INDIAN CORPORATE LAW

SAT on Disclosures Regarding “Promoters”

noreply@blogger.com (V. Umakanth) — Fri, 24 Feb 2012 04:35:00 +0000

The Securities Appellate Tribunal (SAT) has issued its decision overturning an order of SEBI’s adjudicating officer that had found Enam Securities to have violated securities laws in connection with the IPO of Yes Bank.

One of the key issues in contention was whether Rabobank ought to have been disclosed as a “promoter” of Yes Bank. On facts, while the application to the Reserve Bank of India (RBI) for a banking licence recognised Rabobank as a co-promoter of the issuing bank, the prospectus filed with SEBI pursuant to which securities where issued did not disclose Rabobank as a promoter. After analysing the provisions of the erstwhile SEBI (Disclosure and Investor Protection) Guidelines, 2000, SAT came to the conclusion that the disclosure was indeed appropriate. It noted:

The appellant has been successful in demonstrating as to why Rabobank was shown as a co-promoter in its application for banking license with the RBI. Simply because Rabobank was shown as a copromoter of Yes Bank for getting a banking license from the RBI will not ipso facto make it a promoter for the purposes of DIP guidelines or other regulations issue by the Board. To bring Rabobank within the promoter category, it must satisfy the definition of promoter as given in the DIP guidelines. There is no general definition of promoter in the DIP guidelines.

Although the SAT’s reasoning largely involves analysis of the erstwhile DIP Guidelines, they are likely to continue to have some impact under the SEBI (ICDR) Regulations that currently govern disclosures.

The fact that SEBI had not raised its concern while reviewing the draft red herring prospectus or other subsequent filings regarding the company seemed to weigh heavily on SAT:

If the Rabobank falls within the promoter category, we fail to understand how such a vital aspect escaped notice of the regulator while clearing the DRHP where Rabobank is not shown as a promoter. We also fail to understand as to why the regulator continued to accept financial statements, quarter after quarter, year after year, without Rabobank being shown in the promoters’ category and why no action was initiated against Yes bank for making incorrect disclosure in the financial statements. In this background, no fault can be found with the merchant banker of exercising due care and diligence when Rabobank was not shown in the promoter category.

Such an approach likely places a heavier burden on SEBI to scrutinize draft offer documents more carefully when filed with it.

SAT also did not find a failure on the part of Enam Securities on other aspects of the IPO process involving Yes Bank, including on discretionary allocation of shares in the qualified institutions category and other alleged irregularities in the allotment process.

Arbitrability of an Unfair Prejudice Claim (Part II)

noreply@blogger.com (Shantanu Naravane) — Sat, 18 Feb 2012 13:37:00 +0000

(continued from earlier)

The next argument was that any unfair prejudice claim under s.994 attracts a degree of state intervention and public interest such as to make it inappropriate for disposal by anything other than judicial process, independent of the nature of the claim or the company in this particular case. In response, the Court undertakes a historical analysis of the unfair prejudice claim, observing that since the 1980 Companies Act, the scope of the unfair prejudice claim has consciously been given a life independent of the relief of winding up on just and equitable grounds. Thus, although the two may overlap, the legislature has made a conscious effort to allow the unfair prejudice claim and reliefs under it, for reasons which may not apply to other shareholders in the same class as the claimant, or to creditors. Thus, the unfair prejudice claim is more ‘personalised’ than the winding up of the company on just and equitable grounds. The Court observed that while some of the reliefs sought under an unfair prejudice claim could affect third parties, it was not inherently a class remedy. In cases where it did affect third parties, the Court could impose limitations of the reliefs that could be claimed through arbitration.

This conclusion was apparently at odds with Exeter, which had held relied on an Australian decision in A Best Floor Sanding Party Ltd v Skyer Australia Party Ltd [1999] VSC 170, to hold that the shareholders have an inalienable right to approach a Court for an unfair prejudice claim and had denied a stay. However, as the Court of Appeal here rightly points out, the applicable Australian statute was materially different from its English counterpart. It mere included unfair prejudice as an additional ground for winding-up, and not as an independent head of relief. Further, the reliefs sought there were for winding up and not merely a contractual dispute which formed the basis of an unfair prejudice claim. The Supreme Court of New South Wales in ACD Tridon Inc v Tridon Australia Pty Ltd [2002] NSWSC 896 has also similarly narrowed the scope of the Skyer Australia decision, lending further support to this interpretation. The Court observes that certain company law issues like the rights of members; and the duties of directors, or the consequences of insolvency are not such as may be arbitrated. However, the Court observes that Exeter incorrectly extended the rationale of Skyer Australia beyond these limited cases.

Here, the Patten LJ observes that,

the determination of whether there has been unfair prejudice consisting of the breach of an agreement or some other unconscionable behaviour is plainly capable of being decided by an arbitrator and it is common ground that an arbitral tribunal constituted under the FAPL or the FA Rules would have the power to grant the specific relief sought by Fulham in its s.994 petition. We are not therefore concerned with a case in which the arbitrator is being asked to grant relief of a kind which lies outside his powers or forms part of the exclusive jurisdiction of the court. Nor does the determination of issues of this kind call for some kind of state intervention in the affairs of the company which only a court can sanction. A dispute between members of a company or between shareholders and the board about alleged breaches of the articles of association or a shareholders’ agreement is an essentially contractual dispute which does not necessarily engage the rights of creditors or impinge on any statutory safeguards imposed for the benefit of third parties. The present case is a particularly good example of this where the only issue between the parties is whether Sir David has acted in breach of the FA and FAPL Rules in relation to the transfer of a Premier League player ... The statutory provisions about unfair prejudice contained in s.994 give to a shareholder an optional right to invoke the assistance of the court in cases of unfair prejudice. The court is not concerned with the possible winding-up of the company and there is nothing in the scheme of these provisions which, in my view, makes the resolution of the underlying dispute inherently unsuitable for determination by arbitration on grounds of public policy. The only restriction placed upon the arbitrator is in respect of the kind of relief which can be granted.

Having settled this point, the Court (following ACD Tridon) goes further to say that even in cases where a contractual dispute like the one here was being relied on as the basis of a winding up petition, the right to approach the court continued to be contingent on the underlying dispute being settled by arbitration. “The agreement could not arrogate to the arbitrator the question of whether a winding-up order should be made. That would remain a matter for the court in any subsequent proceedings. But the arbitrator could, I think legitimately, decide whether the complaint of unfair prejudice was made out and whether it would be appropriate for winding-up proceedings to take place or whether the complainant should be limited to some lesser remedy.”

Finally, the Court considered the third and fourth prongs of argument. The third was held as not being supported by the statute, while the fourth was rejected on the basis that while the clause was very broad, inherent limitations would be read in based on the arbitrability of the subject matter of the dispute.

In sum, this is an important decision on the extent to which a company law dispute may be arbitrated. Admittedly, the facts of the case played a crucial role in the conclusion arrived at. However, the analysis of the nature of an unfair prejudice claim, and the concept of arbitrability provides useful guidance for future issues of a similar nature.

Arbitrability of an Unfair Prejudice Claim (Part I)

noreply@blogger.com (Shantanu Naravane) — Sat, 18 Feb 2012 13:33:00 +0000

A recent post considered the relation between arbitration and company law, in the context of the inability of arbitration to develop the body of corporate law jurisprudence. Another fascinating area of substantive overlap, is the arbitrability of company law disputes, which the UKCA in Fulham v David Richards was called on to consider in relation to claims of unfair prejudice.

Given the fact-specific conclusion the Court arrives at, a slightly detailed explanation of the factual backdrop is mandated here. Fulham Football Club had filed an unfair prejudice petition in relation to the Football Association Premier League (which manages and regulates the English Premier League) (“FAPL”). FAPL is organised as a company, with the different football clubs in the English Premier League as its members. The claimant contended that the chairman of the FAPL Board had acted as an unauthorised agent in breach of the FA Football Agents Regulations by brokering the sale of a player owned by Portsmouth Football Club (Peter Crouch, for the benefit of those who follow football) who Fulham were interested in to Tottenham Football Club. Under the FA Rules, any player or club is prohibited from using or seeking to use the services of an unauthorised person to act in the capacity of an agent, representative or adviser to a club, either directly or indirectly, in the negotiations or arrangements of any transaction facilitating or effecting the transfer of the registration of a player from one club to another. When Fulham approached the FA for relief, they were informed that the issue would be put to a shareholders’ meeting. In the alternative, the FA asked Fulham to bring arbitration proceedings under the FA Rules. Fulham instead approached Companies Court, alleging that it was an implied term of the FAPL Rules that members of the board of the FAPL would comply with their fiduciary obligations and not act so as to prefer the interests of one member club over another. By way of relief, Fulham sought an injunction restraining Sir David from acting as an unauthorised agent or from participating in any way in negotiations regarding the transfer of players. In the alternative, it sought an order that Sir David should cease to be the chairman of the FAPL and such other relief as the Court thought fit. On the basis of the arbitration clause in the FA Rules which the clubs were bound by, the FA and Sir David sought a stay of the Court proceedings, under section 9 of the English Arbitration Act, 1996.

Against this factual backdrop, the court was called on to determine the arbitrability of this dispute, and to reconcile two earlier decisions of the High Court in Re Vocam Europe Ltd [1998] BCC 396 and Exeter City Association Football Club Ltd. v. Football Conference Ltd. [2004] 1 WLR 2910, which had arrived at seemingly different conclusions. Although the High Court in this case followed Vocam and granted a stay, Fulham appealed on four principal grounds:

(a) the relief in an unfair prejudice claim would affect third parties and hence was not arbitrable;

(b) the very nature of the unfair prejudice claim was one which involved public interest and could not be resolved by a private contractual arrangement;

(c) the 2006 Act impliedly rendered the right to approach a Court for an unfair prejudice claim an inalienable right; and

(d) the arbitration clause here was too wide to be enforced.

The Court begins by clarifying that neither the Arbitration Act nor the Companies Act had anything which expressly indicated the arbitrability or otherwise of such a dispute. Hence, the decision turned on first principles of arbitrability, and the nature of an unfair prejudice claim, both very interesting and complex issues.

On the first issue, the Court admitted that usually, a decision on an unfair prejudice claim had consequences for several other shareholders who would not be parties. However, the special nature of the FAPL (discussed in paragraphs 47 and 48 of the judgment) meant that the nature of disputes were much more limited than in other private companies. Thus, the Court concluded that the nature of the relief it was seeking in this particular case was not one that would render it unarbitrable.

(to be continued)

Informal Guidance on Preferential Allotment

noreply@blogger.com (V. Umakanth) — Sat, 18 Feb 2012 09:02:00 +0000

SEBI has issued an informal guidance to Strides Arcolabs in connection with the company’s eligibility to issue securities to its promoters on a preferential allotment basis. The information guidance essentially pertains to the interpretation of Reg. 72(2) of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 (ICDR), which reads as follows:

The issuer shall not make preferential issue of specified securities to any person who has sold any equity shares of the issuer during the six months preceding the relevant date.

…

Explanation: Where any person belonging to promoter(s) or the promoter group has sold his equity shares in the issuer during the six months preceding the relevant date, the promoter(s) and promoter group shall be ineligible for allotment of specified securities on preferential basis.

On 20-21 October, 2011, there was an inter se transfer of shares among the promoters of Strides. This was effected under the erstwhile Takeover Regulations of 1997 (and prior to the new regulations that came into effect on 22 October 2011), and appropriate reporting requirements were complied with. Strides now wishes to issue securities to certain promoters who were the sellers in that transfer, and sought SEBI’s view on the eligibility to issue securities by way of preferential allotment.

In SEBI’s view, the interpretation of Reg. 72(2) and its explanation would not permit Strides to make a preferential allotment of securities to the promoters who earlier sold shares in the inter se transfer among promoters. SEBI’s reasoning is as follows:

The said regulation and its explanation do not differentiate between inter-se transfers made to entities within promoter group and sales made to others. Hence, the term “any person who has sold any equity shares of the issuer” shall also include any person who has made inter-se transfers within the Promoter group. Thus, as per the extant Regulations, if there is any inter-se transfer among the promoter group entities in the prece[]ding six months, then all the persons/entities forming part of “promoter(s) and promoter group” shall become ineligible for allotment of specified securities on preferential basis.

Arguably, this represents a technical approach, and a more purposive interpretation could lead to different results. For instance:

1. The objective of the set of regulations that prescribe specific holding periods for preferential allottees is to prevent short-termism whereby certain investors can take advantage of price movements to sell shares and then obtain them through preferential allotment at more beneficial price. This particularly applies to promoters as they are in a position to control the allotments through their substantial shareholding. Such an objective does not appear to have a place in the context of inter se transfer among promoters because it is just a rearrangement of shareholding among the promoter group without a sale to persons outside the group. While a literal interpretation would lead such a transfer to be a “sale”, a purposive interpretation would not bring it within the mischief that the rule seeks to prevent.

2. The above broad objective of the regulations is also evident from the scheme of Reg. 72(2) and its explanation. For example, the explanation suggests that when there is a sale by any person belonging to the promoter group, then the promoter group itself is disqualified from obtaining shares through preferential allotment for a period of six month. The disqualification appears to operate not just to the individual or entity that sold shares, but to the entire promoter group. In other words, the attribution of an individual seller’s action extends to the entire group, thereby fortifying the position that the promoter group must be treated as a whole. In that case, transfers within the group should be of no consequence, and should not be treated as a sale at all.

3. This approach is not unique to the ICDR Regulations, but also to regulatory frameworks such as the Takeover Regulations that provide specific exemptions from mandatory open offers in case of inter se transfers among promoters so long as specified conditions have been complied with. Such compliances were adhered to even in the Strides case, but that seems to have held no water with SEBI while interpreting Reg. 72(2).

Calcutta High Court: Stamp Duty on Mergers/Demergers

noreply@blogger.com (V. Umakanth) — Fri, 17 Feb 2012 09:47:00 +0000

We have earlier discussed the peculiar issues that have arisen on whether schemes of arrangement in the form of mergers and demergers are liable to stamp duty in states where the Indian Stamp Act applies or where there is no specific entry for levying stamp duty on such transactions. In relation to several states such as Delhi, Tamil Nadu and Uttar Pradesh, the relevant High Courts have held that schemes would be liable to stamp duty as a “conveyance” despite the lack of a specific entry. These courts seem to have drawn principles from the Supreme Court’s judgment in Hindustan Lever v. State of Maharashtra (2004) 9 SCC 438.

The state of West Bengal was, however, an outlier as the law there developed in a different direction. In our earlier post (link above), we had summarized as follows:

The development of case law in West Bengal has been somewhat mixed. A single judge of the Calcutta High Court held in Gemini Silk Limited v. Gemini Overseas Limited, 2003 53 CLA 328, that an order sanctioning a scheme of amalgamation under section 394 is covered by the definition of “conveyance” under the Indian Stamp Act and therefore liable to stamp duty. That was the case even though “conveyance” was not defined to expressly include an order of amalgamation. Subsequently though, a Division Bench of the Calcutta High Court adopted a contrary view in Madhu Intra Limited v. Registrar of Companies, (2006) 130 Comp. Cas. 510, where it was held that an order of amalgamation was not subject to stamp duty, because it did not fall within the definition of a “conveyance”; moreover even if such an order were to be taken as a “conveyance” or an “instrument” the transfer of assets and liabilities effected thereby is purely by operation of law. The Division Bench even went to the extent of expressly setting aside the order and judgment of the single judge in the Gemini Silk case.

In an interesting development, a single judge of the High Court at Calcutta has last week decided in Re Emami Biotech and Others that stamp duty is payable on schemes of arrangement involving transfers even in the state of West Bengal. This is despite the holding of the division bench in Madhu Intra to the contrary. The reasons are elaborated in the judgment:

It must be respectfully observed in the context that in the light of the judgment in Hindustan Lever, the view expressed in Madhu Intra does not hold good. The judgement in Madhu Intra did not notice the Supreme Court pronouncement in Hindustan Lever. If the Division Bench of this court had noticed Hindustan Lever and had still rendered the opinion in Madhu Intra, it would have been binding on the company Judge of this court. But in Madhu Intra not noticing Hindustan Lever and it being apparent that the question has been answered otherwise by the Supreme Court, it is the Supreme Court view that has to be followed.

The single judge in the Emami Biotech case expresses the background rationale for the ruling as follows in the first paragraph of the judgment:

Considering the stage of the proceedings, the primary issue which has arisen at the behest of the court may be premature; yet the matter is of some importance and it is necessary that an unsavoury practice is immediately arrested. The issue does not appear to be res integra, yet the petitioners insist that there is much to say in support of the continuing practice in this State for veritable sales and transfers of immovable properties to be concluded without offering any stamp duty to the State. Equally, this apparently cash-starved State is to blame for not being alive to its interest and insisting on the payment of stamp duty on the transfer of properties pursuant to the sanction of any scheme of amalgamation or demerger under the Companies Act, 1956. There can be no suspense as to how the question should be answered and the more conventional form needs to be eschewed to pronounce, at the outset, that stamp duty would be payable on transfers effected pursuant to any scheme of amalgamation or demerger under the Companies Act since that is the law of the land as recognised by the Supreme Court in the year 2003.

This judgment appears to create some uncertainty regarding the law in West Bengal on whether stamp duty is payable on transfer of properties through an order of court sanctioning a scheme of arrangement. Although this judgment quite clearly lays down the legal position, the existence of a division bench ruling in Madhu Intra to the contrary will continue to cause anxiety to litigants in the state. Ultimately, it boils down to whether the transfer occurs by operation of law or through contract (as a transfer inter vivos); the prevailing wisdom suggests that it is the latter.

At a broader level, such jurisprudential debates are not confined to India or to stamp duty. There continues to be inconsistencies among courts in different jurisdictions as to whether a scheme derives its efficacy from an order of court (a view adopted by courts in Australia and Singapore) or from the statute (a view adopted by the English courts). A discussion of this issue can be found in: Anil Hargovan, “The source of efficacy for creditors’ schemes of arrangements in England, Australia and Singapore” 31 The Company Lawyer 199 (2010).

Minority Shareholder Protection in M&A

noreply@blogger.com (V. Umakanth) — Thu, 16 Feb 2012 11:43:00 +0000

The Economic Times examines a recent trend whereby companies have preferred asset sales or business sales (also known as “slump sales”, an expression that bears uniqueness to India, as I am yet to come across that expression elsewhere) over takeovers thereby shortchanging minority shareholders of the seller companies. The argument goes: by structuring the deal as a business sale, all that is required is an ordinary resolution of the shareholders, which is not difficult to muster where promoter shareholding is significant; moreover, minority shareholders are deprived of the exit option otherwise available under the takeover regulations. While that is certainly understandable, and I am myself fairly sympathetic to that line of argument, this is a function of the manner in which M&A transactions are subject to regulation.

While teaching M&A, one of the aspects I stress is that parties are usually able to structure transactions in different ways to achieve similar commercial goals (or end-games). However, it is often the case that regulations are structured to address the means rather than the end. That provides sufficient leeway to parties and their advisors to structure deals in a manner that is least susceptible to shareholder veto or that provides minimal protection to minority shareholders (in that it does not enable them to participate in the benefits of the deal on par with promoters or management).

To illustrate, a typical M&A deal involving a public listed company can structured either as a sale of business or slump sale (regulated principally by contract), a scheme of arrangement (governed by sections 391-394 of the Companies Act, 1956) or a takeover (regulated by SEBI through the takeover regulations). Although it is not possible to use any scientific metric or parameter that indicates whether one type of structure is optimal to minority shareholders as opposed to others, some qualitative assessments can certainly be attempted, as follows:

1. A business sale is perhaps least effective for minority shareholders, as a simple majority of shareholders can approve the transaction. Since the voting requirement is a majority of “those present and voting”, it is not even necessary that the controlling shareholders hold more than 50% shares, or sometimes even anywhere close to that, in the company to exercise effective control.

2. A scheme of arrangement provides greater protection to minority shareholders. For example, there is a requirement for approval by “classes of shareholders”, which makes the classification exercise quite crucial. The required threshold for shareholder approval is also higher: majority in number holding 3/4^thin value of shares. More importantly, the scheme and the process are subjected to close scrutiny by courts. Nevertheless, one downside of the scheme from the minority perspective is that, once approved, it is binding even on dissentient shareholders. There is no exit route, as Indian corporate law does not provide for automatic appraisal rights (in the form of buyout of dissenting shareholders) as does exist in jurisdictions such as the US (Delaware) and New Zealand. In theory, an Indian court can order a buyout of dissenting shareholders under section 394(1)(v) of the Companies Act, but I am not aware of such discretion having been exercised in practice, at least not in any of the high-profile schemes of arrangement.

3. The most significant right that a takeover provides is the option to minority shareholders to exit on same terms as controlling shareholders or promoters. In the Indian context, however, this right may be somewhat diluted because the acquirer only needs to accept a minimum of 26% shares from public shareholders. In any event, the takeover regulations are structured primarily with a view to protecting the interest of minority shareholder through the exit and other rights.

Given the current state of regulation, the choice of structure is left to the companies, their management and promoters. Courts and regulators usually tend not to disturb the choice, except in extreme circumstances. This concern also appears to be somewhat universal. For example, even in the US context, there has been a history of companies using business sales and asset sales in order to achieve the same result as a statutory merger (or amalgamation as we understand) without providing shareholders either approval rights or appraisal rights or both. More often than not, courts have accepted the structures and denied the arguments of minority shareholders to treat the transactions as de facto mergers (that would have provided minority shareholders the same rights as in a statutory merger). The other example is the use of statutory merger or amalgamation structures to squeeze out minority shareholders, where the US (Delaware) courts have been more sympathetic to the concerns of minority shareholders than courts in the Commonwealth (in countries such as India, UK and Singapore). We have had occasion to discuss the squeeze outs issue in the past.

Coincidentally, I just read an extremely insightful paper that compares minority shareholder rights under a scheme of arrangement and a takeover: Jennifer Payne, “Schemes of Arrangement, Takeovers and Minority Shareholder Protection”, 11 Journal of Corporate Law Studies 67 (2011) (an earlier version of the paper is available on SSRN). The paper seeks to address issues of the kind discussed in this post, although the author concludes that the different levels of protection available to minority shareholders are justified because the purpose of minority protection is different under the two structures.

Corporate Law and Arbitration

noreply@blogger.com (V. Umakanth) — Sun, 12 Feb 2012 08:10:00 +0000

The virtues of arbitration as a method of resolving commercial disputes are well-known. The primary benefits of arbitration over the conventional court system are the reduction in costs and delays. However, during a recent conversation with a senior corporate counsel, I was given to understand one drawback in using arbitration as a method of resolving disputes in corporate law. And, that is its inability to develop the body of corporate jurisprudence through judge-made law and interpretation. Given that one of the key features of arbitration is the confidentiality of proceedings, the arbitral awards and the reasoning of arbitrators neither operate as precedents (even if they are not binding in subsequent cases on the lines of stare decisis) nor are they even available for consideration subsequently by courts or other arbitrators.

An apt example of this limitation is the arbitral award in the Sterlite-Balco case, which was on a vexed issue of law concerning restrictions on transfer of shares. Although there has been some amount of debate on that arbitration due to its high-profile nature, much of it is based on secondary sources with no public access available to the terms of the award and its reasoning. For instance, one question that remains unanswered is why the arbitrators disregarded restrictions on transfer of shares in contractual arrangements despite a clear ruling to the contrary by a division bench of the Bombay High Court in the Messer Holdings case. For these reasons, the corporate counsel I spoke with suggested an interesting via media, which is to develop a system whereby the principles of law developed in arbitral awards are documented on a no-names basis without reference to specific cases or their facts. That would at least preserve the reasoning for subsequent consideration, reliance and use.

While these issues require some thought, two separate episodes occurring in the US have raised further questions about the use of arbitration in corporate disputes. First, the Delaware legislature has adopted a provision in its corporate law that permits resolution of corporate disputes through a confidential arbitration process. This has attracted a lot of attention because the arbitrators would effectively be judges of the court that adjudicates corporate disputes. As the Race to the Bottom blog notes:

What made the provision unique was the identity of the arbitrator. The provision provided that the Court of Chancery had "the power to arbitrate business disputes when the parties request a member of the Court of Chancery, or such other person as may be authorized under rules of the Court, to arbitrate a dispute." 10 Del. C. § 349. In effect, therefore, parties would get the benefit of one of the Chancellors/Vice Chancellors at the Delaware Chancery Court (or one of the court masters).

It further notes that a constitutional challenge has been mounted to that provision on the ground that it restricts access to free trial.

Second, in its IPO offering document, Carlyle recently inserted an arbitration provision to resolve shareholder claims that effectively barred securities class action litigation. The Deal Professor studies its impact:

The thing that pushes Carlyle’s corporate governance structure over the edge is the arbitration requirements. Carlyle is requiring that public shareholders arbitrate all claims against the company. The arbitration must be confidential, meaning no one would ever even know about it unless it was required to be disclosed by another law. Class-action lawsuits are specifically barred.

The effect of these three provisions is to essentially eliminate any ability of shareholders to sue the board for even the most egregious acts. This includes federal securities law claims as well as any state law claims, though to be honest any grounds for state law claims have largely been eliminated anyway. The costs to most shareholders of bringing this type of litigation are prohibitive unless a class action is available.

However, due to stiff resistance from the Securities and Exchange Commission (SEC), Carlyle was forced to drop the arbitration clause in its offering document. While this seems entirely reasonable, some commentators (here and here) believe that the clause should have been retained since investors have the final choice in whether to invest in the stock or not, and whether to discount its value due to the presence of limitations on class action remedies.

SAT on Scope of Insider Trading

noreply@blogger.com (V. Umakanth) — Fri, 03 Feb 2012 10:40:00 +0000

In the past, the SEBI regulations against insider trading were attracted only if the insider traded “on the basis of” unpublished price sensitive information (UPSI). Since it became unduly onerous on SEBI to prove that the trading was “on the basis of UPSI”, regulation 3 was amended to provide that an insider trading offence would be committed if the trading was carried out merely “when in possession of” UPSI. Surprisingly though, while the SEBI regulations were amended to make it seeming beneficial for SEBI to initiate enforcement of insider trading violations, section 15G of the SEBI Act that provides for the penalty for insider trading continues to carry the words “on the basis of” thereby creating some level of incongruence between the two sets of legal provisions.

In the light of a recent judgment of the Securities Appellate Tribunal in Chandrakala v. SEBI, the requirement that the insider trade “on the basis of” UPSI is read into even regulation 3 of the SEBI regulations, at least partially in the sense of creating a presumption, which is rebuttable by alleged insider. Relevant parts of SAT’s ruling (at para. 7) are extracted below:

The prohibition contained in regulation 3 of the regulations apply only when an insider trades or deals in securities on the basis of any unpublished price sensitive information and not otherwise. It means that the trades executed should be motivated by the information in the possession of the insider. If an insider trades or deals in securities of a listed company, it may be presumed that he / she traded on the basis of unpublished price sensitive information in his / her possession unless contrary to the same is established. The burden of proving a situation contrary to the presumption mentioned above lies on the insider. If an insider shows that he / she did not trade on the basis of unpublished price sensitive information and that he / she traded on some other basis, he / she cannot be said to have violated the provisions of regulation 3 of the regulations.

By requiring an examination of the insider’s motives for trading, this interpretation effectively nullifies the expansion that SEBI sought to bring about by amending the regulations such that mere possession of UPSI is sufficient. While SEBI’s intention in the regulations appears to be driven by the need to introduce some sort of strict liability, the interpretation of the regulation has reintroduced the requirement of a mental element.

In its judgment, SAT also provides further guidance on the manner in which one can consider whether the insider traded “on the basis of” UPSI (at para 7):

… where an entity is privy to unpublished price sensitive information it will tend to purchase shares and not sell the shares prior to the unpublished price sensitive information becoming public if the information is positive. In this case declaration of financial results, dividend and bonus were positive information but the appellant not only bought but also sold the shares not only during the period when the price sensitive information was unpublished but also prior to and after the information becoming public. A person who is in possession of unpublished price sensitive information which, on becoming public is likely to cause a positive impact on the price of the scrip, would only buy shares and would not sell the shares before the unpublished price sensitive information becomes public and would immediately offload the shares post the information becoming public. This is not so in the case under consideration. The trading pattern of the appellant … does not lead to the conclusion that the appellant’s trades were induced by the unpublished price sensitive information.

In arriving at its conclusion, SAT sought to distinguish its earlier decision in Ranjana R. Kothari v. SEBI.

SAT’s observations in the Chandrakala case could potentially have some implications on two other orders of SEBI on insider trading passed last month in the cases involving Manoj Gaur (in respect of shares of Jaiprakash Associates) and V.K. Kaul (in respect of shares of Orchid Chemicals), if those were to be heard on appeal before SAT. A discussion of SEBI’s orders in those cases is available at Moneycontrol – The Firm.

STOCK Act

On a related note, legislative efforts are being made in the United States to impose curbs on members of Congress from trading based on nonpublic information they may have received in their congressional capacity.

Facebook’s Capital Structure and Governance

noreply@blogger.com (V. Umakanth) — Fri, 03 Feb 2012 07:15:00 +0000

In the wake of Facebook’s mega-IPO, the Deal Professor examines the capital structure of the company, whereby it has decided to follow suit from the earlier high-profile Internet IPO of Google and go with a dual-class share structure. He notes:

… an investment in Facebook is really an investment in Mr. Zuckerberg: Facebook’s offering documents show he will retain control over Facebook even when it becomes one of America’s largest publicly traded companies.

Mr. Zuckerberg’s control is based on the structure of Facebook’s shares. Facebook is proposing to go public with a dual-class share structure. Public shareholders will purchase Class A shares that have one vote apiece. Mr. Zuckerberg, Facebook employees and current Facebook investors will hold Class B shares, which have 10 votes apiece. This is a deviation from the one share one vote norm followed by most publicly traded companies.

Although this seems to provide too much control to the founder, there is nothing unusual in this except for the fact that in this case the control rests with a single individual rather than a group of persons. As noted on the Deal Professor column:

Mr. Zuckerberg is not alone in using this type of structure to maintain ownership of a prominent technology company. The founders of Google, Larry Page and Sergey Brin, set up a similar structure and retain voting control over Google.

Yet they are two people who counterbalance each other, not a single individual.

Three other prominent company founders, Andrew Mason at Groupon, Mark Pincus at Zynga and Reid Hoffman at LinkedIn, have also adopted similar dual-class voting structures at their companies. At the time of those public offerings last year, Mr. Mason controlled 19.7 percent of the votes at Groupon, Mr. Pincus controlled 37.4 percent of the votes at Zynga and Mr. Hoffman controlled 21.7 percent of the votes at LinkedIn.

These companies, however, are much smaller than Facebook. And while their stakes are sizable, they do not entitle any of the three founders to remove and replace directors at will.

It appears therefore that deviations from the one-share-one-vote rule are becoming much more common than one would ordinarily imagine.

In the Indian context, after much back and forth regarding the desirability of permitting shares with differential voting rights, the Companies Bill recognizes the need for flexibility to companies and their founders to structure their shareholding along similar lines. However, SEBI continues to deny the issue of shares with “superior voting rights”.

As far as the governance structure of Facebook is concerned, one aspect that is highlighted in the Deal Professor column deserves attention:

Unlike most public companies, Facebook will not have a nominating committee for its directors comprising the independent directors on Facebook’s board. Instead, all of the directors will be selected by the board itself, a group that will be appointed by Mr. Zuckerberg. He can also remove and replace any director at any time.

The company has sought to take advantage of an exemption under the relevant listing requirements to steer clear of some of the conventional corporate governance norms such as board independence and independent nomination of directors that act as a monitoring mechanism on the managers and controlling shareholders. Facbeook's registration statement filed the SEC states:

We have elected to take advantage of the “controlled company” exemption to the corporate governance rules for publicly-listed companies.

Because we qualify as a “controlled company” under the corporate governance rules for publicly-listed companies, we are not required to have a majority of our board of directors be independent, nor are we required to have a compensation committee or an independent nominating function. In light of our status as a controlled company, our board of directors has determined not to have an independent nominating function and has chosen to have the full board of directors be directly responsible for nominating members of our board, and in the future we could elect not to have a majority of our board of directors be independent or not to have a compensation committee. Our status as a controlled company could cause our Class A common stock to look less attractive to certain investors or otherwise harm our trading price.

Given the high-profile nature of the company, its founder and the offering, it is not clear if such concerns regarding the governance of the company will either turn away investors, or force a discount on the valuation of the shares.

Fourth Week of Arguments: Constitution Bench on Bhatia International

noreply@blogger.com (V. Niranjan) — Fri, 03 Feb 2012 05:47:00 +0000

Arguments continued this week before the Constitution Bench comprising the Chief Justice, and Justices Jain, Nijjar, Khehar and Desai. Mr Salve began his arguments this week by pointing out that the choice of the seat of arbitration is of great importance in international arbitration because parties often wish to resolve their disputes in a neutral forum. It is partly for this reason that London, both as an arbitration centre and for its commercial court, is among the most popular dispute resolution venues in the world. Counsel submitted that accepting any theory of “concurrent” jurisdiction undermines this choice and the sanctity of the seat. To the question whether it is possible to challenge in court the validity of an arbitration agreement (especially when it is governed by Indian law) in an arbitration with a foreign seat, counsel’s submission was that the Indian court may consider the issue only if there is a specific provision to that effect (for example, if a suit is brought here and an application under section 45 is filed to refer the parties to arbitration), and that there is no “freestanding” jurisdiction to consider the validity of the agreement or the award simply because the law governing the substance of the dispute is Indian. Similarly, as far as the validity of the award is concerned, counsel’s submission was that if an award is passed by an arbitration with a foreign seat that is contrary to Indian public policy, it is likely that the award will in any event be set aside in the court of the seat, and in support of this submission, reference was made to the decision of the Court of Appeal in Regazzoni v Sethia [1958] AC 301. Counsel argued that there is in any event no remedy if the arbitrators abroad simply “misconstrue” an Indian statute but do not contravene Indian public policy.

Counsel then developed his submission that Indian Arbitration Act, by adopting the UNCITRAL Model Law, firmly committed himself to a territorial approach to jurisdiction. He pointed out that the contesting views before the Model Law, so far as jurisdiction is concerned, were either in favour of the seat of arbitration (the English view), or in favour of what is known as “delocalisation” (principally the French view), and there was never at any point support for the proposition that the court of the country whose law governs the substance of the dispute is entitled to set aside an award. Counsel’s submission was that the drafters of the Model Law, keenly aware of these opposing views, consciously chose the territorial approach based on the seat of arbitration, and that Parliament did likewise in enacting section 2(2). Counsel dealt at some length with the travaux préparatoires to the Model Law, and pointed out that the omission of the word “only”, on which Bhatia International and the Appellants had placed considerable reliance, was in reality irrelevant, because even the UNCITRAL Model Law originally did not contain that word. Counsel placed extracts from the travaux (particularly a statement by the Italian delegate and the Chairman’s response) demonstrating that word “only” was added to article 1(2) of the Model Law because of an apprehension that the exception clause (“except articles 8, 9, 35 and 36”) may otherwise be construed to not apply unless the seat of arbitration is abroad (which was never the intention), and that Parliament did not need to add the word because that exception was itself omitted from section 2(2).

As far as section 34 is concerned, counsel submitted that the words “under the law of which” in section 48(1)(e) do not confer any jurisdiction on the country whose law governs the substance of the dispute, because it is at best only a reference to the lex arbitri. Counsel argued that the judgment of the Supreme Court in NTPC v Singer, on which we have commented, may have been wrongly decided because it misconstrued section 9(b) of the Foreign Awards (Recognition and Enforcement) Act, 1961. As far as section 9 is concerned, counsel’s submission was that Bhatia International was wrongly decided insofar as it relied on the omission of the word “only” for the travaux demonstrated that the inference the Court drew in Bhatia as to this omission was unfounded; and that the only possible remedy a foreign claimant who wishes to preserve Indian assets before or during arbitration has is to obtain a Mareva injunction from an Indian court by way of a suit. Counsel argued that an application under section 45 in such a suit, even if allowed, does not prevent the Court from granting interim relief, and stressed that in any case the lack of such a remedy is in any event no reason to “rewrite” section 9.

Arguments continue on Tuesday.

More on CSR and the Companies Bill

noreply@blogger.com (V. Umakanth) — Wed, 01 Feb 2012 04:15:00 +0000

We had earlier discussed the half-way house approach adopted by the Companies Bill, 2011 regarding corporate social responsibility (CSR), whereby CSR spending was not intended to be mandatory, but disclosure thereof was. It appears that there is continued resistance to this approach, and that the Parliamentary Standing Committee reviewing the Bill proposes to look at this issue afresh with a view to reinstating the mandatory nature of CSR spending by companies. Not altogether unexpected, this has been met with some criticism. Moreover, the need to provide tax breaks for CSR spending has also been highlighted.

More importantly, there seems to be some visibility as to nature of review that the Standing Committee may perform. Since the previous review was extensive in nature, reports suggest that only certain new clauses in the Bill inserted subsequent to that exercise will be reviewed this time around. All of these will have implications on the timing of the legislation, and whether the Bill is likely to be taken up for debate and vote during the forthcoming Budget session of Parliament.

Part II - An Analysis of the Supreme Court’s judgment in Vodafone

noreply@blogger.com (V. Niranjan) — Tue, 31 Jan 2012 13:54:00 +0000

In our first post on the Vodafone judgment, we set out the issues of law arising from the Court’s findings, and discussed two of those – the approach to tax avoidance and the meaning of controlling interest. This post considers two other important issues – India’s approach to the corporate veil, and the scope the “extinguishment” provision under section 2(47) of the Income Tax Act, 1961 [“the 1961 Act”].

1. Corporate Veil

It is as easy to state that the origin of the separate entity principle is often traced to Salomon v Salomon as it is difficult to outline when a court will lift the veil. One of the best attempts in the literature to extract coherent principles in this branch of the law is Professor Ottolenghi’s essay published in the Modern Law Review in 1990, and perhaps the best judicial analysis is Slade LJ’s masterly treatment of the subject in Adams v Cape Industries. In Vodafone, there are important differences in the approach of the Chief Justice and K.S. Radhakrishnan J., and the Chief Justice’s judgment suggests that the court may more readily lift the veil than is commonly supposed. The Chief Justice begins by affirming that “a subsidiary and its parent are totally distinct taxpayers” (¶66), and that the fact that a parent exercises substantial control over the affairs of its subsidiary is not in itself a reason to depart from this principle. The Chief Justice then outlines important exceptions to this principle – in particular, that it is permissible to ignore the separate legal status of the subsidiary if its decision-making is “fully subordinate” to the holding company or if the parent company makes an “indirect transfer through abuse of legal form and without reasonable business purpose”, and clarifies that these are by no means exhaustive. At first sight, the “fully subordinate” language the Chief Justice uses may suggest that a court will readily lift the veil, but it is submitted that the better view is that the Chief Justice is simply referring to the well-known exception (accepted in Adams) in which the business of the subsidiary is in fact the business of the holding company.

The Chief Justice then holds that India has a “judicial anti-avoidance rule” (¶68) which allows the Revenue to invoke “substance over form” or “pierce the corporate veil” if it discharges its burden of establishing that the transaction in which the corporate entity is used is a “sham or tax avoidant”. While the word “tax avoidant” may give rise to the impression that every case in which the use of a corporate entity leads to a reduction in the tax liability of the assessee is covered, it is submitted that the better view, and one which is consistent with the rest of the Chief Justice’s analysis in ¶¶67 and 68, is that no substantial departure is intended from the limited grounds on which the veil may presently be lifted. That view is reinforced by the fact that “sham” is used in conjunction with “tax avoidant”, and by the examples given by the Chief Justice in the sentence that immediately follows – round tripping and payment of bribes. The example of lack of business purpose is also given, but the Chief Justice clarifies that this lack of business purpose must not be a result of “dissecting” the legal form of a transaction as the Revenue sought to do in Vodafone’s case. The most important part of the Chief Justice’s analysis is the list of six factors set out to assist the Court in determining on which side of this test a particular transaction falls: “participation in investment”, duration of existence of holding structure (prior to acquisition), period of business operations in India, generation of taxable revenues in India, timing of exit and continuity of business on exit. This analysis suggests that it may be a mistake to read this judgment as a complete victory for tax planning, because the “dominant purpose” of a transaction may easily be found, on the application of these factors, to lack commercial substance, even though it may not satisfy the traditional tests of lifting the corporate veil. It also suggests, so far as tax avoidance is concerned, that the test in India, unlike in English law after MacNiven and BMBF, is not simply statutory construction, which is difficult to reconcile with the Court’s subsequent finding that it is.

It is also interesting to contrast this with the analysis in Adams v Cape Industries. In that case, Slade LJ clearly stated that the fact that “justice so requires” is never a reason to treat a subsidiary as anything other than a separate legal entity; that certain observations of §Lord Denning MR in DHN Food Distributors may have gone too far; that it is settled in English law that a subsidiary can be ignored only if it is the alter ego or agent or part of a single economic entity with, the parent; and that it is such only if the business of the holding company is the business of the subsidiary. This test may be considerably narrower than the factors outlined in the Chief Justice’s judgment (duration of existence of holding structure etc.). Indeed, the application of the Adams test to the facts of that case so suggest – in that case, although the Court concluded that AMC (the Liechtenstein corporation) was a façade, it held that CPC (the American marketing company set up after NAAC was liquidated) was not the alter ego of Cape and Capasco even though Cape exercised substantial control over it, because CPC had control over its day to day activities, paid rent for its premises, paid income tax separately etc.

K.S. Radhakrishnan J.’s judgment appears to endorse Adams (but see below), and recognises that members of a company have no interest in its assets. More significantly, the judgment appears to implicitly hold that the separate entity will prevail except in very limited circumstances, for it repeatedly observes that the veil can be lifted only if the Revenue establishes that the corporation has been used for a fraudulent or dishonest purpose (as opposed, for example, to a benign purpose through an entity that is part of a single economic unit). It begins (¶44) by holding that many factors may guide the choice of a vehicle for doing business through a corporation, of which one can legitimately be a desire to minimise tax liabilities. K.S. Radhakrishnan J. then holds that the burden is on the Revenue (¶46) to show that the corporation was used for “a fraudulent, dishonest purpose, so as to defeat the law”. In ¶¶ 58 and 59, it is held that the fact that a parent and a subsidiary may have economic union of interest and a consolidated balance sheet does not mean that they are not “distinct legal entities” and that the veil can be lifted only if the Revenue shows that the company has been used to perpetrate “fraud or wrongdoing” (¶59). Even in approving Adams (¶60), K.S. Radhakrishnan J. specifically observes that the Court of Appeal emphasised in that case that a subsidiary can be ignored “where special circumstances exist indicating that it is a mere façade concealing true facts.” This theme is repeated subsequently, when K.S. Radhakrishnan states that the court will not permit a corporate entity to be used as “a means to carry out fraud or evade tax” (¶61). All of this indicates that K.S. Radhakrishnan J. has virtually rejected the single economic entity or alter ego grounds for lifting the veil (or confined its application to rare instances), although there is one reference to “sham” and “agent” (¶61).

It is submitted that K.S. Radhakrishnan J.’s approach, even if it perhaps goes too far, is, with respect, preferable to the approach of the Chief Justice, for the latter analysis would permit the veil to be lifted on a number of grounds that may not be entirely consistent with the sanctity of the separate entity principle. Indeed, the Chief Justice’s analysis leaves one with the impression that Vodafone prevailed not on the ground that the veil cannot be lifted except on Adams grounds, but on the ground that the veil should not be lifted for it had demonstrated business purpose and commercial substance.

2. Extinguishment under section 2(47)

The Revenue’s primary case in the Supreme Court was that there was a capital asset situate in India in the form of various rights that HTIL had which were “extinguished” when the SPA was entered into on 11.02.2007. For example, HTIL by virtue of its shareholding had the “right” to appoint directors, the right to use certain licences, redeem certain shares etc. The Chief Justice rejected this argument inter alia on the ground that the Court was concerned with the sale of shares, not the sale of assets, and that a sale of shares cannot be dissected as the sale of assets unless the six factors set out in para 68 (discussed above) are satisfied. It is implicit in this analysis that there cannot be, at the same time, a sale of property and the extinguishment of rights comprised in the bundle of rights that is sold. It is submitted that this conclusion is entirely correct – indeed, “extinguishment” did not exist in the 1922 Act, and was inserted by Parliament to widen the scope of section 2(47) in order to cover transactions in which there is no sale in the ordinary sense. Although section 2(47) does not so provide, it is submitted that it is not open to the Revenue to invoke “extinguishment” in a transaction in which there is admittedly a sale, simply because that sale is not taxable. The Chief Justice’s implicit approval of this proposition is, it is submitted, to be welcomed.

To put it differently, the Revenue was attempting to convert the sale of a “non-taxable whole” (situate outside India) into the sale of its “taxable component parts” (situate in India). There is an interesting parallel to be drawn with the analysis of the Court of Appeal in IRC v Rysaffe Trustee Co [2003] EWCA Civ 356, in which Mummery LJ held that it is not open to the Revenue to invoke a legal fiction when there is a “disposition of property in its ordinary and natural sense”. In this case, the transaction was a “disposition in its ordinary and natural sense” of an asset situate outside India – the Revenue could not invoke a legal fiction to overcome this fact.

We will continue to discuss other this judgment in subsequent posts, and in particular the analysis of section 9.

Venture Capital Funds: Minimum Investment Norms

noreply@blogger.com (V. Umakanth) — Tue, 31 Jan 2012 03:16:00 +0000

(The following post is contributed by Ravi Shankar Jha, a final year student at the Dr. RML National Law University, Lucknow. It points to a lacuna in SEBI’s Venture Capital Funds Regulations)

Venture capital funds (VCFs) have been envisaged to provide easy capital to start-up firms. In India, VCFs are regulated by SEBI (Venture Capital Funds) Regulations, 1996. Through these regulations, SEBI has sought to lay down conditions within which a VCF must restrict its investments.

The regulations provide for setting up of a venture capital fund by a company, trust or a body corporate. The regulation further provides different eligibility criteria for these forms of vehicles for the purpose of grant of certificate under clause 4 of these regulations. It is further to be pointed that the expression “body corporate” was inserted by an amendment in the year 2000 in clause 3(1) of these regulations.

Clause 11 of these regulations lays down minimum investment in a venture capital fund. To that effect, clause 11(2) provides that no venture capital fund set up either as a company or any scheme of a venture capital fund set up as a trust shall accept any investment from any investor which is less than five lakh rupees (Rs. 500,000). This is where the regulators seem to have left a lacuna in the law. Gathering from the intention of the regulators, it seems that they want to ensure financial soundness of a VCF by providing for such minimum investment norms. But these regulations have failed to cover venture capital funds set up as a body corporate. A bare reading of the provision suggests that this norm of minimum investment of 5 lakh rupees applies only to funds set up either as a trust or a company. There is also no definition of the term given in this regulation. Clause 2(c) defines company as a company incorporated under the Companies Act, 1956 which obviously does not include a body corporate as body corporate under the Companies Act is a much wider concept which subsumes within it companies as well. Also, since the word, “body corporate” was introduced in clause 3 by an amendment in the year 2000, it can be argued that SEBI could have amended clause 11(2) accordingly and provided for such minimum investment norms for venture capital funds set up as body corporate as well. But such prominent absence only strengthens the argument that funds set up as body corporate (not being companies or trusts) are not subject to this minimum investment condition which at best is counter intuitive as there seems to be no logic or rationale in exempting such funds from this minimum investment norms.

This lacuna in the law must be filled as it could potentially be called in question in case a VCF were to be set up in the form of a body corporate that is neither a company nor trust (which is permissible under the Regulations), particularly if the intention is to circumvent the minimum investment norms by contending that clause 11(2) does not apply to investment funds set up as a body corporate under the Venture Capital Regulations.

- Ravi Shankar Jha

Preferential Allotments Liberalized for Certain Institutional Investors

noreply@blogger.com (V. Umakanth) — Mon, 30 Jan 2012 04:32:00 +0000

Over the years, SEBI has gradually tightened the regime relating to preferential allotment of shares in order to prevent possible abuse of the process and to thereby protect the interests of minority shareholders in listed companies. One of the requirements pertains to lock-in on shares of allottees. There are currently three types of lock-in applicable to persons who are allotted shares on a preferential basis (although the requirements are more onerous for promoters):

1. At the outset, persons who have sold shares in a company in the previous 6 months are ineligible to be allotted shares on a preferential basis;

2. Allottees’ pre-existing shares in the company held prior to the allotment will be locked in for a period of 6 months;

3. The shares issued as part of the preferential allotment will be locked in for a period of 1 year.

By way of a press release issued last week, SEBI has made conditions 1 and 2 inapplicable to preferential allotments made to insurance companies and mutual funds “which are broad based investment vehicles representing the interests of the public at large”. This is likely to provide additional avenues to such institutional investors to obtain shares in companies through preferential allotments rather than through the secondary markets. The policy rationale is understandable because these institutions generally represent broader investors and not just the proprietary interests of a limited group of investors.

Third Week of Arguments: Constitution Bench on Bhatia International

noreply@blogger.com (V. Niranjan) — Fri, 27 Jan 2012 10:12:00 +0000

Arguments continued this week before the Constitution Bench comprising the Chief Justice, and Justices Jain, Nijjar, Khehar and Desai. Unlike counsel before him, Dr Singhvi concentrated principally on the applicability of section 9 of the 1996 Act to arbitrations in which the seat is abroad, and it was his case that section 9 ought to apply no matter what view the court takes of the applicability of other provisions of Part I. Counsel reiterated that section 2(2) of the Act is an “affirmative” provision and not one that excludes the jurisdiction of the Indian court, and emphasised that section 2(5), which provides that the 1996 Act applies to “all arbitrations”, has been made subject to section 2(4) but not to section 2(2). The Chief Justice pointed out that there are provisions that although worded positively have a “negative effect” and vice versa, and asked why this is not true of section 9 as well. Counsel’s answer was that the “nature” of section 9 is “seat-neutral”, “Part-neutral” and “asset-based”, intended to ensure that arbitral proceedings are not frustrated by the alienation of assets. Counsel submitted that a petition under section 9 is never maintainable for frustrating arbitral proceedings (for example by seeking an anti-arbitration injunction).

Arguments, especially on Wednesday, also focussed on whether a civil suit is maintainable seeking interim relief in the event a petition under section 9 is not. The Chief Justice put to counsel the possibility that the underlying assumption in Bhatia International that a party is “remediless” unless Part I applies to an arbitration with a foreign seat may not have taken into account the fact that it is open to the claimant to institute a civil suit and seek interim relief to ensure that property is not dissipated. Counsel’s submission was that section 9 is a clearer path to the same result, but that if that is held to be inapplicable, a clear and unequivocal finding that a civil suit is maintainable is necessary, along with guidelines on the circumstances in which it may be instituted. This arose particularly because of the possibility that it is not open to a court to grant interim relief once an application under section 8 or section 45 is allowed. It was suggested that this may not necessarily be the case, despite the observations in Anand Gajapathi Raju and other cases that “nothing remains” to be decided one such an application is allowed, because sections 8 and 45 do not provide in terms that the suit shall be stayed. The thrust of counsel’s submission was, however, that a remedy under section 9 is more appropriate because holding that a civil suit is maintainable may not be entirely consistent with principles of arbitration law. Counsel also referred to the rules of various arbitral institutions and the experience of other jurisdictions to demonstrate that obtaining interim relief from a national court in which assets are located is by no means incompatible or inconsistent with the arbitration agreement. The arbitration legislation of many jurisdictions, including England and Wales, and the rules of arbitration of a number of arbitral institutions, expressly so provide.

The Respondents opened their case towards the end of the week and Mr Salve’s submissions emphasised that the seat of arbitration is a fundamental premise of jurisdiction in international arbitration, and that the existence of “concurrent jurisdiction” is entirely alien to arbitration law.

Arguments continue on Tuesday.

An Analysis of the Supreme Court’s judgment in Vodafone – Part I

noreply@blogger.com (V. Niranjan) — Sun, 22 Jan 2012 06:20:00 +0000

In our post on the judgment of the Bombay High Court, we expressed the hope that the Supreme Court would take a different view. That the Court has now done so has been welcomed as much needed respite in bad times. Even more importantly, it is heartening that the Court has taken what it is submitted is the correct view especially on the facts of Vodafone’s case. But from that qualification it follows that the prevailing assumption that this judgment is a complete victory for tax planning over a more robust approach may not be entirely accurate. As we discuss below, much of the Court’s reasoning, particularly in the judgment of the Chief Justice, is premised on a factual finding that the Vodafone-Hutch deal did not lack commercial substance or business purpose, and its analysis of the legal principles suggests that a finding for the assessee is not a foregone conclusion in “similar” cases.

It is easiest to analyse the two judgments by identifying seven issues of law that emerge from it. This post deals with the two of these issues. The seven issues are: (i) the law on lifting the corporate veil; (ii) the law on tax avoidance; (iii) the meaning of “extinguishment” under section 2(14) of the Income Tax Act, 1961 [“ITA 1961”]; (iv) section 9 of the ITA 1961; (v) section 195 of the ITA 1961; (vi) controlling interest and the situs of shares; and (vii) important factual points in the Vodafone case that illustrate the application of some of these principles. In addition, there are the observations of K.S. Radhakrishnan J. on VB Rangaraj v VB Gopalakrishnan.

Before we turn to these issues, it should be noted that two crucial findings on fact are at the heart of the conclusion of the Chief Justice and K.S. Radhakrishnan J. that the IT Department lacked jurisdiction – first, the rejection of the Revenue’s argument that CGP was “fished out” at the last minute from the HTIL structure solely to avoid tax and secondly, the explanation given in respect of an application made by VIH to the FIPB. As far as CGP is concerned, the Revenue relied on a Due Diligence report submitted by Ernst & Young in which it was stated that the parties had originally envisaged transferring Array Holdings Ltd. [“Array”], a company incorporated in Mauritius, and later decided to instead transfer CGP. The Chief Justice (¶81) and K.S. Radhakrishnan J. (¶124) explain that this change was for an important commercial reason and not simply a device to avoid tax – Global Services Pvt Ltd. [“GSPL”], one of the entities which held call options in respect of HEL shares held by companies controlled by Mr Asim Ghosh and Mr Analjit Singh, was a wholly owned subsidiary of Hutchison Teleservices Holdings Ltd. [“HTIHL”], which was in turn a wholly owned subsidiary of CGP, but not a wholly owned subsidiary of Array. Therefore, as both judgments note, transferring CGP instead of Array had distinct commercial advantages. As for FIPB, the Revenue relied on a letter dated 19.03.2007 addressed by it to VIH asking why VIH proposed to pay $11.08 billion for acquiring approximately 67 % of the equity of HEL when in fact its equity acquisition was only 51.96 %. To this VIH replied that the $11.08 billion was paid not only for the 51.96 % equity but also for control premium, the entitlement to acquire an indirect 15 % interest (through the GSPL call options) and stated that it in sum represented payment for 67 % of the economic value of HEL. The Chief Justice rightly notes that some of these differences arose out of the different accounting standards prevalent in the USA and India, and that in any event, “valuation cannot be the basis of taxation” (¶85).

There are many other important questions of fact which illustrate the scope of the legal principles set out by the Court, and we will discuss some of these in Part II of this post. It is worth bearing in mind, however, that the assessee appears to have prevailed largely because it was able to persuade the Court that there was commercial substance and business purpose, and not on the ground that business purpose is irrelevant. That is especially apparent from ¶68 of the judgment of the Chief Justice, which we will discuss in Part II of this post in the context of the corporate veil.

1. Approach to Tax Avoidance

The correct approach to cases involving tax avoidance has historically been a contentious issue. In India, this has come to consist of two distinct questions: first, whether the approach of the Court in Azadi Bachao Andolan is contrary to the Constitution Bench’s judgment in McDowell’s case; and secondly, independent of this question, the proper approach to tax avoidance. On the first question, doubts had arisen because of the exiguous observation in paragraph 46 of the majority judgment in McDowell endorsing “on this aspect” the concurring judgment of Chinnappa Reddy J., in which the ghost of the Duke of Westminster had been duly exorcised.

While the Chief Justice and K.S. Radhakrishnan J. reach the same conclusion that Azadi Bachao remains good law, there are some differences in the reasoning. The Chief Justice holds (¶46) that the words “this aspect” indicate that the majority’s agreement with Reddy J. was confined to the use of “tax evasion through the use of colourable devices”. The final sentence in that paragraph reiterates that “in cases of treaty shopping and/or tax avoidance” there is no conflict at all. While it may be suggested that this means that the Chief Justice has equated treaty shopping and tax avoidance with “colourable devices”, it is submitted that the better view is that the Chief Justice has distinguished between tax avoidance/treaty shopping on the one hand and the use of “colourable devices” on the other, especially since the expression tax evasion has been used with reference to the former in the same paragraph. K.S. Radhakrishnan J. has gone considerably further, and has clearly stated that: (i) the judgment of Ranganath Misra J. constitutes the ratio of McDowell; and (ii) Reddy J.’s remark that the Duke of Westminster is not good law is incorrect even as a matter of English law.

Having clarified that it was therefore unnecessary to overrule Azadi or refer McDowell to a larger Bench, the Court considered the question of tax avoidance independently. This involved an analysis of the English case law, which has had considerable influence on this subject in India (as elsewhere). In English law, despite many caustic remarks about the Duke of Westminster’s case (perhaps none better than Templeman L.J.’s famous description of it in the Court of Appeal in Ramsay), the recent cases suggest that Ramsay and perhaps even Furniss v Dawson is not an overarching principle of construction, but simply a result of the usual process of interpreting legislation. The Chief Justice accepts this. K.S. Radhakrishnan J. examines it in more detail and interestingly appears to suggest that the distinction between Ramsay and IRC v Plummer lies in the fact that Ramsay was a “readymade” scheme (see ¶ 78). While this is not implausible, the force of the suggestion is diminished by the fact that Plummer was a readymade scheme too, as the judgment of Walton J. at first instance suggests, and also by a subsequent decision of the House of Lords (Moodie v IRC 65 TC 610), in which Lord Templeman expressed the view that Plummer would have been decided differently had “the Ramsay principle” been applied.

One more point must be made about K.S. Radhakrishnan J.’s approach to this issue. His judgment appears to endorse (¶ 87) Lord Hoffmann’s celebrated analysis of the law on tax avoidance in his speech in MacNiven v Westmoreland Investments, in which it was suggested that the apparent difficulty in reconciling the cases on tax avoidance was a failure to appreciate that the legislature sometimes defines a term in a “legal” sense and sometimes in a “commercial” sense. That formulation has subsequently been criticised, and the UK Supreme Court has virtually rejected it in a recent case– Tower MCashback v Revenue and Customs Commissioners (not cited in Vodafone). It is submitted, however, that Lord Hoffmann’s approach is in fact a most useful way of analysing this issue, and some of the criticism is perhaps a result of the belief that Lord Hoffmann intended a formulaic classification of definitions as “legal” or “commercial”. While it is not possible to develop this point in more detail here, it suffices to state that what Lord Hoffmann really appears to have intended is a test to distinguish cases in which legislative intent is consistent with a degree of artificiality (for instance Lord Hoffmann’s own example of conveyancing) from those in which it is not. It is therefore submitted that K.S. Radhakrishnan J.’s remarks on this test are to be welcomed, notwithstanding, with respect, the comments of Lord Walker in Tower MCashback.

2. Controlling Interest and Situs of Shares

The judgment of the Bombay High Court had accepted that in principle “controlling interest” is not an independent capital asset, although it had eventually found that there was “something other than” the transfer of a single share of CGP. On this issue, the Chief Justice’s judgment is especially interesting. It begins by observing that controlling interest is a “mixed question of fact and law” (¶83), and rejects the Revenue’s case not only on the ground that controlling interest is not a distinct capital asset, but also on the ground that Vodafone did not acquire 67 % controlling interest. The Chief Justice reaches the latter conclusion by holding that GSPL’s right under the Call Options with the Asim Ghosh and Analjit Singh companies is “at the highest” analogous to a “potential share” because “till exercised it cannot provide right to vote or management or control”. Similarly, the practice before the SPA was that HTIL would appoint six directors, Essar (which held 33 %) would appoint four, and TII (which indirectly held 19.54 % in HEL) would appoint two directors, who “in practice” were Mr Ghosh and Mr Singh. In a “Term Sheet” Agreement entered into between VIH and Essar on 15.03.2007, it was agreed that this “practice” would continue (ie VIH would appoint 8, and Essar 4). The Chief Justice holds that an agreement to “continue the “practice” concerning nomination of directors on the Board of Directors of HEL which in law is different from a right or power to control and manage…” did not give VIH “controlling interest”. In ¶88, the Chief Justice holds that in any event a sale of shares cannot “as a general rule” be “broken up into separate individual components” and that such components are not distinct capital assets (approving in this respect the well-known judgments in Maharani Ushadevi and Venkatesh (Minor) v CIT). It is submitted that this conclusion is entirely correct – as a matter of law, if it were possible in every circumstance to vivisect the sale of the whole into the sale of its component parts, it would have been entirely unnecessary for Parliament to expressly provide that the sale of the whole is taxable if certain conditions are satisfied.

In subsequent posts, we will consider the other important issues set out above.

Vodafone: Key Points

noreply@blogger.com (V. Niranjan) — Fri, 20 Jan 2012 13:16:00 +0000

The Supreme Court’s judgment today in Vodafone is of enormous importance to a number of branches of Indian law. The majority judgment has been delivered by the Chief Justice and Swatanter Kumar J. A concurring judgment delivered by K.S. Radhakrishnan J. in some respects goes even further. A copy of the judgment is available on the Supreme Court’s website. A detailed analysis of the judgment will follow. This post reproduces key extracts from the two judgments with brief comments, on some of the issues before the Court.

1. Azadi Bachao Andolan and McDowell

Both judgments hold that Azadi Bachao Andolan is good law. The Chief Justice holds that there is no conflict between Azadi and McDowell because the observations of Reddy J. are confined to cases in which a colourable device is used. Radhakrishnan J. appears to have gone even further and has expressly said that the “ghost” of the Duke of Westminster has not been exorcised. We will analyse this in detail in the coming days.

CHIEF JUSTICE

[para 64] The words “this aspect” [ed: referring to the majority’s observation that they “on this aspect” agree with Reddy J.’s judgment] express the majority’s agreement with the judgment of Reddy, J. only in relation to tax evasion through the use of colourable devices and by resorting to dubious methods and subterfuges. Thus, it cannot be said that all tax planning is illegal/illegitimate/impermissible. Moreover, Reddy, J. himself says that he agrees with the majority. In the judgment of Reddy, J. there are repeated references to schemes and devices in contradistinction to “legitimate avoidance of tax liability” (paras 7-10, 17 & 18). In our view, although Chinnappa Reddy, J. makes a number of observations regarding the need to depart from the “Westminster” and tax avoidance – these are clearly only in the context of artificial and colourable devices. Reading McDowell, in the manner indicated hereinabove, in cases of treaty shopping and/or tax avoidance, there is no conflict between McDowell and Azadi Bachao or between McDowell and Mathuram Agrawal.

JUSTICE K.S RADHAKRISHNAN

[paras 110, 112] Justice Reddy has, the above quoted portion shows, entirely agreed with Justice Mishra and has stated that he is only supplementing what Justice Mishra has spoken on tax avoidance. Justice Reddy has also opined that the ghost of Westminster (in the words of Lord Roskill) has been exorcised in England. In our view, what transpired in England is not the ratio of McDowell and cannot be and remains merely an opinion or view. 112. Justice Reddy, we have already indicated, himself has stated that he is entirely agreeing with Justice Mishra and has only supplemented what Justice Mishra has stated on Tax Avoidance, therefore, we have go by what Justice Mishra has spoken on tax avoidance

2. Corporate Veil

Both the Chief Justice and Radhakrishnan J. hold that the existence of a holding-subsidiary relationship is no reason to suppose that the two entities are not separate in law. The Chief Justice sets out circumstances in which the Revenue may appeal to India’s “judicial anti-avoidance rule”. Justice Radhakrishnan cites with approval Adams v Cape Industries.

THE CHIEF JUSTICE

[paras 67, 68] However, the fact that a parent company exercises shareholder’s influence on its subsidiaries does not generally imply that the subsidiaries are to be deemed residents of the State in which the parent company resides

In the application of a judicial anti-avoidance rule, the Revenue may invoke the “substance over form” principle or “piercing the corporate veil” test only after it is able to establish on the basis of the facts and circumstances surrounding the transaction that the impugned transaction is a sham or tax avoidant…the concept of participation in investment, the duration of time during which the Holding Structure exists; the period of business operations in India; the generation of taxable revenues in India; the timing of the exit; the continuity of business on such exit. In short, the onus will be on the Revenue to identify the scheme and its dominant purpose. The corporate business purpose of a transaction is evidence of the fact that the impugned transaction is not undertaken as a colourable or artificial device. The stronger the evidence of a device, the stronger the corporate business purpose must exist to overcome the evidence of a device

JUSTICE K.S. RADHAKRISHNAN

[paras 58, 61] Legal relationship between a holding company and WOS is that they are two distinct legal persons and the holding company does not own the assets of the subsidiary and, in law, the management of the business of the subsidiary also vests in its Board of Directors

3. Shareholders’ Agreements and Rangaraj

Justice Radhakrishnan has expressed the view that Rangaraj v Gopalakrishnan, which we have discussed on several occasions, may have been wrongly decided because shareholders have the freedom to contract unless there are specific restrictions in legislation.

[paras 63, 64] The nature of SHA was considered by a two Judges Bench of this Court in V. B. Rangaraj v. V. B. Gopalakrishnan and Ors. (1992) 1 SCC 160 … This Court has taken the view that provisions of the Shareholders’ Agreement imposing restrictions even when consistent with Company legislation, are to be authorized only when they are incorporated in the Articles of Association, a view we do not subscribe

64. Shareholders can enter into any agreement in the best interest of the company, but the only thing is that the provisions in the SHA shall not go contrary to the Articles of Association. The essential purpose of the SHA is to make provisions for proper and effective internal management of the company

4. Controlling Interest and Extinguishment

Both the Chief Justice and Justice KS Radhakrishnan have held (on this aspect affirming the legal conclusion of the Bombay High Court in the impugned judgment) that “controlling interest” is not a distinct capital asset.

THE CHIEF JUSTICE

[para 88] As a general rule, in a case where a transaction involves transfer of shares lock, stock and barrel, such a transaction cannot be broken up into separate individual components, assets or rights such as right to vote, right to participate in company meetings, management rights, controlling rights, control premium, brand licences and so on as shares constitute a bundle of rights

JUSTICE K.S. RADHAKRISHNAN

[para 144] Further, the High Court failed to note on transfer of CGP share, there was only transfer of certain off-shore loan transactions which is unconnected with underlying controlling interest in the Indian Operating Companies. The other rights, interests and entitlements continue to remain with Indian Operating Companies and there is nothing to show they stood transferred in law

5. Section 9

THE CHIEF JUSTICE

[para 71] Hence, it is not necessary that income falling in one category under any one of the sub-clauses [ed: of section 9] should also satisfy the requirements of the other sub-clauses to bring it within the expression “income deemed to accrue or arise in India” in Section 9(1)(i)… The said sub-clause consists of three elements, namely, transfer, existence of a capital asset, and situation of such asset in India. All three elements should exist in order to make the last sub-clause applicable [emphasis added].

JUSTICE K.S. RADHAKRISHNAN

[paras 171-174] Section 9, therefore, covers only income arising from a transfer of a capital asset situated in India and it does not purport to cover income arising from the indirect transfer of capital asset in India. Section 9 has no “look through provision” and such a provision cannot be brought through construction or interpretation of a word ‘through’ in Section 9. In any view, “look through provision” will not shift the situs of an asset from one country to another. Shifting of situs can be done only by express legislation

6. Situs of the CGP Share

Although both the Chief Justice and Justice K.S. Radhakrishnan hold that the situs of the CGP share is the place of incorporation/register of shares, they appear to have adopted different approaches: the Chief Justice applies the Indian Companies Act, while Justice KS Radhakrishnan applies the well-known conflict of laws rules on situs of shares. This will be discussed in more detail in a subsequent post.

THE CHIEF JUSTICE

[para 82] Be that as it may, under the Indian Companies Act, 1956, the situs of the shares would be where the company is incorporated and where its shares can be transferred. In the present case, it has been asserted by VIH that the transfer of the CGP share was recorded in the Cayman Islands, where the register of members of the CGP is maintained.

JUSTICE K.S. RADHAKRISHNAN

[para 127] Situs of shares situates at the place where the company is incorporated and/ or the place where the share can be dealt with by way of transfer. CGP share is registered in Cayman Island and materials placed before us would indicate that Cayman Island law, unlike other laws does not recognise the multiplicity of registers

Vodafone's appeal allowed

noreply@blogger.com (V. Niranjan) — Fri, 20 Jan 2012 08:29:00 +0000

It has been reported that Vodafone’s appeal has been allowed, the Supreme Court inter alia rejecting the Revenue’s “extinguishment” argument and holding that section 9 is not a “look-through” provision.

We will have an opportunity to discuss this judgment in detail over the coming days once a copy is available.

Second Week of Arguments: Constitution Bench on Bhatia International

noreply@blogger.com (V. Niranjan) — Fri, 20 Jan 2012 07:08:00 +0000

Arguments continued this week before the Constitution Bench comprising the Chief Justice, and Justices Jain, Nijjar, Khehar and Desai. As we noted, counsel for the appellants in the first week concentrated principally on whether the courts of the seat of arbitration have exclusive jurisdiction to test the validity of an arbitral award even when the proper law of the contract is the law of another country.

This week, Mr Gopal Subramanium developed the submissions he had outlined last week. It is easiest to describe counsel’s contentions by dividing his case into two parts: a negative case, which sought to establish that the “seat of arbitration” is not the basis on which the jurisdiction of the courts has been defined under the Indian Arbitration Act; and a “positive” case, which consisted of certain propositions on the correct approach to jurisdiction under the Indian Act, drawing from the principle of party autonomy, the significance of choice of law, English law and from the travaux préparatoires to the UNCITRAL Model Law on International Commercial Arbitration. In his negative case, counsel submitted that the primacy accorded to the “seat of arbitration” in England is in fact judge-made law; that the drafters of the Model Law in 1985 were fully aware of the contesting views, and yet defined “international commercial arbitration” in article 1(3) not only with reference to the seat of arbitration but also the places of business of the parties; and that the Indian legislature went even further because it omitted all references to the seat in section 2(1)(f) of the 1996 Act. Counsel further submitted that it is possible that parties to an arbitration with a foreign seat expressly designate the 1996 Act as applicable, in which event the 1996 Act must ex hypothesi apply even though the seat of arbitration is outside India. Counsel also relied extensively on the judgment of the UK Supreme Court (particularly Lords Mance and Collins) in Dallah Real Estate v Government of Pakistan, which we have discussed here, to suggest that a court must always have jurisdiction to examine matters which are “fundamental” to an arbitration, such as arbitrability of the dispute, whether there was a valid arbitration agreement etc. Counsel then relied on section 48(1)(e) of the Act, which corresponds to art. 5(2)(e) of the New York Convention, to suggest that Parliament clearly contemplates that not only the court of the seat of the arbitration (captured by the words “country in which the award was made”) but also the court of the country whose law governs the arbitration agreement has jurisdiction to set aside the award.

Counsel then argued that the test of jurisdiction under the 1996 Act is therefore not seat, but “subject matter”, for section 2(1)(f) defines an “international commercial arbitration” without reference to its seat, and section 2(1)(e) the jurisdiction of a “court” by reference to the subject matter of the arbitration. Counsel reiterated that section 2(2) only indicates when the Indian court has jurisdiction, and not when it does not, and submitted as a consequence that a Convention award under Part II may be enforced either under Part II or under Part I because the provisions of Part II are “additional” to those in Part I. As an example, counsel pointed out that although sections 8 and 45 deal with similar issues, the right of the defendant to have the parties referred to arbitration is lost under section 8 if he takes the objection after the written statement is filed, but is never lost under section 45. There are of course other differences. The Chief Justice put to counsel that this results in duplication and that it may not have been necessary for Parliament to enact Parts I and II separately, to which counsel said that these provisions are additional for those awards that fall within Part II. Counsel therefore submitted that it is open to an Indian court to exercise the power to appoint an arbitrator under section 11 in respect of a Convention arbitration agreement. Justices Nijjar and Khehar put to counsel the possibility that this is wholly unnecessary since the court under section 45 also has the power to appoint an arbitrator, to which counsel said that this would have the effect of rendering section 11 otiose, for such a power must ipso facto also exist under section 8 as well.

On Thursday, Dr Abhishek Singhvi briefly outlined his submissions, which will be developed next week. In contrast to the submissions of counsel before him, he stated that his case is confined to section 9, and argued that the court is entitled to take an independent view of section 9 – that is, it is possible that section 9 may be invoked in respect of a foreign arbitration even if section 34 or any other provision of Part I cannot be. He started by suggesting that a party may be left entirely remediless if a section 9 power is not available, and gave the example of an arbitration with its seat in Brussels involving a party whose major asset is a castle in the State of Rajasthan. Counsel submitted that the claimant in the Brussels arbitration has only three remedies: (i) obtaining interim relief from a court in Brussels (under its arbitration legislation); (ii) obtaining interim relief from the Tribunal and (iii) obtaining interim relief in respect of property situated elsewhere (for example in America). Counsel submitted that as far as the castle in Rajasthan is concerned, none of these remedies is “worth the paper” it is written on. The Bench put to counsel the possibility that a party may not be entirely remediless, for a civil suit may be maintainable, to which counsel said that it may not be correct to hold that a suit is maintainable despite the existence of an arbitration agreement. In short, counsel’s submission was that “the core of Bhatia” is correct, and the fact that it has engendered other decisions on other sections of Part I should not lead one to conclude that Bhatia is itself incorrect as far as section 9 is concerned.

Arguments continue on Tuesday.

Regulating the Pay of Bankers in the Private Sector

noreply@blogger.com (V. Umakanth) — Thu, 19 Jan 2012 02:44:00 +0000

Last week, the Reserve Bank of India (RBI) issued compensation guidelines for implementation by private sector and foreign banks that become operational from the financial year 2012-2013. This approach is consistent with the trend that corporate governance norms in the banking sector tend to be more controlled than in other industry sectors. Apart from the fact that the pay of CEOs and wholetime directors requires the prior regulatory approval, the compensation guidelines set out detailed principles to be deployed in order for these banks to determine senior bankers’ pay.

The guidelines place emphasis on board’s oversight regarding compensation design and operation. For example, banks must constitute a remuneration committee consisting of independent directors that frames, reviews and implements the compensation policy. The guidelines also stipulate operational matters in sufficient detail, including the distribution between fixed component and variable component of the compensation. It encourages deferral arrangements in compensations so as to eliminate short-termism in the senior management’s approach. Other mechanisms, which received significant attention following the onset of the financial crisis, such as clawback arrangements are also required to be implemented. Reliance is also placed on greater disclosure of compensation arrangements, both at a quantitative level as well as qualitative level. While the guidelines stop short of imposing quantitative limits on pay, they set out stringent requirements that banks will have to comply with starting the next financial year.

On a related note, the Economist has a different take on the politics and economics of executive compensation generally, and bankers more specifically.

QFI Route Operational

noreply@blogger.com (V. Umakanth) — Sat, 14 Jan 2012 04:15:00 +0000

Following the decision of the Government of India to permit qualified foreign investors (QFIs) to invest in the Indian stock markets, SEBI and RBI yesterday issued detailed guidelines (here and here) to operationalise the investment mechanism.

SEBI has introduced a number of checks and balances to prevent misuse of this route. For example, significant KYC obligations have been imposed on the depository participants. Moreover, the QFIs are required to provide details regarding their beneficial ownership to prevent anonymity in trading. In the context of foreign institutional investors (FIIs), SEBI has in the past sought to ascertain details of beneficial ownership of shares, but not always with success. It remains to be seen whether SEBI will be faced with a similar situation with respect to QFIs. Further, QFIs cannot issue offshore derivative instruments such as participatory notes. All these are intended to ensure close scrutiny of investments such that significant inflows or outflows do not cause undue volatility in the Indian stock markets thereby affecting investors in general.

Constitution Bench on Bhatia International: First Week of Arguments

noreply@blogger.com (V. Niranjan) — Fri, 13 Jan 2012 07:09:00 +0000

A Constitution Bench comprising the Chief Justice and Justices Jain, Nijjar, Khehar and Desai heard arguments this week in Bharat Aluminium v Kaiser Aluminium Technical Services, in which the principal issue is whether Part I of the Arbitration and Conciliation Act, 1996 applies to arbitrations where the seat of arbitration is outside India. As is well known, and as we have discussed on several occasions, a three-judge Bench of the Court answered this question in the affirmative in Bhatia International in the context of section 9 (interim measures), and subsequent decisions have applied other provisions of Part I (section 11, section 34 etc.) to such arbitrations. Also before the Court are important questions of the conflict of laws arising from these decisions, principally the juridical significance of the “seat of arbitration” and whether questions of validity of an award are governed by the lex arbitri or the law governing the contract (“the proper law”).

Before giving an account of the first week of arguments in the Supreme Court, it is perhaps useful to describe the manner in which these issues are before the Constitution Bench. This batch of appeals arises from a number of judgments of High Courts across the country, some of which have held that an application under section 34 is not maintainable to challenge a foreign arbitral award in cases in which the parties have provided that the lex arbitri is English (or other foreign) law, even though the proper law is Indian law. Other High Courts have considered whether a petition under section 9 is maintainable, and there are therefore two issues before the Court: (i) the scope of section 2(2) of the 1996 Act and whether Bhatia International was correctly decided; (ii) whether, if the designation of a foreign lex arbitri has the effect of excluding Part I, there is any distinction between provisions that apply during the conduct of arbitral proceedings (such as section 9) and those which apply after the award is made (such as section 34), particularly when Indian law is the proper law.

Although Mr Sundaram, senior counsel for the appellants, opened the appeal by submitting that Bhatia International was correctly decided in its entirety, the thrust of his submissions was that even if the designation of a foreign lex arbitri makes section 9 inapplicable on the ground that the parties themselves have contracted out of it, the right to challenge an award is governed not by the lex arbitri but by the proper law. If this submission is accepted by the Constitution Bench, it would mean that it is open to a party to invoke the jurisdiction of the Indian court under section 34 to challenge a foreign award made pursuant to a contract governed by Indian law, even though it is not open to him to invoke the jurisdiction of the court under section 9 or section 11 during the conduct of arbitral proceedings. Developing this submission, counsel pointed out that denying a section 34 challenge to a judgment debtor in a foreign award could make him “remediless” if the judgment creditor chooses not to enforce the award in India (for section 48 is a shield, not a sword), which may be especially anomalous if the foreign award in question is contrary to Indian public policy, but not contrary to the public policy of the country in which the judgment creditor seeks enforcement. Counsel relied for this submission inter alia on certain observations made by Bharucha J. in Sumitomo Heavy Industries v ONGC, on the expression “under the law of which” in section 48(1)(e), and argued therefore that the recent judgment of the Court in Videocon Industries, on which we have commented here, is wrongly decided.

The Chief Justice put to counsel the possibility that the judgment debtor in the hypothetical described above can challenge the foreign award in the country of the seat: for example, if an award is made pursuant to a contract governed by Indian law but which designates London as the seat of arbitration or English law as the lex arbitri, the judgment debtor can challenge the award under the equivalent of section 34 in the foreign jurisdiction, although he cannot challenge it in India or set up Indian public policy as a ground unless the judgment creditor chooses to enforce it in India (and even if he does, the award is merely not “enforced”, not “set aside”). To this counsel’s answer was inter alia that section 69 of the English Arbitration Act, 1996 does not permit an appeal on a question of law in a contract governed by foreign law (since section 82(1)(a) defines a question of law as a “a question of the law of England and Wales”) and that in any event that it may not be possible to set up Indian public policy in the court of the seat.

Mr Sorabjee, also for the appellants, developed these points by concentrating on the applicable principles of conflict of laws and relied heavily on the judgment of Bharucha J. in Sumitomo for the proposition that while interim measures may be governed by the lex arbitri, the right to challenge an award is governed by the proper law. The Bench put to counsel questions relating to the difference between the tests applicable under section 2(1)(f) and section 2(7), and also about how the extent to which Parliament intended to depart from the New York Convention/Geneva Protocol, and the UNCITRAL Model Law on International Commercial Arbitration. On the third day, Mr Gopal Subramanium submitted that it is wrong to start with the assumption that any interference by a court in the arbitral process is “antithetical” to arbitration because arbitration, to be effective, requires the assistance of the national court. Counsel also emphasised that Parliament, in defining “international commercial arbitration” in section 2(1)(f) based on article 1(3) of the Model Law, chose not to use the “seat of arbitration” (which features in article 1(3)), and suggested therefore that the “seat” may not be decisive in determining whether section 34 applies to a foreign award. Counsel will continue his arguments on Tuesday.

The Constitution Bench’s judgment is likely to be the last word on what has proven to be a hotly contested issue in Indian arbitration law and is also likely to clarify certain unresolved questions on the conflict of laws rules applicable to arbitration in India. Arguments continue next week.

Liberalisation of Foreign Investment in Single-Brand Retail

noreply@blogger.com (V. Umakanth) — Wed, 11 Jan 2012 02:33:00 +0000

Although the proposed policy changes on foreign investment in multi-brand retail had to be put on hold due to stiff resistance, the Government has issued Press Note No. 1 (2012 Series) to increase the limit of foreign investment in single-brand retail from 51% to 100%. Such foreign investment would continue to require the approval of the Government of India (acting through the Foreign Investment Promotion Board). For investments beyond 51%, a new condition requiring domestic sourcing has been inserted as follows:

In respect of proposals involving FDI beyond 51%, mandatory sourcing of at least 30% of the value of products sold would have to be done from Indian 'small industries/ village and cottage industries, artisans and craftsmen'. 'Small industries' would be defined as industries which have a total investment in plant & machinery not exceeding US $ 1.00 million. This valuation refers to the value at the time of installation, without providing for depreciation. Further, if at any point in time, this valuation is exceeded, the industry shall not qualify as a 'small industry' for this purpose. The compliance of this condition will be ensured through self-certification by the company, to be subsequently checked, by statutory auditors, from the duly certified accounts, which the company will be required to maintain.

The Options Saga Continues

noreply@blogger.com (V. Umakanth) — Tue, 10 Jan 2012 03:46:00 +0000

A few months ago, we had discussed a change of policy stance by the Government of India in allowing options (such as puts and calls) on shares of Indian companies to foreign investors. While the Government initially specified that the existence of such options would turn the foreign investment into an external commercial borrowing, it was quick to withdraw this stipulation due to the immediate outcry from various quarters. We had remarked at that time: “it remains to be seen whether the Reserve Bank of India (RBI) will also now adopt a more liberal approach to options and modify their prevailing position”. It appears that the RBI has not changed its approach despite the change in policy stance of the Government of India, and continues to raise doubts with respect to transactions where the foreign investor is conferred such options. The contrary signals emanating from different government authorities does give rise to tremendous regulatory uncertainty in structuring investments in India.

SEBI Prescribes Additional Methods to Meet Free Float Requirement

noreply@blogger.com (V. Umakanth) — Mon, 09 Jan 2012 12:13:00 +0000

In addition to the existing methods available for listed companies to meet the public shareholding (free float) requirements of 10% for public sector undertakings (PSUs) and 25% for other companies, SEBI has recently prescribed two other methods. These are (i) the institutional placement programme (IPP) under which a company can increase its public shareholding up to 10% through an offer to qualified institutional buyers (QIBs), and (ii) an offer for sale through stock exchanges where promoters can offload shares through a separate window of the stock exchange for at least 1% of the paid-up capital of the company, subject to a minimum of Rs. 25 crores.

While this will certainly enhance the possibilities for companies to meet the minimum shareholding requirement and make it less onerous for them, there are lingering questions (see here, here and here) on whether this has been specifically catered towards government disinvestments so as to enable PSUs to meet the free float requirement, and how this process could effectively circumvent participation by retail investors as it favours placements with institutional investors.