INDIAN CORPORATE LAW

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.

QFI Investments in Indian Stock Markets

noreply@blogger.com (V. Umakanth) — Sat, 07 Jan 2012 11:11:00 +0000

With a view to creating further depth in the Indian capital markets and attracting greater foreign investment, the Government has provided another avenue for foreign investors to participate in the stock markets. Until now, the portfolio investment route (i.e. buying and selling on the stock exchange) was available only to two types of foreign investors, i.e. foreign institutional investors (FIIs) registered with SEBI and non-resident Indians (NRIs). However, last year, qualified foreign investors (QFIs) were allowed to invest directly in Indian mutual fund schemes.

Now, the Government has announced (through a press release dated January 1, 2012) that QFIs will be permitted to invest directly in the Indian capital markets. The rationale for this decision has been set out as follows:

Foreign Capital inflows to India have significantly grown in importance over the years. These flows have been influenced by strong domestic fundamentals and buoyant yields reflecting robust corporate sector performance.

In the present arrangement relating to foreign portfolio investments, only FIIs/sub-accounts and NRIs are allowed to directly invest in Indian equity market. In this arrangement, a large number of Qualified Foreign Investors (QFIs), in particular, a large set of diversified individual foreign nationals who are desirous of investing in Indian equity market do not have direct access to Indian equity market. In the absence of availability of direct route, many QFIs find difficulties in investing in Indian equity market.

As a first step in this direction, QFIs have been permitted direct access to Indian Mutual Funds schemes pursuant to the Budget announcement 2011-12. As a next logical step, it has now been decided to allow QFIs to directly invest in Indian equity market in order to widen the class of investors, attract more foreign funds, and reduce market volatility and to deepen the Indian capital market.

Certain checks and balances have been introduced as well. For example, QFIs include only individuals, groups or associations that are resident in a foreign country which complies with requirements of the Financial Action Task Force (FATF) and is a signatory to IOSCO’s multilateral MoU. The QFIs can invest through SEBI registered qualified depository participants (DPs) who must ensure that applicable KYC requirements are met. There are also quantitative investment limits for QFIs, being 5% (individual) and 10% (aggregate) in the paid up share capital of an Indian company.

The Government’s press release appears to be an expression of regulatory intention. The details are to be contained in circulars expected to be issued by SEBI and RBI by January 15, 2012.

This is likely to attract greater foreign investment into the markets as it provides an additional avenue for investors. The current regime for FIIs requires registration with SEBI and compliance with all the requirements under the SEBI FII Regulations, which is often considered onerous. The new proposal appears to rely more on self-regulation through DPs. It remains to be seen whether there would be a gradual migration of FII investment into the QFI route if the latter confers possibilities for regulatory arbitrage. This will become clear only when the operational circulars are issued by SEBI and RBI, and the detailed requirements are known.

This analysis over at VC Circle contains a further discussion of the implications of this move.

Guest Post: Avoiding litigation under Section 11 of the Arbitration Act

noreply@blogger.com (V. Niranjan) — Wed, 04 Jan 2012 17:08:00 +0000

(In the following post, Ms. Renu Gupta, Advocate, discusses ways to avoid protracted section 11 litigation)

There is much litigation in courts under Section 11 of the Arbitration and Conciliation Act, 1996 (hereinafter, “A&C Act”), on appointment of arbitrators. Often, the party resisting the arbitration exploits all its might to stall the appointment of arbitrator, which can easily last a few years. A real threat of rising litigation costs is used to politely arm-twist a weaker party into a settlement, even if the latter has a genuine claim.

This post is aimed at attempting to propose a solution, in order to expedite the actual arbitration proceedings. The solution is Section 11 of the A&C Act, which is the cause of the entire problem as well.

Section 11(2) of the A&C Act provides that the parties are free to agree to the procedure for appointment of arbitrators. It is only in the absence of an agreement between the parties over a procedure, or failure to act according to the agreed procedure, that one of the parties can approach the court for appointment of the arbitrator.

Therefore, the parties are free to agree that if upon expiry of a definite time period, from receiving a request for appointment of an arbitrator, the other party does not appoint its own arbitrator, the former’s arbitrator shall act as a sole arbitrator. This procedure obviates a situation where one party will have to approach the court for appointment of arbitrator. It is a very practical provision, which seems to have been completely ignored in India.

A similar provision, although more clear and elaborate, exists in Section 17 of the English Arbitration Act, 1996.

Relevant portion of the model arbitration clause under London Maritime Arbitrators Association Terms, incorporating the essence of this provision, reads as follows:

“The reference shall be to three arbitrators. A party wishing to refer a dispute to arbitration shall appoint its arbitrator and send notice of such appointment in writing to the other party requiring the other party to appoint its own arbitrator within 14 calendar days of that notice and stating that it will appoint its arbitrator as sole arbitrator unless the other party appoints its own arbitrator and gives notice that it has done so within the 14 days specified. If the other party does not appoint its own arbitrator and give notice that it has done so within the 14 days specified, the party referring a dispute to arbitration may, without the requirement of any further prior notice to the other party, appoint its arbitrator as sole arbitrator and shall advise the other party accordingly. The award of a sole arbitrator shall be binding on both parties as if he had been appointed by agreement.”

This is a useful provision, which could be used while drafting an arbitration clause, in order to avoid a situation where a genuine arbitration claim is stalled under Section 11 of A&C Act.

I am uncertain whether this provision for default appointment of arbitrator has ever been tested in courts in India (I would be grateful if someone could bring to my attention a decision where it has been tested). It would be interesting to see whether our courts adopt a non-interventionist approach or indulge in some ingenuous attempts to exercise jurisdiction.

2011: Year in Review (Income Tax)

noreply@blogger.com (Mihir Naniwadekar) — Wed, 04 Jan 2012 12:00:00 +0000

The year 2011 was in the news (insofar has tax issues are consult) mainly due to a few high-profile matters in the Supreme Court. The public interest litigation relating to black money (Ram Jethmalani v. Union of India) and the hearing in the Vodafone case are few examples of this. In terms of legal issues however, 2011 saw a number of far-reaching decisions of the courts which may not have been as much in the public eye.

The decision of a Constitution Bench in GVK Industries confirms that the doctrine of territorial nexus applies to Union Laws as well. The Constitution bench, however, did not lay down any principles beyond what had already been laid down by three judges in Electronics Corporation.

Arguments in the Vodafone case concentrated on issues surrounding the planning/avoidance/evasion debate. Several High Courts have also weighed in with their pronouncement on this issue. The Punjab High Court in a Full Bench decision in CIT v. Rockman Cycle Industries, confirmed the assessee’s understanding of the Azadi-McDowell relationship; and confirmed that roving enquires into economic realities at the cost of legal substance are not permitted in law. The Karnataka High Court however, in Richter Holding’s case, left a rather broad window open to the Revenue in cases related to lifting of the corporate veil. In Aditya Birla Nuvo, the Bombay High Court came down heavily on what it saw as an abuse of the Mauritius Gateway. Azadi Bachao Andolan was distinguished, and this decision (also pending appeal before the Supreme Court) has the potential to increase uncertainty in the minds of investors. One way to reduce the uncertainty surrounding tax issues in foreign investment has always been in the form of making an application for an advance ruling. Previously, the AAR has been sympathetic to the effective use of treaty benefits (for instance, in E-Trade Mauritius). However more recent advance rulings create some difficulties even in this regard. The AAR relied on Section 245 R (2), proviso-(iii) (which states that the authority shall not allow any application relating to an issue which is design for the avoidance of tax) and also made several observations tending to blur the ratio of Azadi. It appears that the tax payer shall have no repose until the Supreme Court conclusively decides the matter. One hopes that the Supreme Court in Vodafone will provide definite guidance in this regard.

The other burning issue for the past couple of years has been that of whether payment for supply of off-the-shelf software amounts to royalty. A few years ago, it appeared that the issue seen settled at the tribunal level, where in several well-considered judgments (for instance, Sonata) had held that there is a distinction between ‘copyright’ and ‘copyrighted articles’. Consequently, it was held that payment for supply of software would ordinarily be a payment for use of ‘copyrighted article’ and not ‘copyright’. Hence, it would not amount ‘royalty’. However, the past year saw divergences among various tribunal benches resurface. Matters were carried to various High Courts, but certainty once against continues to elude the assessee. The Karnataka High Court decided in favour of the department in Samsung, the Delhi High Court decided the issue against the department (DIT v. Ericsson). The Bombay High Court has admitted appeals on this issue as involving a substantial question of law.

In so far as the issue of deemed dividend is concerned, the issue was decided in favour of the assessee by the tribunal in Bhaumik’s case. Bhaumik was approved in passing by the Bombay High Court; however the same High Court has since admitted departmental appeals, thus signifying that the issue is not yet completely resolved. Decisions of the other High Courts in the past year (CIT v. National Travel Services, CIT v. Ankitech) also do not conclusively point to one out-come.

In procedural matters, particularly on the issue of reopening U/s. 148, assesses had found relief in a Full Bench decision in Kelvinator’s case (256 ITR 1, subsequently approved by the Supreme Court). However the Bombay High Court in Indian Hume Pipe and the Delhi High Court in Dalmia Private Limited have perhaps strengthened the arms of the department in reopening completed assessments, whether within or beyond four years. In Indian Hume Pipe, the Court held (in the context of a reopening beyond four years), “The full and true disclosure which the statute contemplates must be judged in the context of Explanation 1 to Section 147. The assessee cannot merely rely upon the fact that if the Assessing Officer had followed an enquiry with due diligence on the basis of the account books or other evidence produced by the assessee, he could have discovered material evidence. The mere production of account books or other evidence from which material evidence could with due diligence have been discovered by the Assessing Officer does not necessarily amount to a disclosure within the meaning of the first proviso to Section 147… The assessee did enclose copies of the certificates which do bear the date of allotment. However, in our view, it is evident that the Assessing Officer had clearly not applied his mind to the question…”

Another important issue, one which was decided against the assessee, is the issue of whether non-compete fee payments are deductible revenue expenditures. The Delhi High Court in Pitney Bowes v. CIT approved the Special Bench decision in Tecumseh case. It is submitted that neither Tecumseh nor Pitney Bowes lay down an absolute proportion that non-compete fees are always capital expenditure. The issue is a mixed question of law and fact: useful reference can be made to the Delhi High Court decision in Eicher’s case 302 ITR 349. On the point of whether non complete receipts are taxable, the Supreme Court in Guffic’s case has held that Section 28(va) inserted with effect from 1-4-2003 is not retrospective. However, the scope of Section 28(va) itself does not appear to have been specifically considered by the higher judiciary (except in stray observations).

There is greater clarity, however, on at least one issue, that is the issue of treatment of subsidies. The effect of the decisions of the Supreme Court in Sahney Steel and Ponni Sugars is that the purpose behind the subsidy must be examined. If the subsidy is to increase day-to-day profitability, it is a revenue receipt. One issue remained to be answered – i.e. whether a subsidy given after completion of construction can also be treated a capital receipt. In Ponni Sugars, the Court had held that what matters is the substance and essence. The form is not material. However on the facts of Ponni Sugars, the subsidy was meant for repayment of a loan taken for construction purposes only. In Chaphalkar Brothers, the Bombay High court had to decide whether a subsidy given in the form of entertainment duty rebate (given after completion of construction, and with no conditions as to user of the amount) would also be treated as a capital receipt. The revenue argued that in the absence of a condition that the subsidy is to be used solely for making repayments of loans taken for capital purposes, the subsidy must be treated as tending to increase the day-to-day profitability. The court held that the subsidy would be a capital receipt, on the basis that the purposes of the subsidy in that case was stated to be for the promotion of the multiplex industry. It appears that the end-user of the subsidy amount is only one factor which would indicate the true purpose of the subsidy. It is a not a conclusive factor. If it is established on facts that the subsidy is otherwise for capital purposes, the principle in Ponni automatically applies and it is immaterial that there is no condition relating to end-use.

The above cases are in no manner exhaustive of the several issues which have been decided in the preceding year. In sum, though, 2011 was a year where a few tax cases made headlines; yet, behind the public gaze, issues continue to simmer and give more food for thought.

An Unfortunate Judgment: India and the Law of Restitution for Unjust Enrichment

noreply@blogger.com (V. Niranjan) — Mon, 02 Jan 2012 07:07:00 +0000

The law of restitution for unjust enrichment* is so well developed in the common law world today that it is impossible to conceive of a coherent system of private law without it. In India, a part of this area is codified in sections 68-72 of the Contract Act, 1872, and some outstanding judgments of the High Courts, particularly before and around the 1950s (see for example Damodara Mudaliar v Secretary of State for India, Nallaya Goundar v Ramaswami Goundar and Maniagaran v Maniagaran), contain valuable accounts of how, if at all, the common law principles have been modified by the Indian legislature. It is therefore especially unfortunate that this branch of the law has subsequently not developed in India as one might have expected; and the recent judgment of the Supreme Court in Nagpur Golden Transport v Nath Traders, with respect, may not be fully correct insofar as these issues are concerned.

Perhaps the best exposition of the law of unjust enrichment is to be found in the work of the legendary Professor Peter Birks, and an interested reader may also find it helpful to refer to the comprehensive textbooks in the field (such as Burrows and Virgo). Two features sharply distinguish a claim in unjust enrichment from a claim in contract or tort – one, that it is founded neither on consent nor on wrongdoing, and secondly, that it is concerned not with compensating the loss the claimant has suffered (unlike compensation for breach of contract or damages for a tort), but with “disgorging” the gain the defendant has made “at the claimant’s expense”. It is, therefore, as Professor Birks puts it in his famous “map” of private law, an “independent causative event” that consists of four elements: (i) enrichment of the defendant; (ii) at the expense of a claimant; (iii) an unjust factor and (iv) defences, such as change of position. While the scope and correct interpretation of all of these elements are a source of considerable controversy, it is safe to say that the traditional insistence of the English and other common law courts on an “unjust factor” is what separates the common law’s approach from the civilian approach. In the common law, an “unjust factor” is a recognised reason for or basis of granting restitution to the claimant – the English courts have repeatedly emphasised that “unjust enrichment” is not just any enrichment that appears to be “unjust” or “unfair”, but enrichment that is founded on a judicially recognised unjust factor. These unjust factors are, without attempting to be exhaustive: (i) mistake (this is the archetypal unjust factor); (ii) undue influence and duress and (iii) failure of consideration. There are other unjust factors, such as ignorance/powerlessness, free acceptance, Woolwich claims, contribution/reimbursement etc., whose existence or characterisation is contested by some. It is axiomatic, therefore, that a claimant cannot obtain restitution for unjust enrichment simply by demonstrating that the defendant has been enriched and that this is “unfair” or “unjust” on the facts of the case or by “balancing the equities”. The unjust factor is as distinctly a question of law as is establishing in a negligence claim that there was a duty of care, or in a breach of contract claim that there was a valid contract. The word “unjust” should not be taken to suggest otherwise.

In Nagpur Golden Transport, the facts were that a consignor entered into a contract with a carrier (Nagpur Golden Transport, NGT) to transport and deliver monoblock pumps to the consignee. The consignee had paid the consignor the price of these pumps, Rs. 3,61,000. As a result of an accident involving the vehicle in which NGT carried these goods, the pumps were damaged and the consignees refused to take delivery. NGT accordingly returned the 198 damaged pumps to the consignor. The consignee then brought a claim, not against the consignor, but against NGT, in the Consumer Forum, Gwalior, alleging negligence. This claim succeeded and NGT was directed to pay a sum of Rs. 3,61,000 (representing the payment made by the consignee), plus damages and interest. In its appeal to the Supreme Court, the question was whether, in view of its payment of this sum to the consignees, it was entitled to demand that the consignor return the 198 pumps which NGT had delivered to it on the consignee’s rejection of the goods.

At first sight, the “justice” of NGT’s case is powerful: after all, it does not seem right that the consignor retains the 198 pumps (the goods sold) as well as the Rs. 3,61,000 (the sale proceeds) or that in effect NGT had paid the consignee what in truth was the liability of the consignor (assuming that the consignee was entitled to reject the goods as defective). Yet, on closer analysis, there are considerable difficulties: for one, even assuming that the first and second elements of a claim in unjust enrichment are satisfied (enrichment and “at the expense of”), there is no obvious unjust factor that is attracted – NGT did not return the 198 pumps to the consignor under a “mistake”; nor was there a “failure of consideration” unless it is said that the “basis” of the return of goods was that the NGT would not be liable to the consignee. It may also be that NGT had “discharged” a “debt” owed by the consignor to the consignee in respect of the defective goods and that this was sufficient for it to claim in restitution from the consignor. In both of these cases, however, the Court would have had to consider difficult questions of law; in the first case the true scope of the unjust factor of failure of consideration and in the second whether it is at all possible for X to discharge A’s debt to B without A’s consent, and even if it is, whether “free acceptance” is a recognised unjust factor. If the Court had answered either question against the claimant, it would have had to reject the claim, no matter how “unfair” or “unjust” it appears to allow NGT what appears to be a windfall.

The Supreme Court decided that the consignor was liable to either return the 198 pumps to NGT or pay its realisable value. It gave the following reasons:

If the damaged monoblock pumps are not returned by respondent No.3 to the appellant or if the value of the damaged monoblock pumps realized by respondent No.3 are not paid to the appellant, respondent No.3 would stand unjustly enriched. To quote Lord Wright in Fibrosa Spolka Akcyjna v. Fairbairn Lawson Combe Barbour Ltd. [(1942) 2 ALL ER 122 (HL)]:"......Any civilized system of law is bound to provide remedies for cases of what has been called unjust enrichment or unjust benefit, that is, to prevent a man from retaining the money of, or some benefit derived from, another which it is against conscience that he should keep. Such remedies in English law are generically different from remedies in contract or in tort, and are now recognized to fall within a third category of the common law which has been called quasi-contract or restitution.”

It is submitted, with great respect, that this analysis is not persuasive. For one, the Supreme Court did not consider what the unjust factor (if any) might be; nor did it, with respect, apply Lord Wright’s observations accurately. Far from holding that any enrichment that appears to be unjust on the facts of the case attracts the principle of unjust enrichment, Lord Wright’s observations in Fibrosa v Fairbairn actually represent a landmark in the English law of unjust enrichment, for it was this case that discarded what has subsequently been called the “heresy” of Chandler v Webster [1904] 1 KB 493, in which Collins MR had held that “consideration” for the purposes of failure of consideration is to be understood as “consideration” in a contractual sense, with the result that there is no failure of consideration even when a contract is frustrated (because the “promise” to perform has not failed; only the performance of the promise has). In Fibrosa, Lord Wright recognised that “consideration” for the purposes of the law of unjust enrichment normally refers to failure of the performance of the promise (as opposed to the promise itself), and it is a passage from this speech that the Supreme Court has quoted above. However, in Fibrosa, there clearly was a failure of consideration since a contract had been frustrated, whereas in Nagpur Golden Transport, failure of consideration could not have been invoked unless it was shown that the “basis” or “purpose” (construed objectively) of the delivery of goods by NGT to the consignor was that the consignor would return those goods in the event NGT found itself liable to pay damages to the consignee. Since the matter has now been remanded to the Consumer Forum on a question of fact, it appears that the Supreme Court has approved a claim in unjust enrichment without finding that there is an unjust factor, which, with respect, is not correct.

We wish our readers a happy new year.

* It is necessary to use the expression “restitution for unjust enrichment” to distinguish it from “restitution for wrongs” ie cases in which the remedy is still gain-based, but founded on a wrong as opposed to unjust enrichment.

The Court of Appeal on the illegality defence

noreply@blogger.com (Shantanu Naravane) — Thu, 29 Dec 2011 14:58:00 +0000

The role of illegality as a defence to a claim for damages has always been the subject of much debate. There are two principal rationales that can be proposed for illegality being a defence: (a) that the claimant cannot be allowed to rely on his illegal conduct (reliance-based rationale); and (b) that allowing the claim will result in stultifying the law which rendered the claimant’s conduct illegal (stultification/policy rationale). To take a concrete example, let’s assume that A pays B on the assumption that B has it in his power to ‘arrange’ a knighthood for A. If B subsequently fails to deliver, or if A discovers that B never could have arranged such a knighthood, can A claim damages from B? The English High Court in Parkinson v College of Ambulance held not, and seems clearly right. However, what is debatable is whether the claim is denied because A, in making the claim, necessarily must rely on his being party to an illegal act; or because allowing A to recover the amount would stultify the law rendering the procurement of knighthoods illegal. Over the last few years, English courts appear to have moved from the reliance-based rationale to the policy rationale for illegality as a defence. This was also recognized and affirmed by the latest report of the Law Commission of England on illegality, where it observed that legislative reform was not necessary since the policy rationale was gaining judicial ground.^*

A recent decision of the Court of Appeal in Delaney v Pickett again revisited the issue of illegality as a defence to a civil claim. The claim was by the passenger of a car against the driver, for damages caused by negligent driving. However, since the purpose of the journey in this case was the collection and transportation of illegal drugs for subsequent re-sale, the High Court denied recovery. The High Court judge held that since the negligent driving occurred during the course of an illegal activity, it arose ‘directly ex turpi causa’, and hence no claim could lie. The judge also observed that “the conduct upon which the Claimant was engaged in concert with the first Defendant was sufficiently anti-social that public policy prevents him from pursuing a claim arising out of it”.

On appeal, the Court of Appeal considers two important cases on the meaning of ‘directly’ when used in conjunction with ex turpi causa. In Pitts v Hunt, the claim was by the injured pillion passenger on a motorcycle being driven by his friend, both of them drunk, and deliberately driving in a manner designed to frighten others. The Court held that since the pillion passenger was party to, and encouraged the negligent and reckless driving, he could not claim damages for injuries suffered by him from such driving. Dillon LJ observed that what was important was not the seriousness of the illegality, but the connection between the illegality and the injury sought to be compensated. In his words, “Where the plaintiff's action in truth arises directly ex turpi causa, he is likely to fail … Where the plaintiff has suffered a genuine wrong, to which allegedly unlawful conduct is incidental, he is likely to succeed”. This causal view of the ex turpi causa rule was further explained by Lord Hoffman in Gray v Thames Trains Limited, where he observed:

It might be better to avoid metaphors like "inextricably linked" or "integral part" and to treat the question as simply one of causation. Can one say that, although the damage would not have happened but for the tortious conduct of the defendant, it was caused by the criminal act of the claimant? Or is the position that although the damage would not have happened without the criminal act of the claimant, it was caused by the tortious act of the defendant?

Lord Hoffman held that if the criminal act of the claimant caused the injury, no claim would lie. But if the tortuous act caused the injury, even if the tortuous conduct was occasioned by the criminal activity, a claim would still lie.

Relying on this passage from Gray, Ward LJ in Delaney v Pickett holds that,

We are not concerned with the integrity of the legal system. We do not need to ask whether the claim would be an affront to the public conscience. There is no need for an analysis of the pleadings to establish whether or not the claimant is relying on his illegality to found his claim. It is not a question of the claimant profiting from his own wrongdoing. Here the crucial question is whether, on the one hand the criminal activity merely gave occasion for the tortious act of the defendant to be committed or whether, even though the accident would never have happened had they not made the journey which at some point involved their obtaining and/or transporting drugs with the intention to supply or on the other hand whether the immediate cause of the claimant's damage was the negligent driving. The answer to that question is in my judgment quite clear. Viewed as a matter of causation, the damage suffered by the claimant was not caused by his or their criminal activity. It was caused by the tortious act of the defendant in the negligent way in which he drove his motor car. In those circumstances the illegal acts are incidental and the claimant is entitled to recover his loss. (emphasis supplied)

The underlined lines from the passage are clear support for the growing body of judicial and academic opinion that reliance by the claimant on his illegal act is immaterial to the applicability of the illegality defence. However, the passage is unclear as to whether the policy-based rationale is always applicable. The suggestion appears to be that the only question to be asked on the facts of this case was one of causation. While that is certainly one of the important questions to be answered, it is doubtful whether it can be conclusive. In Gray, the claimant, who had suffered post-traumatic stress disorder caused by a train accident, killed a person due to the disorder and was convicted of manslaughter. In a claim against the train operator, he also sought damages for loss of earnings after his detention and for loss of his liberty and damage to reputation and for his feelings of guilt and remorse consequent on the killing. It was denying this claim that Lord Hoffman held that since the detention and damage to reputation was caused by his illegal act and not the train accident, no damages would be recoverable. However, that does not suggest that the causal test is determinative of the illegality question. Undoubtedly, it is possible to ‘explain’ the decision in Delaney on policy grounds, given that it is not inconsistent with the stultification rationale. However, the absence of a specific mention of the rationale, and the emphasis placed on the causal view of the ex turpi causa principle suggests that the case was actually not decided on the policy-basis either.

In sum, the role of illegality as a defence to civil claims is still unclear. While the stultification/policy-based rationale appears to have the most appeal, and does explain several of the cases, it does not seem easy to apply and is not universally followed. Delaney is another example where on facts, causation or some other test may be conclusively applied, without reference to the underlying rationale of the illegality defence.

^*The only exception is the landmark decision in Tinsley v Milligan, where the majority held that in the context of presumed resulting trusts, as long as the claimant does not need to rely in his pleadings on the illegality, the claim will succeed. Although Lord Millet in Tribe v Tribe does appear to have narrowed Tinsley to its facts, this narrowing is not very convincing, and is arguably obiter.

Companies Bill, 2011: Layering of Subsidiaries

noreply@blogger.com (V. Umakanth) — Tue, 27 Dec 2011 00:48:00 +0000

It is quite common for companies to be structured in the form of groups. Apart from various operational advantages of separating businesses into distinct entities, it also has the effect of enabling promoters to maintain control over separate aspects of the business. Group structures are prominent in countries where shareholding is concentrated, and the corporate structures in many Asian jurisdictions typify group holdings. Group structures also have certain incidental effects: the possibility of limiting liability to separate entities that may be thinly capitalized so as to adversely affect the interests of third parties dealing with such entities (especially its unsecured creditors such as tortious creditors) and also provide greater scope for related-party transactions that may not be on arm’s length basis thereby enabling promoters to extract greater value from the company to the detriment of the minority shareholders. These are usually addressed by different principles of law: lifting of the corporate veil in order to deal with the unintended consequences of limited liability, and stricter controls on related-party transactions. The Companies Bill, 2011 goes to the extreme of imposing severe restrictions of the ability of companies to operate as groups.

First, the Bill confers powers on the Central Government to prescribe the number of layers of subsidiaries that a specific class of company may have. Second, in terms of making investments, clause 186 of the Bill states that a company cannot make investments through more than two layers of investment companies. An “investment company” is defined as “a company whose principal business is the acquisition of shares, debentures or other securities”. Of course, the Central Government may make exceptions to this rule. Moreover, investments in subsidiaries outside India are excluded from this limit so long as multiple layers of subsidiaries are permitted in the relevant jurisdictions where the subsidiaries are located.

Although there can be no argument against the need for controlling the use of group company structures as they can be subject to abuses, the present proposal for limiting its use altogether goes too far. It is unusual for jurisdictions to impose such absolute curbs on the use of investment vehicles, and this provision in the Bill appears to be somewhat unique even in the international context. This seems to have emanated again from specific episodes witnessed in the past, in this case the stock market scam involving the use of investment vehicles for routing funds back and forth from companies and their promoters, which was the subject matter of a Joint Parliamentary Committee report nearly a decade ago. Again, the severity of these restrictions is arguably a result of individual experiences in specific cases, and a need for legislative reaction to plug gaps identified through those. However, the downside of such legislative approach is that with a view to ensnaring specific abuses it also has the effect of capturing genuine business transactions and corporate structures within its scope thereby curbing the ability of companies to organize themselves more efficiently. This provision, if implemented, is likely to affect investments and acquisitions using layers of subsidiaries, which may otherwise be optimal from various perspectives, including taxation. Although existing corporate group structures are likely to be grandfathered as clause 186 is likely to be implemented only prospectively, it would affect any further changes to existing structure and to the creation of new structures.

These curbs also far exceed the existing method of dealing with group structures, which are generally considered acceptable. The checks and balances currently employed by the law is through lifting the corporate veil, which is possible only in exceptional circumstances, and with the existence of specific grounds that have been established by case law. At a broader level, even the landmark case of Adams v. Cape Industries plc, [1990] Ch. 433, generally recognizes the utility of these structures and does not proscribe them at the outset. Even when it comes to issues of round-tripping of investments and abusive related-party transactions, it is more advantageous to deal with them through existing (or proposed) governance structures such as an independent board or audit committee, obtaining independent shareholder approval, requiring a transfer pricing report by an external gatekeeper, and the like. These principles-based approaches ensure that while genuine transactions are allowed, the abusive ones are reined in. The Bill, however, deals with both genuine and abusive transactions alike, and paints them with the same brush by restricting them. The saving grace, however, is that these are default provisions, and are capable of being moderated by Central Government through rules, and it is hoped that the rule-making process would consider some of these commercial realities and ensure the required flexibility.

Companies Bill: Stalled in Parliament?

noreply@blogger.com (V. Umakanth) — Fri, 23 Dec 2011 04:21:00 +0000

Newspaper reports (here, here and here) suggest that the Companies Bill has run into some rough weather, with indications that it might be referred to the Standing Committee for further review. This is surprising as well as disconcerting, as it comes within a week of the Government presenting the Bill in Parliament.

It represents further delay in the corporate law reform process, which has been taking place in fits and starts for a decade now, with a logical conclusion still being elusive. Granted that there are areas in the Bill that may require fine-tuning, but the approach of holding back the reform process itself is not desirable. Based on the experience with the Standing Committee’s review of the Companies Bill, 2009, it is possible that there could be a significant reconsideration on fundamental issues in case it goes up for review, which could delay the process much further.

In the meanwhile, a corrigendum to the Companies Bill, 2011 has been issued that apparently contains some changes of a substantive nature as well.

In any event, we hope to continue our periodic analysis of the Bill with a touch of optimism.

Guest Post: Arbitration Update

noreply@blogger.com (V. Niranjan) — Wed, 21 Dec 2011 18:23:00 +0000

(In the following post, Ms Renu Gupta, Advocate, discusses recent developments in Indian arbitration law)

This post provides brief updates about some decisions of the Supreme Court of India in the year 2011 (this excludes cases which have already been discussed on this blog such as Yograj case here, and P.R Shah case here), which have made significant contribution to the field of arbitration.

1. State of Goa v. Praveen Enterprises

In a dispute between the parties, Praveen Enterprises invoked arbitration through proceedings under Section 11 of the Arbitration and Conciliation Act, 1996 (hereinafter, “A&C Act”). State of Goa filed counterclaims against Praveen Enterprises.

Praveen Enterprises argued that these counterclaims were not raised by State of Goa, by way of objection to Section 11 proceedings or at any stage prior to filing its counterclaims (pleadings) before the arbitrator. Therefore, these counterclaims were beyond the scope of reference of disputes to arbitration and State of Goa was barred from raising these counterclaims.

The question before the Supreme Court was, “[W]hether the respondent in an arbitration proceedings is precluded from making a counter-claim, unless a) it had served a notice upon the claimant requesting that the disputes relating to that counter-claim be referred to arbitration and the claimant had concurred in referring the counter claim to the same arbitrator; and/or b) it had set out the said counter claim in its reply statement to the application under section 11 of the Act and the Chief Justice or his designate refers such counter claim also to arbitration.

The Supreme Court held that (a) in an arbitration where the tribunal has been constituted by the court, under Section 11 of the A&C Act, the Chief Justice or the designate is not required to draw up the list of disputes and refer them to arbitration; and (b) where the arbitration agreement provides for referring all disputes between the parties to arbitration, the arbitrator will have jurisdiction to entertain all disputes, even though any such dispute was not raised at a stage earlier to the stage of filing pleadings before the arbitrator.

Judicial precedents show that there has been much litigation on this question. The position was different under the Arbitration Act, 1940, where the Court infact “referred” disputes to arbitration. Accordingly, if a party tried to raise a dispute, which was not covered in the reference made by the Court under the old Act, it was considered to be outside the scope of arbitration

Under A&C Act, there is no “reference” of disputes by the Court to arbitration. Therefore, the position under the two legislations is different. In several arbitrations under the A&C Act, lawyers often tried to use the analysis under the old Act to seek ouster of the adversary’s counterclaims. However, this decision finally lays down an unambiguous position, thus closing doors for the erstwhile famous litigation strategy used in arbitration.

[Disclosure – I have participated in an arbitration where the lawyers for the opponents adopted this strategy]

2. Union of India v. Tantia Construction Pvt. Ltd.

This is an interesting case in which despite existence of an arbitration clause in the agreement between the parties, Tantia Constructions went to Court to seek relief under its writ jurisdiction, which relief was granted by the High Court.

The Supreme Court held that an alternative remedy (arbitration in this case) is not an absolute bar to invocation of writ jurisdiction.

In my view, this decision increases the scope for interference by courts, in cases where the parties have agreed to resolve their disputes by arbitration, beyond the scope of interference warranted by A&C Act. In a situation where arbitration proceedings have already commenced, this decision could enable a party to seek interim relief in the form of a writ, from a Court, even though the A&C Act clearly provides for provisions for seeking interim relief from Court under Section 9 and from the tribunal itself under Section 17.

3. Booz Allen Hamilton Inc. v. SBI Home Finance Ltd., (2011) 5 SCC 532

In this case SBI Home Finance had filed a suit for enforcement of a mortgage made in its favour. An application was filed by one of the parties under Section 8 of A&C Act, for reference of disputes to arbitration, since there was an arbitration clause agreed to by the parties. The question before the Court was, whether the dispute relating to enforcement of mortgage was covered within the arbitration clause.

The Supreme Court observed that there are three facets of arbitrability, relating to the jurisdiction of the arbitral tribunal, (i) whether the disputes are capable of adjudication and settlement by arbitration, i.e., whether the disputes, having regard to their nature, could be resolved by an arbitral tribunal or whether they would exclusively fall within the domain of Courts, (ii) whether the disputes are covered by the arbitration agreement, and (iii) whether the parties have referred the disputes to arbitration.

We are only concerned with (i) here.

The Court observed that an agreement to sell or an agreement to mortgage does not involve any transfer of right in rem but create only a personal obligation. Therefore if specific performance is sought either in regard to an agreement to sell or an agreement to mortgage, the claim for specific performance will be arbitrable. On the other hand, a mortgage is a transfer of a right in rem. A mortgage suit for sale of the mortgaged property is an action in rem, for enforcement of a right in rem. A decree for sale of a mortgaged property requires the Court to protect the interests of persons other than the parties to the suit and empowers the Court to entertain and adjudicate upon rights and liabilities of third parties (other than those who are parties to the arbitration agreement). Therefore, a suit for enforcement of a mortgage being the enforcement of a right in rem will have to be decided by Courts of law and not by arbitral tribunals.

The Court held that the scheme relating to adjudication of mortgage suits contained in Code of Civil Procedure, 1908, provides for the procedure prescribed for adjudication of the mortgage suits, the rights of mortgagees and mortgagors, the parties to a mortgage suit, and the powers of a Court adjudicating a mortgage suit. This scheme makes it clear that such suits are intended to be decided by public fora and therefore, impliedly barred from being referred to or decided by private fora, namely an arbitral tribunal.

4. SMS Tea Estates v. Chandamari Tea

In a dispute arising between the parties, from an unregistered lease deed (which was required to be compulsory registered under the Registration Act, 1908), the question before the Court was whether the parties could rely on such unregistered instrument, as evidence before the arbitral tribunal. The Court also discussed the implications, on the arbitration proceedings, of not stamping the main agreement, which contains the arbitration clause.

The Supreme Court held that an arbitration agreement, forming a part of an instrument, which is required to be stamped under the applicable laws, if not sufficiently stamped, has no legal effect. Although, such deficiency can be cured upon payment of insufficient stamp duty and penalty, as may be applicable.

Such an instrument when required to be compulsorily registered under the Registration Act, 1908, and not so registered, can be received as evidence by an arbitrator only for the limited purpose of (i) evidence of a contract in a suit for specific performance, and (ii) evidence of collateral transaction not required to be effected by a registered instrument.

This is an important development, which should caution parties to adequately stamp and register their agreements, as and when required by law, in order to not face a situation where the agreement itself cannot be received in evidence before an arbitral tribunal.

Amendments to Preferential Allotment Rules

noreply@blogger.com (Satyajit Gupta) — Wed, 21 Dec 2011 12:51:00 +0000

(I would like to thank my colleague, Mr. Saiyam Chaturvedi for his invaluable research.)

The Sahara case has led to certain amendments being made to the Unlisted Public Companies (Preferential Allotment) Rules, 2003 (the "Rules"). While the Sahara case itself has seen itself being argued and debated across various judicial fora over the last couple of years, the Government of India has tried to close some of the potential loop-holes through these amendments.

Firstly, the definition of “preferential allotment” under Rule 3(1) of the Rules has been amended. Earlier, the definition of “preferential allotment” included the issue of shares on preferential basis and/or through private placement made by a company and issue of shares to the promoters and their relatives either in public issue or otherwise. This definition has now been amended to mean allotment of shares or any other instrument convertible into shares including hybrid instruments convertible into shares on preferential basis made pursuant to Section 81(1A) of the Companies Act, 1956 (the “Act”). Further, allotment of shares shall not be made to more than 49 persons as per the first proviso to Section 67(3) of the Act. These amendments are clearly inspired by the Sahara case, as (a) there was an issue of Optionally Fully Convertible Debentures in that case, which was adjudged by the judiciary to be 'hybrid instruments', and (b) the SEBI order in the Sahara case held that allotment of such debentures to more than 49 persons ‘on private placement’ basis would be considered a public issue.

Secondly, Rule 4 (Special Resolution) of the Rules has been amended in light of the new definition of “preferential allotment”. Earlier the said Rule 4 stated that no issue of shares on a preferential basis can be made by a company unless authorized by its articles of association and unless a special resolution is passed by the members in a general meeting authorizing the board of directors to make such issue. The amended Rule 4 also encompasses issue of any other instrument convertible into shares including hybrids convertible into shares on a preferential basis.

Finally, a new Rule 8 (Invitation and allotment of securities) has now been incorporated, which sets out a number of conditions which will now apply to preferential allotments. A few key conditions are:

(a) Any offer or invitation not in compliance with section 81(1A) read with Section 67(3) of the Act, will be treated as a public offer and the provisions of the Securities Contracts (Regulation) Act, 1956 and the Securities and Exchange Board of India Act, 1992, will have to be complied with.

(b) No company offering securities will release any public advertisements or utilize any media, marketing or distribution channels or agents to inform the public at large about such an offer [It is pertinent to note that Sahara, through its marketing agents, advertised its issue leading to around 6.3 million subscribers for the debentures].

Companies Bill, 2011: Amalgamation and Corporate Restructuring

noreply@blogger.com (V. Umakanth) — Wed, 21 Dec 2011 06:11:00 +0000

The provisions of the Companies Act, 1956, specifically sections 391 to 394, contain an elaborate framework that enable companies to give effect to arrangements and compromises with their shareholders and creditors. The expression “arrangement” has interpreted to include a wide range of transactions, such as mergers, demergers and other forms of corporate restructuring (including debt restructuring). This framework has largely functioned well, and in fact these provisions have been extensively used by the corporate sector in India, much more so than similar provisions contained in statutes in other countries. The judiciary has also clearly laid out the parameters within which such schemes of arrangement may be initiated, approved by shareholders and creditors and then accorded the sanction of the court. Miheer Mafatlal and Hindustan Lever are landmark decisions of the Supreme Court in that behalf.

The Companies Bill, 2011 seeks to make a number of changes to this framework that are likely to have an impact on mergers and acquisitions (M&A) transactions involving Indian companies. While some of the proposals are intended to make it easier for companies to implement schemes of arrangement, others impose checks and balance to prevent possible abuse of these provisions by companies. Ernst & Young has a nice comparison of the provisions in the Companies Act and the 2011 Bill on matters relating to M&A. In this post I propose to touch upon only some of the key issues.

Court/NCLT

Under the Companies Act, schemes of arrangement are to be approved by the High Court that has jurisdiction over the companies involved. While this ensures an oversight of the scheme and its fairness, there have been concerns regarding possible delays. For example, the average time taken for a scheme to be implemented from start to finish is no less than 6 months, and in several cases the schemes have taken a couple of years to be approved by the High Court. To that extent, the proposal to move the jurisdiction of the High Court in such matters to the National Company Law Tribunal (NCLT) is welcome as that would be a specialized body dealing only with cases under company and related laws thereby introducing elements of timeliness and efficiency. This is not a new proposal, but its introduction had been mired in litigation (R. Gandhi v. Union of India), and the provisions in the Bill appear to be a result of the resolution that emerged from the Supreme Court in the R. Gandhi case.

Objection to the scheme

Currently, any shareholder, creditor or other “interested person” may object to the scheme of arrangement before a court if such person’s interests are adversely affected under it. However, the Companies Bill, 2011 imposes some onerous requirements such that only persons holding at least 10% shares or at least 5% of the total debt outstanding in the company can object to the scheme. While it is understandable that there must be restrictions against frivolous litigation, the current provision operates against minority shareholders and creditors. One of the reasons that the scheme of arrangement route is adopted by companies is that, once approved, schemes can be implemented in a wide manner as it is binding on all affected parties. The binding nature of the scheme is premised on the fact that the court will adjudge on the interests of all parties that may be affected by the scheme. By substantially eroding the power of minority shareholders and creditors to object, that basic premise has been destroyed. This provision requires serious reconsideration.

It is a matter of some relief for minority shareholders, however, that schemes can provide for exit to dissenting shareholders. Even here, it appears that such exit options are available only if the NCLT specifically provides for that, and not automatically on the lines of appraisal rights that are available in similar circumstances in other jurisdictions (such as Delaware).

Accounting and Valuation

As schemes of arrangement tend to have significant implications on matters of accounting and valuation, specific provisions have been made in the Companies Bill. The scheme must comply with accounting standards. This is to ensure that schemes that primarily involve financial reengineering are not entertained by the courts. This concern of the regulators has already been addressed by incorporating such a requirement into the listing agreement, but now that has been provided for in the statute itself so as to apply even to unlisted companies.

The Bill also specifically provides that the report of an expert valuer has to be disclosed to the shareholders. This is significant because a substantial amount of litigation on schemes of arrangement relates to matters of valuation, and consequently the share exchange ratio. There is currently no requirement to obtain expert valuation, although it has now become a matter of practice for companies to obtain at least one, if not two, valuation reports before embarking on a scheme of arrangement so that the valuation can better withstand scrutiny of the court.

Treasury Shares

When there are mergers between companies that have cross-holdings of shares, e.g. between a parent and a subsidiary, the shares that one company holds in the other will typically be cancelled, and no further shares will be issued under the scheme. However, in the last few years, a practice had developed where shares were in fact issued under the scheme by the transferee company to a trust, to be held for its own benefit. The trust could further sell those shares and pay over proceeds to the beneficiary, being the company. The Companies Bill effectively sets at nought this practice, and requires any cross-held shares to be compulsorily cancelled. This provision appears to directly target the recent practice employed in some cases.

Cross-Border Mergers

Under the present dispensation, while foreign companies can be amalgamated into India companies, the reverse is not possible. This has also been accepted by the courts (see Andhra Pradesh High Court in Moschip Semiconductor). Under the Companies Bill, however, there is a proposal to allow cross-border mergers both ways. However, that is possibly only with companies in jurisdictions with which reciprocity has been established, as the Government may notify. This may provide additional stimulus for cross-border transactions.

Short-form Mergers

At present, all mergers, including those between group companies or between a parent and a subsidiary require compliance with the entire process of section 391 and 394, although in certain circumstances courts are willing to make some dispensations from procedural requirements. Under the Bill, certain mergers can follow an out-of-court approach, without requiring the approval of the court or NCLT. These are mergers between two or more small companies (as defined in the Bill) or between a parent and its wholly-owned subsidiary. In these types of mergers, there is greater emphasis on creditors’ interests: the companies must file a declaration of solvency and the scheme must be approved by at least 90% of the creditors or their classes. Although this simplifies the M&A regime to some extent, it may affect only a small number of transactions without much wider impact.

Reverse Mergers

The Companies Bill appears to plug possible loopholes that may allow backdoor listing of companies. A reverse merger of a listed company into an unlisted company may not automatically result in a listing of the resulting entity, unless it goes through the process of a listing through a public offering. Moreover, in case of such a reverse merger, the shareholders of the listed transferor company must be provided an exit at a fair value to compensate for the loss of liquidity.

Other matters

Some other specific issues where the Bill provides for a different treatment are:

- Notice of the scheme must be provided to various government authorities such as the Income Tax Department, SEBI, RBI, Competition Commission, Official Liquidator such that all of their concerns can be heard by the NCLT before sanctioning the scheme. Although these authorities can object before a court even at present, there is no such notice requirement.

- The requirement of majority of shareholders or creditors is 75% in value. The existing additional requirement of obtaining a majority in number of the shareholders or creditors has been done away with.

Companies Bill, 2011: Class Actions

noreply@blogger.com (V. Umakanth) — Sun, 18 Dec 2011 10:31:00 +0000

Background

In developed markets, one of the key mechanisms used for enforcement of corporate law is shareholder actions against the company or its management for breach of duties and obligations owed under law. Such shareholder actions can be either direct actions for breaches of duties owed to the shareholders directly in which case the remedies will flow to the shareholders, or they can be derivative actions where shareholders bring them on behalf of the company for breach of duties owed to the company where the remedies would flow to the company. Despite the popularity of such actions in countries such as the US, UK and several leading jurisdictions in the Commonwealth, such private shareholder actions are indeed sparsely used in India. This is evident from the fact that while shareholder suits were filed in the U.S. immediately after the Satyam scandal was revealed (and subsequently settled by the company for hundreds of millions of dollars), no significant action was initiated by the Indian shareholders who were left without any remedy for false representations in the financial statements.

In terms of shareholder remedies in India, there is a fair amount of vibrancy in direct actions in the form of claims for oppression and mismanagement brought before the Company Law Board (CLB) under sections 397 and 398 of the Companies Act, 1956. While the CLB has been active in considering these cases, their scope is fairly limited and may not necessarily be available for all instances of breaches of duties either by the company or the management. On the other hand, derivative actions, which are customarily used by shareholders to seek remedies on behalf of the company for breaches of duties by directors and senior management, are rarely utilised by shareholders in India. In a recent study to be published shortly, Professor Vikramaditya Khanna and I found that in the last sixty years only about 10 derivative actions have reached the level of the High Courts or the Supreme Court, of which only 3 have been finally allowed to be pursued. There are a number of substantive and procedural hurdles due to which shareholder derivative actions are rare in India. For example, derivative actions rely on principles of common law in the absence of a statutory provision, and they have to be brought in the normal civil courts, which are subject to delays and heavy costs that make them ineffective.

Considering some of these difficulties, the Companies Bill, 2009 introduced a specific clause on class actions by shareholders as a method to ensure greater enforcement of corporate law. However, as anticipated, this was met with stiff resistance from the industry which feared that this will lead to the opening of floodgates resulting in companies having to face numerous lawsuits from shareholders. The Government seems to have given in to the concerns expressed by the industry, and consequently a substantially whittled down provision has been introduced in the Companies Bill, 2011.

Scope of the Action

Clause 245 provides that a certain number of shareholders or depositors can bring an action before the National Company Law Tribunal (NCLT). The action can be against the company for restraining it from various acts such as those that are ultra vires the memorandum and articles of association, that are based on a resolution of shareholders obtained through suppression of material facts, or that are contrary to the provisions of the Companies Act or any other law. More importantly, a new addition in the 2011 version is that shareholders can claim damages for fraudulent actions, unlawful conduct or misstatements made by the company and its directors, and in certain cases its auditors (including the audit firm) or any expert or advisor or consultant of the company. This new provisions seems to be a result of the discourse that emanated from the Satyam episode so as to pin responsibility not only on insiders of the company but also on various gatekeepers who are responsible for ensuring compliance with the law.

Certain other provisions also support the creation of a regime for shareholder actions. For example, failure to comply with an order of the NCLT will result in a criminal offence. Moreover, the NCLT may provide that the cost of bringing the action may be defrayed by the company or other responsible person. This is a key insertion especially in derivative actions where shareholders may not have the incentive to initiate an action if they have to directly bear the cost, while the ultimate relief will flow to the company.

The Bill also provides for consolidation of similar petitions, while also specifying the manner in which the lead applicant will be chosen.

Limitations

Significant checks and balances have been introduced to ensure that only genuine actions are entertained by the NCLT. First, there is a threshold limit in terms of the support required for bringing an action. The action must be supported by at least 100 shareholders, or such percentage of total number of shareholders or those holding such percentage of shares in the company as the Central Government may prescribe in the rules. Second, the NCLT is required to consider a number of factors while considering an application: whether the shareholders are acting in good faith or have any personal interest in the action, or whether the act or omission involved has been authorised or ratified by the shareholders. Third, frivolous and vexatious actions are discouraged by conferring the NCLT with the powers to impose costs on the initiating shareholders while rejecting applications on those grounds.

In sum, while it is useful that the Companies Bill expressly provides for statutory remedies in the form of class actions, it may not automatically result in greater enforcement of corporate law through increased shareholder actions. One significant advantage of the Bill is that it takes shareholder actions (such as derivative actions) outside the purview of the court and places them within the jurisdiction of the NCLT, which, due to its specialised nature, is expected to be more efficient and time-sensitive than the normal court system. However, with the imposition of significant limitations on the ability of shareholders to bring an action, it is unlikely that there will be a spate of such actions against companies. Nevertheless, the recognition of such remedies under statute will provide some relief to affected minority shareholders.

Companies Bill, 2011: Duties of Directors

noreply@blogger.com (V. Umakanth) — Sat, 17 Dec 2011 13:57:00 +0000

The Companies Act, 1956 does not contain any specific provision that generally governs the duties of directors. The duties are instead governed by common law, which judges are required to apply to a given set of facts and circumstances. Under common law, there are two broad sets of director duties: (i) duty to act with skill, care and diligence, and (ii) fiduciary duties (to act in the interests of the company, to avoid conflicts of interest and to act for proper purposes). However, past track record in India indicates that cases where common law director duties have been applied are few and far between. For this reason, duties of directors are incapable of being defined as clearly as one can in other jurisdictions, particularly in the developed markets.

In order to induce a greater level of clarity in directors’ duties, the Companies Bill, 2011 has a specific provision that deals with the subject matter. Clause 166 of the Bill is substantially similar to the provision contained in the Companies Bill, 2009, with some iteration. The UK too adopted the strategy of codifying directors’ duties in the Companies Act, 2006 (sections 171-177).

The following are some of the primary duties specified by the Companies Bill, 2011:

- to act in accordance with the articles;

- to act in good faith and in the best interests of the company, its employees, the shareholders, the community and for the protection of the environment;

- to exercise due and reasonable care, skill and diligence, and exercise independent judgment;

- not to involve in a situation that presents a conflict of interest;

- not to achieve any undue gain or advantage (and to return any equivalent amount to the company if such gain or advantage is indeed made); and

- not to assign office.

In case of any breach of duties, it would also amount to a criminal offence with punishment of Rs. 1 lakh to Rs. 5 lakhs. This is different from the common law position where there is an only civil liability for breach.

At the outset, it is necessary to note that this is only a partial codification of directors’ duties. It is not possible to prescribe rules for every situation in which directors’ actions can be judged. That necessarily has to be left for a principles-based determination, usually by judges in specific cases, and hence the role of courts in implementing these duties cannot be taken away. While the statutory provisions do give some guidance, much would depend on the manner in which courts interpret these duties, on which previous jurisprudence is scant. Moreover, with issues surrounding delays and costs in the court system, it is not clear if a body of judge-made law (in terms of principles) is likely to emerge to guide the actions of directors. Hence, it is not clear if the codification of the duties will necessarily result in a tangible enhancement when it comes to enforcing the duties.

One crucial change from the duties contained in the Companies Bill, 2009 is noteworthy. The previous Bill required directors to act in the best interest of the company. This epitomizes the shareholder model of corporate governance wherein the primary role of the directors is to protect the interests of the shareholders, and at most the interests of creditors in the event of insolvency. However, the new Bill also requires directors to act in the interests of “employees, the shareholders, the community and for the protection of the environment”. This encapsulates the stakeholder model of corporate governance wherein the directors are required to take into account the non-shareholder constituencies as well. This is consistent with the renewed emphasis on CSR, which has been discussed earlier. While it seems unlikely that any duties owed by directors in connection with non-shareholder constituencies can be justifiable or enforceable in a court of law, this at least prevents shareholders from initiating actions against directors for not solely (or even primarily) considering shareholder interests.

A similar debate was played out when the Companies Act, 2006 was enacted in the UK (and specifically section 172 thereof) where the end-result was the concept of an “enlightened shareholder value” model.

Companies Bill, 2011: Independent Directors

noreply@blogger.com (V. Umakanth) — Sat, 17 Dec 2011 12:34:00 +0000

Corporate governance generally places a fair amount of emphasis on board independence, and it is no different in India. Having a minimum number of independent directors (IDs) on the board is said to enhance monitoring of the management and promoters, and thereby protect the interests of the public shareholders. The Companies Bill, 2011 takes the concept of board independence to another level altogether as it spends several pages (a couple of sections and an entire schedule) to deal with IDs. This has no doubt emanated from the excessive debate on independent directors that emerged in the wake of recent corporate scandals. Some of us have had the opportunity (here and here) to analyze the importance of independent directors and to suggest reforms, a few of which have been incorporated in the Bill. These “Satyam provisions”, if we may refer to them as such, deserve a closer examination. The relevant provisions are clauses 149, 150 and Schedule IV.

Number of IDs

The Bill requires listed companies to have at least 1/3^rd independent directors on their board. This is a slight departure from clause 49 of the listing agreement, which requires at least 50% IDs in case the chairperson is in an executive capacity or a promoter or related to a promoter, and hence this represents a dilution from the existing position. This might, however, have relatively minimal impact, if at all.

Definition of Independence

The definition of an ID has been considerably tightened. For example, if a director is a chief executive of an NGO that receives funding from the company to a certain extent, the person would not qualify as an independent director. Moreover, the definition now includes positive attributes of independence (that was not the case under clause 49): the candidate must be “a person of integrity and possess the relevant expertise and experience” in the opinion of the board. The Central Government is also vested with the power to prescribe qualifications for IDs. Every ID is also required to declare that he or she meets the criteria of independence.

Appointment

One of the key criticisms of the current regime for IDs is that they are appointed like any other director, thereby leaving promoters with tremendous influence in determining the identity of the IDs. That has been partially addressed by making a nomination and remuneration committee mandatory (a departure from clause 49 that does not mandate a nomination committee). The committee is required to consider candidates for appointment as IDs and to recommend them to the board. This brings about greater objectivity to the ID nomination process, at least to some extent. However, the Bill does not go to the extent of providing greater participation by minority shareholders in the ID appointment process through methods such as cumulative voting or proportionate representation, which continue to be optional for companies to adopt rather than a mandatory requirement.

Furthermore, the Bill contemplates the establishment of a data bank of IDs, from which persons may be chosen by companies.

Tenure

In order to ensure that IDs maintain their independence and do not become too familiar with the management and promoters, minimum tenure requirements have been prescribed. The initial term shall be 5 years, following which further appointment of the director would require a special resolution of the shareholders. However, the total tenure shall not exceed 2 consecutive terms.

Remuneration

Under the Bill, IDs are entitled only to fees for attending meetings of the board, and possibly commissions within certain limits. The Bill expressly disallows IDs from obtaining stock options is companies. While it is understandable that excessively remunerating IDs could impinge upon their independence, the present provisions leave little room for companies to attract the required talent by remunerating directors for the services they provide. Since the Bill also imposes significant responsibilities and duties on IDs, as we shall see, positions for IDs on listed companies are unlikely to find takers of the requisite calibre unless they are appropriately remunerated. Attempts to achieve a proper balance may be fraught with difficulties under the present dispensation.

Roles and Functions

Schedule IV of the Bill contains a code that sets out the role, functions and duties of IDs and incidental provisions relating to their appointment, resignation and evaluation. While the guidelines are useful in specifying the roles and functions so as to introduce clarity, they are extremely prescriptive in nature. This makes the role of IDs quite onerous, and may enhance the level of monitoring of listed companies, which is crucial for corporate governance. The downside, of course, is that it could instil fear in the minds of potential IDs that may dissuade them from taking up the position.

Liability

In order to balance the extensive nature of functions and obligations impose on IDs, the Bill seeks to limit their liability to matters directly relatable to them. The Bill limits the liability of an ID “only in respect of acts of omission or commission by a company which had occurred with his knowledge, attributable through board processes, and with his consent or connivance or where he had not acted diligently.” This again seems to be a reaction to specific instances in the recent past where IDs were subject to legal action for no fault of their own, as evident from the Nagarjuna Finance episode that occurred in 2009. While it is useful to provide a limitation of liability clause, much would depend on the manner in which this is interpreted by courts based on the specific facts and circumstances of individual cases. Other ways of addressing the liability issue would be to expressly provide for directors and officer liability insurance, which are also specified in the Bill.

In sum, while several concerns regarding board independence have been addressed in the Bill, some areas require refining as discussed above. Although the intention is noble, the implementation could give rise to difficulties. Corporate governance norms are dynamic in nature and require reconfiguration periodically to keep pace with the changing business climate. Usually, while the basic governance framework is dealt with by statute, the details are dealt with codes of conduct that are more flexible in nature. Since the catastrophes that marked the India corporate sphere in the last 2 or 3 years have assumed significant political overtones, they have resulted in excessive reaction in terms of detailing every single governance norm concerning IDs in the legislation itself. While it may address some immediate problems, it is bound to result in a great amount of rigidity. Experience clearly evidences the enormous difficulties in amending companies legislation in India, and any changes in the governance norms in the future is likely to be as cumbersome. The question remains whether there has been a knee-jerk reaction to current scandals that may adversely impact genuine businesses during times ahead.

SEBI’s FAQs on Takeover Regulations

noreply@blogger.com (V. Umakanth) — Sat, 17 Dec 2011 09:36:00 +0000

SEBI recently put out a set of FAQs relating to the Takeover Regulations, 2011 that came into effect on October 22, 2011. While a substantial part of the FAQs relate to either explanation of matters or elaboration of certain aspects of process and mechanics, they also address substantive issues on a few counts.

We had earlier discussed the issue as to whether hostile takeovers are permissible under the Takeover Regulations, 2011. SEBI has now clarified the position in the FAQs:

15. Whether hostile offers/bids are permitted under the new regulations?

There is no such term as hostile bid in the regulations. The hostile bid is generally understood to be an unsolicited bid by a person, without any arrangement or MOU with persons currently in control.

Any person with or without holding any shares in a target company, can make an offer to acquire shares of a listed company subject to minimum offer size of 26%.

This is also incidental to a distinction made for voluntary offers by persons holding less than 25% of the voting rights and those made by persons holding greater than 25% (please see FAQs no. 17 to 20). In the latter case, various conditions apply that make voluntary offers somewhat more difficult to effectuate.

A notable omission in the FAQs pertains to the concept of “control” and whether negative control through veto rights would qualify for the purpose. The issue continues to remain open given the lack of a decision from the Supreme Court in the Subhkam case, and it is not surprising that SEBI has chosen to keep its cards close to the chest.

Finally, the manner of addressing some of the substantive issues through FAQs (which are expressly stated to be non-binding) rather than through appropriate regulatory mechanisms such as a circular (as Sandeep Parekh suggests) is less than desirable.