Wednesday, December 31, 2014

Derivative Action for Patent Infringement Disallowed

Spicy IP has a post discussing a judgment of the Bombay High Court in Darius Rutton Kavasmaneck v. Gharda Chemicals Limited, which involves a derivative claim by a shareholder of a company that traverses issues of company law and patent law. In disallowing the claim, the Bombay High Court dealt with issues pertaining to derivative actions and clarified circumstances where they would be allowed to proceed. Those circumstances were found not to exist in this case.

Facts and Ruling

The plaintiff was a shareholder holding 12% of the 1st defendant, Gharda Chemicals Limited. The principal claim lay against the 2nd defendant, Keki Hormusji Gherda, who is the chairman and managing director (CMD) of the company. The plaintiff shareholder alleged that the CMD applied for and/or obtained several patents in his own name, while those patents ought to belong to the company. Since the actions allegedly amounted a breach of fiduciary duties owed by the CMD to the company, the plaintiff argued that he was entitled to bring a derivative claim on behalf of the company since he was a minority shareholder. In terms of relief, the plaintiff sought an injunction against the CMD in relation to the utilization of the patents.

The Court began by treating this action as a representative suit as it was brought by a shareholder on behalf of the company. This principle has now been well-established in India, and the court was merely complying with accepted precedents. Although courts generally deal with such suits in terms of Order 1 Rule 8 of the Civil Procedure Code, 1908, in this case the judgment does not make any express reference to that provision or interpret it.

Given that derivative actions in India are essentially a matter of common law, the Court relied on English precedents, principally Smith v. Croft [1998] Ch. 114. In that case, a derivative claim was disallowed because the body of independent shareholders of the company were not supportive of the derivative claim. In other words, the court placed significance on the will of the majority of independent shareholders. The Bombay High Court relied on Smith v. Croft in disallowing the derivative claim in the present case as well. It was found that the plaintiff’s siblings who held 13% shares between them were against the present litigation, and effectively sided along with the defendant CMD. The fact that the plaintiff was only in the minority among the independent shareholders in bring the suit weighed heavily with the Court in arriving at its conclusion.

The Court further supported its conclusion by having regard to the conduct of the plaintiff. This approach is consistent with the requirement that any plaintiff shareholder in a derivative action must approach the court “with clean hands”. In the present case, the Court considered several circumstances that suggested the plaintiff had not met with this requirement. The plaintiff had initiated several rounds of litigation before different fora against the defendants, and that too unsuccessfully, and this action was in similar vein. Moreover, it was found that the plaintiff had not only commenced a competing business, but was also intending to transfer his shares in the company to another competitor. All of these further demonstrated the lack of bona fides on the plaintiff’s part in bringing the claim.

Finally, the Court made certain observations which indicate the unsatisfactory nature of the law relating to shareholder derivative actions in India:

The Courts should be alert in dealing with such speculative suits and shoot down such bogus litigation at an early stage. This action on the Plaintiff, it is quite obvious is inspired by vexatious motives. I observe with regret the infliction of the ordeal upon the Courts by parties like the Plaintiff by presenting a case which was disingenuous or worse. It may be a valuable contribution to the cause of justice if such speculative and frivolous litigations are dealt with a tough hand. Substantial judicial time will be saved if such parties are saddled with substantial costs so that they would not continue the onslaught on precious judicial time.

The Court also directed the plaintiff to pay a sum of Rs. 10 lakhs (Rs. 1 million) towards costs.

Broader Implications

Given the facts of the case, it would be hard to quarrel with the conclusion arrived at by the Court or its reasoning. But, the context and approach permit us to draw some broader inferences.

Shareholder derivative actions are rare in India. As a co-author and I found, “[o]ver the last sixty years only about ten derivative actions have reached the high courts or the Supreme Court. Of these, only three were allowed to be pursued by shareholders, and others were dismissed on various grounds.”[1] A number of reasons can be attributed to this result. Primary among them is the fact that shareholder derivative actions in India are still ensconced in common law. Indian courts rely heavily on English precedent, as the Bombay High Court did in the present case. The problem with this approach is that cases may be decided largely on the facts, with broader legal principles (that can be applied across situations) being rather elusive. For example, the application of the “clean hands” doctrine arises essentially as a matter of common law. It is a different matter that the English Companies Act of 2006 (and several other jurisdictions within the Commonwealth) have transitioned to a statutory form of derivative action where the legislation expressly recognises such actions and also prescribes the more specific circumstances where they can be allowed. India has, however, not chosen to adopt the statutory form. Unfortunately, the deliberations leading up to the enactment of the Companies Act, 2013 are silent regarding the reason for this approach. It is not clear whether the lack of statutory recognition for derivative actions is a conscious choice, or a mere oversight. This result will continue to permit a fact-based determination steeped in common law, as the Bombay High Court has engaged in this case.

While the lack of the statutory form of derivative actions may be a dampener on such claims, other circumstances may add to that as well. Delays in the Indian judicial system, exorbitant costs of bringing civil suits, and the lack of contingency fees (that usually motivate plaintiff law firms) all lead to the minimal utilization of shareholder derivative suits in the Indian context. A different position may ensue upon the effectiveness of the provisions relating to “class action” suits under the Companies Act, 2013, but it is not clear whether that mechanism is intended to address derivative actions. While that mechanism could be wide enough to encompass derivative actions, the provisions do not expressly cover the scope and conditions for invocation of derivative actions. Until some statutory recognition is conferred upon derivative claims, courts in India would continue to treat derivative actions in the same manner as the Bombay High Court had to in the instant case, i.e. a fact-based determination using principles of common law.

[1]     Vikramaditya Khanna & Umakanth Varottil, The rarity of derivative actions in India: reasons and consequences, in Dan. W. Puchniak, Harald Baum & Michael Ewing-Chow, The Derivative Action in Asia: A Comparative and Functional Approach (2012), at 380.

Monday, December 29, 2014

Insider Trading and Tippee Liability

In recent times, there has been a lot of discussion about how the regulators and the prosecution have been enormously successful in obtaining convictions in insider trading cases in the U.S. That momentum may have been somewhat restrained by a ruling of the United States Court of Appeals for the Second Circuit in United States v. Newman, et. al.

In that case, analysts at several hedge funds allegedly obtained material, nonpublic information from the employees of certain publicly traded companies which was not only shared amongst these analysts but also passed on to portfolio managers who traded in the securities of those companies. The persons who traded in the shares were “tippees” who were fed this information from “tippers” who were insiders of the companies. Crucially, the tippers and tippees were separated by several layers of intermediaries through whom the information passed before reaching the tippees. In an influential ruling, the Second Circuit Court of Appeals overturned the conviction of two portfolio managers Newman and Chiasson. The Court arrived at its conclusion after considering two significant decisions on insider trading issued by the U.S. Supreme Court, notably those in Dirks v. S.E.C., 463 U.S. 646 (1983) and Chiarella v. United States, 445 U.S. 222 (1980).

The Court’s ruling is important as it clearly circumscribed the situations in which tippee liability for insider trading arises. It observed:

In sum, we hold that to sustain an insider trading conviction against a tippee, the Government must prove each of the following elements beyond a reasonable doubt: that (1) the corporate insider was entrusted with a fiduciary duty; (2) the corporate insider breached his fiduciary duty by (a) disclosing confidential information to a tippee (b) in exchange for a personal benefit; (3) the tippee knew of the tipper’s breach, that is, he knew the information was confidential and divulged for personal benefit; and (4) the tippee still used that information to trade in a security or tip another individual for personal benefit.

The conditions for invocation of insider trading liability for tippees have been made quite stringent. Not only must the tippee be aware of the tipper’s breach of fiduciary duty due to disclosure of the information but also that the tippee knew that the tipper divulged it for personal benefit. This can often be difficult for the prosecution to demonstrate, particularly when the tipper and tippee have no direct relationship and are several layers removed.

Apart from circumscribing the legal principle as above, the Court’s ruling in Newman also has the effect of imposing more onerous requirements for discharging the burden of proof to establishing tippee liability for insider trading. Although the possibility of using circumstantial evidence to adduce proof insider trading was not disturbed, the Court refused to merely rely upon relationships between various persons as indicative of exchange of information for personal benefits. Hence, mere friendship or other social relationship would not indicate receipt of personal benefits, which must be specifically proven.

This ruling is important in as much as it narrows the scope of insider trading liability for tippees. At the same time, regard must be had to the fact that the ruling was delivered in the context of specific facts and circumstances that involved remote relationships (via intermediaries) between the tippers and the tippees. If a closer relationship exists, the outcome could be different.

Although the ruling in Newman has been delivered in the context of insider trading law as it applies in the U.S., the decision is likely to have a tangential impact on Indian insider trading law. Increasingly, orders of the Securities and Exchange Board of India (SEBI) and the Securities Appellate Tribunal (SAT) have been closely referring to and following the decisions of the U.S. courts as the jurisprudence in this area of the law has evolved substantially in that jurisdiction. While the proposed regulations on insider trading in India are likely to expand the scope of insider trading in the Indian context, the implementation of those regulations by the regulators and courts may be confronted by situations such as those presented in Newman.

Thursday, December 25, 2014

Reverse Cross-Listings: Foreign Companies Accessing the Indian Capital Markets

Corporate and capital markets laws in India have allowed foreign companies to list in India in the form of Indian depository receipts (IDRs). While this facility was allowed with much fanfare, it has been accessed so far by only one company, i.e. Standard Chartered Bank. However, more companies might likely follow in the future.

A new paper titled “Reverse Cross-Listings -- The Coming Race to List in Emerging Markets and an Enhanced Understanding of Classical Bonding” authored by Professors Nicholas Howson and Vikramaditya Khanna analyzes the reasons for why companies domiciled in the developed world may access the capital markets in emerging economies like India and China. Its abstract is as follows:

This paper examines the implications for the traditional "legal bonding" hypothesis arising from future "reverse" cross-listings, meaning the cross-listing by issuers from jurisdictions with stronger investor protections into capital markets and on exchanges where investor protections are deemed less robust. We use as examples the first "Indian Depositary Receipt" or IDR IPO in May 2010, and IPOs we believe will complete on a future Shanghai Stock Exchange "international board". This analysis serves to dilute one of the long-standing negative implications of the traditional legal bonding account -- that reverse cross-listings by issuers from jurisdictions with stronger investor protections into weaker investor protection markets exhibit abnormal negative price effects, allegedly because of market expectations that the foreign listing will facilitate conduct impermissible in the home market. More importantly, this analysis allows for a more nuanced understanding of the bonding hypothesis along either vector, and why firms cross-list into foreign jurisdictions, regardless of the receiving legal and regulatory environment. Those other factors include: the simple quest for capital, the possibility of higher initial valuations in capital controls-segmented markets and eventually higher secondary market values with the easing of such controls and thus enhanced global liquidity, the reduced cost ensured by listing in a less burdensome regulatory and enforcement environment, and a cluster of reasons which we describe as "consumer-commercial markets bonding", distinct from the legal and regulatory system bonding that has featured so long in the traditional legal bonding hypothesis. This "consumer-commercial markets bonding" includes the advertising of goods, services and corporate identity into a given consumer market, identification of the issuer as a global firm but with local identity and ownership, demonstrated commitment to key markets and the customers and regulators connected with those markets, a tipping of the hat to the sovereign legal-regulatory establishment of the receiving jurisdiction, and appeals to the receiving market's regulators for the provision of franchise or licensing benefits.

Wednesday, December 24, 2014

Repeal of the “Swaps Push Out” Rule— An Evaluation

[The following post is contributed by Mandar Kagade, who is a Policy Analyst at the Bharti Institute of Public Policy, Indian School of Business]

The United States Congress recently passed the Consolidated and Further Continuing Appropriations Act, 2015 that made headlines for reasons not at all related to appropriations; it was in the news rather for including provisions that repealed the so-called “swaps push-out” rule (“Rule”) introduced in the Dodd-Frank Act, 2010 in the aftermath of the recent financial crisis. Influential members of the pro-Rule lobby include Nobel Prize winning Economist, Dr. Paul Krugman (likening the repeal to “revenge of the wall street” in a recent op-ed) and Senator Elizabeth Warren, formerly a law professor at the Harvard Law School. Understandably, they, including others, have come down heavily on the repeal of the swaps push out mandate. This post attempts to push back against such rhetoric and argues that repealing the swaps push out mandate is likely to lower (not aggravate) systemic risk and moral hazard that the Rule purported to do.

Briefly, the Rule foreclosed “federal assistance”[1] to all insured depositary institutions (“Banks”) that domicile their swap dealing business in the same entity as the Banks. It permits the Banks to have or establish an affiliate “swap entity” to conduct swap dealing business. The Rule “safe harbored” a few specified swap dealing activities - swap dealing for the purposes of hedging and risk mitigation was permitted, as was dealing in some statutorily defined swaps. Finally, the Rule permitted Banks to deal in credit derivative swaps subject to the condition that they be cleared through a central clearing counterparty (to mitigate the counterparty risk that swap counterparties are exposed to).[2] On the other hand, the Rule excluded Banks from dealing in structured finance swaps (having asset backed securities as the underlying for example) and other non-structured finance swaps that were outside the purview of the relevant safe harbor statute. The purpose of the Rule was to “ring fence” the speculative activities of the Bank from the more traditional maturity transformational intermediation that Banks performed so that excessive risks from the speculative activities have no spillovers to the broader economy through the Banks. This is further to ensure that the speculative activities of the Banks do not benefit from the implicit capital subsidy that Banks enjoy by being part of the federal deposit insurance system (supervised by the Federal Deposit Insurance Corporation, FDIC).[3]

Before proceeding further, a word about the repeal provision is in order: The repeal provision adds to the exemptions already described above, and permits the Bank to conduct all non-structured and structured finance swap activities, provided they are, a) for hedging or risk mitigation purposes, or b) the securities (that are the underlying of such swap activities) are approved jointly by the relevant prudential regulators in terms if the type and the credit quality.[4]

As pointed out above, there was a strong push back and shrill rhetoric arguing against the repeal. The fact that the banking lobby included the amendment in the unrelated law on federal spending was seen as the powerful “Wall Street lobby” arm-twisting the Main Street to get its way. Media reports about certain lobbyists having actually drafted the repeal provisions augmented the view and proved to be a public relations nightmare for Wall Street generally.

The politics of the repeal however only reflect the political economy of financial regulation in the United States. Every time a financial crisis precipitates, lobbying groups and the politicians advocating greater regulation use the opportunity to impose extensive regulation—mostly without adequate cost-benefit analyses. The popular outrage that marks every expose provides the perfect opportunity to risk monger for political and “turf-enhancement” purposes. The Dodd-Frank Act, so also the Sarbanes Oxley Act (that was passed in the aftermath of the Enron scandal) are testimony to this fact.[5] So, it appears to be a case of double standards to protest when the opposing lobbying groups succeed in moderating some extreme regulations down the road. 

Politics apart however, criticism of the repeal appears overstated for the following reasons:

- Contrary to the belief, pushing out swap dealing to affiliate swap entities is likely to increase systemic risk, not decrease it. This is because of the fragmented nature of the United States financial architecture. Under the Rule, Commodity based swaps would be within the domain of the Commodity and Futures Trading Commission (“CFTC”), and the Securities & Exchange Commission (“SEC”) had the jurisdiction to regulate security-based swaps. Banks were permitted to retain a “Swaps Entity” as affiliate, but such affiliate was mandated to comply with the requirements of either the CFTC or the SEC as appropriate in addition to the Federal Reserve. Multiple regulators having jurisdiction over the same/similar financial product can lead to regulatory arbitrage and let the risk aggregate in the system through instruments that have laxer regulator. On the other hand, the Federal Reserve is the sole regulator (backed up by the FDIC intervention in zone of insolvency) if Banks conduct swap dealing activities on their own balance sheet and as such no such regulatory  arbitrage issues exist with respect to its supervision of the Banks’ swap dealing activities. Further, since the swap activities expose participants to counterparty risks, prudential regulator like the Federal Reserve that have access to the entire balance sheet of the Bank appear to be arguably better suited to regulate the swap dealing activities.

- Finally, since the Rule nonetheless permitted the Swaps Entity to be an affiliate of Banks, it failed to isolate the Bank from the systemic risk component that the Swaps Entity was exposed to while at the same time, making the source of that risk to the Bank one step removed from its prudential risk regulators.  In a nutshell, the swaps push out rule had dubious benefits at best.

- On the other side, capitalizing an entity separately and transferring the technology there entails costs and smaller/regional banks potentially would not incur the expense of doing so; as such, their local clientele will be constrained to purchase hedging instruments from third parties at higher cost than hitherto. Overall therefore, the swaps push out rule would have made risk management costlier. Further, as Patrick Bolton has argued, there are economies of scale and scope in retaining both the traditional lending and fee-based services (like swaps) in the same entity that the Banks lose out on, by divorcing the two. For example, Banks may use the information they obtained through lending to also offer swaps to a trader-borrower that wants to hedge its commodity exposure for example. Note that these economies of scale also enable Banks to pass on the savings to their customers such that the latter are able to hedge their exposure at a much lower cost. The society as such would have lost out on such gains under the swaps-push-out framework. 

- A review of testimonies of the then Chairman, Ben Bernanke and FDIC Chair, Ms. Sheila Bair reveals that both of them had reservations about the Rule. Ben Bernanke pointed out that other provisions mandating settlement of OTC derivatives through a central counterparty, higher margin requirements and enhanced disclosures are better means to mitigate the build-up of systemic risks in the system.  In her testimony, Sheila Bair had pointed out that pushing out swaps activity to an affiliate will weaken the amount and quality of capital that will be held against the activity as a prudential measure and put the swap dealing activity beyond the regulatory supervision of the FDIC.

To summarize, repealing the swaps push out mandate appears to be a move that will decrease systemic risk than increase it and thus beneficial to the society rather than the opposite.  It will enable Banks to serve the risk management needs of their constituents at the same time as enabling the prudential regulators to supervise and monitor them and prescribe optimum provisioning requirements against their swap activities, based on their respective exposures.

Finally, the Congress has delegated the authority to determine the type and credit quality of the underlying asset backed securities (against which Banks may write swaps) jointly to the prudential federal regulators.[6] It appears that the Big Bank lobby will (again) try and lobby the regulators for making this permissive universe as wide as possible.[7] However, the mandate to “jointly” promulgate the type and the credit quality of the underlying asset backed securities will presumably mitigate the risk of regulatory capture at the agency rule-making phase.

- Mandar Kagade

[1] Defined widely to include all federal assistance including most notably, federal deposit insurance to such Banks as conduct both traditional lending and swap dealing activities in  the same entity.
[2] (bare text of Section 716 that codified the Rule).
[3] Typically, Banks borrow from retail depositors that lend to Banks on demand on term basis and make loans to corporate and investors that invest the funds in long-term illiquid projects/ assets.  This “maturity transformation” exposes Banks to unique risks (asset-liability mismatch) that may cause their failure in the event the demand depositors demand their deposits back at the same time. (“Run on the Bank”).  The federal deposit insurance scheme mitigates the risk that the retail depositors run on the Bank by insuring deposits to the extent of USD 100,000 in one person and in one account. By thus lowering the risk, the federal deposit insurance system lowers the true cost of capital for the Banks and thus enables them to benefit from an implicit capital subsidy. This in turn enables the Banks to carry out their traditional lending operations without worrying too much about the run on the Banks.
[4]  See  (bare text of the amendment provisions, “The Swaps Regulatory Improvement Act”)
[5] See generally, John Coffee, The Political Economy of Dodd-Frank: Why Financial Reform Tends to be Perpetuated and Systemic Risk Perpetuated, available at,
[6] Supra note 4 at p.4
[7] See Usha Rodriguez, The Political Economy and the Regulatory Sine Curve available at, (arguing similarly).