Tuesday, September 16, 2014

“deposits” existing on 31st March 2014 - how to be treated under new Companies Act/Rules?

Since notification of the Companies Act, 2013 and Rules thereunder, certain transitional issues relating to “deposits” are causing concerns to numerous companies, big and small, listed and unlisted, public or private. They arise from the substantially modified definition of the term “deposits”. Many items of loans and other receipts that were not “deposits” earlier being now treated as deposits. Companies are thus not allowed or severely restricted from accepting such amounts. While there are enough issues in the new definition, certain transitional issues are creating more urgent problems. Differing views by professionals and others to resolve the ambiguities is creating its own further confusion.

The issue is – how are monies received by a company on or before 31st March 2014 and which under the new definition have become deposits to be treated? The wide new definition has resulted in common items like share application monies, certain types of debentures, security deposits, advance against goods/property, loans from shareholders, etc. to be deposits under certain circumstances. If such monies were accepted on or before 31st March 2014, and they remain outstanding on and after 1st April 2014, is there a violation involved? Is there a time period during which such “deposits” should be repaid?

Take an example of share application money. The revised definition says that shares should be allotted within 60 days of receipt of share application monies, failing which the amount should be repaid within 15 days thereafter. Say, a company received on 29th March 2014. The allotment of shares partly took place on 31st August 2014 and remaining will take place in June 2015. Is there any violation of law? More specifically should the company:-
(i)             have repaid the share application money on 31st March 2014?
(ii)           have allotted the shares by 28th May 2014, and failing which repaid them by 12th June 2014?
(iii)          have allotted the shares by 31st May 2014, and failing which repaid them by 15th June 2014?
(iv)         Have allotted the shares by 31st March 2015 or repaid the amount?
(v)           if the monies were received on 1st January 2014, will they have to be repaid on 31st March 2014?

Or can the Company continue to hold these amounts till the Company/the share applicants decide to either allot the shares or refund the money?

Similar concerns arise for numerous other common items that are now treated as deposits.

There are serious penal consequences if the provisions are violated including fine and/or imprisonment.

Section 74 provides that “deposits accepted” before 1st April 2014 and which “remain unpaid” shall be repaid within one year from that date or one year from date when they became due, whichever is earlier. It is not clear whether “deposits” refers to the definition under the earlier law or the new one. It is also not clear whether “unpaid” means due and unpaid or unpaid even if not due.

The issue is further complicated by the Rules. For example, it is provided that shares should be allotted against share application monies within 60 days of their receipt failing which the amounts should be repaid within 15 days after such 60 days. Advances against goods have to be adjusted by delivery of goods or repaid within one year. And so on. Will – and, if yes, how - will these provisions apply to such amounts existing on 31st March 2014? For example, in case of share application monies in the above example, will the allotment have to be carried out within 60 days? For advance received against goods on 1st January 2014, should the goods be delivered or amount repaid by 1st January 2015?

Professionals and even professional bodies are not much helpful in sense of having a consensus. On one extreme is a view that the new law does not at all apply to any amount received on or before 31st March 2014, which will continue to be governed by the old law. Another view is that Section 74 should be interpreted to mean that all such amounts on 31st March 2014 should be repaid within the time specified in that section. Yet another view is that the new law applies to such old amounts too and thus, for example, share application monies received on or before 31st March 2014 should have been repaid within 60 days of receipt. The FAQs of the Institute of Company Secretaries of India opines that share application monies existing on 31st March 2014 should be repaid by 31st May 2014 or else it will be treated as deposits. No detailed reasoning is given for this view.

I submit that amounts received on or before 31st March 2014 ought to be governed by old law. The new law ought to apply only to receipts on or after 1st April 2014.

However, there is ambiguity and resultant anxiety. It is reported that amendments relating to deposits are soon expected. I hope that either these amendments or amendment to the rules or clarification by circulars resolve these ambiguities.

Monday, September 8, 2014

SAT Order on “Flash Crash”

A few days ago, the Securities Appellate Tribunal (SAT) passed its order on an appeal by Emkay Global Financial Services Limited against the National Stock Exchange (NSE) and several investors in a case involving a “flash crash”. This case raises interesting legal and contractual issues, although they were substantially resolved through an interpretation of the bye laws and various circulars issued by the NSE.

The case arose due to a “fat finger” trade, which involves an error in inputing information into a computer while executing a trade. In October 2012, a dealer of Emkay Global placed an order to sell 17 lakh NIFTY 50 units ‘based on quantity’ instead of Rs. 17 lakh in value. Due to this error, the sell order was executed for a value of Rs. 980 crores, which was vastly in excess of the contemplated transaction. While the dealer immediately realised the situation and tried to cancel the order, he was unable to do so as it had already entered the exchange server. The enormity of the situation can be attributed to a confluence of factors that led to a “perfect storm”. The risk management measures at Emkay Global’s end did not function to backstop the human error. Moreover, NSE’s circuit breaker system did not arrest the market fall when the NIFTY index fell by 10%. Following this incident, the Disciplinary Action Committee (DAC) of the NSE investigated the matter and imposed a penalty of Rs. 25 lakhs on Emkay Global and certain other trading parties. NSE also rejected a request by Emkay Global for annulment of the trade on account of the error.

It is against these actions that Emkay Global appealed before the SAT. From a legal standpoint, SAT was concerned with three broad questions, on two of which it returned a finding. First, it considered whether the erroneous trades are liable to be treated as a “material mistake” and hence to be annulled by virtue of NSE’s bye law 5(a). SAT decided to provide a narrow interpretation to the expression “material mistake” and that since the trades occurred due to a failure in the risk management system of Emkay Global, it amounted to breach of duty/ negligence which cannot be a circumstance for invocation of bye law 5(a). SAT’s interpretation suggests that bye law 5(a) contemplates inviolability of dealings on the stock exchange and that “it is evident that the expression ‘material mistake’ in Bye law 5(a) would be attributable to such trades which affect sanctity of the trade in spite of it being executed after exercising due care, caution and diligence”. Moreover, SAT was categorical in that the magnitude of the loss caused it not determinative of “material mistake”.

Second, it was found that various investors had placed unrealistic orders to buy NIFTY 50 at prices distant from the prevailing market price, and that these trades were effected without the stipulated margin money. Hence, apart from the lack of diligence on the part of Emkay Global, there were also violations on the part of the investors who purchased the securities so as to derive unanticipated profits. SAT seemed to display some concern on this count given that NSE does not seem to have considered these matters in detail while rejecting annulment of the trades. Hence, SAT set aside NSE’s orders against the annulment of trades relating to two counterparties and remanded the matter for fresh consideration. Hence, in these instances, the question of annulment of the trades has been left open and for further consideration.

Third, SAT refused to annul the trades on the ground of the failure of NSE’s systems to halt trading when the NIFTY index fell below 10%.

A majority of SAT consisting of two members rejected Emkay Global’s appeal on the first and third issues discussed above, and remanded the second for fresh consideration. In a separate order, the third member refused annulment and rule against Emkay Global.

While the legalities and technicalities of the circumstances  have been discussed in detail in SAT’s order, the essential question revolving around this dispute is whether sanctity of trades ought to be preserved despite the erroneous nature of the trades. SAT’s outcome has largely pointed towards upholding these trades, and therefore preserving the sanctity. This has economic implications as such an approach would preserve market integrity. Where SAT has left the matter for further consideration, the issue does not pertain to the erroneous nature of the trade but rather to the non-compliance of the counteparties with relevant NSE requirements regarding princing and margin. Overall, this approach may be considered somewhat harsh as it leaves no room for error on the parties of trading entities and their dealers, who are cast with the onerous obligations of establishing and maintaining the necessary risk management systems, procedures and practices. The obligations are further enforced by powers conferred upon the stock exchange to penalise the offenders so as to have a deterrent effect against the lack of care and diligence. Given the strict nature of this approach, there is no risk of moral hazard.

On the other hand, unyielding insistence on sanctity of trades could confer windfall gains upon counterparties who are fortunate (and perhaps even canny) to have taken the benefit of the erroneous trades. One method of preventing undue advantage to such counterparties would be to disgorge the profits they may have obtained so as to balance the equities between the parties. The fact that SAT has left the door open for some form of reconsideration (including annulment) suggests it is cognisant of these inequities that need to be rectified.

In all, flash crashes that are caused by errors such as fat finger trades bring about significant complexities in the markets, especially given their magnitudes. While systems and processes can help guard against the occurrence of such events, they may be faced with a “perfect storm” situation wherein the regulatory and dispute resolution mechanisms would have to be invoked to dispense justice to the parties affected by the error.

For a further analysis of the SAT order and its implications, please see “SAT order on NSE's actions after the Emkay crash”.

Sunday, September 7, 2014

The Securities Laws (Amendment) Act, 2014 – A Critical Analysis

[The following guest post is contributed by Mubashshir Sarshar, who is a lawyer and an alumnus of National Law University Delhi. The author can be reached at mubashshir.sarshar@gmail.com.]

Two standalone incidents within a span of one year have managed to change the entire paradigm of the securities market transactions in India. The Sahara and Saradha episodes symbolised the stark loopholes that existed in the regulatory regime controlling the affairs of securities market transactions in India.

While a slew of legislative changes were brought into company law in the form of Chapter III, Part II of the Companies Act, 2013 in line with the Supreme Court judgment[1] to tackle the interpretation of ‘private placement’ given by Sahara.

As for Saradha, since the Parliament was not in session, the President after being satisfied about the gravity of the situation used his emergency law making powers and promulgated an ordinance three times in a row to tackle the situation in the interim. After the expiration of the third ordinance, a Bill was tabled in the monsoon session of the 16th Lok Sabha to give legislative sanctity and to amend certain unilateral provisions contained in the said ordinance. The Bill reinstated certain provisions in the SEBI Act, digressing from the Ordinance to an extent, in order to include a check and balance mechanism for the regulatory authority i.e. SEBI. The Parliament passed the Bill in the first week of August after which it received the assent of the President on 22 August 2014 and was simultaneously published in the official gazette to bring the Securities Law (Amendment) Act, 2014 (“Act”) into force.

As the recital of the Act provides, it is a legislation to amend and plug the existing loopholes in three cardinal legislations controlling the securities market transactions in India, namely the Securities and Exchange Board of India (SEBI) Act, 1992, the Securities Contracts (Regulation) Act, 1956 and the Depositories Act, 1996.

Although, certain reforms introduced under the Act have already been discussed in a previous post when the provisions were in the form of a Bill, the following are certain predicaments which could potentially become a point of judicial interpretation and construction in the days to come.

1.         Power to SEBI to seek permission for search and seizure from a designated Court/Magistrate in Mumbai

The erstwhile Section 11C (8) of the SEBI Act provided that in case the investigative authority had any reasonable ground to believe that any documents associated with securities market may be destroyed, it may make an application to a Judicial Magistrate of the first class having jurisdiction for an order for the seizure of such documents. Further, there were certain other pre-qualifications prescribed under the said section before a magistrate could authorize such search and seizures.[2]

The Ordinance on the other hand removed all such impediments and gave the Chairman of SEBI unfettered powers to authorize the search and seizures without any prior judicial approval.

However, the Act now reinstates the erstwhile position with a minor change,[3] requiring SEBI to approach a Magistrate or Judge of a designated court in Mumbai as may be notified by the Central Government before undertaking the operations.

This is positive step from the erstwhile position as pointed out by the Finance Minister in his introduction to the Bill in the Lok Sabha,[4] stating that while approaching a magistrate of an area where the search was to be conducted, the whole issue would become public and the purpose of a search was defeated as secrecy was an essential element of any search operation. On the other hand, power in the hands of executives without any safeguards is bound to be abused. Hence, the check and balance approach promulgated under the Act is a welcome step.

However, the latest position of the government to designate special magistrates/judges from where a sectoral regulator could obtain permission before conducting a search and seizure operation could have repercussions and judicial scrutiny of other sectoral regulators especially that of the Income Tax authorities under Section 132 of the Income Tax Act, 1961 and more recently that of the Competition Commission under the proposed Section 41(3) of the Competition (Amendment) Bill, 2012.

2.         Excessive delegation of power to SEBI with regard to Collective Investment Schemes

Under Section 11AA of the SEBI Act, two addendums have been added by the Act. The first one being a proviso to sub-section (1) which essentially brings under SEBI’s purview any corpus of funds amounting to Rs. 100 crore or more which is not regulated by any other sectoral regulator and the second one being a new sub-section (2A) which allows SEBI to frame regulations for any scheme to be considered as a collective investment scheme, without prescribing any guidelines on the criteria that SEBI may use to formulate such regulations.

Both these addendums, in my opinion invite huge ramifications for SEBI so far so it is not able to clearly cull out what ‘pooling of funds’ would be deemed to mean and what would constitute a collective investment scheme apart from the four attributes specified under the present Section 11AA(2) of the SEBI Act.

Further, if the delegated authority provided to SEBI to frame regulations for collective investment scheme is tested on the anvil of constitutionality and in the backdrop of the Supreme Court judgment in the case of In Re Delhi Laws Act,[5] it might be considered as a case of excessive delegation of power.

3.         Power of Disgorgement

A new sub-section in the form of sub-section (5) under Section 11 of the SEBI Act has been inserted by the Act to provide that any amounts collected through disgorgement (repayment) i.e. amount of profit made or the loss averted in the said fraudulent transaction, after an issuance of a direction under Section 11B of the SEBI Act or Section 12A of the Securities Contracts (Regulation) Act, 1956 or Section 19 of the Depositories Act, 1996 would be credited to the Investor Protection an Education Fund (“IPF”).

However, again the formulation of a framework to utilise such disgorged funds has been bestowed on SEBI. In my opinion, the amount credited in the IPF should primarily be used to recoup the innocent investors who would have a rightful claim to such amounts.

From the standpoint of SEBI, this addition has lent a fresh lease of life to disgorgement orders because of the clarity in the law that it has offered and the days to come should see SEBI come at par with the US Securities Exchange Commission (SEC) in terms of utilising disgorgement orders to effectively curb securities market malpractices.

4.         Securities Appellate Tribunal’s (“SAT”) power with regard to settlement proceedings

There is a significant change in the position of law with regard to SAT’s power to adjudicate upon an appeal from an order passed by SEBI under settlement proceedings.

The erstwhile Section 15T sub-clause (2) of the SEBI Act essentially provided that no appeal shall lie with the SAT when an order was made by SEBI with the consent of both the parties. However, both, the Ordinance as well as the Act has omitted the concerned sub-section and replaced it with a new addendum in the form of Section 15JB sub-clause (4) which provides that no appeal shall lie against any order passed by SEBI in settlement proceedings.

In my opinion, such a restriction under the new provision would also come under severe judicial scrutiny because once a party receives an adverse order from SEBI under the settlement proceedings and the SAT refuses to entertain the matter for want of jurisdiction, the natural course of action followed would be to file a writ petition before a High Court under Article 226 of the Constitution or challenge the said provision to be unconstitutional before the Supreme Court under Article 32 of the Constitution.

5.         Establishment of Special Courts

A set of new provisions in the form of Section 26A to 26E has been inserted by the Act, which provides for the establishment of Special Courts for speedy trial of all offences committed under the SEBI Act. The Special Court would consist of a single judge appointed by the Central Government with the concurrence of the Chief Justice of High Court within whose jurisdiction the judge to be appointed is working. The Special Court would however, only serve as a Court of Sessions under the jurisdiction of the designated High Court.

This amendment is in line with Section 435 of the Companies Act, 2013 which also provides for the establishment of special courts to deal with all offences under the Companies Act. One could assume that the idea behind this move by the government to designate special courts to deal with offences under a particular statute is to provide a more efficient and specialized system of judicial functioning.

However, in my opinion, the legislature has left a lot of leeway for supposition, as to the rationale for creating a fast track feeder within the criminal justice system, which is not created by the judiciary but at the discretion of the executive. Although, in the backdrop of the vast number of securities frauds’ surfacing of late, such a step is seen in a positive light by the various stakeholders.

- Mubashshir Sarshar

[1] Sahara India Real Estate Corporation Limited & Ors v. Securities and Exchange Board of India & Anr, Civil Appeal No. 9813 and 9833 of 2011.
[2] Proviso to Section 11C (9) of the SEBI Act.
[3] Section 5 of the Act.
[4] Lok Sabha Debates, August 5, 2014.
[5] 1951 2 SCR 747.

Thursday, September 4, 2014

Guest Post: Guarantee Against Loan from Banks and Financial Institutions

[The following post is contributed by Abhishek Bansal and Stuti Bansal, Corporate Professionals, Advisors & Advocates. The authors can be reached at abhishek@indiacp.com and stuti@indiacp.com respectively]

Recently, India saw the enactment of the Companies Act, 2013 (“Act”), replacing the Companies Act, 1956, which governed the incorporation, functioning, transactions and other activities of the companies in India. Witnessing uproar from corporate India, much discussion was seen in the arena of loans and guarantees, e-commerce business, and corporate social responsibility amongst others. This post, while examining the provisions of section 185 of the new Act, throws light specifically on guarantees against loans from banks and financial institutions.

Some background

The provisions of section 185 of the Act, as earlier notified, for the most part, barred granting of any loans, giving of guarantee or providing of any security to the directors or any other person in whom the director is interested; otherwise than for given exemptions. In contrast to the counterpart provisions under the Act of 1956, the section withdrew exemptions with respect to such transactions among private limited companies and transactions between holding and subsidiary companies and also the provision for obtaining approval of the Central Government.

Many corporates filed representations before the Ministry of Corporate Affairs (“Ministry”) requiring clarification on the intent of Section 185 and for making the provisions industry friendly, although the Ministry seemed clear on its intent, citing that it had taken stringent view having regard to the flow of funds from the company to its directors or other person in whom the director is interested. The Companies (Meetings of Board and its Powers) Rules, 2014, legislated under the section, provide for the following exemptions:

- Transactions amongst holding and wholly owned subsidiary company with regard to:

- Any loan made by a holding company to its wholly owned subsidiary company; or

- Any guarantee given or security provided by a holding company in respect of any loan made to its wholly owned subsidiary company and

- Transactions amongst holding and subsidiary company

- Any guarantee given or security provided by a holding company in respect of loan made by any bank or financial institution to its subsidiary Company; wherein such loans are utilized by the subsidiary Company for its principal business activities.

Section 185: A brief discussion

The provisions of Section 185 of Chapter XII of the Act of 2013, which corresponds to Section 295 of the Companies Act, 1956 provides that:

- No company shall, directly or indirectly, advance any loanincluding any loan represented by a book debt, to any of its directors or to any other person in whom the director is interested or give any guarantee or provide any security in connection with any loan taken by him or such other person.

- Exemptions under the section relate to:-

- the giving of any loan to a managing or whole-time director if it is given as a part of the conditions of service extended by the company to all its employees; or pursuant to any scheme approved by the members by a special resolution; or

- a company which in the ordinary course of its business provides loans or gives guarantees or securities for the due repayment of any loan and in respect of such loans an interest is charged at a rate not less than the bank rate declared by the Reserve Bank of India.

- Here, the expression “to any other person in whom director is interested” means—

            - any director of the lending company, or of a company which is its holding company or any partner or relative of any such director;

            - any firm in which any such director or relative is a partner;

            - any private company of which any such director is a director or member;

            - any body corporate at a general meeting of which not less than twenty five per cent of the total voting power may be exercised or controlled by any such director, or by two or more such directors, together; and

            - any body corporate, the Board of directors, managing director or manager, whereof is accustomed to act in accordance with the directions or instructions of the Board, or of any director or directors, of the lending company.

It may be said in terms of Section 185 of the Act that even a promoter company cannot give loan or guarantee against the loan taken by such company, where the directors of such company and its promoter company are common or if there is any other person in such company in whom the director(s) of the promoter company is/are interested. The only exception is given in favour of the holding company which can give guarantee in respect of the loan made by any Bank or Financial Institution only and not from any other entity and the loan amount is utilized by the subsidiary for its business activities. In other words, the said exemption would be available if any only if the loan is made by a bank of financial institution and not by any other body corporate or individual. Thus, understanding the meaning of a ‘bank and financial institution’ becomes crucial here.

Meaning of “Bank”

A “Banking Company” is defined under the Companies Act, 2013, as a Banking Company as defined in clause (c) of Section 5 of Banking Regulation Act 1949.

Section 5(c) of Banking Regulation Act, 1949 defines ‘Banking Company’ as any company which transacts the business of banking in India.

Further, in terms of Section 7(1) of the Banking Regulation Act, 1949, no company other than a banking company shall use a part of its name or in connection with its business any of the words "bank", "banker" or "banking" and no company shall carry on the business of banking in India unless it uses a part of its name at least one of such words.

Meaning of “Financial Institution”

As per the Companies Act, 2013, “financial institution” includes a scheduled bank and any other financial institution defined or notified under the RBI Act, 1934 (2 of 1934). A list of scheduled banks has been provided under Schedule II of the RBI Act, 1934.

Further, “Financial Institution” has been defined under section 45I (c) of RBI Act, 1934 as any non- banking institution. “Non-Banking Institution” means a company, corporation or cooperative society under section 45I(e) of RBI Act, 1934. “Corporation” under Section 45I(b) of RBI Act means, a corporation incorporated by an Act of any legislature.

Thus, it may be said that where the promoter company of a company is not a holding company of such company, it cannot give guarantee for the loan taken by such company. However, if the promoter company of a company is a holding company of such company, it may give guarantee for the loan taken from a bank and even a foreign bank provided such foreign bank falls under schedule II of the RBI Act, 1934. However, this must not be the intention of law, since the loan from any of the foreign banks is coming through the regulated channel. For such cases, representations may be filed before the Ministry of Corporate Affairs seeking clarification.

It is interesting to note that, and also worthwhile to keep a note that, in the event of default/ non-compliance, not only the provider of guarantee but also such company (borrower) who is taking loan is liable for penal provisions under sub-section (2) of Section 185 of the Act.

- Abhishek Bansal & Stuti Bansal