Wednesday, February 26, 2014

Ten Monsters in the Companies Act, 2013 – Part 2

[The following post, which is the second in a three-part series, is contributed by Vinod Kothari of Vinod Kothari & Co. The author can be contacted at

The first part in the series is available here]

3.         Intruding into privacy of private, unlisted companies

While we have made the point about above about sweeping regulation applicable to all private companies, we may specifically make a few more points about regulations sought to be applied, which are highly inappropriate in case of private companies. One such provision is the restriction on related party contracts. Once again, given the nature of private companies, it is a fairly acceptable practice that private companies should be allowed to enter into contracts with their related parties. The law imposes the “majority of the minority” rule for such contracts, which is an exceptional shareholder consent rule applicable to very large companies such as those listed on NYSE. The law makes the fundamental mistake of importing corporate governance norms evolved for a handful of NYSE-listed and LSE-listed entities, and imposing them on the 8 lakh odd tiny companies in India.

There are several provisions which may require a private company to have independent directors. For example, if a private company reports profits of Rs 5 crores or more, it becomes subject to the requirement of corporate social responsibility (CSR) spending, and to frame and monitor a CSR policy, the company must have a CSR committee, which must have an independent director. The presence of an independent director on the board of a private company, which may actually be a family concern, is really a very strange imposition.

4.         Reactive law-making – killing instruments to tackle exceptions

This is quite often noted in mob psychology – for example, if a bus kills a passer-by, the mob catches hold of any bus, and sets it on fire. But to see this reactive law-making in such a serious field affecting capital markets is quite undesirable. It is a known fact that several provisions of the Act were inspired by some of the recent corporate scandals – Sahara’s use of the private placement device is one example, Satyam obviously shaped the anti-auditor stance of the Act, and later incidents such as Sharadha were responsible for the rules pertaining to deposits.

While reactive law-making occurs in lot of countries, but an enthused approach where an instrument is completely killed merely because this instrument was misused in one particular case, depicts a purely myopic and callous view. The best example of this the virtual bar on issue of optionally convertible debentures (OCDs), merely because Sahara misused the instrument. World-over, OCDs are well accepted and respected as an interesting hybrid between equity and debt, and a way to encourage fixed income investments by providing them a kicker in form of the equity conversion option. In the past, in India too, lots of companies have successfully used OCDs to reduce the cost of debt. However, since Sahara indulged a blatant misuse of the instrument, and since the Supreme Court sent inquisitives to the regulators about this hybrid instrument, the result seems to have been a pledge taken by the regulators – never allow this culprit to see the face of the corporate world again! The RBI was the first to act – it virtually barred OCDs for NBFCs in June 2013. The draft deposit rules of the MCA do the same thing – OCDs are now denied the exemption from deposit rules, which makes them practically impossible.

It does not seem as if the lawmakers ever thought – if misuse is the only reason why OCDs should become extinct, then what about hundreds of companies that came with public issue of equity shares, collected money and vanished? Does that mean, equity shares should be abolished?

5.         Aggressive prosecution regime will lead to distorporation

It is common knowledge that there are several provisions of the law that have very aggressive prosecution provisions. There are penalties, fines, imprisonments galore. There are 18 sections that refer to the dreaded section 447 that provides for frauds. If a fraud is established, the culprit cannot escape a minimum 6-month sentence, but on the higher side, he may spend good 10 years! If one thought a fraud must be something very very serious, and therefore, this sort of a penal provision must be appropriate, hold that  - even filing of a wrong return with the Registrar of Companies is a fraud! Borrowing money from a bank or an NBFC, by either deliberately or recklessly misleading them, is also a fraud. Note that a fraud is a non-compoundable, non-bailable, cognizable offence. All this means, one, that the public officer does not need a warrant of arrest for taking someone in custody, and there is no bail without hearing the public prosecutor, and there is no composition, that is, paying of money in lieu of prosecution at all.

There are several sections that have fines running to crores. Violation of the process-ridden private placement provision, which was obviously inspired by Sahara, attracts a penalty of Rs 2 crores.

There is a trend internationally – distorporation, that is, corporates opting to un-incorporate themselves, and opt for non-corporate status. This trend has been noted in the USA already[1]. In India too, given the rigorous regime of fines and prosecutions, corporates may be forced to search for easier alternatives – LLPs or even partnership firms.

6.         Perfunctory filing requirements

The new law has mounted loads of new filing requirements on companies. Particularly disturbing is the new pack of filing requirements in sec 117 by linking it with all the resolutions of the board of directors passed in terms of sec. 179 (3). It is notable that in the past, there was absolutely no filing of board resolutions. In fact, board proceedings were always understood to be sole domain of the directors – even the shareholders of the company, let alone members of the public, could not access board proceedings. Now, the law requires 22 additional items of board resolutions to be filed in terms of sec 179 (3) read with sec 117. Many of these are periodic – they occur several times in a year. Thereby, there is a massive perfunctory burden on companies to file matters with the Registry offices.

It is nobody’s case that as none of these were filed in the past, there was some gaping hole in the scheme of regulation of companies.

Filing is not merely an operational burden – it can culminate into very pernicious penal consequences. For example, if a matter that requires filing is not filed within 300 days, it leads to a mandatory prosecution, with a minimum fine. Being charged with a fine is like carrying a criminal record on one’s profile – which will force companies and officers to opt for compounding, and compounding will mean coughing up of sizeable money. There is also a provision that repetitive offences cannot be compounded. In essence, these perfunctory filing requirements may mean huge compliance burden on companies, the benefits of which are difficult to perceive.

(To be continued here)

- Vinod Kothari

1 comment:

Anonymous said...

I think point 3 is an exaggeration. The proviso makes it clear that the effect of the related party transactions restrictions will not come in to effect if it is done in the ordinary course of business and is at an arms length price?

"Provided also that nothing in this sub-section shall apply to any transactions entered
into by the company in its ordinary course of business other than transactions which are not
on an arm’s length basis"
V Aneesh, Hyderabad.