Tuesday, February 25, 2014

Ten Monsters in the Companies Act, 2013 – Part 1

[The following post, which is the first in a three-part series, is contributed by Vinod Kothari of Vinod Kothari & Co. The author can be contacted at vinod@vinodkothari.com]

The significance of the corporate sector to the economy does not need any emphasis, and the Companies Act is surely the core legislation that affects the corporate sector. It is not that the Companies Act was hastily passed – it has gone through two rounds of Parliamentary committees, besides, of course, being in the public domain for nearly 4 years before it was passed. Yet, it is painful to see that glaring issues have remained in the Act  - issues which really have ruinous impact on the corporate sector and capital markets. India is already abysmally low in terms of the ease of doing business, and this enactment will push it down further.

The problems with drafting ineptitude is that once it is done, those responsible for the legislation start defending what is quite apparently a drafting error[1]. Errors are, after all, human, and it is a shared error since the Act has been in public domain for quite a long time. Therefore, there is no need for those responsible for the law to try and construct elegant arguments to defend what are blatant errors. On the contrary, let us call a spade a spade, and think of moving an amendment.
It is not an effective remedy to try and iron out some of the lapses in law by rule-making. Rules are subordinate law; in addition, rules are in the domain of the executive. If the past experience is any indication, it is always that rule-making has come with several conditions, which complicates the matter further.

While there are some areas which are pure lapses in law-making but will have serious implications if left the way they are, there are other very serious issues which require policy decisions. For example, is bond market something that can be left to the discretion of the Ministry of Corporate Affairs (MCA)? Surely the perspective of the Ministry of Finance and that of the MCA are totally different in the matter. The MCA is approaching the issue from an anti-abuse or investor protection viewpoint, with which the MCA seems to be completely obliterating the bond market. Also, it is an issue of essential policy framework for this law as to whether the exemptions to private companies, which is germane to the whole basis of regulatory framework, could be left to the power of exemption.

This post highlights 10 areas where the implications of the law, if left uncorrected, can be seriously harmful.

1.         Regulation by rule, liberty by exception

 

The Act enacts an all-encompassing regulatory principle by including all companies into the tight regulatory provisions of the law, with the promise that the government has a power to exempt such companies as it deems fit, and that the government will be willing to exercise such power to exempt as and when the government feels appropriate.

Here lies a fundamental issue – where there is no reason to regulate in the first place, it is not appropriate to state that the Act will by default apply to all companies, and companies that deserve to be liberated will be let off the hook by way of exemption. This is almost like taking the entire corporate sector as hostage, with a promise to take deserving companies or classes of companies out by executive action. The power to exempt companies was there in the 1956 Act also – but that was never a reason all these 6 decades of implementation of the law to regulate by rule, and exempt by choice. After all, the fundamental rule on which humanity works is – regulation is an exception, liberty is the rule. Admittedly, corporates are the product of regulation – so they cannot demand fundamental liberty that individuals can; however, regulation is not a self-serving need. It is warranted for a reason – there seems to be no good reason to support the “negative listing” approach of the regulatory framework, whereby all companies are prima facie regulated, with a power to exempt exceptionally.

If everyone thought, when the draft Bills were being discussed from 2008 to 2012, that the power to exempt will be logically and liberally exercised, such expectations have already been belied. The sections that were enforced on 12th Sept 2013 have cast rigorous restrictions on private companies, which are totally out of place. For example, if a private company, admittedly a private affair, gives loans to its own directors, who could be complaining of prejudice? After all, the shareholding and management in case of private companies is the same – so the owners are lending to themselves, and there is no reason for regulation to worry.

Likewise, on the issue of financial transactions (loans and guarantees) between holding and subsidiary companies, it is grossly illogical to take a position that a subsidiary company cannot piggyback on its holding company’s support. After all, if a toddler does not get support from its own parents, where else will the support come from? It is a settled way of doing business world-over that holding companies provide loans and guarantees to subsidiaries. In fact, in case of overseas direct investment, the Reserve Bank of India (RBI) specifically requires that loans be given only to subsidiaries and none else. Having lost all practicality, section 185 was enforced without any exemption in case of financial transactions between holding and subsidiary companies. Here too, the government might have easily used its powers under the Act to exempt transactions between holding and subsidiary companies from the sweep of the law; however, after nearly 5 months of the enforcement of sec 185, a half-hearted “clarification” was issued by the MCA on 14th Feb 2014 to state that guarantees between holding and wholly-owned subsidiaries will be exempted from sec 185. There were several riders in this so-called clarification – first, it is only a temporal relief, since the clarification says so clearly. Second, the relief is only for guarantees and not for loans. Third, the relief is only for wholly-owned subsidiaries, and not for any subsidiary. On the contrary, if the MCA was using the power to exempt as the justification before the Parliamentary committee for the otherwise-rigorous scheme of the law, there was no reason why the power of exemption was not used, rather than the half-hearted clarification, apparently arising out of a so-called “harmonious interpretation” of sec. 372A of the 1956 Act and sec 185 of the 2013 Act.

In essence, it is quite clear that to obtain any exemption from the government is a near impossibility. In light of this experience, the sweeping scheme of regulation is most unreasonable, and particularly in cases like the public-private company distinction and the holding-subsidiary company exemption, it defies all rationale as to why should there be regulation in the first place.

2.         FDI investors in for a shock

This is quite an unintended implication of the law, but if it is not corrected soon, it will lead to a major setback for the already weakened flow of foreign direct investment (FDI) into the country. By a combined reading of sec. 2 (71) and section 2 (87) of the new Act, a private company which is subsidiary of a foreign body corporate will be deemed to be a public company, and the law will be applicable to it as if it were a public company. There was a protection against such an unhappy situation in terms of sec. 4 (7) of the 1956 Act, but in their bid to shorten the definition of a subsidiary into a clause from a full-fledged section, the regulators have deleted sec. 4 (7). The completely shocking implication of this is that every private company, which is subsidiary of a foreign company, is a deemed public company.

What makes it even more alarming is that since sec 2 (87) of the new Act has been notified on 12th Sept 2013, section 4 (7) has ceased to be effective from that date, and therefore, the deeming fiction has already taken effect. Literally, this will mean from 12th Sept 2013, all Indian companies which are subsidiaries of foreign companies, have become deemed public companies. Notably, the compliances under the old Act, in case of public companies, are far more intensive than in case of a private company. One trite regulation is the control on managerial remuneration – thus, the Indian subsidiary of a foreign company cannot pay what it wishes to its Indian CEO – it must remunerate only in accordance with the scales set in Schedule XIII.

Most companies in India which receive FDI are private companies. They might be having huge turnover, but they are constitutionally private, as they are held almost entirely by their foreign parents. IBM India is an example – it is a private company.

For variety of reasons, international investors have lately been shunning India. If they run the risk of sleep-walking into the regulations applicable to public companies, it will really be  a shocker for them, and obviously, India as a country could not have a worse time if FDI investors turn their back.

(To be continued in Parts 2 and 3)

- Vinod Kothari




[1] One prominent example is the definition of “subsidiary company” in sec. 2 (87) where the intended reference to “total voting power” was wrongly worded as “total share capital”, thereby making preference shares, which are non-voting shares, as the basis of subsidiarisation. Apparently, attempts were made to justify this error, but the error is quite evident from the use of the words “exercises or controls”, which obviously cannot relate to share capital, as share capital cannot be “exercised”.

4 comments:

dvmgopal said...

Section 185 starts with "Save as otherwise provided in this Act". I understand that unless contradictory provided in other section, this section shall prevail. Therefore, since 186 still not notified, we can take the Shelter of Section 372A to give loans, guarantees, to Wholly owned Subsidiary Companies.

Anonymous said...

It think it is incorrect to say that subsidiary of a foreign body corporate will be a public company. Section 2(71) refers to subsidiary of a company, not being a private company , shall be deemed to be a public company. The definition of a company is a company incorporated under the Indian law. The expansive definition of company to include body corporates with reference to holding companies is only for the term subsidiary company.

Vinod Kothari said...

I would respond to both the comments.
Re the meaning of "subsidiary company". The expression "subsidiry company" or cognate expressions cannot be read de hors of sec 2 (87). In essence, we cannot pick up the meaning of "subsidiary" from sec 2 (87) and disregard that part of sec 2 (87) - which is the defining section - which says the word company includes a body corporate. The meaning given in the definition section is pervade through the Act and cannot be limited to the defining section. Hence, when it comes to sec 2 (71) defining publi company, being subsidiary, etc., we have to take the word subsidiary as subsidiary of a body corporate too. That was the precise reason why there was a carve-out in sec 4 (7) of the earlier Act, which was deleted for unspecified, ununderstanable reason.

I know the interpretation I am taking is quite harsh for all FDI companies, but unfortunately that is inescapable.

Next, regarding holding-subsidiary companies, our view is that none of the 5 items in Expln below sec 185 (1) cover holding-subsidiary relationship. Clause (e) is purely circumstantial and may be rebutted by facts.

TSP said...

I would agree to the second comment that the company in the provisio must be incorporated under the Indian Law. In the 2013 act, there are only two types of cos can be incorporated public and private (including one person co). If we take your corollary that "not being a private company" will include body corporate and apply to the definition of a public company i.e. 71 (a) & (b), then all body corporates with over 5 lakhs of paid of capital would be public companies under the act. Surely, this is not the intention of the legislators.