Thursday, February 26, 2009

Is it time to sentence Share Warrants to Dishonorable Discharge?

(SEBI DIP Guidelines amendments Part 2)

Several amendments have been made to the SEBI DIP Guidelines as briefly highlighted here. I am sharing a few more thoughts on two areas, but in separate posts.

This post focuses on the increase of minimum deposit on Share Warrants from 10% to 25% of issue price. This amendment was the least unexpected, even too late. Too late because it has already been heavily misused and abused and also made at a time when Promoters are least likely to subscribe to Share Warrants.

In fact, there appears to be literally a flood of cases of Promoters allowing the 10% deposit on existing Share Warrants to be forfeited. I have even heard that advisors are straining their legal creativity in finding ways in which even this 10% could be returned to the Promoters! True, most I have heard of till now sound bird-brained but, considering the stakes involved, further efforts are on.

Coming back, let us quickly highlight some aspects of Share Warrants to place the recent amendment in context. Share Warrants are instruments that give a right and option to the holder to acquire shares within a specified time and at a specified price. They are thus similar to ESOPs and also to options traded in markets, though the latter represent private contracts where the listed company is not involved.

Share Warrants thus have several advantages. You don’t need to pay the full share price upfront. You can exercise the Share Warrants anytime. You even have the option to back out and let the deposit be forfeited. And so on.

For the Company, they were often useful as, for example, acting as sweeteners to otherwise unattractive Unsecured, Non-Convertible Bonds. They also had the weak justification, in the early years of globalization, of allowing Promoters to increase their stake to prevent hostile takeovers. However, they quickly degenerated to being used almost exclusively to enrich Promoters, at the cost of the Company and other shareholders.

Consider, from the point of view of the Promoters, the free lunch of Share Warrants.

You get the Share Warrants (earlier for free) by paying just 10% deposit. Even if this deposit is forfeited, you still get to share it to the extent of your holding (e.g., a Promoter holding 50% of the Company thus shares 50% of the forfeited deposit).

Even this deposit of 10% was an absurdly low amount – it barely covered the interest on the balance 90% for 18 months. But interest is obviously not the only factor. Often the bigger advantage is of the option. Having done and reviewed several valuations of options in context of ESOPs, I have found that in numerous cases, particularly in times of higher volatility, even the increased 25% deposit may be found to be too low.

Further, in case of market-traded options, the option premium is an additional cost and not part-payment of the purchase price. Thus, even if you decide to actually purchase the shares, you pay the full purchase price in addition to this premium. In case of Share Warrants, the deposit paid is adjusted against the issue price.

Till a recent prohibition, Share Warrants also represented simple arbitrage. Sell today and buy Share Warrants by paying 10% deposit. This also meant that the surplus cash could be used to acquire higher shares and raise the balance amount later.

It was also quickly realized by Promoters that Share Warrants could help avoid the creeping acquisition limits. Well planned, the Promoters could increase their holding by 15% over 18 months without violating the 5% creeping acquisition limits. All this by paying just 10% today and that too at today’s prices! Needless to say, this technique was widely used.

How sound was the deal from the point of view of the Company? Almost certainly a loss making one since if the same deal was offered to a third party, he would have paid a far higher amount. The public shareholders obviously also lost.

SEBI of course has been chipping away slowly at the anomalies. The early amendments included reducing the conversion to period to the current 18 months and the 10% deposit, increased to 25% now. There is a ban on preferential allotment to those who have sold in last six months. The lock-in has been effectively increased, as discussed separately here.  And so on.

Consider, though, from a different perspective, these very amendments over time which appear mainly intended to protect Share Warrants from misuse by Promoters. What was the result on Share Warrant itself as an instrument? How sound a financial proposition they appear to third party, non-Promoter investors? How attractive would Share Warrants sound, if one has to pay 25% upfront, if one has to convert them within 18 months, if one has to suffer double lockin, if the conversion price has to be a minimum one related to recent prices, and so on?

The latest amendment comes not only too late but also at a time when Promoters are least in the mood to acquire Share Warrants simply because the six monthly average prices are typically higher than the current market price.

What then is the justification for continuing to allow issuance of an instrument that is a win-win proposition for the Promoters and a lose-lose one for the Company and the public shareholders? Is it not time for, instead of making marginal improvements, simply sentencing Share Warrants to a dishonorable discharge, having led, far more often than not, a disgraceful existence?!

Alternatively, major changes are required if they are to be continued. Linking pricing and deposit for Share Warrants to past average prices is absurd. Share Warrants are equivalent to options and should be valued as such. Even a rudimentary version of the Black-Scholes formula would give a fairer price. Remember, this technique is already being used, albeit as an alternative, for valuing and accounting for ESOPs.

And, at the very least, it is this price that should be paid. The amount should be paid as a premium for being granted the Share Warrants and not as a deposit that is adjustable towards the issue price!

Also, at the risk of sounding petty, I would even suggest that if this amount paid by Promoters is to be forfeited, it should be distributed as a special dividend/bonus to non-Promoter shareholders! (as I said, sharp minds are hard at work, so I keep hearing, to find ways to return the forfeitable deposits to the Promoters on existing Share Warrants suddenly found to be out of the money).

There should also be a commercial justification for issuance of Share Warrants, especially from the point of view of the Company. The Company puts itself in a peculiar position when it issues Share Warrants. Other Potential investors are wary of the potential dilution and thus the Company becomes slightly unattractive to them. The Company may or may not receive the balance amount for the shares. And it may receive this balance price at any time the Promoters deem fit. Is it a commercially sound proposition for the Company to issue Share Warrants on such terms and where monies come in such uncertain manner and timing? Only if the answer is a clear yes, that the Share Warrants should be issued.

Another alternative is to ban issuance of Share Warrants to Promoters altogether, just as ESOPs are so banned.

-       Jayant Thakur

Wednesday, February 25, 2009

Precision Remains Elusive with Investment Law

I wrote the following column in the Business Standard on February 23, 2009:

In a bold move, the government has opened up foreign investment in an unprecedented manner. The move legitimizes many a structure that would have hitherto been keeping even their authors shy.

The Cabinet Committee on Economic Affairs has taken a policy decision that any Indian company in which foreign ownership is not more than 50% of the equity stake and where foreigners do not have a right to appoint a majority of the directors on the board, could freely invest in other Indian companies. Such investments would not be regarded in any manner as a foreign investment even indirectly.

In a press note issued by the Department of Industrial Policy and Promotion (“DIPP”), the government has stated that unless an Indian company is “owned” (ownership of more than 50% equity) or “controlled” (power to appoint a majority of directors) by foreign investors, investments by it into other Indian companies would not be regarded as foreign investment at all. The investment by such an Indian company – one over that a foreign neither “owns” nor “controls” would be regarded as an investment by an Indian company.

The term “control” has been defined purely as the ability to appoint a majority of the directors – a statutory right that would flow in India from owning at least one share more than 50% of the equity of a company – the DIPP’s definition of “owned” picks exactly the same thing.

Therefore, in a company in which foreign investment is regulated by way of sectoral caps, a foreign investor could take a direct equity stake to the fullest extent of the permitted sectoral cap, and the balance beneficial interest could be taken through one or more Indian companies where the foreign investor holds not more than 50% equity.

There is a flip side to this approach. Even if multiple unrelated foreign investors
cumulatively hold more than 50% in an Indian company, the Indian company would be treated as a foreign investor.

Therefore, any investment by such Indian company into the equity of another Indian company would be treated entirely as a foreign investment, rather than as a proportionate investment. For example, if foreign holding in an Indian company is 51% and that company invests 26% in another Indian company, the foreign investment in the second company would not be regarded as 51% of 26% i.e. a bit more than 13%, but would be regarded as a foreign investment of 26%.

Such an approach poses several challenges. While this may be a legitimate way to deal with a single foreign investor who owns a majority in Indian company and uses its Indian subsidiary to make further investments, there are a number of board-driven Indian institutional companies that have attracted foreign investment, and would get similarly treated.

For instance the new approach of the government will not differentiate between a Hindustan Unilever Ltd. and say, an ICICI Ltd. The former is clearly a subsidiary of
a foreign company while the latter is an Indian company that has majority ownership in foreign hands, and therefore, technically, entailing the power to appoint a majority of the board of directors being vested in foreign hands.

There is one other major anomaly with the DIPP’s latest approach. In treating the entire holding by an Indian company owned or controlled by foreign investors, an exception has been made for investment in wholly owned subsidiaries. The foreign equity stake in a wholly owned subsidiary would be regarded as a mirror image of level of foreign equity shareholding in the parent.

Therefore, if a 51% foreign-owned Indian company invests in 100% of another Indian company’s equity, the foreign holding in the latter would be regarded as 51%. However, if the 51% foreign-owned Indian company were to give 5% in its subsidiary to another Indian investor, and holds 95%, the foreign investment in the subsidiary would be regarded as 95%. Surely, this is a clear disincentive for foreign investors to share their holdings with other Indian investors.

Clearly, all of this would be relevant only in the case of sectors where foreign holding is regulated. There is yet another self-inflicted problem that the DIPP needs to resolve. Last year, in a first, the DIPP started objecting to Indian companies having foreign investment acting as “operating-cum-holding companies” i.e. as companies that have legitimate foreign investment, their making investments in other Indian companies has been regarded as being per se illegitimate.

Nobody has challenged this stance in a court of law so far. With the notification of the new dispensation, the DIPP ought to hasten to clarify that henceforth, having brought clarity to the meaning of the term “foreign owned Indian company”, such a stance will not be taken by the government.

Predictability is the hallmark of good investment law. However, precision continues to be elusive.

Tuesday, February 24, 2009

A Resurgence of Bank Nationalisations

An offshoot of the global financial crisis has been the significant changes in economic policies in the developed world. The recent phenomenon relates to increasing calls from leading economists to nationalise troubled banks, particularly in the U.S. The concept of nationalisation was previously associated with the so-called ‘socialist’ economies, but is now becoming closer to reality even with proponents of the free market.

As Paul Krugman notes in his column in the New York Times, “Comrade Greenspan wants us to seize the economy’s commanding heights. O.K., not exactly. What Alan Greenspan, the former Federal Reserve chairman — and a staunch defender of free markets — actually said was, “It may be necessary to temporarily nationalize some banks in order to facilitate a swift and orderly restructuring.” I agree.”

Further, Matthew Richardson and Nouriel Roubini, professors at New York University's Stern School of Business note: “As free-market economists teaching at a business school in the heart of the world's financial capital, we feel downright blasphemous proposing an all-out government takeover of the banking system. But the U.S. financial system has reached such a dangerous tipping point that little choice remains.” Such comments arise in the context of concerns regarding the continued viability of leading U.S. banks such as Citibank and Bank of America.

Apart from the policy rhetoric, nationalisations tend to invoke certain fundamental questions. Often, there is a conflict of interest between shareholders of banks (who tend to take a ‘haircut’, as they say, in a nationalisation by having to give up their shares at low values) and that of other stakeholders (such as tax payers and the public who suffer if Governments have to continually backstop troubled banks without being taken over). There is also the question of whether governments are in a better position to run businesses such as banks as opposed to the private sector.

These issues are not novel in the Indian context with a substantial part of the Indian banking industry being populated by nationalised banks. Many of these issues have been the subject matter of intense debates in 1969 and 1980 when several Indian banks were nationalised. Some of these were even litigated all the way in the Supreme Court of India (R.C. Cooper v. Union of India, AIR 1970 SC 564). What is interesting in the current scenario is that the revival of this debate in the U.S. and other countries has thrown the spotlight on the Indian experience with reference to bank nationalisations – while the analysis in the Knowledge@Wharton suggests caution regarding adopting the Indian model of nationalisation, an interesting fact reported yesterday is that Citibank’s market capitalisation has become less than that of the State Bank of India (which is not only India’s largest bank but is also in the public sector). The key difference, however, is that the recent moves recommend nationalisation as a temporary measure, while in India it has become a permanent feature (although several nationalised banks do have public shareholders and their shares are listed and traded on stock exchanges).

Indirect FDI: More Changes on the Anvil

In order to address the concern that Press Notes 2 and 3 of 2005 (discussed here) will allow foreign investors to take indirect stakes in sectors where foreign investment is otherwise prohibited (e.g. multi-brand retail trading), it is reported in the Economic Times that the Government is proposing to issue another Press Note that clarifies this issue. The concern arises because, under these Press Notes, investment by an Indian company (that is owned and controlled by an Indians) in one of these sectors will be treated as domestic investment, although there may be foreign investment in that holding company up to 49%. The Economic Times reports that “sectors where foreign investment is prohibited, such as multi-brand retail, agriculture, lottery and atomic energy, would be kept out of the reach of even indirect foreign investment.” It appears that we will have to await yet another Press Note on this issue.

The Policy Over ECBs

Satyajit Gupta has an interesting column in The Mint that reviews the changes in the external commercial borrowings (ECBs) policy over the last few years in the context of changing economic conditions both within India and around the world. As for recent efforts by the Reserve Bank of India (RBI), Satyajit notes:
“ECBs have suffered in view of the adverse economic conditions coupled with the regulatory hurdles; a quick look at statistics shows that the quantum of ECBs accessed through the automatic route (that is, without prior RBI approval) fell drastically, from $1.104 billion (Rs5,508.96 crore) in October 2007 to $321 million in October 2008. RBI has tried to address the problems faced in the realm of ECBs by announcing a number of steps to liberalize the policy. These steps include increasing the all-in-cost ceiling (the all-in-cost ceiling is the total amount including interest, fees and expenses, except certain specified fees and expenses, per loan) allowing rupee expenditure from ECB proceeds, and so on. The all-in-cost ceiling can now also be dispensed with altogether, with specific RBI approval. The scheme with regard to foreign currency convertible bonds (FCCBs), a type of ECB, has also been liberalized and prepayment has been allowed for FCCBs without RBI approval upon fulfilment of specified conditions. While RBI officials have tried to stimulate the ECB market to provide the required foreign exchange liquidity at affordable rates, lenders globally have been either increasing rates of interest or demanding prepayment of existing loans.”
Despite RBI’s efforts, the inflow of ECBs is still slow. This shows that no amount of liberalisation in the policies will help stimulate flow of capital (both debt and equity) in conditions where liquidity is tight and valuations (and interest rates) are not conducive to deal flow. On a similar note, SEBI too has been making efforts to liberalise the securities markets - with some recent measures implemented today to stimulate the markets for public offerings of securities (highlighted here a short while ago by Mr. Jayant Thakur) – but securities market reforms too have been met with limited success so far in view of concerns over liquidity and valuations. Although these measures will not stimulate market activity by themselves, they will certainly help facilitate smoother capital flow once market conditions improve.

SEBI amends DIP Guidelines - quick highlights

SEBI has amended the DIP guidelines vide circular dated 24th February 2009. Several amendments have been made and while some are minor or consequential to other amendments made recently, some are far reaching. While I will post more detailed comments later, let me quickly highlight a few important changes.

1)      Listing of equity shares with differential rights as to dividends, voting or otherwise:- 

a)      Conditions for listing of such equity shares that are issued otherwise than by making an IPO have been laid down. Important substantive conditions are that such shares should be issued by way of rights/bonus to all existing shareholders and the Company should be compliant of minimum public shareholding norms for its equity shares already listed and also for the fresh issue.

2)      Listing of warrants offered along with NCDs under Chapter XIII-A (Qualified Institutions Placements):-

a)      Such warrants can be considered for listing if there is a combined issue of NCDs/warrants and Chapter XIII-A is fully complied with for such issue.

b)      There would be a minimum trading lot of such NCDs/warrants of Rs. 1 lakh.

3)      The application for listing of the equity shares with differential rights and warrants/NCDs shall be made through the designated stock exchange who will forward the application to SEBI with its recommendations.

4)      Guidelines for Preferential Issues:-

a)      Finally, the minimum amount payable with application for Share Warrants in case of preferential issues has been raised from 10% to 25% of the issue price.

b)      Readers may recollect that in August 2008, the lock in period relating to warrants, etc. were amended. There was controversy arising out of such amendment. SEBI has attempted to simplify the wording and make it internally consistent. It has done this by bifurcating the ambiguous clause relating to lock in of instruments/shares into two parts.

i)      The first part talks of lock in period of instruments allotted to Promoter/Promoter Group and shares allotted to them on exercise of Warrants. Both shall be locked in for 1 year. These lock in periods are obviously in addition to the 3 year period otherwise applicable for allotments to such persons, read with of course the 20% limit for the 3 year lock in.

ii)     The second part is almost identically worded, except that it refers to instruments/shares allotted to persons other than such Promoters.

iii)    In clause (d), which refers to set off of lock in suffered by instruments, it is now provided that such instruments shall not include warrants.

iv)     The amended clauses are certainly worded better, if one compares only to the earlier wording, which was convoluted, being the result of redrafting exercises over time. However, despite such amendments and consistency in wording, certain basic ambiguities remain. Actually, the lock in requirements are intended to be quite simple and they whole clause could have been redrafted, instead of focusing on the recent changes. More on this later.

c)      The Satyam amendments:- Several relaxations to pricing, disclosures, etc. are now provided for where SEBI has already granted exemption under the new Regulation 29A. Considering that Regulation 29A itself had, I think, effective applicability of one single case, the amendments will have similar shelf life. However, they will remain as part of Regulations and the DIP Guidelines till they are dropped.

5)      Bonus shares:- These shall now be issued within 15 days of Board approval, where shareholder approval for such issue is not required. And the Board cannot change such decision. Where approval of shareholders is required as per the companys Articles of Association, the issue shall be made within 2 months of the Board meeting where such issue was announced.

6)      There are a few IPO related amendments, relating to roll-over of NCDs, etc.

7)      The amendments are generally prospective but with two interesting exceptions.

a)      The amendment increasing the minimum amount payable for issue of Share Warrants from 10% to 25% applies if the shareholders approval is obtained after 24th February 2009. This would affect all those cases (I presently do not know how many or if any) where notices are already issued and the general meeting is convened on 25th February 2009 or later.

b)      It would be interesting to examine how the amendments relating to lock-in apply to issues made since the last amendment in August.

-       Jayant Thakur

Monday, February 23, 2009

Interim Budget: A Brief Overview

A few days ago, the Union Government announced the Interim Budget 2009-2010. This post seeks to briefly highlight some of the important issues it raises.

The long title of what is usually the year’s-most-awaited legislation – the Finance Bill – set the tone of the budget. The Finance Bill, 2009, is stated to be a bill “to continue the existing rates of income-tax.” That may well sum up the interim budget itself – hardly anything new was announced; and the budget speech was more or less a listing of the achievements of the UPA government. Due to this, the budget evoked reactions of disappointment from several industry commentators.

One reason for this lack of fresh inputs may be that general elections are around the corner; and propriety would demand that no major decisions are taken so soon before a new government is formed. As this article notes, “With elections around the corner, fairness demands that the government desist from making announcements that will target narrow constituencies. The UPA government has correctly announced nothing of importance in the `Interim Budget 2009-10' speech. While we live in an exceptional macroeconomic environment, fairness in elections is even more important than macroeconomic stabilization. The UPA can and should chip away at economic policy reform - but only in areas that are invisible to voters.” Given this, it is understandable that the budget does not seek to initiate anything.

More important, however, was the Finance Minister’s description of the state of the economy. The budget notes that the fiscal and revenue deficits are down to 2.7 percent and 1.1 percent respectively for the period 2007-2008. The GDP growth rate is around the 7% mark in the current year. FDI inflows in the period April-November 2008 were US$ 23.3 billion. This represents a growth of 45% over the corresponding period in 2007. Exports have also picked up considerably in this period.

While this appears to paint a relatively solid picture, particularly considering the impact of the global slowdown, at least a few areas do appear to be worrisome.

Here is an extract on the subject of subsidies from the Medium-term Fiscal Policy Statement released by the Government:
“This year has witnessed unprecedented rise in the subsidy bill of the Government. Provision for major subsidies on food, fertilizer and petroleum products were Rs. 66,537 crore in B.E.2008-09 accounting for 11 per cent of net revenue receipt of the Government… total provision for subsidies on these three items, including Rs. 95,942 crore of Special Securities, has gone up from Rs. 66,537 crore in B.E.2008-09 to Rs. 2,18,294 crore in R.E.2008-09 amounting to about 4 per cent of GDP… Total subsidy is estimated to decline to Rs. 1,00,932 crore amounting to 1.7 per cent of GDP in B.E.2009-10. In medium to long term, there is a need for policy objectives to focus on measures and means to cap this expenditure to create further fiscal space for increased investment in physical and social infrastructure.”

Although the Government estimates total subsidies to decline, the subsidy bill is still a cause for concern. The declined estimate does not signal any change in policy; but as this Hindu Business Line report notes, it reflect the expected savings due to the drop in fertilizer prices. Furthermore, although the impact of the financial crisis has not been felt as strongly in India yet as in the west, it is important to remain alert on this front too. This is what the Government had to say on this issue in its Fiscal Policy Strategy Statement:
“The Government had two policy options before it. In view of falling buoyancy in tax receipts, the Government could have taken a decision to cut expenditure and thereby live within the estimated deficit for the year. The second option was to increase public expenditure, even with reduced receipts, to stimulate economy by creating demand and maintain the growth trajectory which the country was witnessing in the recent past. The Government took the second option of adopting fiscal measures to increase public expenditure to boost demand and increase investment in infrastructure sector. Ensuring revival of the higher growth of the economy will restore revenue buoyancy in medium term and afford the required fiscal space to revert to the path of fiscal consolidation.”

In this context, the government has approved investments of Rs. 70,000 crore in infrastructure projects from August 2008. Additionally, the budget reiterates the Rs. 20,000 crore recapitalization package for banks. The new government will have its work cut out in order to ensure that the Indian economy remains solid. It remains to be seen what measures will be put in place after the elections. Hopefully, the new administration will see the wisdom in Nani Palkhivala’s words, “We keep on tackling fifty-year problems with five-year plans, staffed by two-year officials, working with one-year appropriations – fondly hoping hat somehow the laws of economics will be suspended because we are Indians!”

The budget documents, speech and The Finance Bill, 2009 are available on this site. A Business Standard analysis is available here. Another Hindu report is linked here.

Securitization: ‘True Sale’ of Receivables

In order to make a securitization transaction bankruptcy-proof with respect to the originator (seller) of receivables, it is necessary that there is a ‘true sale’ of the receivables to the assignee (purchaser). Failing this, the transaction could be recharacterized as a secured loan, thereby altering the rights and obligations of the parties under law (sometimes contrary to their original commercial intent). This issue is often critical in securitization transactions even in the Indian context.

An article True Sale of Receivables: A Purposive Analysis posted on SSRN by Kenneth Kettering elaborates on this issue. Although the article essentially relates to the U.S. law position (Article 9 of the Uniform Commercial Code), several of the general principles discussed therein have universal applicability, and hence may bear relevance in the Indian context as well. The abstract is as follows:

“An enormous market exists in securitized debt backed by receivables. For the product to achieve its intended purpose, it is essential that the receivables be conveyed by the beneficiary of the financing to its securitization vehicle in a "true sale" - that is, a conveyance that courts will respect as being a sale, in accordance with its form, and not recharacterize as a loan secured by the receivables. Article 9 of the Uniform Commercial Code declines to provide guidance on the proper conditions for recharacterization, and cases have been incoherent. This paper analyzes the purposes of the recharacterization doctrine, inside and outside of bankruptcy, and the conditions for recharacterization that follow from those purposes. Different conditions for recharacterization may apply in different legal settings. The paper concludes that cases have been more aggressive in recharacterizing sales under Article 9 than is justified by the purpose of the doctrine. By contrast, the true sale status for bankruptcy purposes of the conveyance of receivables made in a typical securitization transaction is inherently doubtful under current law. Assurance that the typical securitization structure would survive legal challenge in bankruptcy therefore rests largely upon nondoctrinal factors.”

Friday, February 20, 2009

Have liaison offices escaped the tax net?

After the Department’s partial victory of sorts in the Vodafone tax battle, recent decisions of various Tribunals holding that liaison offices are generally not subject to taxation come as much needed relief for MNCs.

This, however, is subject to a few qualifications. As the decision of the AAR in Ikea Trading v. Director of Income Tax, [2009] 308 ITR 422 illustrates, an MNC can avail of this benefit for its liaison office only if the scope of the latter's commercial activity is extremely limited. A ticklish situation arises when the liaison office operates in conjunction with other units of the same enterprise, or when it is heavily involved in the procurement of goods or services. In the first case, the Department may seek to characterize it as a full-blown commercial undertaking masquerading as a liaison office. The second, more troublesome case, is one where the Department often argues that the liaison office is an ‘agent’ for the MNC, and therefore subject to taxation.

Ikea Trading falls into the second category. The IKEA Group, as is well known, is a multinational furniture retailer, and has established units all over the world. It allocates its operations in such a manner that each company in its group is responsible for sales of IKEA products in predefined geographically contiguous areas. For example, Ikea Trading (Hong Kong) Ltd. is responsible for sales of IKEA products in India. In this connection, a liaison office was set up in New Delhi to assist in selection of suppliers, quality control, collecting samples from manufacturers, monitoring with Indian exporters, ensuring that suppliers adhered to applicable environmental standards and so on. The question was whether this liaison office was liable to pay income tax on money received under Section 9(1)(i) of the Income Tax Act, 1961. Section 9(1)(i) states that any income that accrues or arises, even indirectly, through any “business connection” in India is deemed to accrue or arise in India for the purposes of the Act. Under Section 5(2) of the Act, the total income of a non-resident includes any income that is deemed to accrue or arise in India.

The Department argued that the liaison office is an ‘intermediate entity’ – an entity which gets ‘remuneration for services’ rendered by it in its capacity as an ‘agent’ of the wholesale companies of the IKEA Group. In other words, the Department suggested that a liaison office which assists in procurement is nothing but an agent for the company who benefits from its procurement activities. This contention, if accepted subsequently, has the potential to substantially widen the tax liability for liaison offices, since such offices typically assist in the purchase or sale of goods, although not engaging in commercial activity of their own. The AAR rejected this contention, holding that the activities of the liaison office are confined to the purchase of goods which are then exported by other entities. The AAR applied Explanation 1(b) to Section 9(1)(i), which states “in the case of a non-resident, no income shall be deemed to accrue or arise in India to him through or from operations which are confined to the purchase of goods in India for the purpose of export”.

This decision comes on the back of other rulings of Tribunals holding that liaison offices cannot be characterized as permanent establishments. A recent report suggests, however, that the Department has decided to challenge all these decisions, in a bid to get an authoritative ruling from the High Court that such transactions are subject to taxation under the Income Tax Act.

Amendments to Takeover Regulations differently wide and narrow

The SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 (“Takeover Regulations”) were amended last week to empower SEBI to grant exemptions from the strict operation of various operative provisions of the Takeover Regulations – initial comments on this blog were posted here.

I wrote the following comment in the Economic Times, edition dated February 16, 2009:-

The Securities and Exchange Board of India had said earlier this month that it would amend the Takeover Regulations in a general context to exempt strict application of the law to listed companies that are victims of fraud, as opposed to providing special exemptions to specific cases.

The Takeover Regulations already provided SEBI with discretion to exempt specific cases from making of an open offer. Therefore, one expected SEBI to lay down a clear-cut principle that would permit regulatory intervention by way of exemption from various provisions when fraud in listed companies rendering financial statements unreliable, is discovered. However, the actual amendments fall short of the standard.

SEBI has armed itself with powers to grant exemption from any or all the operative provisions of the Takeover Regulations, but there is no reference to discovery of fraud. Instead, any listed company in which a government or regulatory authority has appointed new persons to act as directors “for the orderly conduct of affairs” would qualify for exemptions at SEBI’s discretion.

Such an amendment is extremely wide from one perspective, and extremely narrow from another. The government replacing the board (without any reference to even alleged fraud) being a trigger for SEBI to exempt the operation of the Takeover Regulations lets the state qualify public sector companies for exemption from the Takeover Regulations. The scope of state-sponsored abuse is therefore huge.

From the standpoint of discovery of fraud, the amendment is too narrow and therefore unfair. Without government being involved, shareholders could discover management fraud and themselves change the board of directors without involving government.

Fraud vitiates all solemn acts. When financial statements of a listed company are discovered to be fraudulent, the price at which its shares were traded would be rendered unreliable –without the government playing a role, such cases would be equally fit for exemptions from application of many operative provisions of the Takeover Regulations.

The exemption power of SEBI is ultimately discretionary. Therefore, the scope for abuse is as wide or as narrow as SEBI permits. The amendments ought to have been linked to the principle of discovery of fraud rather than change of the board of directors by a government agency.

Some linkage to mismanagement or oppression would have been useful. Under current SEBI dispensation, there may be no abuse, but since law is written for all times to come, there is a danger of governmental abuse even while leaving out meritorious cases involving private action by shareholders.

Thursday, February 19, 2009

New PCAOB Rule: Impact on U.S.-listed Indian Companies

The PCAOB or Public Company Accounting Oversight Board is a body established in the aftermath of Enron and the enactment of Sarbanes-Oxley and reviews the intensity and the integrity of audits by auditors on a regular basis. Until recently, the requirements of review pertaining to foreign companies (such as Satyam) that are registered with the SEC were somewhat lenient compared to domestic U.S. companies. However, Blog points to some recent developments that may result in tighter control over audits of non-U.S. companies that are registered with SEC. The Blog notes:
“Last month, the PCAOB adopted an amendment to Rule 4003 (as well as proposed a separate amendment to that rule) relating to the timing of certain inspections of registered non-US companies. Given the breath-taking revelation by Satyam's CEO of prevalent fraud perpetuated by the CEO, it's unfortunate that the PCAOB has not been inspecting the foreign affiliates of the US audit firms, such as the Indian firm auditing Satyam, because the budget that the PCAOB submits to the SEC has not provided sufficient funds for such inspections.”
Although the PCAOB release is dated December 4, 2008 (before the Satyam misstatements came to light), it is likely to result in greater scrutiny of Indian companies that are listed on U.S. stock exchanges. The release states:
"The Board has proposed for public comment Rule 4003(g), which would extend the current 2009 deadline for the first inspection of 50 non-U.S. firms located in 24 jurisdictions where the Board has not previously conducted inspections.
Under the proposal, the Board would conduct those inspections over the period from 2009 to 2012 according to a schedule based on criteria described in the release. The proposed rule would not extend the deadline for other non-U.S. inspections currently required by 2009.

The Board's release also discusses the possibility that in some cases non-U.S. firms might decline to provide information requested in a PCAOB inspection because of a concern that doing so could violate local law.

The release discusses possible Board courses of action related to that issue including the possibility of imposing disciplinary sanctions on the firm for failing to cooperate with the inspection, and the possibility of a rule that would require a principal auditor to make certain public disclosures in connection with an audit report if the auditor is, or has used the work of a firm that is, in the position of declining to cooperate with a PCAOB inspection."

Wednesday, February 18, 2009

Imminent Developments in Competition Law

Guest contributor R.V. Anuradha points to a news report indicating that the long-awaited Competition Commission of India (CII) would be functional on April 1, 2009. This will replace the existing Monopolies and Restrictive Trade Practices Commission (MRTPC) signifying an important step in Indian competition law. As the news report states, that day will also mark another milestone, which is the commencement of registration of limited liability partnerships (LLPs) in India.

A Way around Daga Capital?

An earlier post had discussed a decision of a Special Bench of the Mumbai Income Tax Appellate Tribunal (ITAT) in Daga Capital [26 SOT 603], highlighting its far-reaching implications on expenditures incurred ‘in relation to’ the earning of tax-free income under the Income Tax Act (Act). The Special Bench, following the Supreme Court decision in Doypack Systems [(1988) 2 SCC 299], held that the phrase ‘in relation to’ includes both direct and indirect connection, thus significantly widening its scope. However, one other aspect of the decision, which was only touched on earlier, has now proved to be of possibly greater significance.

Along with the discussion of the phrase ‘in relation to’, another issue that arose in Daga Capital was whether the computation provisions in section 14A are retrospective. This issue is significant due to the scheme and legislative evolution of the provision. Section 14A was originally introduced by the Finance Act 2001, with retrospective effect from 1st April, 1962. In its original form, the provision merely provided that expenditure incurred in relation to tax-free income shall not be deductible. However, there was no provision for the mode in which such relatable expenditure was to be determined. This computation provision was introduced by the Finance Act, 2006, without explicit retrospective effect. Thus, one of the issues that arose in Daga Capital was whether these computation provisions under section 14A were retrospective. The Court, relying on a recent decision of the Apex Court in Gold Coin Health Foods Ltd. [304 ITR 308 (SC)], held that these provisions merely gave effect to section 14A(1), which was explicitly retrospective. Thus, these provisions being procedural, were held to be retrospective.

While this seems to be a straightforward and unsurprising result in law, the practical effects of the decision have led to more than a fair share of debate and discomfiture. This is because of the actual content of the computation provisions. Section 14(A)(2) provides that if the Assessing Officer (AO) ‘is not satisfied’ with the assessee’s claim as to the amount of expenditure relatable to exempt income, he shall determine the amount of expenditure ‘in accordance with such method as may be prescribed’. This prescribed method in provided in Rule 8D of the Income Tax Rules, according to which the amount of expenditure disallowed is proportionate to the amount of tax-free investments made, irrespective of the source of the investment. Thus, the mode of computation uses the proportion of the investment vis-a-vis the total assets of the company, to determine what proportion of the total expenditure should be disallowed. Further, section 14A(3) provides that this mode of computation applies also when the assessee claims that no expenditure has been incurred by him in earning the tax-free income. An archetypical case would be when an enterprise has sufficient reserves of interest-free funds to make a tax-free investment. In such a case, there is no question of there being any expenditure in relation to earning tax-free income, since the funds invested in the earning of the income have been internally provided. In such a case, ideally, there should be no disallowance of deductions for expenditures that may have been incurred in other activities of the business. Prior to the decision in Daga Capital, there were a few decisions, specifically in the context of section 14A, stating that the burden was on the Revenue to show the link between the expenditure incurred and the tax-free income earned. However, after the broad interpretation of the provision and the retrospective application of the computation provisions vide Daga Capital, the position seems to have undergone a change. This means that even if an enterprise has not, in fact, borrowed for the purposes of making tax-free investment, but borrowed for other purposes, it still would be denied deductions to the extent worked out by Rule 8D.

On the text of the provision, there was only one way left out of the situation. Section 14A(2) provides that Rule 8D should be applied only when the Assessing Officer ‘is not satisfied’ with the claim of expenditure made by the assessee. However, given that this is a requirement of mere subjective satisfaction, prima facie it does not seem to have any significant implications. However, a recent decision of the Bombay High Court in CIT v. Reliance Utilities & Power [221 CTR (Bom) 435] has possibly provided a way out of the labyrinth. The decision concerns section 36(1)(iii) of the Act, which allows for deducting the amount of interest paid on capital borrowed for the purposes of business. The inquiry necessitated to determine the amount of interest (expenditure) deductible is similar to that under section 14A, i.e. the link between the expenditure incurred and the use of the funds has to be established. In this context, the High Court held that the existence of interest-free funds sufficient to meet the capital requirement would create a presumption against the possibility that the moneys were borrowed for the purposes of the business. Admittedly, at first sight, the fact that this decision is not on section 14A, and is based on a differently worded provision, takes away from its relevance in the context of Daga Capital. However, its significance lies in the fact that Daga Capital is silent on the precise effect of the retrospectivity of section 14A(2) & (3), since on facts there, the expenditure was clearly for the investment, the question was only whether the income had a sufficient nexus to the expenditure. Also, it does not throw light on the level and type of satisfaction of the Assessing Officer to be established before the mode of computation laid down in Rule 8D may be used. The decision in Reliance, especially given that it has been made in a relatively broad fashion [i.e. not specifically restricted to section 36(1)(ii)] makes possible an assertion that although the AO may use the computation provided in Rule 8D, he can do so only on satisfactorily rebutting a presumption against the use of borrowed funds for earning tax-free income, when sufficient interest-free funds are available. Thus, until such time as the ghost of Daga Capital is laid to rest in the High Court or even higher, this may be a source of much-needed respite to assessees.

Tuesday, February 17, 2009

Direct and Indirect Foreign Investment: Is There Clarity Now?

Last week, we had blogged about new guidelines that were announced on indirect foreign investments, wherein some questions were raised regarding the scope of these guidelines. However, since then, the Government has issued two Press Notes on February 13, 2009 that contain detailed provisions for implementation of the new guidelines. Press Note 2 of 2009 deals with calculation of total foreign investment in Indian companies, and Press Note 3 of 2009 relates to transfer of ownership or control of Indian companies in sectors with caps from resident Indian citizens to non-resident entities.

In the post below, Rajvendra Sarswat, an associate with an Indian law firm, discusses the implications of these new guidelines and raises some further questions for consideration.

The Ministry of Commerce and Industry has recently issued guidelines for calculation of total foreign investment, i.e., direct and indirect foreign investment in Indian companies. The basic object of the guidelines is to provide clarity by segregating the direct and indirect foreign investment in India. It is to bring clarity, uniformity, consistency and homogeneity into the exact methodology of calculation across sectors/activities for all direct and indirect foreign investment in Indian companies. It is stated that investment in Indian companies can be made both by non-resident as well as resident Indian entities. Any non-resident investment in an Indian company is direct foreign investment. Investment by resident Indian entities could again comprise of both resident and non-resident investment. Thus, such an Indian company would have indirect foreign investment if the Indian investing company has foreign investment in it. The indirect investment can also be a cascading investment i.e. through multi-layered structure.

The method of calculation of total foreign investment in an Indian company including indirect foreign investment through other Indian companies has been detailed either in sectoral regulations contained in various press notes or in rules and regulations under specific statutes. Essentially, the present FDI guidelines provide for three different regimes for calculation of indirect foreign equity. This includes the following:
· Telecom/Broadcasting: Proportionate method is used in Telecom/ Broadcasting sectors through Press Note 5 of 2005, Press Note 1(2006) and Press Note 3(2007);
· Insurance: Outlined in IRDA regulations (IRDA (Registration of Indian Insurance Companies) Regulations, 2000); and
· Other: In all other sectors, for an investing company in the infrastructure / service sector attracting equity caps, indirect equity is calculated as was set out in Press Note 2 of 2000: According to this, foreign investment in an investing company will not be set off against this cap where the foreign equity in the investing company does not exceed 49% and the management of the investing company is with Indian owners. Hence, for any downstream investment, FIPB approval is required by investing companies.
The new guidelines for calculation of foreign investment, direct and indirect, in an Indian company take into account two factors. For direct foreign investment, all investment directly by a non-resident entity into the Indian company would be counted towards foreign investment. For indirect foreign investment, the foreign investment through the investing Indian company would not be considered for calculation of the indirect foreign investment in case of Indian companies which are ‘owned and controlled’ by resident Indian citizens and/or Indian Companies (which are in turn owned and controlled by resident Indian citizens). Hence, the condition to be satisfied is that the Indian company should be owned and controlled by Indian residents; in other words, both the ownership and control conditions are to be satisfied. For the purpose of the explanation, ownership and control by Indian residents has been defined: if more than 50% of the equity interest in an Indian company is beneficially owned by resident Indian citizens and Indian companies, which are owned and controlled ultimately by resident Indian citizens; and, if the resident Indian citizens and Indian companies, which are owned and controlled by resident Indian citizens, have the power to appoint a majority of its directors.

Hence, in a case where the investing company is owned or controlled by ‘non resident entities’, the entire investment by the investing company into the subject Indian company would be considered as indirect foreign investment, and shall be regarded as foreign investment. First, there could be confusion as to the resultant position where the shareholding pattern is 50-50%. Second, if there is a shareholders agreement inter-se between the existing/proposed shareholder which provides for veto power or which reclassify the ‘control’ within the company. In such case, though the Guidelines provides that in any sector/activity, where Government approval is required for foreign investment and in cases where there are any inter-se agreements between/amongst share-holders which have an effect on the appointment of the Board of Directors or on the exercise of voting rights or of creating voting rights disproportionate to shareholding or any incidental matter thereof, such agreements will have to be brought to the notice of the approving authority. The approving authority will consider for determining ownership and control such inter-se agreements when considering the case for granting approval for foreign investment. Although there is some ambiguity in interpretation, it is likely that where both ownership and control cannot be demonstrated to be in the hands of the Indian owners, the investment by the Indian investing company would be treated as indirect foreign investment.

Interestingly, an exception is provided which states that the indirect foreign investment in only the 100% owned subsidiaries of operating-cum-investing/investing companies will be limited to any foreign investment in the operating-cum-investing/ investing company. The Department clarified this by saying that since the downstream investment of a 100% owned subsidiary of the holding company is akin to investment made by the holding company, the downstream investment should be a mirror image of the holding company.

In explanation to the same, the department provided the following example. It provides that, where Company A is a wholly owned subsidiary of Company B (i.e. Company B owns 100% shares of Company A), and if foreign investment in the holding Company B is 75%, then only 75% would be treated as indirect foreign equity and the balance 25% would be treated as resident held equity. The indirect foreign equity in Company A would be computed in the ratio of 75: 25 in the total investment of Company B in Company A.

The complete details about the foreign investment including ownership details etc. in Indian company and information about the control of the company would be furnished by the Company to the Government of India at the time of seeking approval.

As per the Guidelines, in certain sectors (such as the information & broadcasting and the defence sectors) the equity held by the largest Indian shareholder would have to be at least 51% of the total equity, excluding the equity held by Public Sector Banks and Public Financial Institutions, as defined in Section 4A of the Companies Act, 1956. Hence, though the object of the Guidelines is to simply the process of calculation or computation, in my view it is still left open with confusion and possible multiple interpretations.

- Rajvendra Sarswat

Friday, February 13, 2009

Proposal for Uniform Par Value on Shares

In a previous post, we discussed the difficulties posed by the current system of par value of shares whereby companies are free to determine the par value of their shares. Some of these difficulties will be addressed in SEBI’s proposal to create a uniform par value system for all listed companies. However, the current proposal falls short on two counts: (i) unlisted companies can still have differing par values on their shares (as SEBI is only concerned with listed companies’ shares), and (ii) it does not go as far as abolishing the par value system altogether as we have previously considered. Perhaps these are matters to be viewed from a larger perspective by Parliament while amending the Companies Act.

SEBI amends Takeover Regulations - but on a narrow, Satyam-type cases, compass

SEBI has amended the Takeover Regulations today, Friday, 13th February 2009 (see here) and the subject is what we had all been expecting and that it is an enabling provision to exempt open offer requirements in Satyam-like cases.

The amendment empowers SEBI to exempt from one or more provisiions of the Chapter III of the SEBI Act, mainly thus from the requirement of making an open offer and certain other requirements, in cases where certain circumstances are present. The very first of this circumstance all but narrows down the possible eligible companies today to just one - and that is Satyam. This requirement is that the Central Government, etc. should have removed the Board of Directors and have appointed other persons as directors. The other conditions are intended to ensure that the Target Company has ensured, obviously under the new Board, that there is a competitive process in place for invite potential acquirers. Thus, the Board of the Target Company would be expected to shortlist acquirers and probably select one through a transparent and unbiased process and having selected one, should approach SEBI for exemption. SEBI would then grant exemption at its discretion.

In essence, therefore, these amendments are for companies in trouble where persons in control have been removed and a new set of Promoters are desired.

A related amendment bars competitive bids where a public announcement has been made after SEBI grants amendment under the amended provisions. The logic is obvious. If an acquirer desires to participate, he should give his bid at the first instance when the Company is transparently shortlisting bids. I had wondered why the new provisions were needed and why the existing provisions of Regulation 4 were not found sufficient for granting exemption. This was more so since a Takeover Panel is already in place for this purpose. Probably this specific exemption from competitive bids is part of the answer.

Curiously, there is no specific provision for making the detailed order granting such exemption public but it is hoped SEBI will publish such order on its own, an approach it has been taking in many other areas.

The application for exemption is to be made by the target company.

had started this post by saying that it is almost a Satyam-specific amendment - probably it will be used just once in its lifetime ! - but that is good news also. A general amendment giving wider powers would have had scope for misuse.

A few more thoughts in a later post.

- Jayant Thakur

p.s.:_- I would have missed this amendment today - the amendment was published just after I left my office for the day but Mr. Umakanth's email was in my inbox by the time I reached home! Thanks, Mr. Umakanth.

"Beyond Satyam: Analyzing Corporate Governance in India"

That was the theme for a panel discussion organized last week in New York by the Jindal Global Law School. The panel consisted of internationally renowned academics and practitioners of corporate governance: Mr. Roel Campos, former SEC Commissioner, Professor John Coffee of Columbia Law School, Professor Michael Useem of the Wharton Business School and Professor Vikramaditya Khanna of Michigan Law School. I enjoyed the distinct privilege of moderating this panel. This was the first of a two-part series of panels put together by the Jindal School, with the second, a full-day conference to be held in New Delhi on February 23, 2009 that will include among other speakers, the Law Minister and Commerce Minister of India.

The goal of this panel was to consider reforms arising out of the Satyam episode as well as other occurrences globally. While a number of interesting thoughts emanated during the discussions, I will attempt to summarize some of the key outcomes in terms of recommendations below:


It is important to lay out the taxonomy of corporate frauds and governance failures. In jurisdictions such as the US and UK, managers (such as the CEO, CFO and other senior executives) are compensated through stock options and equity and hence there is a strong incentive to inflate earnings. On the other hand, in countries such as India where there is concentrated shareholding, the critical actor is not the senior management but the controlling shareholder (a.k.a. the promoter). In such a scenario, where fraud is involved, it usually does not result in an inflation of earnings, but in related party transactions whereby assets of a company are siphoned out to other companies owned by the controlling shareholder. In that sense, and in drawing international parallels, although the media has called Satyam “India’s Enron”, this case is more akin to the Parmalat case which also involved affiliated transactions and misstatement of financials. The regulatory response in terms of reforms will have to take into account the differences in the systems where diffused shareholding is the norm (US and UK) and where concentrated shareholding is the norm (e.g. India).

Audit Process

There is clearly a case for reforms in the audit system.
- The appointment of auditors ought to be shifted from the purview of the controlling shareholders to the independent audit committee so that auditors do not owe any allegiance whatsoever to the controlling shareholders, and that the process of appointment and removal of auditors is effected in a manner that is truly independent of controlling shareholder influence.

- There is a case for the establishment of a body such as the Public Company Accounting Oversight Board (PCAOB) (that was established in the U.S. a few years ago), as that body would review the intensity and the integrity of audits by auditors on an annual basis.

- There is need for auditor rotation as it prevents creation of any affinity between auditors and controlling shareholders, and avoids “capture” of the audit process by insiders in companies.

- Auditor liability is currently an unresolved question, and the affixation of liability for malfeasance needs to be clearly defined. In some countries, the public regulatory authorities (such as the securities regulator) could directly initiate action against auditors and the merits of such an approach require careful consideration.

- Other precautionary processes may help as well. This could include meetings between audit committee members and auditors without the presence of management.
Independent Directors

Independent directors tend to be in an unenviable position. Unless there are any red flags or warnings in a company’s operations, it is difficult to pinpoint board failure per se. For example, a board that receives false information, without any other warnings, is in a tough spot. Further, in controlling shareholder situations, the independent directors are often appointed by the controlling shareholders, and may hence owe a sense of responsibility to those shareholders. Having said that, the current norms on corporate governance in India do not go far enough to deal with independence of the board in controlling shareholder situations. Some of the possible reforms are as follows:
- Making nomination committees mandatory for Indian companies. Currently, there is no requirement to have nomination committees, although several companies have established such committees voluntarily. When independent directors are chosen by an independent nomination committee and without the influence of controlling shareholders, there is a sense that it would instill greater independence of such directors from the controlling shareholders

- Other processes relating to the functioning of independent directors may induce greater credibility in board decision making. These include:
- The requirements of lead independent directors

- Executive sessions among independent directors without the presence of management

- Appointment of advisors (such as lawyers and accountants) by independent directors to advise them on significant transactions involving a company. Such advice would be provided independent of the management or controlling shareholders.
- More fundamentally, there needs to be a re-evaluation of who appoints independent directors. Under the current system, they are appointed by the shareholder body as a whole, which is often considerably influenced by the controlling shareholder. What is required is a reform to consider other methods of appointing independent directors. For instance, they can be appointed by a majority of the minority shareholders, whereby the controlling shareholders do not have a say on the matter. Alternatively, there may be proportionate representation on boards of listed company where all shareholders have some level of say in appointment of directors and that the board is not dominated by controlling shareholder nominees. For example, in such a system, the minority shareholders obtain the right to elect such number of directors in proportion to the percentage holding of such minority shareholders. [Note: The system of proportional representation is already available under the Companies Act, in Section 265, but is only optional]

- Moving from a regulatory perspective into standards of conduct and ethics, perhaps it would be useful for industry bodies such as the Confederation of Indian Industry (CII) to draw up guidance for directors that would help independent directors clearly determine what is expected of them in the boardroom.
Investor Activism

There is greater need for activism on the part of the investors directly. Often, that is not possible because of the lack of coordination among various investors, referred to as the collective action problem. One method by which this has been resolved in the U.S. is through the existence of proxy consultants such as Institutional Shareholder Services or Risk Metrics who knit together coalitions of investors to actively play a role in significant decisions involving a company. Similarly, an active business press would also play an important role in enhancing governance practices.

These are some of the key recommendations emanating from the panel discussion. Clearly, there is recognition that none of these systems will be failsafe. However, the solution in these circumstances is that if a number of such systems are put in place, it would reduce the statistical likelihood of things turning sour from a governance standpoint.