Saturday, October 25, 2014

Revisiting penalty clauses in contract

Last year, the English Court of Appeal in Talal El Makdessi v Cavendish Square Holdings [2013] EWCA Civ 1539 considered the enforceability of penalty clauses under English contract law, and was one of the few decisions in recent times to have concluded that the clauses in question were penal and therefore unenforceable. The decision was notable for affirming that the English law rule against the enforceability of penalty clauses applies not only to clauses requiring a payment to be made by a defaulting party, but also to (i) clauses permitting the innocent party to withhold a payment from the defaulting party, and (ii) clauses requiring the transfer of assets from the defaulting party to the innocent party at a reduced price. Both of these propositions are not entirely settled under English law, with no conclusive House of Lords / Supreme Court decision on either point.

The other point of interest arising from the case was a reference in Clarke LJ's leading judgment to a significant anomaly at the foundation of the English law on penalties – it doesn't cover clauses which apply when there has been no breach of contract. To borrow the illustration used by Heath J way back in 1801 in Astley v Weldon (1801) 2 Bos. & P. 346, "It is a well-known rule of equity, that if a mortgage covenant be to pay £5 per cent. and if the interest be paid on certain days then to be reduced to £4 per cent. the Court of Chancery will not relieve if the early day be suffered to pass without payment; but if the covenant be to pay £4 per cent. and if the party do not pay at a certain time it shall be raised to £5 there the Court of Chancery will relieve". This anomaly provides latitude for draftsmen to avoid the rule against penalties, and has led to calls from leading academics (including Edwin Peel in the July 2014 issue of the Law Quarterly Review) to call for the abolition of the rule against penalties. It is however interesting to note that a 2012 decision of the Australian High Court (Andrewsv Australia and New Zealand Banking Group Ltd [2012] HCA 30) addressed this anomaly by applying the rule even when there has been no breach of contract and the Indian position has been discussed by Niranjan in a previous post.  

In May this year, the UK Supreme Court granted leave to appeal from the Court of Appeal's decision in Cavendish and the outcome of that appeal will be of great interest (although it is not clear whether the rule against penalties is a subject of the appeal, since the decision also involved findings on two other claims).

However, in the meanwhile, the English High Court last month decided another interesting case in which a liquidated damages provision was held to be penal and unenforceable. Although the facts of Unaoil v Leighton Offshore [2014] EWHC 2965 are rather complicated, the relevant chain of events is easy to summarise. Unaoil, a BVI company which provided a wide range of services across the oil and gas sector, entered into a memorandum of agreement (MOA) with Leighton Offshore in relation to a substantial oil infrastructure project in Iraq. Pursuant to the MOA, Leighton agreed to appoint Unaoil as its sub-contractor in relation to the project, subject to Leighton being appointed by the relevant Iraqi authorities, in consideration for a payment of $70 million. The MOA also contained a liquidated damages clause which provided for the payment of $40 million if Leighton breached the MOA. In particular, the liquidated damages clause stated – "After careful consideration by the Parties, the Parties agree such amount is proportionate in all respects and is a genuine pre-estimate of the loss that Unaoil would incur as a result of Leighton Offshore's failure to honour the terms of the MOA".

Subsequently, there were further discussions as to pricing between Unaoil and Leighton, leading to a supplementary agreement to the MOA pursuant to which the agreed consideration was reduced to $55 million. The liquidated damages clause was left unamended.

Eventually, Leighton was awarded the project but did not appoint Unaoil as its sub-contractor, thereby breaching the MOA as amended. This led to claims by Unaoil on several bases, including a claim for the $40 million payable under the liquidated damages clause. However, the High Court held that the clause was penal and not enforceable. A slightly frustrating aspect of the decision is that the reasoning underlying this conclusion is very brief and leaves a few questions unanswered. It does however lay down an interesting proposition of law, and one for which there was no authority previously.

The rule against penalties does not apply if the amount payable under the contract is a genuine pre-estimate of loss or if it has a commercial justification. However, both these tests are to be applied as on the date of the contract and not on the date of the breach. The question posed in Unaoil however was slightly different, what is the relevant date when the contract has been subsequently amended? The High Court held that- "where, as here, the contract is amended in a relevant respect, the relevant date is, in my judgment, the date of such amended contract … Here, once the original contract price was reduced by Supplementary Agreement No. 2, the figure of US$40 million was, even on Unaoil's own evidence, manifestly one which could no longer be a genuine pre-estimate of likely loss by a very significant margin indeed". Eder J goes on to state- "The reason why the figure of US$40 million was not reduced at the same time as when the contract price was reduced was not explained. Perhaps it was a mistake or an oversight. I do not know. In any event, once the original contract price was reduced, it was, on any objective view, “extravagant and unconscionable with a predominant function of deterrence” without any other commercial justification for the clause".
There are aspects to this decision and the underlying reasoning which are not entirely satisfactory, but contracts draftsmen can draw two important lessons from the passages reproduced above:
  • When key provisions relating to the performance timetable and the consideration payable are amended over the course of long term contracts, it is important to assess the impact of the amendments on the liquidated damages clause, if any. Unfortunately, the phrase "in a relevant respect" does not offer much by way of guidance, but one would think that if the amendment is such that it affects the underlying basis of the "genuine pre-estimate of loss" on which the liquidated damages amount has been arrived at, or affects the commercial justification of the clause, the continued validity of the liquidated damages clause should be considered.
  • If on such consideration, it is decided that the amendment to the substantive terms of the contract does not impact the liquidated damages clause (or indeed, even if it does), it may be helpful to document the basis on which the conclusion was reached – perhaps in the preamble to any amendment agreement. In Unaoil, the absence of a sufficient explanation for why the liquidated damages clause wasn't amended played an important role in the decision. It could be argued that this reliance is difficult to reconcile with Clarke LJ's statement of settled law in Cavendish that "The burden of proving that a clause is penal is on the party making the assertion". However, the point does remain that better drafting of the MOA and the subsequent amendment would have avoided a lot of the controversy – in the words of Eder J, “the disputes which are now the subject of the present proceedings are probably due, in large part, to such bad drafting (of the MOA)". 

Friday, October 24, 2014

SEBI’s Order in the DLF Case: A Summary

[The following post is contributed by Supreme Waskar, partner at Sterling Associates, Mumbai]

In its order dated October 10, 2014, the Securities and Exchange Board of India (“SEBI”) has restrained DLF Limited (“DLF”), its 5 directors and CFO (“Noticees”) from accessing the securities market and prohibited them from dealing in securities for the period of 3 years on the ground of active and deliberate suppression of material information in its red herring prospectus (“RHP”)/ Prospectus so as to mislead and defraud the investors in the securities market in connection with the issue of shares of DLF in its IPO, thereby violating the provisions of the SEBI Act, the SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003 (“PFUTP Regulations”), the SEBI (Disclosure and Investor Protection) Guidelines, 2000 ("DIP Guidelines") and the SEBI (Issuance of Capital and Disclosure Requirements) Regulations, 2009 ("ICDR Regulations").


DLF had filed a draft RHP (“DRHP”) with SEBI in January 2007 for raising Rs. 9187.5 crore through an IPO. Thereafter, DLF issued the RHP on May 25, 2007and the Prospectus was filed with the Registrar of Companies (“ROC”) on June 18, 2007. One Mr. Kimsuk Sinha ("Mr. Sinha") had filed complaints with SEBI on June 4, 2007 alleging the Sudipti Estates Private Limited ("Sudipti") and certain other persons had defrauded him of 34 crore in relation to a transaction between them for purchase of land (“Complaint”) and also registered a first information report (“FIR”) dated April 26, 2007 alleging that two of DLF’s wholly owned subsidiaries (“WOS”) were the only shareholders of the Sudipti and requesting to disallow the listing of DLF pursuant to the IPO and for immediate action. Subsequently the allegations in Complaint were denied by DLF.

SEBI’s investigation pursuant to Delhi High Court’s order

Pursuant to the inaction of SEBI in relation to Complaint against DLF, Mr. Sinha filed a Writ Petition before the Delhi High Court (“DHC”) and the DHC vide order dated April 9, 2010 (“Order”) issued directions to SEBI to undertake an investigation into the aforementioned Complaints. Accordingly SEBI, vide an order dated October 20, 2011 ordered an investigation into the allegations levied by Mr. Sinha in his complaints to ascertain the violations, if any, of the provisions of the DIP Guidelines read with corresponding provisions of ICDR Regulations and the relevant provisions of the Companies Act, 1956 ("Companies Act") and issued a Show Cause Notice (“SCN”) to the Noticees.

Charges levied by SEBI

1.   Non disclosure of material information in relation to alleged subsidiaries by DLF in RHP/Prospectus

At the relevant time, 3 WOS of DLF held entire equity shares in Sudipti, Shalika Estate Developers Private Limited ("Shalika") and Felicite Builders & Construction Pvt. Ltd. ("Felicite"). On November 29, 2006, the entire shareholding in Felicite held by WOS of DLF was sold to 3 who were wives of key managerial personnel (“KMPs”) of DLF. On November 30, 2006, WOS of DLF sold their entire shareholding in Shalika to Felicite. On the same date, the 3 WOS of DLF sold their entire shareholding in Sudipti to Shalika. The said three “Housewives” were shareholders of Felicite until their respective husbands were KMPs of DLF and when they ceased to be KMPs, shares were transferred to other KMPs' 'Housewives'. Further payments even in respect of those transfers were made by the respective husbands of the purchasers. Hence SEBI alleged that DLF never lost control of Sudipti, Shalika and Felicite (“Alleged Subsidiaries”) and they were and are subsidiaries of DLF. In terms of the provisions of DIP Guidelines and AS-23, certain disclosures with respect to its subsidiaries should have been disclosed in the RHP/Prospectus of DLF and was not disclosed. Therefore, it was held that DLF has violated provisions of clause of the DIP Guidelines.

2.   Non-disclosure of related party transactions by DLF in RHP/Prospectus

There was no change in the members of board of Alleged Subsidiaries, who were also the employees of DLF and continued to be the directors of these companies even after the aforesaid sale of shareholding. Also there was no change in any of the authorized signatories of the bank accounts, registered office and statutory auditors of Alleged Subsidiaries even after the date of claimed dissociation. Hence, it was inferred by the SEBI that DLF was in a position to control the boards and through its employees was involved in day-to-day operations and associated with Alleged Subsidiaries even after the date of claimed dissociation. Therefore, the Alleged Subsidiaries were related parties of DLF in terms of AS-18. Hence, SEBI held that DLF has failed to disclose its related party transactions.

3.   Non-disclosure of outstanding litigation relating to Alleged Subsidiaries by DLF in

Further, the DIP Guidelines required DLF to disclose outstanding litigation in respect of its subsidiaries or any other litigations whose outcome could have a materially adverse effect on the financial position of DLF. However, the RHP/Prospectus of DLF did not provide any information of the FIR.

4.   Violations of DIP guidelines by five directors and CFO of DLF

Since the directors and CFO of DLF had authorised the RHP/Prospectus and signed the declarations certifying the compliance of DIP Guidelines, SEBI held that they have failed to ensure disclosures to be true and correct thereby violating provisions of DIP guidelines read with ICDR regulations.

5.   Deliberate and active suppression of material information amounting to Fraud in terms of PFUTP

In compilation of all the aforesaid facts, SEBI held that the entire share transfer process in the Alleged Subsidiaries was executed through sham transactions by DLF and its associates/subsidiaries by camouflaging the association of Sudipti with DLF as dissociation thereby failing to ensure disclosures of Alleged Subsidiaries.

DLF’s arguments before SEBI

1.      SEBI has transgressed its authority by not limiting its investigation to Complaint as directed in Order and extended its authority to invocation of DIP Guidelines, PFUTP Regulations, etc. without jurisdiction;

2.       SEBI has violated the principles of natural justice by denying request for inspection of documents;

3.       At the relevant point of time, Mr. Sinha was neither an investor nor a subscriber to the shares of DLF or related to the securities market and therefore had no legitimate cause to take recourse to the jurisdiction vested in SEBI;

4.       The RHP/Prospectus also fairly disclosed the developmental rights in the land owned by Sudipti and the risk relating to the said development rights;

5.       SEBI has exercised its regulatory powers at distant point of time, which would only be   counterproductive to the interests of the securities market and millions of investors who have invested in shares of DLF;

6.         SEBI had reviewed and issued comments/observations on DRHP;

7.         SEBI did not allege any motive behind the alleged acts;

8.        DLF acted in good faith on the basis of expert advice of Merchant Bankers and legal advisors and no mala fide intent can be imputed on them;

9.      SEBI has applied incorrect to test for determining Alleged Subsidiaries as “related party” or “subsidiary”;

10.       There was no dealing in securities, hence no fraud under PFUTP Regulations;

11.      No shareholding/voting rights in or control over Alleged Subsidiaries for the purpose of holding-subsidiary relationship;

12.   SEBI has adopted an incorrect yardstick to deduce control by relying upon the definition of “control” under AS-23 and the SAST Regulations;

13.     FIR is neither a litigation nor one which could affect the operations and finances of DLF, as required to be disclosed of DIP Guidelines.

Key Conclusions in SEBI’s order

SEBI concluded that non-disclosure/omission of material information in RHP/Prospectus makes the Issuer, its directors and CFO liable for violation of DIP guidelines/ICDR regulations. Active and deliberate suppression of material information in RHP/Prospectus amounts to fraud in terms PFUTP Regulations and consequently restraining access and prohibiting dealing by Issuer, its directors and CFO in securities market.

However, DLF has filed an appeal before the Securities Appellate Tribunal (“SAT”) against the order of SEBI which is pending.

- Supreme Waskar

Thursday, October 23, 2014

A Case Study for Spinoffs

Mergers and acquisitions (M&A) transactions tend to be analyzed mostly from the acquirer’s perspective, whether they involve mergers or takeovers. At the same time, they have enormous implications for the target or the seller. Businesses may have to be downsized, contracted or split due to which companies may have to engage in sale transactions or restructuring of their business undertakings. There are a number of such restructuring options in the form of divestitures, which involve sales of subsidiaries or business divisions by a company. Other sophisticated forms of restructuring predominantly used in the U.S. include equity carve-outs, spin-offs, split-offs, and split-ups, which provide a number of transactional options for corporate restructuring. In India too, such transactions are fairly common in the form of slump sales, spin-offs as well as demergers.

Despite the varied nature of these M&A transaction structures, the focus of business and legal literature has largely been on mergers and takeovers, and far less on divestitures. In this context, a brief analysis in Knowledge@Wharton of the proposed spin-off of Hewlett-Packard into two companies is interesting. This transaction seeks to represent a case study in the manner in which corporate spin-offs can be structured and implemented.

On the one hand, there are similarities among the various transactions in that they are undertaken with the expectation of unlocking shareholder vaue. On the other hand, as the study indicates, there are striking dissimilarities between mergers or takeovers as well as spin-offs. While the essence of a merger or takeover involves synergies in the operations due to which the profitability of the combined businesses is greater than the sum of their parts (popularly referred to as the “2+2=5” phenomenon), in a spinoff the value is unlocked by separating the businesses because “the whole is worth less than the sum of the parts”. On another count, while the focus in a merger or takeover is on the post-transaction integration, in a spinoff it is on disintegration which must lead to two companies that can be independently freestanding.

These intricacies in the business rationale for different types of M&A transactions is worth noting. Given profile of the company and the size of the transaction (with each of the two resultant companies expected to earn annual revenues of over US$ 50 billion), the HP spinoff is likely to be closely watched as a suitable case study for the busines and legal outcomes of the transaction.

Wednesday, October 15, 2014

Foreign Direct Investment: Trusts as Investment Vehicles

[Vishal Achanta has contributed the following guest post. Vishal is a 5th year student at the National University of Advanced Legal Studies, Kochi]

Recently, two investment vehicles have been introduced that as per the relevant SEBI regulations are to be set up as trusts: Real Estate Investment Trusts (‘REITs’) and Infrastructure Investment Trusts (‘IITs’). Both are intended to be pooling vehicles for domestic and foreign capital, and the Securities and Exchange Board of India (‘SEBI’) indicated that further guidelines regarding foreign investment into these vehicles would be laid down by the Reserve Bank of India (‘RBI’). This turns the spotlight onto a rather dimly lit corner of our Foreign Direct Investment (‘FDI’) policy that will need to be evolved to accommodate these vehicles: that of FDI into trusts. The aim of this post is to explore the rules that currently govern these transactions, and suggest the direction that future regulation might take.

Trusts have been the fund vehicle of choice for Venture Capital Funds (‘VCFs’; these are nowadays better referred to as Alternate Investment Funds or ‘AIFs’[1], and are employed by private equity and venture capital investors) due to their tax efficient nature. Much like REITs and IITs, AIFs are ‘domestic pooling vehicles’: they are regulated by SEBI and situate in India, but will often collect and deploy foreign capital.

An AIF set up as a trust will issue ‘units’ in exchange for contributions from investors; the possession of a unit will make the investor a beneficiary of the trust. Again, like REITs and IITs, an AIF’s units come with some management rights and entitle the holder to a share of the vehicle’s profits (making these ‘units’ similar to a company’s equity).  AIFs set up as trusts essentially twist the trust form to mimic a closely held private company or a limited liability partnership (‘LLP’); the closest analogy for a REIT or IIT would be a listed company with diffused shareholding.

Thus, in the context of trusts, the FDI is made in consideration for the issue of trust ‘units’ as opposed to equity or hybrid securities of a company. The transfer or issue of a trust unit for consideration could be regarded as a ‘capital account transaction’ as defined in section 2(e) of the Foreign Exchange Management Act, 1999.

Consequently, the Department of Industrial Policy & Promotion’s (‘DIPP’) Consolidated FDI Policy 2014, and the RBI’s 2014 Master Circular on Foreign Investment lay down that the only trusts that can receive FDI are AIFs[2] set up as trusts, and that such investments will always require a Foreign Investment Promotion Board (‘FIPB’) approval. That trusts are treated with skepticism is apparent from the Consolidated Policy’s readiness to allow AIFs set up as companies to take in FDI through the automatic route, while denying this benefit to AIFs set up as trusts[3].

This discriminatory treatment of trusts is seen in each of the Consolidated FDI Policies released since 2010, and the rationale for this can perhaps be found in the FIPB’s 2009 Review[4]. Therein, the DIPP observed that unlike a company, it was difficult to ascertain with whom the ownership and control of a trust lay; in this connection, there have been news reports of proposals for FDI into trusts being rejected because the identity of the beneficiaries was unknown[5]. The DIPP acknowledged that the application of DIPP Press Notes regarding downstream investment to trusts was difficult, and expressed the concern that trust vehicles were largely unregulated[6].

In the 2009 Review, the DIPP had also insisted that a foreign investment made into the defence sector through a VCF set up as a trust adhere to the sectoral cap and other conditions, interestingly reasoning that the units of that particular trust were nearly akin to equity in a company, since the unit holders (i.e., the investors) were able to exercise a high degree of control over the trust.  The DIPP suggested that the downstream investment made by a trust into investees should itself be regarded as an indirect FDI in terms of Press Note 2 of 2009, implying that the investment into the trust is the ‘upstream’ FDI.

In its 2011-2013 Review[7], the FIPB clarified that investments made by the AIF would be regarded as FDI and would have to confirm to sectoral caps and conditions laid down in the Consolidated FDI Policy. The FIPB also seemed to suggest that an AIF could only raise funds (investment into the trust) from investors registered with SEBI as Foreign Venture Capital Investors (‘FVCIs’; importantly, FVCIs are not subject to pricing restrictions when they buy, sell or redeem trust units). Another condition imposed by the FIPB was that an AIF’s investors must be resident in a country that is a member of the Financial Action Task Force and is a signatory to IOSCO’s Multilateral MoU.

From the above paragraphs, two conclusions may be drawn: Firstly, the FIPB Reviews and the news reports cited above point to the conclusion that the concerns that the DIPP/FIPB have with trust vehicles has engendered an attitude of suspicion; resultantly, they only feel comfortable with trust vehicles if the investors into the trust are themselves regulated (like FVCIs are by SEBI), if the investments are subject to their approval, and if certain safeguards against money laundering, securities fraud and terrorist financing exist. For REITs and IITs, the implications of this may be that investors will be required to go through a lengthy and cumbersome approval process before multiple regulators and/or subjected to heavy regulation.

Secondly, an FDI employing a trust, when permitted, is potentially comprised of two ‘legs’. The ‘first leg’ is the issue of trust units to an investor. In the context of AIFs, this is the ‘pooling’ or ‘fund raising’, which requires an FIPB approval. The ‘second leg’ is the downstream investment by the trust: this is regarded as a direct FDI. Whether the ‘first leg’ is also characterized as a direct FDI, and must comply with FDI rules such as pricing guidelines on purchase and sale/redemption of trust units, is unclear. The Consolidated FDI Policy is silent on this aspect, and it seems strange to suggest that both the ‘first leg’ and the ‘second leg’ should be regarded as direct FDIs.

From a conceptual point of view, an argument might be made that the ‘first leg’ should stand outside the FDI regime, since it is a pooling of capital and not a deployment of it. This would mean that the foreign investment into the trust would be free from FDI conditions such as seeking approvals and pricing guidelines on purchase and sale/redemption of trust units. In the context of REITs and IITs however, the DIPP/FIPB will most likely try to regulate the ‘first leg’ by making it subject to their approval due to the nature of the investment and the vehicle. It would be desirable if REIT and IIT investors were not subject to pricing guidelines.

The law as it currently stands lacks clarity with regard to the rules that govern the ‘first leg’, and is marked by a cautious approach to trusts as vehicles for FDI. The status of the ‘second leg’ also needs to be clarified, given that REITs and IITs may employ special purpose vehicles (‘SPVs’), and that these SPVs may be organized as LLPs. Unless addressed promptly in the correct manner, these might prove detrimental to the success of REITs and IITs. It might be productive to begin from the ground up when laying down rules for investment into REITs and IITs, rather than trying to integrate these rules into the current FDI framework. In conclusion, it is worth noting that the only thing that might dissuade investors as much as an adverse regulatory climate is regulatory uncertainty.

- Vishal Achanta                                                                                 

[1] In 2012, SEBI replaced the Venture Capital Fund Regulations, 1996 with the Alternative Investment Fund Regulations. The latter delineates three categories of AIFs, of which VCFs are one sub-category.
[3] See also, Paragraph of the 2014 Consolidated FDI Policy, which requires FIPB approval to be obtained for FDI into every Indian company that is engaged only in the activity of investing in other Indian companies.
[6] At the time the DIPP made these observations, VCFs set up as trusts could choose to remain unregulated by SEBI. This is no longer the position; VCFs, as a sub-category of AIFs, must register with, and be regulated by SEBI.