Thursday, August 30, 2012

The AAR’s ruling in Schellenberg Wittmer: Partnerships and Tax Treaties

The entitlement of partnerships to the benefits of a double taxation avoidance agreement [“DTAA”] is a contentious issue. The main reason is asymmetry in the manner in which partnership income is taxed in the two Contracting States – India, for example, in certain circumstances taxes the income of a partnership in the partnership’s hands, but the Contracting State with which it has a DTAA (for example the UK) may tax such income in the hands of the partner directly, treating the partnership as “fiscally transparent”. In such cases, it is possible that the entity assessed in the UK does not qualify as a “person” or a “resident” under (typically) articles 3 and 4 of the DTAA. A consequence of this is that the income of a partnership from the same transaction may be taxed in the United Kingdom (in the hands of its partners) and in India (in the hands of the partnership), India taking the view that those “liable to tax” in the UK are not assessed in India, and those who are assessed in India are not liable to tax in the UK.

The question whether a partnership firm is a “resident” is a more complex issue than whether it is a “person”. In general, there are two approaches to this problem. The OECD’s view is that a partnership is not a resident under article 4 if it is treated as transparent in the State of residence, but that the source State (India, in our example) must extend the benefit of the treaty to the individual partners, in respect of their share of the partnership income. In the leading Indian decision on the point, Linklaters v ITO, this solution has been rejected. In an elaborate judgment that repays study on a number of important questions of international tax law, Pramod Kumar, AM gave two reasons for the conclusion that the partnership firm is itself entitled to the benefit of the treaty. The first was that it is the fact of taxation that is significant, and not its mode, and that if the “entire income” of the firm is taxed in the hands of its partners, the firm is itself a “resident” under article 4. The second was that India defines “liable to tax” more widely than does the OECD, which (virtually) makes fiscal transparency a non-issue. This, of course, is because the Supreme Court, in Azadi Bachao Andolan, held that the words “liable to tax” “by reason of domicile…” refer to the right of a State to tax a person on those yardsticks (as Pramod Kumar, AM, has put it in a subsequent case, a “locality-related attachment”). Whether the State exercises the right or not is irrelevant, as is the fact that the assessee is not even a taxable entity in the other Contracting State. While the view the AAR took in Cyril Eugene Pereira was incorrect, the Supreme Court’s approach goes further than the generally accepted international view (see, for example, Mr Baker QC’s Commentary at ¶4B.06). In Linklaters, the Tribunal held that the UK partnership, on this view of “liable to tax”, was a UK resident and entitled to the benefit of the treaty.

Significantly, the question whether a partnership is a “person” for the purposes of a treaty did not arise in Linklaters, because of specific provisions in the India-UK treaty. In a ruling given earlier this week in Schellenberg Wittmer, the Authority for Advance Rulings has held that a Swiss partnership firm which was engaged by an Indian party in relation to a foreign arbitration was not entitled to invoke the India-Switzerland DTAA, because it is not a “person”. The definition of “person” in the Swiss treaty is:

(d) the term “person” includes an individual, a company, a body of persons, or any other entity which is taxable under the laws in force in either Contracting State;
The AAR held that a partnership, which was treated as transparent under Swiss domestic law, is not a “person” because it is not “taxable under the laws in force in either Contracting State (Switzerland)”. Unfortunately, the AAR, with respect, appears to have overlooked one point: that the words “which is taxable under the laws in force…” qualify the words “or any other entitybut not the words “individual, company, a body of persons”. There are two reasons in support of this construction: (i) that there is no “comma” after the words “other entity”, and the word “which” is used to describe the class to which the following words were intended to apply; and (ii) the words “other entity” imply that "individual, company, a body of persons” are deemed to be entities, perhaps on the assumption that these entities are taxable under the laws in force in the Contracting States. If this were not the case, the treaty would not use the word “other”, and there is no room for applying an independent taxability analysis to the three designated entities.


The AAR also rejected the alternative argument (based on the OECD Model) that the partners are entitled to invoke the Swiss treaty if a “partnership” is not considered a “person”, for the reason that India has entered a reservation, and because what India seeks to tax is not the income the partner derives from the partnership, but the income the partnership derives from India. With respect, the second reason does not appear to be correct, because the rationale for the OECD’s view is that the source State must take into account the residence State’s characterisation of a partnership – if the partnership is transparent, there is no distinction between the income of the firm and the income derived by the partners from the firm. The AAR would also have had to consider whether this reasoning is consistent with the Supreme Court’s approach to “liable to tax”, since there was a finding in this case that the individual partners were also residents of Switzerland.

Ultimately, two questions arise when any court or tribunal asked to decide whether a partnership is entitled to the benefit of a DTAA is this:
  1. Is the definition of “person” in the treaty in question qualified by a residence taxability condition as to bothbody of personsand the residuary class? If the answer is in the negative, the partnership is a “person”.
  2. Is the partnership “liable to tax” under article 4? The answer, applying Azadi Bachao Andolan, is that it always is (as the Tribunal points out in Linklaters, though it may be that the Supreme Court perhaps did not envisage this consequence of its “liable to tax” analysis when it decided Azadi). If Azadi is distinguished on this ground, the question is whether the treaty applies to the partnership because of the fact/mode analysis, or to the individual partners.

Wednesday, August 29, 2012

Relaxations on IDR Redemption


Last year, SEBI issued a circular that imposed some curbs on redemption by holders of Indian depository receipts (IDRs). Under that circular, redemption was permitted only if the IDRs are infrequently traded on the stock exchanges in India. This was a method of limiting exit options to investor exclusively to the Indian markets, except where they are illiquid (in which case conversion into underlying shares and sale on foreign markets will be permissible). This was considered to be highly restrictive to IDRs as an investment opportunity. In any event, the instrument does not appear to have met with any success given that there is only one company that has thus far listed its IDRs on the Indian exchanges.
SEBI has now issued another circular dated August 28, 2012 that permits partial fungibility of IDRs. The objective is “to improve the attractiveness of IDRs as an instrument thereby ensuring long term sustainability of IDRs ...” Under the revised regime, redemption/ conversion of IDRs into underlying equity shares is permissible up to the extent of 25% in each financial year.
While this provides some headroom for fungibility, it is unlikely to result in any significant expansion of the market for IDRs. In that sense, it is only a limited step.

Update: The Reserve Bank of India has also issued a circular giving effect to limited two-way fungibility of IDRs.

Saturday, August 25, 2012

Committee for Reforming the Regulatory Environment for Doing Business in India


The Ministry of Corporate Affairs (MCA) has established a 20-member committee to make recommendations to improve the regulatory environment for conducting business in India. Some of the background to this effort is contained in the MCA’s office memorandum:
1. The report of The World Bank and the International Finance Corporation, entitled “Doing Business 2012: Doing business in a very Transparent World”, India has been ranked at a low of 132 amongst a sample of 183 countries. Although, there is a seven – point improvement over 2010 ranking of 139. However, India continues to lag behind even the BRIC and SAARC countries on most of the parameters.
2. Easing of business environment mandates extensive examination of regulations in different areas of root functioning such as financial reforms, governance reforms, liberalized policy framework, process reforms, etc.,. Thus there is a need to conduct an in-depth study into the entire gamut of regulatory framework and come out with a detailed roadmap for improving the climate of business in India in a time bound manner. Such an exercise needs to be undertaken for periodical improvement in the ranking, leading to a situation where India gradually moves towards upward position with almost zero hassles.
The committee is expected to hold consultations and invite opinions, and present a report in six months.
Unsurprisingly, this comes close on the heels of various concerns regarding policy paralysis and retrograde steps that have resulted in India’s image waning as an investment destination. While this is likely to assuage some of the concerns from a perception standpoint, it is not certain if the consultation and recommendations could result in concrete measures given that the terms of reference of the committee are somewhat wide and open-ended.

Prohibition on Acquisition of Shares by Employee Trusts


One of the decisions taken at SEBI’s board meeting escaped attention until some recent discussion in the financial press (here and here). The relevant paragraph in SEBI’s press release is as follows:
Listed entities shall frame employee benefit schemes only in accordance with SEBI (ESOS and ESPS) Guidelines, 1999.  Entities whose schemes are not in conformity with the same would be given time to align with the said Guidelines.  Further, such schemes will be restrained from acquiring their shares from the secondary market. 
The reasons generally propounded for SEBI’s ban include the following:
- risk of stock manipulation, resulting in possible fraudulent and unfair trade practices;
- the utilisation of company funds to make these acquisitions, since funding employee welfare trusts constitutes an exception to the rules against financial assistance;
- lack of clarity in the SEBI guidelines on employee stock options and stock purchases on whether they apply to secondary market acquisitions by employee welfare trusts; and
- lack of consistency on whether holdings of shares by such trusts fall within promoter shareholding or not.
This raises important issues regarding the use of employee welfare trusts. First, it is possible to utilise the company’s funds to acquire shares in these trusts, since this constitutes an exception under section 77, proviso (b) of the Companies Act. There is no limit as to the amount that can be paid over by the company for such acquisition. Second, much would depend on the manner in which the trust is constituted and managed. For example, if the trustees are entirely independent, that would lend a certain amount of credence to the process. However, if the trustees are largely the managers or promoters of the listed company, that would give rise to issues regarding corporate governance.
From a legal perspective, there could be two issues that emerge. The first is what SEBI seems from press reports to have zeroed in, which is the issue of price manipulation. In case there is a close connection between the trustees and the listed company’s management, that concern could be fairly valid. However, it is not clear if a blanket ban by SEBI against all acquisitions is necessary and warranted. SEBI may always initiate actions in specific cases under the SEBI (Fraudulent and Unfair Trade Practices) Regulations. While this extreme step of SEBI may have been occasioned due to reasons such as possible extensive use (or abuse) of the employee welfare trusts, it has the incidental (and perhaps unintended) consequence of affecting bona fide trusts as well.
The second concern, which has arisen in other jurisdictions too, is the possible use of the employee welfare trusts to shore up holdings in the listed companies, which would effectively operate as a takeover defence in favour of the promoters. This concern is valid in the context of SEBI’s finding that there is no consistency in the disclosures made by the trusts, i.e. whether they are treated as part of the promoter group or not (particularly for disclosures made under the SEBI Takeover Regulations). Moreover, this would also strike at the heart of directors’ duties, and whether the board has acted “for proper purpose” in the establishment of the trusts. Although the jurisprudence on this count is scant in India, there are landmark rulings in the UK (e.g. Hogg v. Cramphorn, [1967] Ch 254 – also Howard Smith v. Ampol Petroleum, [1974] AC 821, although the latter was not in the context of employee welfare schemes).

Liberalisation of FDI from Pakistan


Hitherto, a person resident in Pakistan or an entity incorporated in that country was not allowed to purchase shares or convertible debentures in an Indian company. This was by virtue of Regulation 5 of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000.
By way of a circular dated August 22, 2012, the Reserve Bank fo India (RBI) has partially removed this prohibition. Now, a person who is a citizen of Pakistan or an entity incorporated there may invest in an Indian company under the approval route, i.e. with the prior approval of the Foreign Investment Promotion Board (FIPB). However, investment is not permitted in specific “sectors/activities pertaining to defence, space and atomic energy and second/activities prohibited for foreign investment”.
The blanket ban has given way to a more restricted avenue for investments.

Friday, August 24, 2012

Lord Saville: 15 Years of the English Arbitration Act


The UKSC Blog has highlighted a speech by Lord Saville, “Reflections on the English Arbitration Act 1996 after fifteen years”. Lord Saville, who was intimately connected with the drafting of the English Act, makes several interesting points.

He deals with the narrow right of appeal on questions of law u/s 69 of the English Act. In does so, he addresses the argument that having a narrow right of appeal hinders the orderly development of principles of commercial law. Hence (the argument goes), there ought to be a wide review of an arbitrator’s decision on pure questions of law. Lord Saville addresses the argument thus: “The fear has been expressed that by this means, English commercial law runs the risk of atrophying and losing its world-wide reputation as about the most developed system of laws governing international trade and commerce. There is undoubtedly force in this point, at least from the point of view of the development of English commercial law. But from the point of view of the majority of those using arbitration, I believe things look rather different. Commercial entities do not generally choose to resolve their disputes by arbitrating in order, at of course their expense and with added delay, to contribute to the body of English commercial law. They have chosen arbitration, as Michael Moser put it, because they do not want to go to court. I do find some difficulty (as did Lord Devlin many years ago) in accepting the proposition that those seeking a resolution of their disputes by arbitration rather than litigation should somehow be obliged nonetheless to finance the development of English commercial law by dragging their dispute from their chosen tribunal to the court…

Next, on the issue of independence and impartiality of arbitrators, Lord Saville questions “with great temerity… the need for independence as well as impartiality…” Undoubtedly, he says, a judicial officer and an arbitrator must be impartial and must have the appearance of impartiality. Given this, what is the additional need for “independence”? “Independence and impartiality are fine-sounding words. They form a phrase that sounds good. It has a ringing tone. But to my mind the phrase creates serious problems, because it contains two words where one would do on its own. The object is to ensure that arbitrators act fairly and even-handedly between the parties. The object is met by requiring impartiality and the appearance of impartiality. Independence adds nothing of value…” 

Lord Saville also deals with the issue of whether arbitrators should have the power of granting ex parte interim measures. He is convinced that they should not. On consolidation of connected arbitrations, he is of the view that consolidation is dealt with best by means of appropriate contractual drafting and not be means of external legal imposition. He also touches on issues of privacy and confidentiality. The text of the speech is available here.

Thursday, August 23, 2012

Recent AAR Rulings on the 'Mauritius route'


Some recent reports have pointed out that the Authority for Authority for Advance Rulings has once again sanctified the “Mauritius route”.  While the law since Azadi Bachao Andolan’s case has upheld the sanctity of a tax residency certificate (TRC), the Revenue has not given up its efforts to find the “hidden reality” or “true facts”.  The Revenue has also met with some success in its attempts, before the High Court (Aditya Birla Nuvo) and also the AAR (for example, see Re Groupe Industrial Marcel Dassault). Two recent rulings of the AAR – while on facts ruling in favour of assessee – do not really forestall the Revenue’s attempt to go behind a TRC.

In the case of Dynamic India Fund (AAR 1016/2010 dated 18th July, 2012), it was contended that sale of shares in an Indian company by a company having a Mauritius TRC was not taxable in India.  The Revenue’s objections were that the use of the Mauritius Company was for evading tax.  Further, only 2 directors were from Mauritius, and three were from India.  These objections were rejected not by a straight forward reference to the TRC, but because “there is no adequate (factual material to support this contention (that control vests in a non-Mauritius jurisdiction).”  

Another ruling is in the case of Moody’s Analytic (AAR 1186 to 1189/2011 dated 31st July 2012). In this case, the Revenue contended that the beneficial owner of shareholding was in Jersey, and not Mauritius. Accordingly, Mauritius treaty benefits were not permissible. Additionally, the Revenue argued that management and control of seller companies did not lay in Mauritius.  It was argued that the decision of the Supreme Court in Vodafone has modified the ratio on the decision in Azadi Bachao Andolan.  The AAR answered this contention not by rejecting it outright as a matter of principle, but only on the facts. The AAR held, “… on the conclusiveness of a tax residency certificate, it cannot be said that it has been shown that the effective management of the companies is not from where their Board of Directors function.  Normally, the management of a company vests in its Board of Directors as authorized by the General Body.  The role of Rishi Khosla highlighted by the Revenue is in respect of the sale transactions undertaken and in pushing them through. It does not appear to be a role in connection with the running of the businesses of the companies concerned.  It is not shown that the management of the companies in Mauritius in general, is not with a Board of Directors of those companies sitting in Mauritius Khosla is a resident.  Even if one were to take the Business Advisory Agreement relied on by the applicants with a pinch of salt, it cannot be said that the role played by Rishi Khosla in these transactions establish that the management and control of the Mauritian companies is with Rishi Khosla.  It is therefore not possible to accept the contention of learned counsel for the Revenue that by applying the place of management test, the seller companies could be held to be non-Mauritian companies…”

The AAR then held, “There may be some substance in the argument of the learned counsel that this Authority has to consider only the negative, namely that the control of the companies is not in Mauritius and it is not necessary for this Authority to find positively that the control and management is with Rishi Khosla, before coming to a conclusion that the applicants are not entitled to claim the benefit of the India-Mauritius DTAC.  But on the available fact, the presumption that the control and management of the companies rest with the Board of Directors cannot be said to have been rebutted by sufficient or cogent material  I overrule the arguments in this behalf….” In other words, a TRC creates at best a rebuttable presumption, and is not conclusive. On the aspect that beneficial ownership of shares was in Jersey and not in Mauritius, the AAR rejected the argument clearly: “As things now stand, in such cases the theory of beneficial ownership has not prevailed over the apparent legal ownership.  Company law also recognized the recorded owner of the shares and not’ the person on whose behalf it may have been held (even if, possible).  I am, therefore, satisfied that this attempt of counsel for the Revenue must also fail.” In this background, the issues were answered in favour of the assessee.

Thus, while the importance of a TRC must be acknowledged, it is still not clear whether a TRC is absolutely conclusive.  The rulings of the AAR would suggest that it is not. To what extent Vodafone has affected the correctness of the decision in Azadi on this point is a matter which will require further judicial examination, particularly in light of the arguments of the Revenue before the AAR in these two cases.

[Another recent ruling of the AAR – not on the same issue – is that in Re Castleton Investment Ltd. The AAR has questioned the correctness of a number of its previous rulings (including Re Dana Corp and re Timken): this will be further considered in a subsequent post.]

Monday, August 20, 2012

Indemnity clauses in intra-group asset transfers

The English Court of Appeal recently considered an interesting and important issue arising out of an indemnity clause in an agreement for a transfer of assets and liabilities between two wholly owned subsidiaries in a corporate group. Dealing with a scenario not uncommon in intra-group transfers of assets and liabilities, the Court of Appeal in Rust Consulting v PB [2012] EWCA Civ 1070 considers the indemnity clause in such an agreement, and also scenarios in which the indemnifying company would be estopped from denying liability to third parties with claims against the indemnified company.


The claimant (Rust) carried on business as geotechnical consultants and was engaged by developers (Eagle) in 1995 to provide geotechnical engineering services in connection with the proposed development of a shopping centre. Rust was a member of the PB Group, and along with the defendant (PB Limited) was the immediate subsidiary of a UK holding company. Rust ceased trading in 1996, and entered into an Assets Purchase Agreement with PB Limited. The consideration for the transfer of assets from Rust to PB Limited was: "(i) the sum of £1,000 and (ii) the Purchaser assuming responsibility for the satisfaction, fulfilment and discharge of all of the Liabilities and the Contracts of the Business outstanding at the Effective Date and the Purchaser hereby indemnifies and covenants to keep indemnified the Vendor against all proceedings, claims and demands in respect thereof" (emphasis added).

Ten years later, Eagle gave a notice of claim to Rust, alleging negligent advice and resulting structural damage to the shopping centre. The costs of defending these legal proceedings soon exceeded the £1,000 which now constituted Rust's assets, and were borne by the UK holding company which now became Rust's creditor. Rust was then placed into creditor's liquidation. Within the group, it was decided (with the consent of the liquidators) that PB Limited (the defendant) would take over the defence of the proceedings initiated by Eagle and this led to a consent judgment being entered for Eagle against Rust for the entire amount of its claim (£8,069,822). Rust's solicitors also wrote to Eagle stating that they did not believe that Rust was liable for the entire amount but agreed to the consent judgment solely because Rust was insolvent and could not discharge the liability in any case.

Eagle then discovered the existence of the indemnity clause in the asset purchase agreement between Rust and PB Limited, and using its position as Rusts's only significant creditor, changed the liquidators and initiated proceedings against PB Limited pursuant to the indemnity clause. This posed two questions for determination:

(1) Whether the terms of the indemnity clause included not only actual liabilities, but also liabilities incurred pursuant to a consent judgment; and

(2) If not, whether PB Limited was estopped from denying its liability to Eagle on account of its involvement in Rust's defence.

PB Limited's first line of defence was that the indemnity clause indemnified Rust only against liabilities 'outstanding at the effective date'. Therefore, liability under the consent judgment, which arose from the consent judgment itself and not from the negligent performance of Rust's contract with Eagle, was not covered by the scope of the indemnity clause. PB Limited conceded that this argument was based purely on the language of the particular indemnity clause, and if the language was instead that "the purchaser shall indemnify the vendor against all proceedings, claims and demands in respect of all liabilities of the business at the effective date", the argument would not stand.

The Court of Appeal held that this textual difference did not assist PB Limited, and would also lead to uncommercial consequences (paragraph 19). By way of illustration, the Court pointed out that the implication of PB Limited's argument was that Rust's costs of defending legal proceedings against third parties would have been recoverable only if it was unsuccessful and not if it was successful. Further, the application of the indemnity clause to a consent judgment would depend on whether there was a 51% or 49% chance of the underlying claim against Rust succeeding. Relying on the 'commercial sense' approach to contractual interpretation, the Court of Appeal concluded that the indemnity clause was "capable of including bona fide settlements of claims, or sums reasonably incurred in the defence of claims, whether successfully or unsuccessfully defended". Since PB Limited had played an active role in the proceedings between Eagle and Rust, and since the Rust's original liquidators had submitted to a consent judgment on PB Limited's instructions, there was no basis on which PB Limited could now deny liability under the indemnity clause.

This finding made it unnecessary for the Court to consider the estoppel point, but it made passing observations that if required, it would have held that PB Limited was estopped from denying its liability to Eagle. PB Limited argued that the only reason it instructed Rust's liquidators to submit to a consent judgment in Eagle's favour was legal advice that this liability was outside the scope of the indemnity clause. Therefore, this mistaken belief made it unjust for PB Limited to be treated as being estopped from denying its liability to Eagle.

Rejecting this argument, Toulson LJ, who delivered the lead judgment, observed that "The underlying justification for the conclusion which I have reached is that it is not, and should not be, open to a party who causes a judgment to be entered in the belief that it is in its financial interest to do so, thereafter to challenge the correctness or reasonableness of the judgment because it comes later to perceive its commercial interest rather differently and regrets its earlier calculated decision … I am not persuaded that the motivation of the Group to try to prefer its interests over those of Rust's potential creditors is a factor which this court should take into account in PB Limited's favour. On the contrary it should be remembered that once a company has become insolvent the interests of the shareholders take second place to the rights of creditors … I do not see why it should make a difference that PB Limited acted as it did under a mistaken view of the effect of the APA and of its commercial interests. It took a deliberate step; its judgment of its commercial interests may have been erroneous, but that is not of itself a reason for this court to disapply the natural consequence of the choice which it in fact made" (paragraphs 23, 25 and 26).

In summary, this is an important decision, both for the purposes of drafting indemnity clauses in intra-group asset-purchase agreements, and when formulating dispute resolution strategies for claims made by third parties against shell companies within a group. The decision affirms that Courts may not be swayed by minor textual differences in contractual terms (especially if they have uncommercial consequences), unless the language is clearly intended to mark a departure from standard market practice. Further, it also highlights the caution required when group companies conduct legal proceedings on behalf of other shell companies within the group, against the backdrop of indemnities or other protections contained in intra-group contracts.

Business Responsibility Reporting


The debate continues over the nature of the corporate social responsibility (CSR) requirements that should be imposed on Indian companies through the Companies Bill, 2011, i.e. whether voluntary or mandatory. Although the Government had proposed a hybrid approach, the Parliamentary Standing Committee on Finance appears to be keen on retaining the mandatory approach, as we had previously discussed.
While this debate continues at the legislative level, SEBI has introduced some amendments to the listing agreement that will require large listed companies to include business responsibility reporting as part of their annual reports. SEBI formalised this by way of a circular dated August 13, 2012 issued to the stock exchanges. This comes on the heels of the “National Voluntary Guidelines on Social, Environmental and Economic Responsibilities of Business” issued by the Ministry of Corporate Affairs last year.
According to SEBI’s circular, the requirement to include business responsibility reports as part of the annual report is mandatory for the top 100 listed entities based on market capitalisation at BSE and NSE as on March 31, 2012. The circular contains an elaborate set of details to be disclosed, including principle-wise performance.
The business responsibility reporting is applicable with effect from the financial year ending on or after December 31, 2012 (although entities that are yet to submit their annual reports for the financial year ending March 31, 2012 may include this on a voluntary basis).
Although there are arguments in favour of disclosure and transparency as methods of altering corporate behaviour in its impact on society, it remains to be seen whether efforts such as this are likely to make a significant difference. The downside, which has been experienced in other forms of reporting, is that over a period of time certain standardized disclosures and templates will evolve that will make differentiation between companies somewhat difficult and thereby erode the significance of such disclosures.
(On a related note, here is another one in the series of critiques against CSR, particularly of the mandatory variety)

Sunday, August 19, 2012

SEBI’s Capital Market Reforms


In what is clearly the most extensive set of capital market reforms in recent years, SEBI announced a series of measures following its board meeting last week. These are intended to boost the capital markets in India (both primary and secondary), and also to streamline various process. The principal recommendations have been divided into the following categories (in the words used in SEBI’s board meeting press release):
- steps to re-energise mutual fund industry;
- reforms in the primary market;
- regulations on investment advisors; and
- amendment of SEBI (Issue and Listing of Debt Securities) Regulations, 2008.
Most of these recommendations will have to find their way into specific regulatory changes by way of amendments to relevant regulations or the operation of new regulations (as in the case of investment advisors). Much of the impact of these changes can be determined in specifics only when the detailed language of these changes is available. Nevertheless, in this post I briefly touch upon only some of the key developments and also the issues that some of them may pose.
Capital Raising By Issuers
Two interesting issues emerge. One relates to the minimum public shareholding in listed companies, and the other to continual disclosures by listed companies, both of which are dealt with below.
In order to achieve the minimum public shareholding of 25% (and 10% in the case of government companies), two additional routes have been permitted. They are the rights issue and bonus issue routes. It is understandable that promoters may dilute their stake in case of a rights issue where they specifically opt not to take up the rights, and where other shareholders subscribe to their rights. However, in case of a bonus issue it would be interesting see how this idea will be implemented from a company law perspective. This is because bonus shares must, as a general matter, be issued pro rata to all shareholders of the company by way of stock dividend. Whether bonus shares can be issued selectively to the non-promoter shareholders, or whether the promoter shareholders can opt not to receive the bonus shares remain to be seen. Whether such distinction in bonus issuances would militate against the concept of all equity shares being pari passu is an issue that may have to be contended with. Of course, details are yet to be available, and hence these are only some preliminary thoughts (some of which might even be allayed once the detail emerge).
The introduction of an integrated system of disclosures is a giant step towards development of the Indian capital markets. SEBI’s decision is as follows:
To provide updated information to investors, listed entities shall file a comprehensive annual disclosure statement in addition to the existing requirements on the lines of 20F filing prescribed by the US SEC. Such filings, updated by the prospectus, shall also serve as a reference in the offer documents for further capital offerings.
As previously discussed on this Blog, a sub-committee of SEBI had recommended such a system of integrated disclosures way back in 2008. It appears that the recommendation has been finally implemented only now. This would go a long way in streamlining disclosures in the primary and secondary markets. It would enhance disclosures standards in the secondary markets by requiring detailed filings as in the US, and considerably improve secondary market disclosures which are dismal in India as compared to the primary market disclosures which have significantly evolved over a period of time. As far as listed companies are concerned, it would ease the disclosure regime and facilitate more follow-on public offerings as companies would be able to include information in the prospectus by reference to previous filings made. This is a welcome move, and was long overdue.
Regulation of Investment Advisors
This is also an important step, and brings within the scope of regulation an important constituency in the stock markets that was hitherto outside the purview of regulatory supervision. As Sandeep Parekh notes in this Financial Express column:
With this regulation, the entire industry, which is involved in distribution of securities products and even financial products, is sought to be covered. Therefore, anyone peddling a security to an investor would be covered by the regulation and any wrong advice and misconduct would attract scrutiny and punishment by Sebi. Until today, Sebi was sceptical about introducing these regulations because just the number of distributors would run into hundreds of thousands and regulating such a large number would be outside the available manpower and bandwidth of Sebi. Many of the ills of the financial industry actually have their origin in distributors and advisors, some of whom are unscrupulous and would sell the worst product for a given investor merely because they get a higher commission from selling that product.
Debt Market Reforms
The corporate bond market has been in a continuous stage of evolution for the last few years. While substantial regulatory efforts have been made to enhance the market for corporate bonds, those have been incremental in nature and have not resulted in great success. This trend of facilitating the debt securities market continues in the present phase of reforms as well. Some of the reforms include standardization of format for presenting information (particularly the financials), and also the provision of an enabling facility for shelf placement document in case of frequent issues through private placement.
The trend in the corporate bond market is that despite these regulatory developments, there is an emphasis on private placements rather than public offerings. While some of these efforts such as standardization may help address some of the concerns of the market, there are other key impediments, as some of us have observed elsewhere, such as the lack of a robust corporate insolvency framework that may inhibit vibrant corporate debt markets in India.
In the end analysis, this round of decisions taken by SEBI can be considered to be a positive development, given the slow pace of overall economic reforms lately in India.

Friday, August 17, 2012

Prepayment fees in loan transactions


It is common practice for loan agreements to provide for a fee/ premium where a loan is repaid earlier than its contractual due date. The said fee is designed to compensate the lender/s for the loss of anticipated income from the transaction and is usually expressed as a percentage of the principal amount prepaid. While the loan agreement sets out the circumstances in which the prepayment fee will be payable, usually it is in cases of voluntary prepayment by the borrower and does not include situations where the prepayment is compulsory/ mandatory, e.g. acceleration of the loan due to occurrence of an event of default etc.
While this should normally be easily decipherable from the loan agreement itself, a recent decision of the English High Court (QBD/ Commercial Court) in the matter of Aston Hill Financial Inc v African Minerals Finance Ltd, [2012] EWHC 2173 (Comm.) demonstrates that  a potential area of difficulty may arise where the loan agreement is not clear on this matter.
Brief Facts
A facility agreement was executed on February 4, 2011 for a loan of upto US$ 500,000,000 for the development of Phase I of Tonkolili iron ore project in Sierra Leone. On February 11, 2011, the lenders disbursed US$ 417,700,000 to the borrower, African Minerals. On January 31, 2012, it was announced that Standard Bank Group had agreed to refinance the original loan. A syndicated facility led by Standard Bank was signed on February 3, 2012. 
The borrower noted that pursuant to Clause 8.3 of the loan agreement, it was obliged to prepay the loans with any finance proceeds promptly after receipt of such funds and asked for detail as to (among other things) the amount required to prepay the Facility in full on a daily basis from February 7, 2012 to February 9, 2012 inclusive. The facility agent replied by a letter of the same date, stating that the outstanding loan amount of $417,000,000 and details of the accrued interest but making clear that 'any other amounts that may be due under the Finance Documents are not included in this notice'.
On the same day, the lenders' solicitors responded to the borrower, notifying it that if the prepayment was made before February 10, 2012 (the first anniversary of the Closing Date), the borrower was required to pay the prepayment fee referenced in Clause 8.8(d). The letter went on to state that Clauses 8.3 and 8.5 of the Facility were not mutually exclusive and that, as the borrower was aware, prepayment fees were included to compensate the lenders for early repayment of the loan. The letter (i) noted that in this case, the lenders negotiated and agreed the prepayment fee with the defendant in order to ensure that they would be properly compensated for their costs of funds and risks incurred by virtue of entering into the Facility; (ii) stated that the defendant was seeking to obtain more favourable terms by refinancing the loans; and (iii) stated that the failure of the defendant to pay the prepayment fee in the event the Facility was prepaid on or before the first anniversary of the Closing Date would constitute a breach of a contract.
On February 8, 2012 the borrower prepaid the full amount outstanding under the Facility of US$417,700,000. Such prepayment included a prepayment of US$291,100,000 to the claimants in respect of the full principal amounts outstanding in respect of their loans to the defendant under the Facility.
Relevant provisions
It is pertinent at this time to cast a quick glance at the relevant provisions of the Aston Hill loan agreement:
(a) Clause 8.3(a) (Disposal Proceeds and Finance Proceeds) stated that "The Borrower shall prepay, and the Parent shall ensure that the Borrower prepays, the Loans in an amount equal to the amount of Disposal Proceeds or Finance Proceeds promptly upon receipt of any Disposal Proceeds or Finance Proceeds by any member of the Group."
(b) Clause 8.5 (Voluntary Prepayment of the Loan) stated that "The Borrower, if it gives the Facility Agent not less than five Business Days' (or such shorter period as the Majority Lenders may agree) prior notice, may prepay the whole or any part of the Loan (but, if in part, being an amount that reduces the Loan by a minimum amount of $100,000,000)."
(c) Clause 8.8(c) stated that "On prepayment of all or any part of the Loans pursuant to Clauses 8.5 (Voluntary prepayment of the Loan), the Borrower shall pay to the Facility Agent (for the account of each Lender) a prepayment fee on the date of such prepayment, in the following amount: (i) 6 per cent. of the amount prepaid or repaid if the prepayment is made on or before the first anniversary of the Closing Date; and (ii) thereafter, no prepayment fee will be payable."
Court's decision
The court found that the principles of construction are well established and were not in dispute. Both the lenders/ claimants and the borrower/ defendant sought to rely upon the passage in Rainy Sky SA v. Kookmin Bank [2011] 1 WLR 2900; [2011] UKSC 50 at [21] to [30]. Thus, it was common ground that it is necessary when construing a commercial contract to strive to attribute to it a meaning which accords with business common sense and to have an eye on the commercial consequences of a particular construction; and that: "(i)f there are two possible constructions, the court is entitled to prefer the construction which is consistent with business common sense and to reject the other".
The court however found it difficult to come to a decision as regards whether the prepayment was mandatory/ voluntary, as the wording of the agreement was unclear and ambiguous. The two prepayment clauses were difficult to reconcile. While the decision to refinance the original loan was a voluntary decision on the part of the borrower, especially since the Standard Bank facility was more competitively priced, the prepayment could not have happened in the absence of refinancing arrangements contracted to by the borrower. It is therefore attractive to categorize the prepayment as voluntary, with the result that the lender would be entitled to the prepayment fee. On the other hand, Clause 8.3 envisages that if the borrower issues new equity or incurs new debt, prepayment becomes mandatory to the extent of the proceeds received by the borrower.
The court ultimately accepted the latter interpretation and held that the prepayment made was mandatory under Clause 8.3 and hence, no prepayment fee was due. The case highlights the need for clarity around prepayment provisions in loan agreements. From a lender's perspective, this decision is an unattractive precedent as it is more than probable that a borrower interested in prepaying an existing loan would seek to do so from a capital infusion or a new loan (both, in this case, being grounds for mandatory prepayment and hence, not liable to a prepayment fee).

Wednesday, August 15, 2012

NUJS Law Review: Call for Papers


[The following announcement is being posted on behalf of NUJS Law Review]
The Copyright Amendment Act, 2012 recently passed by both houses of parliament promises to thoroughly revise the laws currently governing the Indian Copyright regime. This legislative moment provides an appropriate opportunity for academic reflection on the proposed changes, their probable impact and a holistic appraisal of the provisions as they now stand.
The Editorial Board of the NUJS Law Review invites contributions for its forthcoming special issue on “The Copyright  Amendment Act, 2012: Welcome change or missed opportunity?”. Interested contributors should submit their respective entries no later than 15 November, 2012 to nujslr@gmail.com

A Review and Analysis of the CDR Mechanism


The out-of-court approach for corporate debt restructuring (CDR) was instituted by the Reserve Bank of India (RBI) over a decade ago. While it has been successful in several cases, there have also been significant shortcomings with the CDR mechanism.
In a recent speech, a Deputy Governor of the RBI undertakes a review of the CDR mechanism. A number of issues are examined in the speech, including –
- reasons for the large numbers of restructurings;
- excessive leveraging by borrowers, coupled with slowdown in the economy;
- lack of transparency in the restructuring process;
- the disproportionate burden assumed by the public sector banks; and
- operation of the moral hazard problem, leading to misuse of the CDR process by borrowers.
These and other issues, including the way forward are considered in the speech.
Although the CDR mechanism, despite its flaws, has helped in turning around companies, any review efforts can only be piecemeal in nature. The absence of a comprehensive and functional law on corporate insolvency in India will continue to be sorely felt.

Tuesday, August 14, 2012

High-Frequency Trading and Short Termism


The Economist has a piece that advocates a cautious approach towards high-frequency trading. It argues:
This newspaper seldom finds itself on the side of restraining either technology or markets. But in this case there is a doubt whether the returns justify the risk. Society needs a stockmarket to allocate capital efficiently, rewarding the best companies with higher share prices. But high-frequency traders are not making decisions based on a company’s future prospects; they are seeking to profit from tiny changes in price. They might as well be trading baseball cards. The liquidity benefits of such trading are all very well, but that liquidity can evaporate at times of stress. And although high-frequency trading may make markets less volatile in normal times, it may add to the turbulence at the worst possible moment.
The argument appears to highlight the tendencies of high-frequency trading to generate more short-termism in the market. This is to be contrasted with the incentives of long-term investors, which the closing observations in the Economist piece quite elegantly capture:
The most successful investor in history, Warren Buffett, says his ideal holding period for shares is for ever. So it surely will not do much harm to investors if, on occasion, they have to wait a second or two before dealing.


IPO Lock-in on ESOP Shares


SEBI recently issued an informal guidance to clarify that in the case of an IPO only shares held by employees of the company or other qualifying group entities (such as a holding company) are entitled to exemption from the one-year lock-in period on pre-existing share capital. Specifically, employees who are no longer in employment of the company at the time of the IPO would be subject to the one-year lock-in even though they received shares upon exercise of employee stock options (ESOPs) granted to them while in employment.
A request for informal guidance was made by MCX Exchange to SEBI. It had two ESOP plans under which shares were allotted to its employees and that of its holding company Financial Technologies India Limited (FTIL) (which subsequently ceased to be the holding company). The request specifically pertained to the interpretation of Regulation 37 of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 (the “SEBI Regulations”) that imposes a one-year lock on all pre-existing share capital of a company undertaking an IPO, where one of the exemptions relates to equity shares allotted to employees under ESOP schemes. What is determinative is the definition of “employee” and whether that includes past employees. The specific questions raised for SEBI’s guidance were as follows:
- Whether the employees of the Company who have received shares pursuant to the ESOP schemes and who have ceased to be the employees of the Company as on the date of the allotment of shares pursuant to the IPO would be considered as “employees” for the purposes of exemption from the one year lock-in under proviso (a) to Regulation 37 of the SEBI Regulations;
- Whether the existing employees and ex-employees of FTIL, which was an erstwhile holding company of the Company, who had received shares pursuant to ESOP 2006, would be considered as “employees” for the purposes of the exemption from the one year lock-in under proviso (a) to Regulation 37 of the SEBI Regulations[.]
SEBI, in its informal guidance letter, answered both questions in the negative. After examining the definition of “employee” in Regulation 2(1)(m), it observed:
As per the above definition, any person who ceased to be in the employment of the company as on the date of allotment of shares pursuant to the IPO is not considered as employee and hence the shares held by them would not be considered for the purpose of exemption from one year lock-in ... In other words, such shares held by ex-employees have to be locked in ...
This is consistent with SEBI’s previous informal guidance on a similar issue relating to Firstsource Solutions Limited, which was approach advanced by MCX in the present case.
As for the second issue, SEBI observed as follows:
The definition of the ‘employee’ under Regulation 2(1)(m) as discussed above, covers employees of the issuer, holding company, subsidiary or material associate of the issuer and director of the issuer. Accordingly, the employees and ex-employees of FTIL (which is a[n] erstwhile holding company of the issuer) would not be considered as ‘employees’ for the purpose of exemption from one year lock-in ...
This might appear to be somewhat harsh to the ex-employees of the company, but there is some rationale as it is the continued employment that confers the benefit of free transferability without lock-in. However, the continuing employees of the erstwhile holding company suffer an even harsher situation as the change in their position is not on account of any matter within their control, but due to corporate restructuring that severs the parent-subsidiary relationship between their employer and the issuer.

Thursday, August 9, 2012

The interpretation of time limit clauses in contracts


A claimant approaches a court one day after the limitation* period expires, in the mistaken impression that the limitation period had in fact not expired. This limitation period is set by a clause in a contract that is by no means a model of certainty or clarity. The question is whether the suit is time-barred. In ENER-G Holdings plc v Hormell, the Court of Appeal (Longmore, LJ dissenting) held that it is. The judgment, as we discuss below, is an example of a careful application of what Lord Grabiner has called the “iterative process” of contractual interpretation (see (2012) 128 LQR 41). What is, however, even more striking is that the argument that “Please hear my case, I was just one day late” was not even made by counsel for the appellant, and Gross, LJ took the opportunity to point out that sympathy has no place in the interpretation of contracts, particularly in relation to time limits that the parties have voluntarily agreed:

Strict time bars are an aspect of certainty; there is certainly nothing uncommercial about them and they are not infrequently encountered in commercial contracts. When there is a time bar, then, as Lord Nicholls observed in Valentines Properties Limited v Huntco Corporation Limited [2001] UKPC 14, at [20]
Inherent in a time limit is the notion that the parties are drawing a line. Once the line is crossed, a miss is as good as a mile.”
Mr. Bompas [counsel for the appellant], rightly, disclaimed any suggestion of seeking sympathy as to the operation of clause 6.3.7(a); his submissions were instead exclusively focused on the proposition that service of the proceedings was just in time, not just too late.

This was a case in which ENER-G was entitled to bring a claim for breach of warranty against Mr Hormell, provided it adhered to two notice requirements. First, by clause 6.3.3(b) of the Contract, ENER-G was required to give notice of its intention to bring the claim within “the second anniversary of completion”, ie 2 April, 2010. Secondly, by clause 6.3.7(a), ENER-G’s claim “should be deemed to have been irrevocably withdrawn and lapsed unless” proceedings in respect of it have been issued and “served on the seller not later than the expiry of twelve months after the date of that notice”.

Clauses 13.2 and 13.3, central to the case, defined “notice” in the following terms:
13.2 Service
Any such notice may be served by delivering it personally or by sending it by pre-paid recorded delivery post to each party (in the case of the Buyer, marked “for the attention of directors”) at or to the address referred in the Agreement or any other address in England and Wales which he or it may from time to time notify in writing to the other party.
13.3. Deemed service
Any notice delivered personally shall be deemed to be received when delivered (or if delivered otherwise than between 9.00 a.m. and 5.00 p.m. on a Business Day, at 9.00am on the next Business Day), any notice sent by pre-paid recorded delivery post shall be deemed to be received two Business Days after posting and in proving the time of despatch it shall be sufficient to show that the envelope containing such notice was properly addressed, stamped and posted.’
ENER-G sent notice of its claim in two ways. On 30 March 2010, a process server visited Mr Hormell’s farm, called Ringlane, and, finding that Mr Hormell was away, left a copy of the notice on a table in the porch, which Mr Hormell found and read on the same day [“the First Notice”]. ENER-G sent an identical copy of the notice by pre-recorded delivery on 30 March 2010 which, by virtue of clause 13.3 above, was deemed to have been served on 1 April, 2010. It served the claim form (the suit) in the same way: a process server left a copy at Ringlane on 29 March, 2011, but Mr Hormell found and read this only on 2 April, 2011, and, by the rules of the English CPR, the claim form was deemed to have been served on him on 31 March, 2011.

If the First Notice was effective, the limitation period of one year began to run on 30 March, 2010. If it was not, it began to run on 1 April, 2010 (the date of Second Notice). As the Master of the Rolls observes, ENER-G could therefore succeed if it proved either that:

(a)   The words “delivering it personally” in clause 13.2 mean that it must be delivered by some person, not that it must be delivered to Mr Hormell himself. If this is correct, the First Notice was validly served on 30 March 2010, but so was the claim form on 29 March 2011. When Mr Hormell discovered it was irrelevant on this construction; or
(b)   That the two modes of delivery prescribed in clause 13.2 are exhaustive and not illustrative. If this is correct, the First Notice would be ineffective and the limitation period would start to run only on 1 April, 2010 (when the second, valid, notice was deemed to have been served) and the claim would be in time.

The Court of Appeal unanimously rejected, and it is submitted correctly, the first contention. The words “delivered personally”, as Longmore LJ points out, are a reference to the recipient, not the sender. As the Master of the Rolls rightly observes, if it were a reference to the sender, even communication by post would be covered, because letters are delivered by a postman, and this was plainly not the intention of the parties who separately provided for service by post.

The case therefore turned on the second contention. The Master of the Rolls and Gross, LJ held that clause 13.2 is illustrative. This meant that although the First Notice was not in accordance with clause 13.2, the fact that Mr Hormell happened to find it and read it on 30 March, 2010 was sufficient to satisfy the notice requirement, and the clock began to run on that date. Longmore, LJ dissented, principally on the ground that parties who take the trouble to indicate two ways in which a document can be served must be taken to have excluded other modes of service.

As the division in the Court of Appeal indicates, there are strong arguments for both sides, not only on the language used in the contract, but also on the commercial consequences of each position. The strongest point in favour of the view that clause 13.2 is illustrative is the use of the word “may”. However, as against this, it can be said that the word “may” is used because the clause contemplates two modes of service (service may be either by X method or by Y method).

The obvious point in support of ENER-G – and the one Longmore LJ makes – is that two parties who identify two modes of service of the many available modes must be taken to have intended that they be served only in those ways. The answer of the Master of the Rolls is that the parties identified two modes of service not to exclude other modes, but to dispense with proof that service was complete or effective if the chosen modes are used. That is, if Mr Hormell or ENER-G sent a document by recorded delivery post, it was irrelevant whether this was actually received by the other party, because it is deemed to have been served two days after it is posted. In other words, the commercial purpose of clause 13.2 is to shift the risk of non-delivery from the sender to the recipient. Of course, such a risk does not exist for the other mode of service (“delivered personally”) on the Court’s construction of it because ex hypothesi it contemplates that the recipient must himself receive and sign for it. But the Master of the Rolls points out that while that is so in the case of Mr Hormell receiving notice, it would ordinarily be open to ENER-G to say that it was not served if the documents were delivered personally to an ENER-G employee or agent who lacked actual or ostensible authority to accept service. The commercial purpose of clause 13.2 is to foreclose that argument – again transferring the risk of non-delivery from the sender to the recipient.

All three members of the Court agreed that both views had some unattractive consequences. For instance, on the view of the majority, it was impossible for the claimant to know when the period of limitation began to run, because this depended on whether Mr Hormell happened to find the extra-contractual notice before the two days from the despatch of the contractual notice. But Longmore LJ’s view meant, hypothetically, that if ENER-G had sent an extra-contractual notice which Mr Hormell nevertheless happened to read, Mr Hormell could argue that notice was never served, even though he in fact received a copy.

On balance, it is submitted, with respect, that Longmore LJ’s view is correct. But the more important point made by this judgment is that the solution to disputes about contractual interpretation lies in an iterative process of construction, without any attempt to rewrite the contract in order to make it “fair” or “just”.

* I use the expression “limitation period” in a loose sense – the one year limit was created by the contract, and its effect was to extinguish the claim, not merely the remedy.