Tuesday, December 16, 2014

Disqualification of Directors: A Dichotomy in the Companies Act, 2013

[The following post is contributed by Nivedita Shankar, who is a Senior Associate at Vinod Kothari & Company. She can be contacted at nivedita@vinodkothari.com]

In case a director were to incur disqualification under section 164(2) of the Companies Act, 2013 (the “Act, 2013”), then such director shall not be eligible to be re-appointed as a director of that company or be appointed in other company for a further period of 5 years from the date on which the company commits certain failures. Thus, disqualification under section 164(2) does not envisage immediate vacation of office. Of course, disqualification is immediate but the director is allowed to serve the present tenure in that company and in other companies in which such person is a director. The intent behind this is of course to not render the company ‘board-less’. A company can possibly not function without a board and it is keeping this in mind that section 164(2) provides a carve-out to the boards of companies which have defaulted under this section. Further, one may note that a similar provision existed under section 274(1)(g) of Companies Act, 1956 (the “Act, 1956”). However, neither was that section applicable to private companies nor did it attract the provisions of section 283 of the Act, 1956 which pertained to disqualification.

The Act, 2013 has linked section 164 to section 167 leading to an impression that disqualification under section 164 leads to automatic vacation. This may seem logical if one were to be disqualified under section 164(1) i.e. become an undischarged insolvent or is declared as being of unsound mind by a Court. Most certainly such a person cannot continue as a director. However, section 164(2) is on a different footing than section 164(1).

The failure to file financial statements or inability to redeem debentures may be due to circumstances beyond the control of the company. It is under such circumstances that the board of the defaulting company will have to take steps to make good the failure. If the company was rendered board-less, then in the absence of the decision making authority, it is incomprehensible as to how will the company make good the default.

Further, one may argue that section 167(3) of Act, 2013 tackles the possibility of a board-less company by providing that the directors will be appointed by the promoters or in their absence, by the Central Government. Such a provision did not exist under Act, 1956. With increased liabilities under Act, 2013, companies are currently finding it difficult to appoint directors on the board.  Add to that the restriction on the number of directorships, which has made it difficult for companies to scout for probable directors. Clearly, in its zeal to mitigate the possibility of a ‘board-less’ company, the law-makers have not apprehended the difficulty in finding a suitable director.

One thus has to harmoniously interpret the provisions of section 164(2) and section 167 of Act, 2013. The intent of law cannot be to incorporate such a provision which will render some other provision completely otiose. If one were to conclude that sections 164(2) and 167 were to be read together, then section 164(2) will be rendered completely redundant. Thus, section 164(2) does not lead to ipso facto vacation. It envisages vacation only at the end of the present tenure which is logical also. To conclude, a plain reading of sections 164 and 167(1)(a) may give an impression that both are linked. However, given the intent behind section 164(2), it can be taken that section 167 pertains to vacation in case of disqualifications under section 164(1) only.

Does disqualification to section 164(2)(b) of Act, 2013 also apply to  directors newly appointed in the company?

It is important to note the starting lines of section 164(2)(b), which read as follows:

            “No person who is or has been a director of a company which XXX”

Thus, to attract disqualification under section 164(2)(b), it is important that the individual has to be on the board of the company when the default actually happened. However, what if the company appoints a director after incurring the default envisaged under section 164? Will the provisions of section 164(2) also apply to such a director?

In this regard, one may first refer to the provisions of Rule 3(b) of Companies (Disqualification of Directors under section 274(1)(g) of the Companies Act, 1956) Rules, 2003 which read as follows:
“If a company has failed to repay any deposit, irrespective of the enactment, rules or regulations under which the deposits have been accepted by the companies, or interest thereon, or redeem its debentures, or pay any dividend declared on the respective due dates, and if such failure continues for one year, as described in sub-clause (B) of clause (g) of sub-section (1) of section 274, then the directors of that company shall stand disqualified immediately on expiry of that one year from the respective due dates:

Provided that all the directors who have been directors in the relevant year, from the due date to the expiry of one year after the due date, will be disqualified:


Thus, under Act, 1956 it is clear that the provisions of section 274(1)(g) are applicable to only such directors who were directors – (i) during the relevant year (ii) from the due date to the expiry of one year after the due date. Any director appointed any time after these timelines will not be liable under the provisions of section 274(1)(g). The reasoning behind the same is also logical in the sense that the section acts as a deterrent to existing directors from incurring any disqualification under the section. Admittedly, a new director, during whose directorship the default did not occur, cannot be held responsible for the same and suffer the misdeeds of his predecessors. If that was to be the reading of section 274(1)(g) read with allied Rules, then the proviso to section 274(1)(g)(B) would have been rendered meaningless. The intent of the proviso is to ensure that the director who has incurred disqualification under section 274(1)(g) will be disqualified for a period of 5 years from being appointed but not beyond that. Thus, where the defaulting director is freed of disqualification after a period of 5 years, then it is not logical to conclude that a new director, who is the victim of such misdeeds, will incur any disqualification under section 274(1)(g).

Further, if one were to read the provisions of section 274(1)(g) with the allied Rules to mean that even new directors will attract the disqualification, then possibly no director will be willing to get appointed in such a defaulting company. This, however, cannot be the intent of law. The law cannot de-motivate directors from taking up new directorships. On the contrary the intent of law ought to be to deter companies from defaulting.  Even if companies end up defaulting, then adequate opportunity should be given to the company and its directors to make good the default.

Conspicuously there is no corresponding provision to Rule 3 of Rules, 2003. This will however, not change the premise of section 164(2)(b). Even if an express provision has been dropped altogether, the intent of law cannot be taken to have changed. Hence, section 164(2)(b) needs to be interpreted on similar lines as section 274(1)(g) of Act, 2013. To conclude, any director inducted after the company has defaulted as envisaged under section 164, will not be disqualified for the purpose of this section.

- Nivedita Shankar

Tuesday, December 9, 2014

Winding-up Petitions and Arbitration Clauses

The relationship between the statutory remedies provided by the Companies Act and the Arbitration Act has proven to be controversial in recent times. The difficulty arises usually because the basis on which the statutory remedy is invoked (eg oppression, winding-up) is often an underlying commercial dispute which is the subject matter of an arbitration clause. The courts have given different answers to this depending in particular on the nature of the statutory remedy: thus, in Fulham, which this Blog discussed, the Court of Appeal held that an arbitration clause is effective even if a claim is made for unfair prejudice claim (oppression and mismanagement). The Court there expressly distinguished between unfair prejudice and winding-up; and the latter question was considered in a judgment given yesterday in Salford Estates v Altomart.

Altomart was the lessee of commercial premises in the Salford Shopping Centre in Manchester. The Shopping Centre was owned by the lessor, Salford Estates. The Lease Deed, which contained an arbitration clause, provided that Salford would provide certain facilities, such as the insurance of the premises, for which the tenant would pay by way of a service charge over and above the annual rent. In 2012 a dispute arose about Altomart’s liability to pay this service charge and this was referred to arbitration. The sole arbitrator held that Altomart was liable to pay about £64,000 for the three years from April 2010 to March 2013. Salford claimed, in addition, a sum of about £22,000 towards the service charge for the year ending 31 March 2014. As this was not paid immediately, Salford presented a winding-up petition on the ground that Altomart was unable to pay its debts. In India, this ground, of course, was formerly section 434(1)(a) of CA 1956 and is presently to be found in section 271 of CA 2013 (in England it is section 122(1)(f) of the Insolvency Act 1986). Altomart claimed that since the underlying debt was disputed the court was required to stay the winding-up petition by virtue of section 9 of the English Arbitration Act, 1996. Section 9 of that Act roughly corresponds to section 8 of the Indian Act, which provides that a ‘judicial authority’ seized of a matter which is the subject matter of an arbitration agreement shall stay those proceedings.

Salford argued that section 9 did not apply because a winding-up petition is either not arbitrable or because it is not a ‘claim’ for the payment of the debt that was the subject matter of the arbitration agreement. The Chancellor, Sir Terence Etherton, who gave the leading judgment in the Court of Appeal, agreed that section 9 does not apply to a winding-up petition presented on the ground of inability to pay debts but reached this conclusion on a different ground. His Lordship held that non-payment of the underlying debt is only evidence of the company’s inability to pay its debts: a winding-up petition is not, therefore, a claim for payment of that debt. Indeed, it is an abuse of process—in England as in India—to institute a winding-up petition to compel the payment of a disputed debt. Etherton C gave two other reasons in support of the conclusion that section 9 does not apply. First, and it is submitted that this is correct, the making of a winding-up order need not result in an order for the payment of the petitioner’s debt. Whether it does depends on the value of the company’s assets and claims by other creditors. Secondly, if the winding-up petition alleges non-payment of more than one debt, and some of these debts are the subject matter of an arbitration agreement while others are not, the mandatory stay contemplated by section 9 (in India section 8) is essentially unworkable: the petition as a whole obviously cannot be stayed, and if the petition is not stayed, the arbitration cannot proceed because the winding-up order, if any, can extinguish or modify the debt. This, Etherton C held, was another indication that Parliament could not have intended to fetter the jurisdiction of the Company Court by requiring a mandatory stay of a winding-up petition. His Lordship pointed out that the problem in Fulham was different because there:

No order was sought to wind up the FAPL.  Furthermore, that case, typical of the usual section 994 petition, was essentially a private dispute in relation to the affairs of a solvent company which, therefore, neither engaged any public policy objective of protecting the public where a company continues to trade despite being unable to pay its debts nor involved a class remedy for the company’s creditors.

However, it does not follow that the arbitration clause is irrelevant either, because the court—under the Companies (in England, Insolvency) rather than the Arbitration Act—has a discretionary jurisdiction to stay a winding-up petition, and Etherton C held that it would be wholly exceptional to not take into account the legislative policy of the Arbitration Act in exercising this discretion. That is, if the company disputes the debt (whether bona fide on substantial grounds or not), and there is an arbitration clause, that constitutes a ‘dispute’ for the purposes of the Arbitration Act ‘irrespective of the substantive merits of any defence’, and the Court would exercise its discretion to stay the winding-up petition in favour of arbitration. The main difference between the analysis of the judge below and that of the Court of Appeal is that the stay is discretionary rather than mandatory, although Etherton C could not envisage circumstances in which it would be appropriate to not exercise the discretion consistently with the policy of the Arbitration Act.

Saturday, December 6, 2014

Flexibility for Investments by Trusts

Trusts in India are governed by a colonial-era legislation, the Indian Trusts Act, 1882. This legislation severely restricts the investments that trustees may make out of trust funds. Section 20 of the Trusts Act provides a list of instruments into which the trustees could invest the trust funds. These include securities of the type that were issued in the colonial period, including “promissory notes, debentures, stock or other securities of … the United Kingdom of Great Britain and Ireland”. Some of these provisions have outlived their utility and relevance in more modern times. Apart from its archaic nature, section 20 also limited the options available to trustees – for example, investment in shares of companies is proscribed as a general matter.

The purpose behind the restrictions on investments is understandable. Trustees, while handling beneficiaries’ funds, cannot afford to take decisions that might place those funds at risk. On the other hand, there are a number of countervailing factors as well. Trustees may be hamstrung in making investments with lucrative returns so as to deprive the beneficiaries from those. Also, given that the Trusts Act applies largely to private trusts, the beneficiaries ought to be capable of bearing that risk.

After assessing these matters, the Cabinet has now cleared amendments to section 20 of the Trusts Act to rid it of its obsolescence and also to facilitate the broadening of the types of securities into which the trustees may be allowed to invest. Under this dispensation, either the trust instrument can expressly state the types of securities into which investment may be made, or investments may be made in any securities or class of securities the Central Government may specify by notification in the Official Gazette. This move could result in further flow of investment into the securities markets.

Paper on Limited Liability Partnership Law in India

Professor Afra Afsharipour has a paper titled The Advent of the LLP in India, the abstract of which is follows:

In 2008, India passed a ground-breaking law to introduce the Limited Liability Partnership form into Indian business law. The Indian LLP Act was the first major introduction of a new business form in India in over 50 years. While the partnership and corporate forms (i.e. companies under the Indian Companies Act) have long flourished in India, both forms have presented challenges for certain Indian businesses. The Indian government’s impetus for the LLP Act was to develop a business association form that could better meet the needs of entrepreneurs and professionals with respect to liability exposure, regulatory compliance costs and growth. This chapter begins with a broad overview of the political and legislative process which led to the adoption of the LLP Act. It then addresses the critical aspects of the Indian LLP Act, and analyzes some of the challenges and uncertainties that may derail the success of the LLP form.

The paper’s detailed analysis of the evolution and rationale for the LLP Act is extremely relevant and timely, especially given the limited literature about this business form in India.

Readers interested in this topic may also refer to two previous papers:

Thursday, December 4, 2014

Revised FDI Norms for Construction Notified

Last month, we had carried a guest post summarising and commenting upon the changes to the FDI norms in the construction industry, which relaxed several conditions. Now the Department of Industrial Policy and Promotion (DIPP) has made these changes effective in the form of Press Note No. 10 (2014 Series).

Wednesday, December 3, 2014

Proposed Amendments to the Companies Act, 2013

It has been just a year since certain provisions of the Companies Act, 2013 (the 2013 Act) were brought into force, and the Government has already yielded to pressure from industry to address some concerns within the legislation. The Union Cabinet has approved the introduction of the Companies (Amendment) Bill, 2014 in Parliament. At the time of this writing, only a press release of the Government highlighting the amendments is available, and not the actual text thereof.

The amendments proposed can be categorised broadly into two types. The first relates to ironing out drafting deficiencies and inadvertent errors in the 2013 Act. I do not propose to deal with those in this post. The second, and more important, amendments are intended essentially “for the ease of doing business”. Some of the changes suggested on this count are substantive and could have a wider impact. It is on these changes that I propose to focus in this post.

In order to “meet corporate demand”, the Government proposes to prohibit the public inspection of board resolutions filed with the Registrar of Companies. This is understandable as board resolutions may contain commercially sensitive information, which need not be disseminated widely. Another amendment relates to the relaxation of restrictions in section 185 of the 2013 Act, which will now exempt loans to wholly owned subsidiaries and guarantees/securities on loans taken by banks from subsidiaries. Section 185 came under heavy criticism due to its excessively onerous nature, as it did away with exemptions previously available under the Companies Act, 1956. The amendments propose to substantially revert to the previous position.

One of the significant areas affected by the amendments is related party transactions (RPTs). Three principal changes are suggested. First, the audit committee will be empowered to give omnibus approvals for RPTs on an annual basis. Presumably this is to avoid consideration of RPTs on a case-by-case basis. Second, the current requirement of obtaining a special resolution (75% majority) of disinterested shareholders for material RPTs is to be altered to that of an ordinary resolution (simple majority). Third, RPTs between holding companies and wholly owned subsidiaries are to be exempt from the requirement of disinterested shareholder approval. While these changes may seem miniscule at the outset, they could have a significant effect of diluting the regulation of RPTs, particularly the relaxation of the approval requirements relating to disinterested shareholders. As we have previously discussed on this Blog, the regulation of RPTs forms the bulwark of corporate governance efforts in India where shareholding tends to be concentrated added with the significant presence of corporate group structures. The focus of the 2013 Act has been to address the agency problems between the controlling shareholders (promoters) and minority shareholders. Any dilution to these basic principles would compromise the protection to be conferred upon minority shareholders. To that extent, some of the relaxations on RPT regulation must be viewed with circumspection.

Also, while one cannot quarrel with the need for the Companies Act and the SEBI norms on corporate governance (currently represented by clause 49 of the listing agreement) to operate in tandem, the need for harmonization ought not to drive the standards down. For instance, SEBI amended clause 49 of the listing agreement with effect from October 1, 2014 to bring it in line with the 2013. Now, the justification for altering the audit committee approval mechanism for RPTs in the 2013 Act is to “[a]lign with SEBI plicy and increase the ease of doing business”. It is unclear whether SEBI norms are to be aligned with the legislation or vice versa. The iterative exercise of streamlining the legislative provisions (i.e. 2013 Act) and the SEBI norms (i.e. clause 49) should not unwittingly result in a drop in the standards of governance.

Finally, something must be said about the justification for the “ease of doing business”. No one can argue with the assertion that regulation should not stifle innovation and entrepreneurialism. All factors must be carefully balanced in the legislation and rulemaking process. They must provide the requisite comfort to investor as well as other stakeholders that are affected by business activity. However, some of these efforts also appear to be operating in the shadow of doing business rankings (principally those put out by the World Bank group) and the need to demonstrate better environment in India for foreign investors. While these indicators are representative of the relative ease of doing business among various countries, they must be considered only as a means and not the end.

Tuesday, December 2, 2014

New Delisting Regulations - tougher rather than easier

New regulations on delisting have been approved by SEBI.  I wrote a column on December 1, 2014 (print edition) of the Business Standard, on how a new element of requiring at least 25% of the public shareholders as of a certain date to have participated in selling their shares, would nudge toward counter-productive outcomes.  I have pasted the copy below.

Earlier, Umakanth had commented on the new delisting regulations too, which in turn, also tagged my earlier column on the need to synchronize the takeover regulations and the delisting regulations.  SEBI’s press release suggests that there has been effort in the new regulations to address that aspect of the regulatory problem – the actual draft of the regulations is awaited.

"Sebi eases de-listing norms," was the theme of nearly every single media report after the board meeting of the securities market regulator held on November 19. Even before the board meeting, scores of reports had dotted the media about how at that meeting, Sebi would be making life simpler for transparent de-listing of shares from Indian stock exchanges.

The fine print is yet to be out. However, even while waiting for the fine print, the very first paragraph in Sebi's press release on the subject makes it clear that de-listing transactions have been made far more difficult - they have not been made easier. The paragraph says: "The de-listing shall be considered successful only when (A) the shareholding of the acquirer together with the shares tendered by public shareholders reaches 90 per cent of the total share capital of the company and (B) if at least 25 per cent of the number of public shareholders, holding shares in dematerialised mode as on the date of the board meeting which approves the de-listing proposal, tender in the reverse book building process."

The widening gap between approval of regulations by Sebi at a board meeting and the actual draft regulations being notified is worrisome. This practice demonstrates that the directors on the Sebi board, despite presiding over the governance of a regulatory body, consider the actual language of the regulations as too trivial to bother themselves with. It is evident that they approve regulatory prescriptions in abstract concept, although anyone involved with regulations anywhere in the world would know that the devil in regulatory frameworks lies in the detail. That is worthy of comment in a separate column altogether.

Coming back to the Sebi press release, not only has de-listing been made tougher, the new intervention in the regulations is a material deviation from well-established principles of Indian corporate law. The prescription that 25 per cent of the public shareholders in number have to tender their shares is seriously problematic in implementation. Worse, it is blatantly in contradiction with the colour sought to be given to the "reform" of the regulations i.e. of making things easier. Two other new conditions have been imposed. First, the number of shareholders should have tendered their shares in dematerialised form. Second, the number of shareholders should be reckoned on the date on which the board approves the de-listing.

It is well possible that a company can never delist simply because shareholders who held shares on the date the board approved may have sold their shares. Therefore, if there is a churn in the holdings of public shareholders, it is possible that more than 75 per cent of the shareholders who held shares on that date are no longer shareholders. In other words, the condition of at least 25 per cent shareholders in number as of a certain date should tender shares, could never be met.

The most serious problem with the new approach is that Indian securities law would deviate for the first time from the well-established norm of corporate democracy - of reckoning voting rights in terms of percentage of shareholding rather than in terms of number of shareholders. For example, when company law lays down the standard for a resolution to be passed, it prescribes counting the vote in terms of voting rights attached to the shares. It does not provide for attaching equal voting rights to all shareholders regardless of how many shares each one owns. Sebi's new approach or introducing the number of shareholders as a metric, would initiate new jurisprudence that is wholly unnecessary.

Such an approach could in fact incentivise fraud and impose enormous transaction costs on market players and serious administrative costs on Sebi to monitor compliance. When Sebi's stated objective is to combat fraudulent collusion between large public shareholders and the promoters when a company is being de-listed, it simply has to step up the game for enforcement. By changing the law, it is imposing an unwarranted burden on the market and on itself. Take the law on oppression and mismanagement under company law.

The law places a materiality threshold for eligibility to approach the enforcement machinery in terms of 10 per cent of the voting rights or a hundred shareholders in number. This is to enable a greater access to justice if there were widespread discomfort among shareholders regardless of number of shares held. However, this very provision is a source of enormous litigation. Often, just before initiating litigation, shares get transferred to multiple persons to meet the eligibility threshold of the larger number of aggrieved shareholders.

Weeks and months are then spent in intense litigation to determine the legitimacy of the very threshold to assert rights. Company managements typically allege that the transfers are a fraud only to meet eligibility norms. Shareholders argue that the literal meaning of the law should be adopted. In short, the new regulatory measure will nudge the securities market too towards adopting such bad practices, with the resultant litigation.

Sebi's shoulders are very broad and their muscles are highly empowered to act against fraudulent practices when it finds collusion between promoters and sections of public shareholders. Both the Sebi Act and the regulations prohibiting fraudulent and unfair trade practices give Sebi sweeping powers. It should use that muscle for enforcement if it finds abuse in the de-listing market. The propensity to legislate against every problem, real and perceived, makes life difficult for all, and worse, seeds further bad conduct.

SEBI’s Proposal for a Dividend Policy

Last week, media reports indicated that SEBI is considering imposing a requirement on listed companies to come out with a dividend policy that will compel (or at least nudge) profitable cash-rich companies to distribute their profits to shareholders. The introduction of more stringent requirements on companies to state their dividend policies will introduce a great deal of transparency on this count. But, at the same time caution must be exercised not to curb the business decision-making process of companies which is left to the management and boards who possess the necessary knowledge and expertise.

The analysis must begin with the separation of powers between the board and the shareholders. Since boards are vested with the powers of management, they are naturally best-placed to determine whether the profits of the company are to be distributed or to be ploughed back into the business. Hence, within the scheme of company law, the board propose dividends which are then to be approved by shareholders. Shareholders effectively possess only a veto over the decision on dividend. They can reject the dividend or reduce its rate, but they cannot increase the dividend over and above what the board has proposed.

Given this scenario, if SEBI’s proposal brings about transparency as to dividend declaration by companies through the need for specifying their policy, that would be beneficial to the markets. Shareholders then have the necessary information about dividend declaration without necessarily impeding the flexibility of the boards to adopt any policy as they deem fit. But, if SEBI’s diktat is likely to impose obligations on boards to distribute excess cash through profits, that would be undesirable.

The question of compelling profitable companies to distribute their hordes of cash is not a new one: it has been daunting global companies like Apple for the last few years with activist investors applying pressure on them to distribute profits either through dividends or buyback of shares. The use of market mechanisms to compel companies to distribute profits is understandable. Investors may either impose discounts on companies that horde cash profits, exit such companies or even put pressure on companies through activist investors. They may in turn be aided by informational intermediaries such as proxy advisory firms.

What SEBI must avoid is a prescriptive approach towards dividend declaration, in terms of imposing rules or guidelines on when to distribute profits, or how much. Historically, the law has operated in somewhat converse fashion. Companies are not allowed to distribute all their profits in the form of dividend, and are compelled to transfer some part of the profits towards reserves, as it were “to save for a rainy day”. This philosophy continues in section 123 of the Companies Act, 2013 as well. So, now to force companies to distribute their profits would be at variance with this principle. Hence, as dividend declaration is dependent upon the cash needs of the companies business it must be a matter left to the management and boards to decide (of course with the required level of transparency and checks and balances required by corporate law and governance norms).

The usual concern when companies do not distribute profits is that they may be instead be utilised in a manner that adversely affects minority shareholders, such as by enriching management (e.g. executive compensation) or the controlling shareholders (e.g. related party transactions). However, other mechanisms in corporate law effectively address these concerns of transactions that enrich insiders at the risk of outside shareholders. Imposing tighter regulation on dividend declaration is an area where the regulator must tread carefully and with circumspection.