INDIAN CORPORATE LAW

Do Auctions in Public Offerings Work?

v.umakanth@gmail.com (Umakanth V.) — Wed, 10 Feb 2010 10:01:00 +0000

The SEBI (Issue of Capital and Disclosure) Regulations, 2009 were recently amended to provide for “French” auction as one of the methods of price discovery in follow-on public offerings. This was supposedly brought about with a view to encourage the use of such auction mechanism in Government disinvestments.

However, the results emanating from the first offering where the auction mechanism was deployed are not all that encouraging. It has been reported that due to the lack of adequate response in the NTPC offering, the Government may reconsider the use of auctions and revert to the tried-and-tested bookbuilding method. As a column in the Financial Express notes:

And the government may want to give the French auction method a miss. Perhaps the method does facilitate better price discovery when the market sentiment is good because institutions do tend to put in a higher bid if they believe they will get a bigger allotment. But this time it didn’t work. The price of Rs 209 can hardly be called a discovered price and the signalling by the government may have kept other institutional investors away. In the normal book building process an investor can put in an application even on the last day and hope to get shares, and many investors may have done so had it not been for the large bids at Rs 209. Also, even if the government got itself a few rupees more, a fairly big chunk of the shares is now concentrated in the hands of two big investors, which cannot be good for the stock. That need not have been the case.

Intriguingly, the auction mechanism is used more as an exception in pricing public offerings as compared to the bookbuilding route which is more popular. One recent honourable exception has been the IPO of Google in 2004, which used the Dutch auction route, and not the French auction route that has been adopted in India. For a general discussion of the two methods, see the following:

… French auctions where the bidders who have bid at less than or equal to the cut-off yield get allotments at their bids – the bids at cut-off get pro-rata. Unlike this, in a Dutch auction, …, all the bidders who have bid at less than or equal to the cut-off get pro-rata allotment at the cut-off. The French auction imposes a bidding risk on the investors by imposing a penalty on successful bidders for being off the cutoff. Generally the standard deviation of bids in a French auction will be much lower than the Dutch auction. It has been seen that the Dutch auction brings down the cut-off in a bullish market.

Moreover, academic research has shown that auctions are less likely to succeed in a public offering of securities. The two reasons proffered in studies conducted by Ravi Jagannathan and Ann Sherman are ‘winner’s curse’ and the ‘free rider’ problem:

The winner’s curse, as its name suggests, is the tendency for the winner of an auction to overbid. Theory predicts that this will occur when the extent to which a bidder values the auction item depends on other bidders’ valuation. The winner’s curse applies to the case of tradable shares, since one’s valuation of the share depends on everybody else’s valuation.

In principle, the winner’s curse can be easily overcome: a bidder could simply revise her bid downwards to make allowance for her optimism. In reality, however, bidders often find it difficult to adequately adjust for the winner’s curse, especially when the number of bidders is uncertain and difficult to anticipate. Jagannathan and Sherman provide a simple, stylized example to illustrate what happens when the actual number of bidders turns out to be far bigger than what each bidder had assumed when they computed their bids. The winner’s curse will be severe, and opting out of the auction may make more sense.

The free rider problem, on the other hand, arises because some investors have the incentive to rely on others to collect information on the IPO stock. These uninformed investors will bid high, hoping that the auction clearing price will be set by those who have done their homework. However, high bidding by uninformed bidders reduces the incentives of sophisticated investors to devote time and resources to correctly value the shares—since they are less likely to win due to the aggressiveness of the uninformed investors. Hence the standard, uniform-price auction mechanism becomes unstable.

These may explain (at least partly) the lukewarm response received in the NTPC auction. For further detailed analysis, please see the two papers by Jagannathan and Sherman (here and here).

Enhanced Corporate Governance Practices

v.umakanth@gmail.com (Umakanth V.) — Wed, 10 Feb 2010 09:58:00 +0000

Although the Satyam episode invited close scrutiny of the corporate governance norms and practices that were prevalent in India, there is some evidence that it has acted as a wakeup call in enhancing board practices. As Arun Duggal observes in a recent Wall Street Journal column:

The first reaction of corporate boards when Satyam blew in January 2009 was to have an independent verification that the cash, bank deposits and financial investments recorded in the company's books were accurate. The board of directors, particularly independent directors, met with the external and internal auditors to assure themselves that the reported financial statements were true and accurate and that the auditors were independent and diligent. Over 100 independent directors resigned from various boards as they realized that with directorship come certain responsibilities and obligations.

Over the last year, there has been a steady improvement in the functioning of boards. The audit committee function has become more thorough and meetings have become more substantial and longer. Some audit committees meet for half a day or longer rather than a superficial one hour meeting in the past. They also meet with the auditors without management being present. Related party transactions are scrutinized in greater depth and promoters have to disclose if they have pledged their shares to raise financing.

Duggal favours the approach followed by the Indian regulators through adoption of voluntary guidelines for corporate governance rather than acting through a knee-jerk reaction (a reference to Sarbanes-Oxley), although he highlights some shortcomings of the voluntary guidelines and provides suggestions for improvement.

Legal Issues in Stock Lending

v.umakanth@gmail.com (Umakanth V.) — Mon, 08 Feb 2010 10:57:00 +0000

We had earlier noted the recent relaxations introduced by SEBI in order to provide a thrust to the securities lending and borrowing (SLB) mechanism and thereby short selling of securities. Some doubts were expressed regarding the sustainability of even the reformed process.

In a column in today’s Mint, Jayant Thakur highlights several legal issues that are bound to arise when the SLB mechanism acquires widespread practice. These include issues pertaining to taxation (particularly capital gains), the use of stock lending by promoters and the applicability of insider trading regulations and the takeover code. While the column seeks a comprehensive identification of the issues, it points towards the need for a fuller appreciation of the issues involved (all of which understandably cannot be accomplished within the constraints of a column’s word limit). It does provide ample fodder that justifies a thorough legal analysis of the issues involved.

New Blog for Indian Legal Research

mihircn@gmail.com (Mihir Naniwadekar) — Sat, 06 Feb 2010 04:33:00 +0000

I would like to highlight the Legal Research India blog recently started by Arjun Sheoran, student at the National Law School of India University. Essentially, the blog allows readers/users to search the web for relevant legal materials. The search is a Google custom search; with the advantage that it is restricted to some selected websites, listed here – so the results are likely to be more relevant for those engaged in Indian legal research than a general Google search. According to the homepage of the blog, “Legal Research India provides customized search engines for legal research for Indian and foreign law as it searches relevant websites only. It can be used searching for judgments, legislations, articles, journals, reports or any other legal information/material from India, UK, USA or any other jurisdiction…” I have not used it too much yet; but in the couple of instances when I did use it, I found it extremely helpful. I hope the readers of this blog find it useful too.

Corporate Restructuring and the Business Purpose Rule

noreply@blogger.com (V. Niranjan) — Wed, 03 Feb 2010 11:07:00 +0000

In 1935, the House of Lords famously observed that “every man is entitled to order his affairs” in order to minimise his liability to tax (IRC v. Duke of Westminster, [1936] AC 1). This is the dictum that is often cited as the source of the rule that while tax avoidance is legal, tax evasion is not. The distinction between the two, while not always clear, is regarded by some as especially thin after the growth of the corporation as the preferred vehicle of investment, and defining the use of the corporation as a tax planning device is one of the greatest challenges that corporate and taxation law face today.

India has seen its fair share of controversy in this area. Traditionally, it followed the Westminister rule that tax avoidance is legal, and that a citizen is entitled to the benefit of the letter of the law, even if the result is manifestly contrary to its spirit. This seem rather well-established, until Justice Chinnappa Reddy’s “concurring” opinion in McDowell v. CTO, where he observed that the “ghost” of the Duke of Westminster must be “exorcised” and that any device intended to avoid tax liability is illegal. It is difficult to conclude that the majority endorsed this reasoning, although some dicta in the case suggest that it did. In 2003, however the Supreme Court rejected Justice Reddy’s view in Azadi Bachao Andolan, and the law continues to be the position expressed in Andolan.

In this connection, the recent decision by the Authority for Advance Rulings in Star TV v. Director of International Taxation, Mumbai is a welcome one. A copy of the decision is available on the AAR website. In this case, three Star TV companies incorporated in the British Virgin Islands decided to amalgamate with the Star TV Indian entity, known as Star India Pvt. Ltd. [“STPL”]. The reason offered was that it was to the commercial advantage of Star TV to consolidate its holdings in one company. Before the AAR, the Revenue argued that approving this merger would have adverse consequences on the Revenue, and more importantly that the AAR should itself decline to answer the question since the transaction was designed to avoid tax. The power of the AAR to answer a reference is circumscribed by s. 245R of the ITA, which provides that the “Authority shall not allow the application” where the question raised in the application relates to a “transaction which is designed prima facie for the avoidance of income tax”. Consequently, the AAR considered tax avoidance not in the context of chargeability, but as a jurisdictional question. Indeed, even if the AAR had concluded that the transaction in question was designed primarily to avoid tax, it would not have followed that it is chargeable to income tax merely for that reason.

In any case, an analysis of the opinion reveals support for the Westminster principle. The Revenue argued that the object of the arrangement was to avoid the payment of existing tax dues. This, it is clear, could not have been the case, since, as the AAR held, an amalgamating company transfers its liabilities to the entity into which it amalgamates. As to the argument that this reduces the capital gains tax payable in the future, the AAR noted the developments in India leading upto to Andolan, and that the Westminster principle continues to be applicable. Consequently, the AAR construed “designed for the avoidance of tax narrowly”. The following observations are apposite:

“A design to avoid the tax within the meaning of clause (iii) of the proviso to Section 245 R(2) apparently covers such of the transactions which are sham or nominal or which would lead to the inescapable inference of a contrived device solely with a view to avoid the tax. The corollary thereto is that there is no real and genuine business purpose other than tax avoidance behind such transaction.”

The “business purpose” test, according to the AAR, only requires that the arrangement afford some commercial benefit. In this case, the test was satisfied by the business purpose of consolidating various entities into one entity, which achieves “synergies of operation and enhanced operational flexibility.”

In sum, this decision is another indication that India’s tax avoidance jurisprudence is continuing to recede from Justice Reddy’s observations in McDowell, and accepts any device short of a sham. There continues to be some doubt, however, over whether a transfer arising out of an amalgamation is a "transfer" in the first place, for the purposes of s. 2(47) of the ITA. This has interesting implications for the taxability of share transfers in a scheme of amalgamation.

Buyback and Takeover Regulations - Yet another development

jmthakur@gmail.com (Jayant Thakur, CA) — Tue, 02 Feb 2010 05:02:00 +0000

See my earlier post on a recent decision of SEBI on whether increase in percentage holding consequent to buyback of shares would amount to "acquisition" under the Takeover Regulations. If that and earlier posts are reviewed, one would note that SEBI has taken a fairly consistent stand that such increase does amount to acquisition.

Now, in a recent order granting exemption under the Takeover Regulations, SEBI has taken the matter even further and made its stand even more consistent.

Let's quickly review the background first.

SEBI, with the help of the Takeover Panel, considers applications for exemption from the relevant provisions of the Takeover Regulations. SEBI has granted in several earlier cases such exemption when the percentage holding of the Promoters increases on account of buyback of shares. However, till now, at least in the cases I have read and recollect, the exemption was total. For example, if the holding of the Promoters increased because of this from, say, 60% to 68%, SEBI would exempt the whole of such increase. Thus, the acquisition of shares upto 5% under the creeping acquisition limits (where available - see further comments later) was additionally available.

Now, SEBI, in a recent exemption order, has tightened this further and has stated that only the increase beyond the 5% creeping acquisition would be granted and thus, effectively, the creeping acquisition limit would not be additionally available. Thus, where, in this case, the holding of the Promoters was to increase from 66.82% to 73.92, i.e., an increase of 7.10%, the exemption was granted to the increase of 2.10% only.

SEBI has observed that an increase upto 5% on account of buyback (amongst other ways) was available and hence such limit should be exhausted first and exemption be granted to the 2.10% beyond such 5%. The Promoters thus would not be entitled to use that creeping acquisition.

Such exemption orders are of course granted on a case to case basis and one does not know whether this order reflects a change in policy and whether in all future cases, the creeping acquisition limits would be allowed to be used up first. Nonetheless, this order makes the stand of SEBI even more consistent with its views on the matter.

Let us watch this issue for further developments which may be possible. As discussed earlier, while there are some difficulties in law, considering that SEBI has taken such a consistent stand, no person - Promoters in particular - may want to take SEBI head-on on this issue and risk such an increase without exemption and hence the issue may be deemed to be closed for practical purposes for future buybacks.

- Jayant Thakur

Buyback, increase in shareholding and open offer requirement

jmthakur@gmail.com (Jayant Thakur, CA) — Fri, 29 Jan 2010 12:46:00 +0000

Yesterday's decision of SEBI revives the discussion on whether an increase in shareholding on account of a buyback could result in an open offer. The issue can be explained mathematically as follows. A company, has, say, Rs. 100 of share capital. It carries out a buyback of Rs. 20 shares in which some shareholders do not participate fully. Since the share capital reduces to Rs. 80, the holding of such shareholders as percentage of the reduced capital increases. Will an open offer be required to be made if one of the cut-off points triggering such an open offer is crossed?

This issue could arise under several situations such as:-

- When a shareholder holding less than 15% finds his holding increased to 15% or more.

- When a substantial shareholder holding 15% or more finds his shareholding increased by more than 5%.

Actually, the issue has even broader implications. An increase in shareholding, e.g., may even trigger off immediate disclosure requirements. Thus, a person holding less than 5% shares and who finds his holding increased to more than 5% would be required to make certain timely disclosures.

This issue has been the subject of discussion in this blog (see, e.g., my article here, and this post and several other posts.

To some extent, this issue was academic since SEBI had amended the law relating to creeping acquisitions in such a way as if the law was very clear (at least to SEBI - ;)) that increase in shareholding on account of buyback would attract creeping acquisition requirements. See my post here where I had discussed, inter alia, this issue. See also earlier posts referred to therein.

SEBI has now held in the decision referred to above that an increase of 12.44% from 62.56% to 75% arising solely out of buyback of shares would result in open offer being required to be made.

I repeat that this is consistent with SEBI's stand all through. Firstly, while making the amendment relating to creeping acquisitions as referred to above, it assumed that open offer is required. Secondly, it has considered several exemption application of cases where holding increases on account of buyback. This implies that it believes open offer is required.

This decision is in a sense an interim decision though certain issues are decided. It, firstly, holds that there is a violation in not making an open offer. Secondly, it does not direct that an open offer should be made since the price of the shares has increased substantially thereafter. However, it directs that adjudication proceedings for levying penalty be commenced. To have a complete view, one would have to also see what penalty is levied and with what reasoning. Hence this article is also an interim one - :)

There are several interesting issues though.

A strong argument for holding a view that open offer should result to Promoters if their holding crosses the trigger on account of buyback is that Promoters cannot claim that the increase was entirely involuntary. They were the persons who would have proposed such a buyback and knowingly avoided participating in it. Such argument could also be made in the present case where the group's holding increased from 62.56% to 75%. Strangely, this was not the ground on which it was held that there was an "acquisition".

SEBI holds that "...it is not the mode of acquisition that matters. On the other hand, it is the right that which accrues to such acquirer to exercise such increased voting rights (more than 5%), acquired by whatever means... The said acquisition can be direct or consequential".

An incidental issue raised was whether the word "or" in the words "acquisition of shares or voting rights" should be read as "and" so as to mean that the increase in voting rights should be the result of acquisition of shares. SEBI negated this argument.

Though the issue is academic for Promoters, the present decision has wider implications as discussed above. SEBI has not applied the reasoning that a person holding 62.56% cannot plead that there was "no acquisition". It has not restricted the applicability of this decision to such large shareholders only (though of course one could argue on general principles that this decision should apply to the unique facts of the case).

In such a case, the decision could create issues for several other persons. As discussed, a person holding 14% and whose shareholding would increase to, say, 16% on account of the buyback would also be required to make an open offer. Of course, the person could avoid the open offer simply by offering his shares too for buyback.

While I have stated that this issue is academic, the debate may continue if the order is appealed against. It is possible that the Promoters may appeal since there is a finding of violation of law. Though the Order says that the Adjudicating Officer should consider the matter on merits and not be influenced by the observations of this Order, one wonders whether the Adjudicating Officer would hold to the opposite. In several earlier SEBI decisions, a hefty penalty, related to the open offer amount involved has been levied and hence the stakes could be high. If an appeal is made, one could expect a decision that is clearer and more comprehensive than this one.

- Jayant Thakur

Political Contributions by Companies

v.umakanth@gmail.com (Umakanth V.) — Thu, 28 Jan 2010 03:52:00 +0000

Last week, the U.S. Supreme Court pronounced an important judgment in Citizens United v. Federal Election Commission on the issue of political spending by corporations in elections. The New York Times has a summary:

Overruling two important precedents about the First Amendment rights of corporations, a bitterly divided Supreme Court on Thursday ruled that the government may not ban political spending by corporations in candidate elections.

The 5-to-4 decision was a vindication, the majority said, of the First Amendment’s most basic free speech principle — that the government has no business regulating political speech. The dissenters said that allowing corporate money to flood the political marketplace would corrupt democracy.

The ruling represented a sharp doctrinal shift, and it will have major political and practical consequences. Specialists in campaign finance law said they expected the decision to reshape the way elections were conducted. Though the decision does not directly address them, its logic also applies to the labor unions that are often at political odds with big business.
…

Eight of the justices did agree that Congress can require corporations to disclose their spending and to run disclaimers with their advertisements, at least in the absence of proof of threats or reprisals. “Disclosure permits citizens and shareholders to react to the speech of corporate entities in a proper way,” Justice Kennedy wrote. Justice Clarence Thomas dissented on this point.

The majority opinion did not disturb bans on direct contributions to candidates, but the two sides disagreed about whether independent expenditures came close to amounting to the same thing.

The decision also has implications on the nature and character of corporations as well as aspects of corporate governance.

Interestingly, the position in India appears to be more liberal (at least from a company law standpoint). Section 293A of the Companies Act, 1956 in fact allows companies (other than Government companies and those in existence for less than 3 financial years) to make political contributions subject to a maximum of 5% of the average net profits during 3 immediately preceding financial years. Companies also have to comply with accompanying disclosure obligations.

What is hidden beneath the mere text of the statutory provision though is the intense debate that has occurred in the preceding decades resulting in several amendments to Section 293A. A review of the commentary to this section will reveal that the position has fluctuated from uncertainty about the validity of a political contribution by a company to a complete ban and finally resting with the current position as a compromise.

U.S. Financial Reforms: The “Volcker Rule”

v.umakanth@gmail.com (Umakanth V.) — Wed, 27 Jan 2010 09:18:00 +0000

Last week, the U.S. unveiled a series of reforms to deal with some of the lessons learnt from the financial crisis. Following is an extract of the President’s remarks that outline the proposals:

First, we should no longer allow banks to stray too far from their central mission of serving their customers. In recent years, too many financial firms have put taxpayer money at risk by operating hedge funds and private equity funds and making riskier investments to reap a quick reward. And these firms have taken these risks while benefiting from special financial privileges that are reserved only for banks.

Our government provides deposit insurance and other safeguards and guarantees to firms that operate banks. We do so because a stable and reliable banking system promotes sustained growth, and because we learned how dangerous the failure of that system can be during the Great Depression.

But these privileges were not created to bestow banks operating hedge funds or private equity funds with an unfair advantage. When banks benefit from the safety net that taxpayers provide –- which includes lower-cost capital –- it is not appropriate for them to turn around and use that cheap money to trade for profit. And that is especially true when this kind of trading often puts banks in direct conflict with their customers' interests.

The fact is, these kinds of trading operations can create enormous and costly risks, endangering the entire bank if things go wrong. We simply cannot accept a system in which hedge funds or private equity firms inside banks can place huge, risky bets that are subsidized by taxpayers and that could pose a conflict of interest. And we cannot accept a system in which shareholders make money on these operations if the bank wins but taxpayers foot the bill if the bank loses.

It's for these reasons that I'm proposing a simple and common-sense reform, which we're calling the "Volcker Rule" -- after this tall guy behind me. Banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers. If financial firms want to trade for profit, that's something they're free to do. Indeed, doing so –- responsibly –- is a good thing for the markets and the economy. But these firms should not be allowed to run these hedge funds and private equities funds while running a bank backed by the American people.

In addition, as part of our efforts to protect against future crises, I'm also proposing that we prevent the further consolidation of our financial system. There has long been a deposit cap in place to guard against too much risk being concentrated in a single bank. The same principle should apply to wider forms of funding employed by large financial institutions in today's economy. The American people will not be served by a financial system that comprises just a few massive firms. That's not good for consumers; it's not good for the economy. And through this policy, that is an outcome we will avoid.

The gist of the reforms is set out in this press release:

The proposal would:

1. Limit the Scope – The President and his economic team will work with Congress to ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit.

2. Limit the Size – The President also announced a new proposal to limit the consolidation of our financial sector. The President’s proposal will place broader limits on the excessive growth of the market share of liabilities at the largest financial firms, to supplement existing caps on the market share of deposits.

While the first proposal seeks to address the consequences of commingling banking and proprietary trading activity, the second seeks to tackle the “too big to fail” phenomenon.

Although some believe that these proposals are driven by political factors, others are either sympathetic to or supportive of this move. In any event, the significance of this step is that it seeks to address issues that go to the root cause of the crisis.

Duties of an Official Liquiator: TCI Distribution v. OL

mihircn@gmail.com (Mihir Naniwadekar) — Tue, 26 Jan 2010 20:19:00 +0000

I had previously posted on a decision of a Single Judge of the Madras High Court on the role and duties of an Official Liquidator. The facts in TCI Distribution Centres v. Official Liquidator (C.A. 1953/2008 in C.P. 526/2000) were that the Official Liquidator had sold certain properties through an auction-sale. The auction-purchaser later found out that the properties were not exactly the same as described in the sale advertisement. On this basis, the purchaser sought to set aside the sale which had been conducted on an “as is where is whatever there is” basis. The Single Judge had held that the doctrine of caveat emptor would apply in such cases; and the purchaser must be able to show the existence of either deceit or negligent mis-statement before he can succeed in getting an auction-sale by the OL set aside. This decision of the Single Judge has been reversed on appeal by a Division Bench. The judgment of the Division Bench is reported as TCI Distribution Centres Ltd. v. Official Liquidator, [2010] 153 Comp Cas 437 (Mad).

The Division Bench has held that the doctrine of caveat emptor does not apply. It was held that the doctrine “… cannot be extended to a case, where the vendor did not have title to the property…” The judgment indicates that an OL carrying out an auction-sale is under a statutory obligation to verify the title of the properties of the company-in-liquidation which are being brought to sale. The observations of the Court are not easily reconcilable with the judgment of the Supreme Court in United Bank of India v. Official Liquidator, [1994] 79 Comp Cas 262. In that case, the Supreme Court had held that the intending purchaser must satisfy himself as to the title and condition of the property. Accordingly, the DB judgment may need reconsideration.

From 'Oppression' to 'Prejudice'?

mihircn@gmail.com (Mihir Naniwadekar) — Tue, 26 Jan 2010 19:32:00 +0000

In this post, I had noted that the proposed Companies Bill appears to introduce some substantive changes in the law dealing with oppression (covered under Section 397 of the present Act). The proposed Companies Bill, 2009 states, in Section 212:

“212. (1) Any member of a company who complains that— (a) the affairs of the company have been or are being conducted in a manner prejudicial to public interest or in a manner prejudicial or oppressive to him or any other member or members … may apply to the Tribunal, provided such member has a right to apply under section 215, for an order under this Chapter.”

This language of “prejudicial or oppressive” is different from the present Section 397’s requirement of “oppression”. The basic difference appears to be that the proposed Section 212(1) allows actions in cases where the affairs of the company are being conducted in a manner “prejudicial” to the public interest or “prejudicial or oppressive” to the shareholders. Under the present Act, the acts complained of must be “prejudicial” to the public interest or “oppressive” to the shareholders (and not “prejudicial or oppressive” to the shareholders).

The impact of this development can be ascertained by a comparative reference to the English position. The earliest statutory development in this field appears to have been in Section 210 of the Companies Act, 1948 (UK). This provided a remedy only in cases of oppression. Furthermore, the facts much be such as would justify an order of winding up on the just and equitable ground (but for the hardship caused to the petitioners). The same requirements are now found in Section 397 of the Companies Act, 1956 (Indian).

Section 210 was interpreted to mean that it allowed for a remedy only when the petitioner was being oppressed qua member – only oppression against the petitioner in his capacity as member was covered. The leading case on this point is a decision from Scotland in Elder v. Elder, 1952 S.C. 49. That case involved two petitioners seeking relief under Section 210. One of the petitioners had been removed from the Board and had been forced to resign from his position as secretary. The other petitioner had dismissed from his post of factory manager. Both these petitioners were shareholders. The re-constituted Board had refused to buy the petitioners’ shares when called upon to do so. These facts were alleged to be oppressive. The Inner House of the Court of Session of Scotland however dismissed the petition, on the ground that the facts did not indicate any oppression of the petitioners in their capacity as shareholders. Thus, the decision seemed to limit the scope of Section 210 to oppression qua member. This was reaffirmed by English Courts in Ebrahimi v. Westbourne Galleries, [1973] A.C. 360 – a leading case on the principles of winding up of small companies which are in the nature of “quasi-partnerships”. It was held that while certain conduct must be oppressive qua shareholder for relief under Section 210 to be available; the “qua shareholder” requirement did not apply if the company was being wound up on the just and equitable ground. Conceivably, on the facts of Elder, while relief under Section 210 may not be available, a petition to wind up the company on the just and equitable ground would be available. The requirements for invocation of Section 210, then, appeared to be that there must be oppression qua shareholder; and the oppression must be such as would otherwise justify winding up on just and equitable grounds. The Supreme Court of India has approved of Elder in Shanti Prasad Jain v. Kalinga Tubes, AIR 1965 SC 1535, in the context of Section 397.

Section 210 (and the corresponding Section 397) with these requirements would seem to be a rather narrow Section. In the Companies Act, 1985 (UK), the scope was enlarged. English law moved away from “oppression” to “unfair prejudice”. Under Section 456, it was no longer necessary to show that the facts justified winding up; and the “qua shareholder” requirement was also diluted. This same position exists under Section 994 of the Companies Act, 2006 (UK). Furthermore, cases have held that “unfair prejudice” is broader than mere “oppression” – it might involve ‘breach of legitimate expectations’ and breach of the standards of fairness. Lord Hoffman has in fact stated that the legislative reforms have served to “free the Courts from technical considerations of legal right and to confer a wide power (to do what is fair)…” – O’Neill v. Philips, [1999] 2 BCLC 1. As Professors Gower and Davies argue, this would mean that “unfair prejudice” seems to encompass not just the rights of shareholders, but also their interests.

The proposed Indian Bill’s language seems to mirror these developments in the transition to “prejudice” from “oppression”. The change in the Section appears to have at least three consequences: (a) the requirement to demonstrate that the facts justify winding up has been done away with; (b) the “qua shareholder” requirement has been diluted; (c) the movement from an oppression-based test to a prejudice-based test is indicative of the widening of scope of the provision to deal with unfairness which would not necessarily amount to oppression. In interpreting this provision, therefore, the existing case-law under Section 397 may not be entirely suitable.

(These three changes are reflective of the position under the proposed Section 212. How the next Section - Section 213 - affects this analysis remains to be seen. Particularly, Section 213(1)(b) eems to indicate that the requirement in relation to winding up has not been done away with. This issue will be discussed in a subsequent post)

'Manufacture' in Income Tax

noreply@blogger.com (Shantanu Naravane) — Mon, 25 Jan 2010 09:08:00 +0000

The decision of the Supreme Court in CIT v. Oracle Software is set to add another controversy to the many that already exist with respect to taxation. Involving the interpretation of the term ‘manufacture’, which has been a contentious issue in the excise law context, the decision gives rise to a couple of interesting issues.

The assessee was a wholly owned subsidiary of Oracle Corporation, USA, which imported the Master Media of software from Oracle, and duplicated it on blank discs, packed and sold in the Indian market. The assessee only had the right to replicate/duplicate the software, and not to vary, amend or make any value addition to the Master Media. Now, in order to claim a deduction under section 80IA of the Income Tax Act, it was required for the assessee to show that it was engaged in the process of ‘manufacturing’. It was in this context that the long-standing debate in excise law on the meaning of ‘manufacture’ surfaced in the income tax context, with the Court holding that this process of duplication was ‘manufacture’.

There are two parts of Justice Kapadia’s opinion that merit attention- the first is the possible dilution of the meaning the manufacture which the decision has effected, the second is the reason why he thought the dilution was justified. The learned judge observed that the real input for the process of duplication was the blank CD onto which the Master Media was replicated, as a result of which the CD became available for a specific use different from its original use. The Department rightly contended that the Master Media itself was not changed in any way as a result of the duplication. While the Court did not differ with the Department on this factual assertion, it held that the transformation of the CD was sufficient to render the process a manufacture. In the words of the Court,

If an operation/ process renders a commodity or article fit for use for which it is otherwise not fit, the operation/ process falls within the meaning of the word ‘manufacture’. Applying the above test to the facts of the present case, we are of the view that, in the present case, the assessee has undertaken an operation which renders a blank CD fit for use for which it was otherwise not fit. The blank CD is an input. By the duplicating process undertaken by the assessee, the recordable media which is unfit for any specific use gets converted into the programme which is embedded in the Master Media and, thus, blank CD gets converted into recorded CD by the afore-stated intricate process. The duplicating process changes the basic character of a blank CD, dedicating it to a specific use. Without such processing, blank CDs would be unfit for their intended purpose. Therefore, processing of blank CDs, dedicating them to a specific use, constitutes a manufacture

In arriving at this conclusion, the Court relied on its previous decision in Gramophone Co. v. The Collector of Customs, (2000) 1 SCC 549, where the Court had held that the process by which blank cassettes were converted into pre-recorded audio cassettes amounted to manufacture. The Court in Oracle opined that the facts in the two cases were nearly identical, and should result in the same conclusion. However, it is important to note that this decision in Gramophone was decided under the Customs Act, and is not necessarily reflective of the position of law under excise. While the evolution in the meaning of manufacture in excise is too long to document here, the broad test accepted by Courts has been whether the process has resulted in the creation of a commercially distinct product. However, this test has run into difficulties when it comes to processes like labelling or packing, which do not add to the product per se, but merely embellish it, or add to its marketability. There is no clear guidance available on whether and which forms of labelling/packing amount to manufacture, but Courts have been content with observing that if the labelling/packing play a significant role making the product excisable, or if the product was not marketable without the process, the labelling/packing will amount to a manufacture.

In my opinion, a similar issue arises on the facts of Oracle. There are two ways in which the process of duplication can be viewed. One way is to say that the CD is merely the medium through which the software is being made available to its customers, and there is nothing about the CD that changes/alters the Master Media. On this view, the process of replication cannot be considered manufacture. Another view, which the Court espoused, is that the CD forms an essential part of the marketability of the Master Media, and after replication, the CD and the software form a common integrated unit, with an independent commercial identity. It placed reliance for this purpose on the definition of ‘goods’ provided in Tata Consultancy Services, AIR 2005 SC 371. On this view, the Court seems to have elaborated on and explained the general meaning of ‘manufacture’, which could be relevant in the excise context too.

However, the Court took great pains to assert that the test put forth is inapplicable in any context other than the specific deduction under section 80IA. This is emphasised by the fact that a subsequent decision in CIT v. Emptee Poly-Yarn, again a decision of deductibility under section 80IA, cites Oracle for this limited proposition, and again insists that the meaning of manufacture put forth in the income tax context cannot be extended to excise. The Court observes that the decision in Oracle must be understood in light of the fact that at issue was ‘computer technology’; and that in modern times, it would be advisable to borrow from American jurisprudence, which applies a broader test of manufacture.

Thus, the decision in Oracle and its interpretation in Emptee Poly-Yarn has clarified the meaning of manufacture in the income tax context, while leaving its effect on excise laws undecided. There is nothing in the decisions which makes them necessarily inapplicable to the excise context- indeed many observations suggest that the reasoning adopted may be equally applicable in excise law too. However, by specifically disclaiming its applicability, the question that has surfaced is whether the scope of the decision was narrowed because the Court thought it prudent not to over-extend itself, or because it thought that the test in excise is different. If the reason in the former, the decisions are an admirable exercise of restraint by the judiciary; if it is the latter, the decisions may lead to renewed debates in excise law.

Southern Technologies and Sticky Interest - Part II

noreply@blogger.com (V. Niranjan) — Sun, 24 Jan 2010 15:44:00 +0000

We discussed the recent decision of the Supreme Court in Southern Technologies that rejected a challenge to the constitutionality of ss. 36(1)(vii) and 43D of the Income Tax Act, 1961. The Court held that non-banking-financial institutions [“NBFC”] must account as income interest received from loans that are, for commercial purposes, bad debts. Four important issues were considered in the case: the impact of the 1998 RBI Directions on the Companies Act, 1956, and on the Income Tax Act, secondly, the distinction between the accounting concepts of a “reserve” and a “provision”, thirdly, the application of the real income principle to NBFCs and finally, the principles of interpretation of an economic legislation.

As discussed in the previous post, the 1998 RBI Directions requires NBFCs to debit a “Provision for NPAs” to the Profit & Loss account of the company. The assessee’s contention was this “provision” cannot be treated as “income”, for the purposes of s. 2(24) of the Income Tax Act. The assessee relied on s. 45Q of the RBI Act, under which directions issued by the RBI prevail over all laws to the contrary. In rejecting this contention, the Supreme Court held that the RBI Act overrides the Companies Act, but not the ITA. In particular, the Court held that the RBI Directions override the Companies Act in three respects: first, in deviating from Schedule VI on the manner of presentation of financial statements; secondly, in not recognising the mercantile system for the purposes of NPA, and requiring that it be credited to the books of the company only on actual receipt; thirdly, creating a provision for all NPAs. The RBI Directions pertain to disclosure, and not to computation of total income. Moreover, the Revenue correctly argued that if the RBI Directions on presentation of financial statements determines taxable income under the ITA, this would be true of exemptions as well, and agricultural income, dividend income etc., which are exempted under the ITA would be taxable. The conclusion of the Court that the RBI Directions operate in a different field and do not affect taxability appears, therefore, to be correct.

The second issue that the Court considered is the distinction between a “reserve” and a “provision”. Under principles of accountancy, a provision is a charge on profit, and a reserve is an appropriation of profit. The assessee argued that a reserve cannot be created in a loss-making year, and that it is created out of appropriation of post-tax profit, while a provision is charged to pre-tax profit in the Profit & Loss account of the company. The RBI Directions mandated the creation of a “provision”, not “reserve”, which the assessee argued could not constitute “income”. In view of the Court’s conclusion that the Directions operate in a different field, it did not resolve this question.

However, in what is the most controversial part of this decision, the Court seems to have assumed that the non-applicability of the RBI Directions to the ITA automatically makes the receipt “income” under the ITA. In particular, the Court’s analysis of the “real income” principle may, with respect, require reconsideration. The real income principle, as the previous post discussed, posits that the chargeability of a receipt in law depends, in significant part, on the commercial nature of the receipt. On this basis, assesses have long argued that the interest on a principal that is unlikely to be recovered is not “income”, and is not understood to be income by those engaged in that business. While the principle is subject to statutory provisions to the contrary, s. 36(1)(viii) is not such a provision, because it merely provides that banks are entitled to deduct provisions made for bad and doubtful debts under certain circumstances. It cannot be assumed that the legislature intended by this provision to treat sticky receipts as income, especially in view of the settled principle that interpretive ambiguities in tax legislation are resolved in favour of the assessee. The Supreme Court did not hold that the real income principle is not applicable, but held that a provision for bad and doubtful debts is only a “notional expense”, which would have to be “added back” to arrive at “real income”. Tulzapurkar J. had observed in his minority opinion that an entry in the accounts of a certain item is “neither accrual nor receipt of income” where income does not in fact result (State Bank of Travancore v. CIT, AIR 1986 SC 757). Whether applying the real income principle to sticky interest leads to the conclusion that it is not taxable is a matter of great disagreement, and it is unfortunate that the Court chose not to resolve this controversy.

Finally, the Court rejected a challenge to the constitutional validity of ss. 36(1)(viia) and 43D of the ITA. The assessees argued that confining the benefit of deducting provisions for bad debts to banks, thus excluding NBFCs, is contrary to Art. 14, for there is no rational nexus between this distinction and the object of the ITA. The Court rejected the challenge, holding that “liquidity” is a more important concern for banks than it is for NBFCs, and that the beneficial provisions in ss. 36(1)(viia) and 43D were enacted to avert a possible “liquidity crunch” for banks.

The Court also made general observations on the standard for challenging the validity of an economic legislation, and held that “laws relating to economic activities should be viewed with greater latitude”. Consequently, such legislations will not be invalidated unless the distinction is patently arbitrary.

In sum, while the Court has clarified the true import of the RBI Directions vis a vis the Companies Act and the ITA, the controversy over the scope of the real income principle looks set to continue.

Expansion of Currency Futures Trading

v.umakanth@gmail.com (Umakanth V.) — Wed, 20 Jan 2010 04:41:00 +0000

Currently, only US Dollar-Indian Rupee (INR) currency futures contracts can be traded on Indian stock exchanges. It has been decided to expand the market by introducing trading on currency futures in 3 other currencies: Euro-INR, Japanese Yen (JPY)-INR and Pound Sterling (GBP)-INR. Both SEBI as well as RBI have issued notifications to that effect.

OTC Derivatives: On the OTC side, there have been developments of a different nature, as reported here.

Newer Pricing Options in Public Offerings

v.umakanth@gmail.com (Umakanth V.) — Wed, 20 Jan 2010 04:28:00 +0000

A couple of months ago, SEBI permitted companies undertaking follow-on public offerings (FPOs) to price their shares freely above a floor price and on the basis of the price the bidders have quoted. However, retail investors would be allotted shares at the floor price. This was also in preparation for a slew of offerings by public sector undertakings (PSUs).

The Hindu Business Line reports that the PSUs, starting with NTPC Limited, may be adopting the ‘French auction’ model for their FPOs under this dispensation:

Under this alternative book building model, institutional buyers would be free to bid above a certain floor price and the allotment would be on price-priority basis and at differential prices.

FRENCH MODEL

About half of the 41.23 crore shares to be sold in the issue is reserved for the QIB (qualified institutional buyer) portion and would be allocated to investors based on the `higher the bid, higher the allocation' basis. The `French auction' model is likely to be replicated for the institutional portion of the upcoming Rural Electrification Corporation (REC) and mining major NMDC's share sales as well.

… The highest bidders, in the descending order, will get preference based on the price bids they have placed for the shares. …

This is being implemented on the expectation that the French auction would lead to a more optimal price discovery.

ACGA White Paper on Corporate Governance

v.umakanth@gmail.com (Umakanth V.) — Wed, 20 Jan 2010 03:59:00 +0000

Continuing with the spate of reform-related activity surrounding Indian corporate governance, the Asian Corporate Governance Association (ACGA), based in Hong Kong, yesterday issued the ACGA White Paper on Corporate Governance in India.

I find the White Paper of interest for two reasons. First, it seeks to supplement the existing reform process in India that is already underway and one that has culminated, at least for the moment, with the issue of the Corporate Governance Voluntary Guidelines 2009 by the Ministry of Corporate Affairs. Second, and more importantly, it side-steps most of the conventional issues that have inundated the corporate governance discourse in India recently and offers some different perspectives, like a whiff of fresh air.

The goal of the effort is set out as follows:

The aim of the “India White Paper” is to provide officials, financial regulators, listed companies, investors and others with constructive and detailed suggestions for the broadening and deepening of sound corporate governance in India. While India has undertaken numerous reforms in corporate governance over the past decade, especially in the area of company boards, independent directors and disclosure and accounting standards, certain critical areas remain to be addressed—particularly relating to the accountability of promoters (controlling shareholders), the regulation of related party transactions, and the governance of the audit profession.

We believe that reforms are needed in these areas to strengthen the integrity of India’s capital markets and to enhance its goal of becoming an international financial centre. We also believe that improvements in these areas should not be delayed for too long.

The White Paper states that despite “wide-ranging developments in regulation and policy, what becomes apparent in India is that the reform process has not addressed, or effectively addressed, a key challenge at the heart of the governance problem, namely the accountability of promoters to other shareholders”. In other words, this is recognition of the fact that a large number of governance problems in Indian companies are related to the position of controlling shareholders or promoters relative to that of minority shareholders. The White Paper finds that the overwhelming focus on board reforms is misplaced and is not adequate to deal with these problems:

In this context, relying largely on independent directors (appointed by controlling shareholders), independent board committees and greater corporate disclosure as the primary mechanisms to check abuses of power by promoters and to safeguard the interests of minority shareholders is likely to prove weak and insufficient (as indeed it did in the Satyam case). Board reform is fundamentally important, and is a major issue of concern to institutional investors, but it needs to be complemented by other regulations that directly address the relationship between controlling and minority shareholders—in other words, a proper regime for the regulation of related-party transactions.

However, this is not to discount the value of independent directors; it is just that the White Paper does not address the matter and instead focuses on other issues:

1. Shareholder Meetings and Voting: The White Paper stresses on the importance of reforming the requisite processes in India. It states that voting should be by way of poll rather than show of hands, and that proxies must be allowed to speak at meeting. Greater disclosure is called for in terms of notices and results of meetings. Writ large in this effort is the intention to empower institutional investors (particularly foreign institutions) to obtain a greater role in decision-making at general meetings. The effect of these reforms is that they will enable greater shareholder activism on the part of institutional investors, and overcome any collective action problems on the part of non-promoter shareholders as there could be greater certainty as to the impact that minority shareholders can make at general meetings.

2. Related-Party Transactions: The White Paper’s contribution is this area is welcome as it is an issue that has received inadequate attention yet. Related party transactions (RPTs) tend to pose a significant risk where there are controlling shareholders. The current trend of reforms has been to leave RPT oversight largely to audit committees who focus on RPTs from an accounting and disclosure standpoint. It is no surprise that even the definition of RPT is drawn from the accounting standards (AS-18). More is required. There should be a clear, independent and impartial process for approval of RPTs. To that extent, the White Paper does well to focus on matters such as giving independent shareholders the power to approve large transactions and requiring the appointment of an independent financial advisory and an independent board committee to determine whether the transactions are fair and reasonable to all shareholders. While the concept of independent shareholders has not received much recognition in India (please see a previous discussion on this concept), the requirement of “pre-approval” of RPTs by the audit committee had been suggested by the CII Task for on Corporate Governance, but has not yet been accepted by the Government (at least not in the Voluntary Guidelines 2009).

3. Preferential Warrants: Recognising that this is a stark form of perpetuation of control in companies, the White Paper calls for a prohibition on issue of warrants or other securities to promoters and connected persons.

4. Corporate Disclosure: Suggestions have been made for streamlining the scope and timing of various corporate disclosures so as to bring about greater certainty and transparency. SEBI has already taken some steps in this direction.

5. The Auditing Profession: The White Paper calls for removal of caps on number of audit trainees and audit partners, and encourages consolidation of firms. It also seeks the establishment of an independent regulatory body for the audit profession.

Update – January 21, 2009: I was also pleased to note that Jayant Thakur’s post on this Blog titled Issue of Banning Share Warrants to Promoters – SEBI order finds mention in the White Paper at page 34.

Supreme Court Rejects NBFC Claim on Sticky Interest - Part I

noreply@blogger.com (V. Niranjan) — Sun, 17 Jan 2010 17:07:00 +0000

Non-banking-financial institutions (“NBFCs”) face a serious setback after the judgment of the Supreme Court this Monday (11 January 2010) in Southern Technologies Ltd. v. JCIT. This blog has discussed a long-standing controversy in Indian law on the treatment of “sticky” advances. It is useful to briefly recapitulate the contours of this controversy before considering the impact of the Supreme Court’s judgment in Southern Technologies. Four circumstances are relevant in this connection – the jurisprudence of the Supreme Court on the “real income theory”, a set of circulars issued by the CBDT on the treatment of “sticky” interest, the provisions of the Income Tax Act, 1961, and directions issued by the RBI in 1998 on the treatment of NPAs.

Of the entire sum of money that is lent to various borrowers by banks and NBFCs, a significant part of the interest payable is considered “sticky”, for it represents interest on principal that is unlikely to be recovered, and which the borrower has not serviced for some length of time. Under certain circumstances, these sticky advances are considered “Non-Performing Assets” (NPA) and in other cases, are written off entirely as bad debts. The latter case presents no difficulty, since a bad debt is a deductible business expenditure, provided it is written off bona fide. However, assessees argued that sticky loans do not constitute “income” in the first place, and relied for this purpose on the “real income theory”, which posits that the classification of a receipt as an income must bear some relationship to commercial reality. In 1952, the CBDT issued a circular clarifying that interest entered in the suspense account by an assessee is not part of total income, because of the “extreme unlikelihood” in recovering the principal. This circular was withdrawn in 1978. In 1986, the Supreme Court, in State Bank of Travancore v. CIT, partly relied on this withdrawal to hold that the real income theory does not support the proposition that sticky interest is non-taxable. However, the CBDT, in 1984, had issued another circular clarifying that interest on loans that have not been repaid for three successive years is not taxable. As the Court in SBT had not noticed this circular, the case was overruled in 1999, and again in 2006. However, what is significant is that this was not an unqualified approval of the real income theory, but rather a decision that the particular circulars applied to banks to the extent specified in those circulars.

A series of retrospective amendments to the Income Tax Act added to the lack of clarity in this area. S. 36(1)(vii) of the Act originally provided that the amount of any bad debt written off in the accounts of the assessee as irrecoverable is a deductible expense. However, an Explanation was added to this provision in 2001 with retrospective effect, providing that this does not include a “provision” for bad debts. In 1997, an amendment with retrospective effect from 1989 added clause vii(a), which provided that a scheduled bank could deduct provisions for bad and doubtful debts upto a specified percentage. S. 43D was also amended in 1999 to provide that income in relation to categories of bad and doubtful debts prescribed by the Reserve Bank of India are chargeable to tax only when the income is actually received by the scheduled bank or credited to the Profit & Loss account in its books. Notably, neither s. 36(1)(viia) nor s. 43D applies to NBFCs. To complete the account of the circumstances that led to Southern Technologies, it is relevant to refer to what turned out to be the crux of the controversy – the effect of the 1998 directions of the RBI. In these Directions, the RBI defined an NPA as “any asset in respect of which interest has remained due for more than six months”, and directed NBFCs to recognise these assets as income only when income is actually received. By virtue of s. 45Q of the RBI Act, these Directions override all laws to the contrary.

In Southern Technologies, NBFCs relied on all these circumstances to challenge the taxability of NPAs and other sticky assets. In particular, assessees argued that the beneficial provisions of s. 36(1)(viia) and s. 43D must be construed to be applicable to NBFCs as well, and that confining their application to banks violates Art. 14 of the Constitution. In short, NBFCs contended that they were on exactly the same footing as banks for the purposes of the treatment of NPAs, and that the differentia between banks and NBFCs in this provision lacks any rational nexus. The assessees also relied on the real income theory to suggest that sticky interest is non-taxable. The Supreme Court rejected all these contentions and held that such income is taxable.

In a subsequent post, I will analyse the decision of the Supreme Court in greater detail, which, with respect, does not appear to be entirely correct. The following is a summary of the decision of the Court:

(a) The RBI Directions do not have any relevance to the treatment of taxable income, for the RBI Act and the IT Act operate in different fields. The RBI Act overrides the Companies Act, 1956, to the extent of presentation of accounts, but does not override the Income Tax Act.

(b) The distinction between banks and NBFCs in ss. 36(1)(viia) and 43D is not violative of Art. 14 of the Constitution.

(c) The “real income” theory requires courts to recognise that a mere provision for bad and doubtful doubts is not a “real” expense that may be deducted.

(d) Section 37 does not apply to cases that fall within s. 36 but are specifically excluded by an Explanation.

This decision appears to have settled the latest chapter in a long-standing and complex controversy on the treatment of sticky interest. I will examine the reasons the court cites in greater detail in a subsequent post.

Relief for Investor Community on “Control” Debate

v.umakanth@gmail.com (Umakanth V.) — Sun, 17 Jan 2010 11:43:00 +0000

Background

Under the SEBI Takeover Regulations, there are two methods by which an acquirer could be obligated to make an open offer to the public shareholders of a listed target company. The first is when the acquirer acquires shares or voting rights beyond certain defined thresholds (as contained in Regulations 10 and 11, with the initial threshold being 15%). The second is when the acquirer acquires “control” over the company, whether or not it acquires shares or voting rights of the company (in terms of Regulation 12).

Financial investors such as private equity investors and sometimes venture capitalists tend to invest minority stakes in listed companies in transactions usually referred to as PIPEs. If the investment exceeds 15%, as it often does, the investors are required to make an open offer under the Takeover Regulations. Moreover, in terms of deal structure, such financial investors typically seek protection through specific rights under transaction documentation such as the ability to appoint a nominee director or an observer, quorum rights at board and general meetings and, most importantly, certain supermajority or veto rights whereby the target company cannot undertake certain actions without the prior approval of the investor.

For quite some time, such investors made open offers under Regulation 10 as they exceeded the 15% limit. However, about 5 years ago, SEBI began insisting that such offers should be made under Regulation 12 as well because such investors are deemed to have obtained “control” over the target company by virtue of obtaining several rights under the transaction documents. This came as a complete surprise to the investing community and the corporate lawyers who were advising them. This is because such investors are pure financial investors with no intention of obtaining any control over day-to-day management or other aspects of functioning of the company. Moreover, designating them as persons in “control” could give rise to other unintended consequences (such as designating them as promoters) that may expose them to greater obligations under law and consequent liability. Since then, investors and their advisors have repeatedly made submissions to SEBI arguing that the existence of such negative rights does not amount to control. But, in view of SEBI’s position remaining constant, there had not been much progress towards resolution.

Given this background, the Securities Appellate Tribunal (SAT) passed an order on Friday in the case of Subhkam Ventures that provides considerable succor to investors. SAT has held that protective rights conferred on financial investors, such as board representation, quorum rights and supermajority rights by themselves are inadequate to constitute “control” by the acquirer.

The Subhkam Case

The case involved Subhkam Ventures (I) Private Limited acquiring more than 15% shares in MSK Projects Limited, the target company. Subhkam made the public announcement of open offer under Regulation 10 and filed a draft letter of offer with SEBI, which then required the acquirer to state in the letter of offer that the offer is being made under Regulation 12 as well. This is because the subscription and shareholders agreement entered into among Subhkam, the promoters and target company contained protective provisions in favour of Subhkam. As the issue remained unresolved, the acquirer preferred an appeal to SAT.

At the outset, SAT laid down some general principles on what constitutes “control” in such a situation involving a financial investor. Noteworthy is the distinction being made between proactive power (positive control) and reactive power (negative control):

The term control has been defined in Regulation 2(1)(c) of the takeover code to “include the right to appoint majority of the directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert directly or indirectly, including by virtue of their shareholding or management rights or shareholders agreements or voting agreements or in any other manner.” …
…

Control, according to the definition, is a proactive and not a reactive power. It is a power by which an acquirer can command the target company to do what he wants it to do. Control really means creating or controlling a situation by taking the initiative. Power by which an acquirer can only prevent a company from doing what the latter wants to do is by itself not control. In that event, the acquirer is only reacting rather than taking the initiative. It is a positive power and not a negative power. In a board managed company, it is the board of directors that is in control. If an acquirer were to have power to appoint majority of directors, it is obvious that he would be in control of the company but that is not the only way to be in control. If an acquirer were to control the management or policy decisions of a company, he would be in control. This could happen by virtue of his shareholding or management rights or by reason of shareholders agreements or voting agreements or in any other manner. The test really is whether the acquirer is in the driving seat. To extend the metaphor further, the question would be whether he controls the steering, accelerator, the gears and the brakes. If the answer to these questions is in the affirmative, then alone would he be in control of the company. In other words, the question to be asked in each case would be whether the acquirer is the driving force behind the company and whether he is the one providing motion to the organization. If yes, he is in control but not otherwise. In short control means effective control.

Thereafter, SAT examined the types of specific rights provided to Subhkam under its agreement. First is the right to nominate one director on the board of the target company. SAT held that a single nominee on a board of ten members constitutes a “microscopic minority”, and that the purpose of such nomination is only to provide certain informational rights to the investor rather than any veto rights as such. Second are the “standstill” provisions in the agreement which prohibit the company from carrying out certain actions between signing and closing of the agreement. SAT found that this was a transitional provision with a limited purpose and does not give any control. The third provision relates to quorum rights to the investor. Even here, SAT held that quorum rights by themselves do not confer any veto power on the investor and hence that does not amount to control.

The last, and perhaps most contentious, provision is the supermajority rights under which the affirmative vote of the investor’s nominee on the board is required for the company to carry out any matter among a list of 22 items. These include certain fundamental corporate matters such as amendment to the memorandum and articles, change in share capital, amalgamation, winding up, etc., and also certain matters pertaining to the business such as approval of the business plan, sale of property, appointment of key officials, capital expenditure, etc. Although at first blush this list appears to be quite extensive in nature covering a range of matters involving the company, SAT did not have any hesitation in ruling that these did not constitute control by the investor. Although SAT found that these matters do not cover the day-to-day operation of the company, its logic seems to be premised on the fact that a veto right is only a negative right and does not allow the investor to carry out these actions on its own. In other words, emphasis has been placed on the inability of the investor to carry out any positive acts rather than on the nature of the matters themselves that are on the list of veto items.

Relevance

The importance of this SAT ruling is that it sets to rest an issue that has caused a great amount of consternation amongst investors and their advisors. It now equips private equity funds, venture capitals and other similar venture capitalists from being able to obtain customary contractual rights while undertaking PIPE transactions without the fear of inviting unintended consequences of becoming controllers of the target company. In a sense, the ruling also emboldens the financial investors’ position by a long stretch as it has permitted a great number of supermajority rights that can be included without being in control. A review of the list of 22 veto items in the Subhkam agreement set out in SAT’s order will provide a feel for the magnitude.

It is hard to assume that the last word has been said on the issue. The possibility of an appeal by SEBI cannot be discounted. Considering the importance of this issue, it is also reasonable to anticipate recommendations from the Takeover Regulations Advisory Committee.

Another SEBI Order on Participatory Notes

v.umakanth@gmail.com (Umakanth V.) — Sat, 16 Jan 2010 10:16:00 +0000

About a month ago, we discussed SEBI’s order in the case of Barclays Bank in relation to the issue of participatory notes/ offshore derivative instruments (ODIs). Barclays had been prohibited from issuing, subscribing or otherwise transacting in any ODIs until reporting systems are put in place to the satisfaction of SEBI.

Close on its heels comes another SEBI order, this time involving Societe Generale. SEBI’s case is that Societe Generale failed to provide appropriate information regarding onward issuance of PNs as required under the appropriate SEBI regulations. The transactions are somewhat similar to those in the Barclays case, where the issuance of ODIs was to Hythe Securities Limited in relation to the underlying shares of Reliance Communications Limited. Accordingly, Societe Generale has been ordered not to issue/subscribe or otherwise transact in any fresh/new offshore derivative instrument till such time that it provides correct reporting of these instruments to SEBI.

New Development on Section 14A, Income Tax Act

noreply@blogger.com (Shantanu Naravane) — Tue, 12 Jan 2010 16:53:00 +0000

Several prior posts have discussed the decision of the Special Bench of the Mumbai Income Tax Appellate Tribunal in Daga Capital, on the appropriate interpretation of section 14A of the Income Tax Act. It was also observed that the problem was not so much with the provision per se, as with Rule 8D of the Income Tax Rules, which laid down the computation mechanism for the amount to be considered non-deductible under section 14A. It appears that a Writ Petition (No. 50 of 2010, Indian Exporters Grievances Forum v. CIT) has been admitted today in the Bombay High Court, challenging the constitutional validity of Rule 8D. The hearing on the matter is scheduled for 15^th February.

Another report on this is available here, and good summaries of the position under section 14A and Rule 8D are available here and here.

SEBI moves the Supreme Court over SAT order

noreply@blogger.com (Shantanu Naravane) — Tue, 12 Jan 2010 08:27:00 +0000

An order by the Securities Appellate Tribunal (SAT) in August last year has again stirred the hornet’s nest with respect to the powers of the regulatory bodies, and the resolution of areas of overlap.

S. Kumars Nationwide, is a company listed on the Bombay Stock Exchange (BSE), and engaged in the business of buying selling, manufacturing and marketing of textile products. In a bid to repay loans of around Rs. 850 crore, one of the lenders filed an application with the Corporate Debt Restructuring Cell (CDR), which is a mechanism provided by the Reserve Bank of India for restructuring debts. The CDR approved the proposed restructuring package, in pursuance to which, the promoters pledged the equity shares held by them with the lending bank. Further, one of the promoters of the company, subscribed to preferential shares valued at Rs. 15 crore, to comply with the conditions. Some other promoters were also allotted preferential shares valued at Rs. 5 crore which were then pledged with the lenders. The company filed an application before BSE seeking an in-principle approval for the issue, allotment and listing of these preferential shares to its promoters, which the BSE denied. The company, S. Kumars Nationwide, appealed against this decision of the BSE to the SAT, under section 22A(1) of the Securities Contracts (Regulation) Act, 1956. Exercising this power, the SAT set aside the order, and directed the BSE to grant the approval. It is this exercise of appellate authority by the SAT that is now being challenged before the Supreme Court by the SEBI (news report available here).

The primary basis of challenge is not the merits of the decision, but that the SAT did not have the jurisdiction to exercise the powers that it did. In arriving at its decision, the SAT relied on the SEBI (DIP) Guidelines, which grant powers to the SEBI to make certain determinations. For instance, one of the bases on which the BSE had refused permission was that the issue violated Guideline 13.3.1(f) (dealing with which persons a company can make a preferential issue of equity shares to). The SAT highlighted Guideline 17.2A.1, which allows the Board to grant an exemption from one of the provisions of the Guidelines, ‘on being satisfied that the violation was caused or may be caused due to factors beyond the control of the applicant’. Based on its finding that the company was in breach of Guideline 13.3.1(f) for ‘no fault of its own’, the SAT exercised this power of the SEBI, and rejected this ground of rejection by the BSE.

Now, the SAT admits in its order that they could have remitted the case back to the Board, but that they did not think it necessary to adopt that course in the circumstances, and that they “can issue the same direction and exercise the same powers which the board could”. With respect, I do not think that this approach adopted by the SAT is the most prudent. Admittedly, in the facts at hand, the SAT may have thought it unnecessary to go through the formality of referring the case to the SEBI. However, there are two major arguments against the SAT assuming such a power for itself:

First, on a pure textual reading of the relevant provisions, the Guidelines provide that if the SEBI is satisfied that the violation of a provision is due to factors out of the control of an applicant, it can waive the Guidelines. Thus, the decision is to be made by the SEBI, and the SEBI alone. Admittedly, the SAT would have appellate authority over the decision of the SEBI under section 15T of the SEBI Act. However, there is an essential difference between exercising review over the satisfaction of another authority, and exercising the satisfaction itself. Further, there may be some dispute over whether this satisfaction of the SEBI is administrative or judicial in nature, which would then affect the extent of review which the SAT would have.

Secondly, in continuation of the first argument, such an assumption of power deprives the company of an important stage in the review process. Let us assume, for the sake of argument, that the SAT had concluded that the violation of Guideline 13.3.1(f) was not due to circumstances beyond the control of the company. The only remedy from such a finding would be an appeal to the Supreme Court. On the other hand, if the case had been sent to the SEBI, there is an extra layer of appeal. It is well accepted that an exercise of judicial authority that has the effect of depriving a person of a level of judicial review is impermissible [Garhwal Mandal Vikas Nigam Ltd. (2008 SC) and Bharat Cooking Coal (2008 SC)].

Thus, while the exercise of the power by the SAT may have been expedient, the legality of the order is seems suspect. However, since there is insufficient clarity in this area, the response of the Supreme Court to this issue is indispensable to understand the precise scope of powers of the SEBI and the SAT and other similar regulatory bodies.

Multiplicity of Stock Exchanges

v.umakanth@gmail.com (Umakanth V.) — Tue, 12 Jan 2010 06:35:00 +0000

Usually, stocks are listed on one major stock exchange in a given jurisdiction. For example, a U.S. stock will be listed either on the NYSE or NASDAQ. But, the position in India is different, perhaps for historical and other reasons, where not only there are multiple stock exchanges, but a number of companies are listed on more than one such exchange.

In an interesting column in the Business Standard, Pratip Kar argues that the economic relevance of multiple stock exchanges no longer exists. As Kar notes:

A congenital rather than acquired, idiosyncratic feature of the micro structure of our stock market is that the same security is permitted to be simultaneously listed and traded in more than one stock exchange. Our stock market also has the unique distinction of having the maximum number of stock exchanges in the world, registered with the market regulator — 22 to be precise. Of these, trading used to take place in four stock exchanges, the Bombay Stock Exchange (BSE), the National Stock Exchange (NSE), the Calcutta Stock Exchange (CSE) and the Uttar Pradesh Stock Exchange (UPSE). But from 2005-06, trading in the CSE and the UPSE trickled to driblets, while the share of cash market trading volume of the BSE began to decline rapidly. … But winding up is unlikely to happen, because none of the stock exchanges would be agreeable to pay taxes on the proceeds of the winding up, and neither will the government agree to let go a few hundred crore of taxes.

He notes that “with the introduction of rolling settlement in 2001, and with the derivatives replacing the age-old badla, the differentiation was lost and so was the economic relevance of multiple stock exchanges”. This suggests that there may be merit in having only one or two stock exchanges, so long as that ensures efficiency.

Update – January 13, 2010: On a related note, Sandeep Parekh points to the difficulties created by caps on ownerships in Indian stock exchanges and the consequent governance issues that may give rise to.

Inculcating Business Ethics

v.umakanth@gmail.com (Umakanth V.) — Tue, 12 Jan 2010 06:32:00 +0000

Following the financial crisis, there has been a reconsideration of the manner in which business schools have been imparting education. Questions are being raised as to whether alternate methods of business education could have modified some of the ethical and behavioural traits that may have fuelled the crisis. In this scenario, an article in the New York Times provides an interesting perspective, showing how business schools are moving towards a liberal arts type of curriculum. The following is what it calls a “radical idea in business education” in order to broaden horizons:

… that students needed to learn how to think critically and creatively every bit as much as they needed to learn finance or accounting. More specifically, they needed to learn how to approach problems from many perspectives and to combine various approaches to find innovative solutions.

Here is a flavour of the changes occurring:

As a result, a number of prominent business schools have re-evaluated and, in some cases, redesigned their M.B.A. programs in the last few years. And while few talk explicitly about taking a liberal arts approach to business, many of the changes are moving business schools into territory more traditionally associated with the liberal arts: multidisciplinary approaches, an understanding of global and historical context and perspectives, a greater focus on leadership and social responsibility and, yes, learning how to think critically.

Another notable example is the increased focus on corporate social responsibility among business educators.

Nevertheless, not all are optimistic about the impact such moves can make:

Will any of these changes have a big role in preventing future economic crises? Opinions here are more mixed. If businesses’ pay systems keep rewarding short-term, high-risk or narrowly focused behavior, many say, what business programs teach is unlikely to have much impact.

Beyond business education is a related effort – a recent newsreport points to the effort by Global Business Oath, an initiative of the Young Global Leaders of the World Economic Forum, that has drafted a pledge to be taken by business school graduates and entrepreneurs in order to instill moral and ethical values in the conduct of business. Although it may be criticised as being purely symbolic, it nevertheless represents a change in mindset.

As far as legal education is concerned, it already takes into account a liberal arts approach. Moreover, legal ethics is usually mandated in the curriculum. Although many of the issues discussed above do not directly impact legal education, there are certainly lessons to be learned as far as corporate and business laws are concerned. Fortunately, legal education too seems to have caught up with this trend with increasing visibility on issues such as corporate social responsibility and sustainable development. Even though these are yet to be firmly embedded in the Indian law school curricula, it is only a matter of time before that happens.

Relaxation in Short Selling Norms

v.umakanth@gmail.com (Umakanth V.) — Sat, 09 Jan 2010 10:40:00 +0000

SEBI has introduced changes to the securities lending and borrowing (SLB) framework which may help uplift the market for short sales. The contract tenure for SLB has now been increased to 12 months. The Economic Times notes the rationale:

SLB was introduced in April 2008, starting with a contract tenure of seven days. With hardly any interest from market participants in the product, the regulator increased the tenure to 30 days in November that year. But even that has not helped in attracting investors to the SLB window.

But, whether this set of reforms will achieve the intended results is not clear. It has been observed that other obstacles continue to exist in this market: stringent margin norms, and a restriction that confines borrowing and lending to the stock exchanges.

Internal Audits for Credit Rating Agencies

v.umakanth@gmail.com (Umakanth V.) — Sat, 09 Jan 2010 10:10:00 +0000

The role of credit rating agencies has been the subject-matter of discussion ever since the sub-prime crisis erupted, and the industry has been subjected increased scrutiny and regulation. However, much of that has not affected India, and there has been no serious overhaul of the system regulating rating agencies in India. SEBI, in its recent annual report observed as follows (on page 18):

The poor performance of these agencies, especially in the context of the East Asian financial crises and the sudden collapse of Enron, has brought renewed criticism of their methods, their regulatory status and their role in financial markets. Following recent sub-prime crisis, there is a world wide demand for tightening regulations for CRAs. Though the recent crisis has not impacted India as much as it did others, there is a need to learn from their experiences.

One measure recently introduced by SEBI though is that credit rating agencies will be required to conduct an internal audit on a half-yearly basis that covers all aspects of operations and procedures. This appears to be a form of self-regulation in order to enhance standards. Some news reports on this development are available here and here.