Monday, December 31, 2012

Blog Anniversary; Season’s Greetings


The end of the year marks the fifth anniversary of this Blog. Its first post appeared on December 26, 2007. I would like to take this opportunity to thank all the contributors and guests for their thoughtful posts on various areas of corporate and business laws and for fostering a healthy debate and discussion in a manner that is widely disseminated and easily accessible to the interested reader. I would like to express our gratitude to our readers for their wonderful support on an ongoing basis and for their comments and feedback.

Wishing all of you a New Year filled with success, happiness and prosperity.


Royalty Payments and Corporate Governance


In the past, the corporate governance discourse pertaining to Indian companies has revolved substantially around family owned businesses and government-owned (public sector) companies. Another type of companies that is quite prevalent in the corporate scenario, but usually does not receive specific attention, is Indian listed subsidiaries of multinational companies (MNCs). A significant governance issue in respect of such MNC subsidiaries has now been highlighted due to the unintended consequences of a change in regulation pertaining to foreign investment and foreign exchange.

Earlier, the Government had imposed restrictions (including limits) on the amount of royalties and trademark fees that Indian companies could pay under foreign collaboration agreements. However, in December 2009, these restrictions were removed, and Indian companies were free to make these payments to foreign collaborators without any restrictions or limits. The purpose of this change was to ease such payments from a foreign exchange perspective. The matters that transpired since have sparked off major concerns from the point of view of corporate governance and minority shareholder protection in Indian listed companies that are subsidiaries of MNCs.

The Institutional Investor Advisory Services (IIAS), a proxy advisory firm, has issued a recent report that indicates a spurt in royalty payments by Indian listed MNCs to their parent companies. This has also attracted follow-up discussion and commentary (see Business Standard and Spicy IP). What emerges is that since the liberalization in December 2009, royalty payments have increased substantially despite the lack of commensurate increase in revenues and the faster increase in revenue and margins of local competitors. The net result of these efforts is that what would have otherwise been paid out as dividend pro rata to all shareholders is now being paid out as royalty only to the parent company (controlling shareholder). This operates to the detriment of minority shareholders in such listed companies. The discussion also indicates a lack of transparency in the manner in which such payments are made, which also does not require any specific shareholder approval under current law.

Such royalty payments are a classic case of related party transactions (RPTs) between the company and a controlling shareholder. As we have previously lamented, the regulation of RPTs in India is far from the desirable. Current corporate governance norms only require appropriate disclosure in the financial statements, a responsibility imposed on the auditors and the audit committee. One way of approaching the issue is to consider disclosure as fulfilling an important function because investors can then decide their further course of action depending on the nature of disclosures. However, there are problems with disclosure as the sole option. First, disclosures can sometimes lack meaning if they are not appropriately and accurately made. Second, disclosures tend to acquire an element of standardization over a period of time thereby leaving investors with little information to distinguish among companies that make the royalty payments.

Due to the failure of disclosure as an adequate option, it is necessary to consider other possibilities through amendment to corporate governance norms. Essential among them is the need for a committee of independent directors to specifically consider and approve such royalty payments (or any other material RPTs for that matter) after specifically expressing their views on the impact of such transaction on the interest of minority shareholders. Another option would be to mandate shareholder approval for such royalty payments (or other RPTs), wherein the recipient of the royalty payment (i.e. the parent company) must be required to abstain from voting in view of the conflict of interest.

Unless such checks and balances are introduced, the minority shareholders in such MNC subsidiaries will be exposed to considerable risk that the parent companies will likely treat the Indian listed companies as if they are merely arms of themselves.

Companies Bill: From the Rule of Law to the Law of Rules


[The following guest post is contributed by Vinod Kothari and Vrinda Bagaria of Vinod Kothari & Company. These can be reached at vinod@vinodkothari.com and vrinda@vinodkothari.com respectively.

In this post, the authors critically analyze the extensive nature of rule making powers conferred upon the Central Government under the Companies Bill, 2011]

Introduction

Parliament makes legislation, and the executive, that is, the Central government or any other statutory authority, is primarily concerned with the implementation of the law, but is quite often given powers to make rules. The power of rule-making commonly comes by words such as “as may be prescribed” in the law.
The Companies Bill 2012 goes a little overboard in liberally setting aside matters which may be prescribed by the Central Government.  The word “prescribed” occurs 416 times in the Bill. Though at lots of instances where the said word is used, the idea may be the prescription of the form/e-form whereby filing is to be done, there is an enormous extent of law that is reserved for prescription by the executive in form of rules. This would mean, besides the law with 470 sections and 5 schedules, subjects will have to keep in mind the massive body of rules to be framed under the law.
Rule-making has its own advantage – rules are flexible, and may be amended from time to time without going to the Parliament. Rules may contain matters of details, for example, the procedural rules, which may be parked into rules to keep the body of the law light.
However, there is a curious balance between what needs to be in the law and what may be parked into the rules. There are certain matters which relate to the very core, the vey policy of the regulation. For instance, whether a particular regulation will apply to a private limited company or not cannot be left for the executive to decide. Given the nature of the curb being imposed, it may be wholly inappropriate for the Parliament to apply the law in general, and then give a scope for the executive to relax it for a class of companies.

Liberties of Private companies, small companies and one person companies

One may notice that exemptions in case of private companies, unlike the existing Act, are not a part of the law in the Bill – these are to be notified by the Central Government.  However, the liberties enjoyed by private companies are not a matter of magnanimity on the part of the executive. Given the nature of a private company, it is a closed group of persons with strictly private fund raising, and hence, there is no question of certain regulatory concerns for such companies. It is not sufficient in such cases to say, the executive may exempt such companies from certain provisions. One good example is the provisions applicable to private placements. Every issue of securities, in case of a private company, is a private placement. If the placement is a private affair, there is no reason for the intervention of the law. There is large restrictive set of rules applying to private placements under the Bill[1]. There is no good reason for such rules to be applicable to private companies. This is something which is an integrated part of the philosophy of the law, and cannot be left for the rules to lay down.

Principles of excessive delegation: Balancing between subordinate law and Parliamentary law:

The balance between Parliamentary law and subordinate law has been one of the key features of our Constitution and our legislative set up. Unlike England, the principle of subordinate legislation in India is inspired by the US constitution.
A leading US case on the point is Panama Refining Co v. Ryans[2] wherein it was held that the Congress can delegate legislative powers to the Executive subject to the condition that it lays down the policies and establishes standards while leaving to the administrative authorities the making of subordinate rules within the prescribed limits.
In India, courts have taken a more liberal attitude on the principle of excessive delegation. The Constitution of India does not contain specific provisions for delegated legislations. It imposes restrictions based on general theories and principles of constitutional law and judicial precedents. The purpose for introducing the principle for delegated legislation is that the legislature being over burdened and the needs of the modern day society being complex it cannot possibly foresee every administrative difficulty that may arise after the Statute has begun to operate[3]. Delegated legislation fills those needs and comes to aid during situations of emergency. However, this does not imply that the doctrine of delegated legislation can be used arbitrarily or unreasonably. The Parliament can only delegate to the executive the power to make ancillary or sub-ordinate legislations to the principal legislation and not the principal legislation itself.
Where the vires of section 6(2) of the Bombay Tenancy and Agricultural Lands Act, 1948 was challenged on the ground of excessive delegation[4], the Hon’ble Supreme Court held that a statute challenged on the ground of excessive delegation should be subjected to two tests i.e.:
a.     whether it delegates essential legislative function or power; and
b.     whether the legislature has enunciated its policy and principle for the guidance of the delegate.
In the same case[5], Subba Rao J. observing that there is a danger inherent in the process of delegation, also opined that:
It may not lay down any policy at all; it may declare its policy in vague and general terms; it may not set down any standard for the guidance of the executive, it may confer an arbitrary power on the executive to change or modify the policy laid down by it without reserving for itself any control over subordinate legislation. This self effacement of legislative power in favour of another agency either in whole or in part is beyond the permissible limits of delegation. It is for a Court to hold on a fair, generous and liberal construction of an impugned statute whether the legislature exceeded such limits. But the said liberal construction should not be carried by the courts to the extent of always trying to discover a dormant or latent legislative policy to sustain an arbitrary power conferred on executive authorities.”
The proposed Companies Bill, 2012 confers wide powers to the Central Government to prescribe the applicability or non-applicability of some provisions to a certain class of companies’ which might in the long run lead to arbitrary exercise of powers and hence excessive. Earlier also, there have been many statutes where the provisions were made applicable to a certain class or certain area and simultaneously, the government was authorized to make those provisions applicable to the excluded classes or areas as well, as the case may be.
In the landmark case of In re Delhi Laws Act[6](“Delhi Laws Act case”), Fazl Ali J. rightly quoted what was laid down by the American Judges as an exception to the general rule of delegated legislation, that
The legislature cannot delegate its power to make a law; but it can make a law to delegate a power to determine some fact or state of things upon which the law makes, or intends to make, its own action depend - To deny this would be to stop the wheels of government.”
In the same case, Justice Fazl Ali, also observed that:
“No legislative body can delegate to another department of the government, or to any other authority, the power, either generally or specially, to enact laws. The reason is found in the very existence of its own powers. This high prerogative has been entrusted to its own wisdom, judgment, and patriotism, and not to those of other persons, and it will act ultra vires if it undertakes to delegate the trust, instead of executing it.”
Despite the above observations, the Hon’ble Supreme Court admitted the necessity of a delegated legislation and formulated the general limit of delegation on the broad formula that “what cannot be delegated is its essential functions.”
Further, the case of Raj Narain v. Chairman, Patna Administration[7] subtly summed up the limitations laid down in Delhi Laws Act case as:
a.     Parliament may not destroy its legislative power by delegation;
b.     It may not abandon its control over the delegate; and
c.     It may not create a new legislative power not contemplated in the Constitution.
It is noteworthy, that along with the power of delegated legislation, also comes hand to hand the power of discretion conferred on the administration. ‘Rule-making power’ and ‘discretionary power’ can be said to constitute two sides of the same coin i.e. delegated legislation. It implies that subordinate legislation is a medium for administrative authorities to further confer discretionary powers upon themselves by formulating rules to that effect. In spite conferral of such arbitrary powers of rule-making and exercise of discretion by the administrative authorities, the courts have taken a backseat and hardly rendered any statute or legislation invalid on grounds of excessive delegation unless the same appears widely to be so, on the face of the provision. Even when the courts have found the delegated legislation to confer wide powers on the administration, availability of safeguards have been held to be sufficient against the abuse of power. This only shows that the standard accepted as sufficient has been so general and vague that it raises a doubt on whether it solves the purpose of controlling administrative discretion[8].
Nevertheless, in the present epoch, both the legislative as well as the judicial authorities have very conveniently overlooked the restrictions applicable in case of delegated legislation and adopted a more lenient approach towards the doctrine of delegated legislation such that the legislature lays down the general provisions of law leaving the specification to be filled in by the executives. Sometimes, the executive authority is also conferred with the power of modifying the existing statute before its application which is in essence a drastic power resulting in an amendment to the statute itself, essentially the same being a function of the legislature.
The Companies Bill, 2012, is also an example of excessive delegation as major arenas have been left open for the government to make rules on the same, as is evident from a bare reading of the provisions. Moreover essential provisions required to be incorporated in the Bill, for instance, in the case of a private company, small company or a one person company, the legislature has completely failed to provide that the law will be applicable to companies involving public interest.
The doctrine of delegated legislation has become an integral part in the legislative process. Nevertheless, it should not be used excessively so as to defeat the purpose which legislation seeks to achieve and to render it ineffective. It is the primary and most essential duty of the legislature to frame the laws of a country and it should not try to escape from its duty under the garb of subordinate legislation. Proper checks and balances should be imposed to ensure that the doctrine of delegated legislation is adopted reasonably. The legislature alone cannot be held responsible for the arbitrary exercise of authority under delegated legislation and the judiciary has an equally important role to play in ensuring the same.

Conclusion

The Companies Bill, 2012 is a significant step taken by the legislature to effectively regulate corporate affairs in India and to improvise the present Companies Act, 1956 according to the current requisitions of the corporate world.  However, leaving such major areas in the Bill open to the discretion of the administration shall prove to be a hindrance in meeting the true intent and purpose of the statute in the future. It is necessary to bear in mind that the statute should not be drafted to fulfil the short-term goals of the society but be sufficient to meet the requirements of the present as well as the future. The true intention to a statute can be accorded only by the law-makers of the society i.e. the legislature and not the executive. The executive can only be delegated enough powers to ‘fill in the gaps’ where necessary and nothing in excess of the same. In the backdrop of such considerations, there is a need to review the statute and eliminate any possibility of excessive delegation.
- Vinod Kothari & Vrinda Bagaria


[1] See Vinod Kothari and Nidhi Ladha: http://www.moneylife.in/article/fallout-of-the-sahara-case-companies-bill-2012-too-strict-on-private-placement-provisions/30344.html
[2] (1935) 79 L. Ed- 446. 438
[3] St. Johns Teachers Training Institute v. Regional Director, National Council for Teacher Education & Anr.,  http://indiankanoon.org/doc/633712/
[5] Ibid.
[7] AIR 1954 SC 569
[8] http://upendrabaxi.net/documents%5CDevelopments%20in%20indian%20administrative%20law.pdf, Public Law in India, Developments in Indian Administrative Law, Page 141-142.

Sunday, December 30, 2012

Supreme Court on Sukanya Holdings and section 45


It is well-known that the Supreme Court in Sukanya Holdings held that a cause of action cannot be “bifurcated”. Applying this rule, the courts held in several cases that a dispute involving several parties, some of whom are not parties to the agreement containing the arbitration clause, is not arbitrable. Although attempts were made to limit Sukanya, there was considerable doubt as to its scope, particularly in foreign arbitrations in which an attempt is made by a party to invoke the jurisdiction of the Indian court. In Chloro Controls v Severn Trent, a three-judge Bench of the Supreme Court was invited to overrule Sukanya. Although it declined to decide this issue, it made several important observations about its applicability to foreign arbitrations.

Chloro Controls was a dispute between an Indian company and an American joint venture partner. The facts are of some importance. Chloro Controls, a company run by the “Kocha Group”, was engaged in the business of manufacturing and selling gas and electrical chlorination equipment. Severn Trent agreed to appoint Chloro Controls as its exclusive distributor in India and a joint venture company [“the JVC”] was incorporated in India for this purpose. As is not uncommon in such transactions, there was a network of several interlinked agreements, each dealing with a different aspect of the commercial relationship between the parties. In all, there were seven agreements, of which the Shareholders Agreement was the principal agreement, to which Mr Kocha, Severn Trent and Chloro Controls were parties. Clause 4 of the SHA provided that Chloro Controls could not, during the subsistence of the agreement, deal with similar products manufactured by any other entity. Clause 30 provided that disputes would be resolved by English law arbitration in London. The SHA made reference to the other agreements to be executed between these and other parties. The difficulty arose because not all parties had signed all the ancillary agreements, and some of the ancillary agreements did not contain an identical dispute resolution clause. For example, the International Distributor Agreement, by which the JVC was appointed as the exclusive distributor, was signed by Severn Trent and the JVC: neither Mr Kocha nor Chloro Controls was party, and it contained a dispute resolution clause in favour of the courts of Pennsylvania, USA. Similarly, Chloro was not a party to the Export Sales Agreement, which contained an arbitration clause, but seated in the USA, not London.

Eventually, a dispute arose as to whether the JVA covered electrical chlorination equipments as well, and Severn purported to terminate it. Chloro instituted a derivative suit in the Bombay High Court impleading inter alia Severn, the JVC, the Kocha group and the directors of the JVC as parties. It also impleaded two respondents who were not parties to any of the agreements. Severn sought a reference under section 45 of the Arbitration Act to arbitration, pleading that the dispute was essentially about the scope of the JVC and the validity of its termination, matters eminently within the arbitration clause. A Division Bench of the Bombay High Court agreed.

In the Supreme Court, Chloro’s case was that a litigant has a right to approach the civil courts, displaced only by express or clear language; that Sukanya was correctly decided, and that it is impermissible to refer these multi-party disputes to arbitration when some agreements contain no arbitration clause or an arbitration clause on materially different terms. Severn’s case was that Sukanya has become a charter for the disgruntled litigant to avoid the arbitration clause and subject the other party to lengthy proceedings in the Indian courts, notwithstanding the express selection of arbitration as the preferred means of dispute resolution; and that Sukanya was wrongly decided and in any event a complete irrelevance to section 45.

The Supreme Court held that section 45 leaves no room for discretion: if the conditions in sections 44 and 45 are satisfied, the civil court is required to refer the parties to arbitration. With respect to whether it is appropriate to do so in multi-party arbitrations, the Court examined many theories on the basis of which such references have been made: group companies, claiming “through or under” a party to the arbitration clause etc. It accepted that a reference is permissible if the agreements are “intrinsically interlinked” and the ancillary agreements serve no purpose except in connection with the principal agreement which contains the arbitration clause. In other words, a composite transaction can be referred to arbitration even if some of the parties named as respondents are not parties to the arbitration clause. It also observed that Sukanya Holdings is of no relevance to an application made under section 45 for a reference to arbitration because that case was decided under section 8. The following observations of the Court illustrate the point:

In a case like the present one, where origin and end of all is with the Mother or the Principal Agreement, the fact that a party was non-signatory to one or other agreement may not be of much significance… In cases involving execution of such multiple agreements, two essential features exist; firstly, all ancillary agreements are relatable to the mother agreement and secondly, performance of one is so intrinsically inter-linked with the other agreements that they are incapable of being beneficially performed without performance of the others or severed from the rest. The intention of the parties to refer all the disputes between all the parties to the arbitral tribunal is one of the determinative factor.
Although the Court has stopped short of overruling Sukanya Holdings, its judgment enhances the prospect of resolving multi-party disputes through arbitration and ensuring that the jurisdiction of the civil courts remains excluded.