision requires serious reconsideration.

It is a matter of some relief for minority shareholders, however, that schemes can provide for exit to dissenting shareholders. Even here, it appears that such exit options are available only if the NCLT specifically provides for that, and not automatically on the lines of appraisal rights that are available in similar circumstances in other jurisdictions (such as Delaware).

Accounting and Valuation

As schemes of arrangement tend to have significant implications on matters of accounting and valuation, specific provisions have been made in the Companies Bill. The scheme must comply with accounting standards. This is to ensure that schemes that primarily involve financial reengineering are not entertained by the courts. This concern of the regulators has already been addressed by incorporating such a requirement into the listing agreement, but now that has been provided for in the statute itself so as to apply even to unlisted companies.

The Bill also specifically provides that the report of an expert valuer has to be disclosed to the shareholders. This is significant because a substantial amount of litigation on schemes of arrangement relates to matters of valuation, and consequently the share exchange ratio. There is currently no requirement to obtain expert valuation, although it has now become a matter of practice for companies to obtain at least one, if not two, valuation reports before embarking on a scheme of arrangement so that the valuation can better withstand scrutiny of the court.

Treasury Shares

When there are mergers between companies that have cross-holdings of shares, e.g. between a parent and a subsidiary, the shares that one company holds in the other will typically be cancelled, and no further shares will be issued under the scheme. However, in the last few years, a practice had developed where shares were in fact issued under the scheme by the transferee company to a trust, to be held for its own benefit. The trust could further sell those shares and pay over proceeds to the beneficiary, being the company. The Companies Bill effectively sets at nought this practice, and requires any cross-held shares to be compulsorily cancelled. This provision appears to directly target the recent practice employed in some cases.

Cross-Border Mergers

Under the present dispensation, while foreign companies can be amalgamated into India companies, the reverse is not possible. This has also been accepted by the courts (see Andhra Pradesh High Court in Moschip Semiconductor). Under the Companies Bill, however, there is a proposal to allow cross-border mergers both ways. However, that is possibly only with companies in jurisdictions with which reciprocity has been established, as the Government may notify. This may provide additional stimulus for cross-border transactions.

Short-form Mergers

At present, all mergers, including those between group companies or between a parent and a subsidiary require compliance with the entire process of section 391 and 394, although in certain circumstances courts are willing to make some dispensations from procedural requirements. Under the Bill, certain mergers can follow an out-of-court approach, without requiring the approval of the court or NCLT. These are mergers between two or more small companies (as defined in the Bill) or between a parent and its wholly-owned subsidiary. In these types of mergers, there is greater emphasis on creditors’ interests: the companies must file a declaration of solvency and the scheme must be approved by at least 90% of the creditors or their classes. Although this simplifies the M&A regime to some extent, it may affect only a small number of transactions without much wider impact.

Reverse Mergers

The Companies Bill appears to plug possible loopholes that may allow backdoor listing of companies. A reverse merger of a listed company into an unlisted company may not automatically result in a listing of the resulting entity, unless it goes through the process of a listing through a public offering. Moreover, in case of such a reverse merger, the shareholders of the listed transferor company must be provided an exit at a fair value to compensate for the loss of liquidity.

Other matters

Some other specific issues where the Bill provides for a different treatment are:
- Notice of the scheme must be provided to various government authorities such as the Income Tax Department, SEBI, RBI, Competition Commission, Official Liquidator such that all of their concerns can be heard by the NCLT before sanctioning the scheme. Although these authorities can object before a court even at present, there is no such notice requirement.

- The requirement of majority of shareholders or creditors is 75% in value. The existing additional requirement of obtaining a majority in number of the shareholders or creditors has been done away with.

Sunday, December 18, 2011

Companies Bill, 2011: Class Actions

In developed markets, one of the key mechanisms used for enforcement of corporate law is shareholder actions against the company or its management for breach of duties and obligations owed under law. Such shareholder actions can be either direct actions for breaches of duties owed to the shareholders directly in which case the remedies will flow to the shareholders, or they can be derivative actions where shareholders bring them on behalf of the company for breach of duties owed to the company where the remedies would flow to the company. Despite the popularity of such actions in countries such as the US, UK and several leading jurisdictions in the Commonwealth, such private shareholder actions are indeed sparsely used in India. This is evident from the fact that while shareholder suits were filed in the U.S. immediately after the Satyam scandal was revealed (and subsequently settled by the company for hundreds of millions of dollars), no significant action was initiated by the Indian shareholders who were left without any remedy for false representations in the financial statements.
In terms of shareholder remedies in India, there is a fair amount of vibrancy in direct actions in the form of claims for oppression and mismanagement brought before the Company Law Board (CLB) under sections 397 and 398 of the Companies Act, 1956. While the CLB has been active in considering these cases, their scope is fairly limited and may not necessarily be available for all instances of breaches of duties either by the company or the management. On the other hand, derivative actions, which are customarily used by shareholders to seek remedies on behalf of the company for breaches of duties by directors and senior management, are rarely utilised by shareholders in India. In a recent study to be published shortly, Professor Vikramaditya Khanna and I found that in the last sixty years only about 10 derivative actions have reached the level of the High Courts or the Supreme Court, of which only 3 have been finally allowed to be pursued. There are a number of substantive and procedural hurdles due to which shareholder derivative actions are rare in India. For example, derivative actions rely on principles of common law in the absence of a statutory provision, and they have to be brought in the normal civil courts, which are subject to delays and heavy costs that make them ineffective.
Considering some of these difficulties, the Companies Bill, 2009 introduced a specific clause on class actions by shareholders as a method to ensure greater enforcement of corporate law. However, as anticipated, this was met with stiff resistance from the industry which feared that this will lead to the opening of floodgates resulting in companies having to face numerous lawsuits from shareholders. The Government seems to have given in to the concerns expressed by the industry, and consequently a substantially whittled down provision has been introduced in the Companies Bill, 2011.
Scope of the Action
Clause 245 provides that a certain number of shareholders or depositors can bring an action before the National Company Law Tribunal (NCLT). The action can be against the company for restraining it from various acts such as those that are ultra vires the memorandum and articles of association, that are based on a resolution of shareholders obtained through suppression of material facts, or that are contrary to the provisions of the Companies Act or any other law. More importantly, a new addition in the 2011 version is that shareholders can claim damages for fraudulent actions, unlawful conduct or misstatements made by the company and its directors, and in certain cases its auditors (including the audit firm) or any expert or advisor or consultant of the company. This new provisions seems to be a result of the discourse that emanated from the Satyam episode so as to pin responsibility not only on insiders of the company but also on various gatekeepers who are responsible for ensuring compliance with the law.
Certain other provisions also support the creation of a regime for shareholder actions. For example, failure to comply with an order of the NCLT will result in a criminal offence. Moreover, the NCLT may provide that the cost of bringing the action may be defrayed by the company or other responsible person. This is a key insertion especially in derivative actions where shareholders may not have the incentive to initiate an action if they have to directly bear the cost, while the ultimate relief will flow to the company.
The Bill also provides for consolidation of similar petitions, while also specifying the manner in which the lead applicant will be chosen.
Significant checks and balances have been introduced to ensure that only genuine actions are entertained by the NCLT. First, there is a threshold limit in terms of the support required for bringing an action. The action must be supported by at least 100 shareholders, or such percentage of total number of shareholders or those holding such percentage of shares in the company as the Central Government may prescribe in the rules. Second, the NCLT is required to consider a number of factors while considering an application: whether the shareholders are acting in good faith or have any personal interest in the action, or whether the act or omission involved has been authorised or ratified by the shareholders. Third, frivolous and vexatious actions are discouraged by conferring the NCLT with the powers to impose costs on the initiating shareholders while rejecting applications on those grounds.
In sum, while it is useful that the Companies Bill expressly provides for statutory remedies in the form of class actions, it may not automatically result in greater enforcement of corporate law through increased shareholder actions. One significant advantage of the Bill is that it takes shareholder actions (such as derivative actions) outside the purview of the court and places them within the jurisdiction of the NCLT, which, due to its specialised nature, is expected to be more efficient and time-sensitive than the normal court system. However, with the imposition of significant limitations on the ability of shareholders to bring an action, it is unlikely that there will be a spate of such actions against companies. Nevertheless, the recognition of such remedies under statute will provide some relief to affected minority shareholders.

Saturday, December 17, 2011

Companies Bill, 2011: Duties of Directors

The Companies Act, 1956 does not contain any specific provision that generally governs the duties of directors. The duties are instead governed by common law, which judges are required to apply to a given set of facts and circumstances. Under common law, there are two broad sets of director duties: (i) duty to act with skill, care and diligence, and (ii) fiduciary duties (to act in the interests of the company, to avoid conflicts of interest and to act for proper purposes). However, past track record in India indicates that cases where common law director duties have been applied are few and far between. For this reason, duties of directors are incapable of being defined as clearly as one can in other jurisdictions, particularly in the developed markets.
In order to induce a greater level of clarity in directors’ duties, the Companies Bill, 2011 has a specific provision that deals with the subject matter. Clause 166 of the Bill is substantially similar to the provision contained in the Companies Bill, 2009, with some iteration. The UK too adopted the strategy of codifying directors’ duties in the Companies Act, 2006 (sections 171-177).
The following are some of the primary duties specified by the Companies Bill, 2011:
- to act in accordance with the articles;
- to act in good faith and in the best interests of the company, its employees, the shareholders, the community and for the protection of the environment;
- to exercise due and reasonable care, skill and diligence, and exercise independent judgment;
- not to involve in a situation that presents a conflict of interest;
- not to achieve any undue gain or advantage (and to return any equivalent amount to the company if such gain or advantage is indeed made); and
- not to assign office.
In case of any breach of duties, it would also amount to a criminal offence with punishment of Rs. 1 lakh to Rs. 5 lakhs. This is different from the common law position where there is an only civil liability for breach.
At the outset, it is necessary to note that this is only a partial codification of directors’ duties. It is not possible to prescribe rules for every situation in which directors’ actions can be judged. That necessarily has to be left for a principles-based determination, usually by judges in specific cases, and hence the role of courts in implementing these duties cannot be taken away. While the statutory provisions do give some guidance, much would depend on the manner in which courts interpret these duties, on which previous jurisprudence is scant. Moreover, with issues surrounding delays and costs in the court system, it is not clear if a body of judge-made law (in terms of principles) is likely to emerge to guide the actions of directors. Hence, it is not clear if the codification of the duties will necessarily result in a tangible enhancement when it comes to enforcing the duties.
One crucial change from the duties contained in the Companies Bill, 2009 is noteworthy. The previous Bill required directors to act in the best interest of the company. This epitomizes the shareholder model of corporate governance wherein the primary role of the directors is to protect the interests of the shareholders, and at most the interests of creditors in the event of insolvency. However, the new Bill also requires directors to act in the interests of “employees, the shareholders, the community and for the protection of the environment”. This encapsulates the stakeholder model of corporate governance wherein the directors are required to take into account the non-shareholder constituencies as well. This is consistent with the renewed emphasis on CSR, which has been discussed earlier. While it seems unlikely that any duties owed by directors in connection with non-shareholder constituencies can be justifiable or enforceable in a court of law, this at least prevents shareholders from initiating actions against directors for not solely (or even primarily) considering shareholder interests.
A similar debate was played out when the Companies Act, 2006 was enacted in the UK (and specifically section 172 thereof) where the end-result was the concept of an “enlightened shareholder value” model.