Monday, October 26, 2015

Changing Nature of the Corporation

The latest issue of the Economist carries two columns (here and here) that analyze the significant changes that have occurred in the nature of the modern corporation, particularly with respect to ownership. This is an addition to an earlier column in September. These columns highlight the more recent developments relating to the nature of the corporation, and question whether the diffused shareholding model that has been prevalent in countries such as the US and UK is likely to be prominent in the future.

According to the Economist, the anonymity in the large listed corporation with diffused shareholding creates several problems. The first is in the typical agency problem between the managers and the shareholders, which tends to be prevalent in such companies. Other problems include the lack of clarity over who controls the company. More recent concerns relate to phenomenon of short-termism due to the pressure of maintaining strong quarterly financial performance. While over the years tighter regulation has been introduced as a measure to curb the excesses of managers, it has also had the unintended effect of increasing the costs of regulation due to which more companies are either not entering the public capital markets or, if already listed, are going private. Furthermore, there is a drastic change in the nature of shareholding even in listed companies. For instance, institutional shareholding has become much more prominent in the US, and has overtaken shareholdings held by individuals.[1]

For this reason, it has been found that a new type of corporation is becoming more prominent in the contemporary business world, which is focused on technology and disruptive innovations. The columns refer to the increasing presence of start-ups, which operate with a clearer ownership structure, due to which some of the problems present in the large corporations with diffused shareholding may not exist. They note that in this “novel type of corporate arrangement … [i]nvestors, founders, managers and, often, employees have stakes that are delineated by carefully drawn contracts, rather than shares of the sort that trade on exchanges”. The role of lawyers too has attracted attention not only in terms of their role in structuring these arrangements, but also in the manner in which they themselves are incentivized. As one column notes:

Lawyers in the startup world play a vastly different role from those who advise—or sue—large companies. This is in part because of the nature of their clients; often tottering between failure and success they rely more heavily on outside advice. But it is also because lawyers, in the early stages, have replaced banks as the key intermediary for financing. But most importantly they negotiate directly with investors and physically maintain the “cap structure”—the all-important legal contract noting who owns what.

The ambiguities and obfuscation of public companies contrast sharply with the new corporate structures set out by legal contracts that make the rights of both investors and owners more explicit. These legal agreements tackle two fundamental difficulties. The first is the need to mitigate agency problems. This is handled by detailed agreements that include control issues, such as the allocation of board seats. Investors usually insist that management, and often employees, own large stakes to ensure their interests are aligned to the success of the venture.

The second difficulty concerns enabling investment in the absence of an important detail: a plausible valuation. Startups are pioneering a novel answer: an agreement at the early investment stages that enables an investor to buy a proportion of the venture, but at a price determined at a subsequent round of fund-raising, typically a year or two in the future.

Even if the modern startups subsequently access the capital markets, they may structure their offerings differently on the lines adopted by firms such as Google, Facebook and Alibaba whereby the founders will continue to maintain strong control over the firms so as to provide clarity to the investors on this count.

Although the columns in the Economist do not discuss these in detail, they refer to another alternative to the Western corporation, being companies from the emerging markets that are gaining influence on the global scene. Such companies tend to be either family-owned companies or state-owned enterprises (SOEs). In these cases, while the question of control is rather clear and categorical, they give rise to the agency problems between controllers and minority shareholders. Typical problems with such companies tend to be governance issues such as related party transactions and tunneling. However, arguably the issues associated with dispersedly held companies such as short-termism may operate to a lesser extent given the longer term interests and outlook of the controlling shareholders (whether the business family or the state) who are in the business in the longer run. A lot more effort is now being spent in understanding and analyzing the benefits and disadvantages of such companies which carry concentrated shareholdings.

In all, there appears to be a radical change in the outlook among analysts and commentators. It was only at the turn of this century that arguments were proffered about the supremacy of the American shareholder-centric model with dispersed shareholding that should form the paradigm for companies from other countries to follow, resulting in a convergence of corporate governance around the world on the lines of the U.S. model.[2] Just over a decade later, serious doubts are being raised regarding the efficacy of the model, especially when alternative models are beginning to look attractive.

[1] See, Ronald J. Gilson & Jeffrey N. Gordon, The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights (2013), available at

[2] Henry Hansmann & Reinier Kraakman, The End of History for Corporate Law (2000), available at

Major Changes Proposed by the Arbitration (Amendment) Ordinance, 2015

[The following guest post is authored by Paavni Anand, a 4th Year B.A., LL.B. student at the National University of Juridical Sciences, Kolkata]

President Pranab Mukherjee has promulgated the Arbitration and Conciliation Amendment Ordinance, 2015 to amend the Arbitration and Conciliation Act 1996. The Ordinance is largely aimed at encouraging the ease of doing business in India in a bid to promote foreign investment. The following major amendments that have been proposed:

1. A distinction has been made as regards jurisdiction for international commercial arbitration, and for all other matters. For the former, the appropriate High Court shall have jurisdiction, whereas for the latter, the principal Civil Court of original jurisdiction or the High Court shall have jurisdiction.

2. The following sections shall apply to international commercial arbitration even when the place of arbitration is not in India:

- Section 9 which deals with interim measures by the Court;

- Section 27 that deals with Court assistance in taking evidence;

- Section 37(1)(a) which states than an appeal shall lie on orders granting or refusing to grant measures under Section 9; and

- Section 37(3) which states that no second appeal shall apply in such cases.

3. In case the arbitration agreement or certified copy thereof is not available to the party applying for reference for arbitration, such party can file an application requesting the Court to call upon the other party to produce the same.

4. If the court passes any interim measure under Section 9, the arbitral proceedings must commence within 90 days of the court doing so.

5. No application for interim measure under Section 9 shall be entertained after the arbitral tribunal has been constituted unless the remedies under Section 17 have been rendered inefficacious.

6. The High Court may frame rules for the purpose of determination of fees of the arbitral tribunal and the manner of its payment to the arbitral tribunal. However, such rules shall not apply to international commercial arbitration and in arbitrations where parties have agreed for determination of fees as per the rules of an arbitral institution.

7. The provisions to ensure independence of arbitrators have been elaborated upon under Section 12. A Fifth Schedule has also been inserted enumerating certain grounds for the same. A potential arbitrator must disclose in writing circumstances such as the existence of direct or indirect, past or present relationship with any of the parties or in relation to the subject matter of the dispute which is likely to give doubts as to independence. Further disclosures shall be made in writing with respect to circumstances which are likely to affect the ability of arbitrators to devote time towards the arbitration. The applicability of this sub-section can be waived by the parties in writing, subsequent to the dispute having arisen.

8. Interim measures ordered by the arbitral tribunal have been delineated as follows:

- Appointment of a guardian for a minor or person of unsound mind;

- Measures protecting goods, or amount of money, or property which is subject matter of the dispute;

- Interim injunction or appointment of receiver;

- Such other measures for protection.

9. A time limit of twelve months from the date of entry of the tribunal upon reference has been provided under Section 29A before which the award shall be made by the tribunal. Additional fees shall be provided to the tribunal if an award is made between six months. If the parties give consent to an extension, it shall be made for a further period up to six months.

10. Fast track procedures have been instituted under Section 29B wherein parties may agree in writing to have their dispute resolved by such procedures. The award shall be made within six months. There shall be no oral hearing, and decisions shall be made on the basis of written pleadings, documents, and submissions filed by the parties, along with any further information called for from the tribunal. Oral hearings shall be made if all the parties agree and the tribunal finds it necessary. A new Section 31A has been added giving specific provisions for costs regime.

11. The ambit of setting aside an award for being in conflict with public policy under Section 34 has been broadened to include not only contravention with Section 75 or Section 81, but also if it is in contravention with the “fundamental policy of Indian law” or if it in conflict with the “most basic notions of morality or justice”.

The proposed amendments would be a step forward in making arbitration an easier, faster and more cost effective method of dispute resolution, especially to attract foreign investors to invest in India.

The full text of the ordinance can be accessed here.

- Paavni Anand

Insurance Companies: IRDA Seeks Control in Indian Hands

[The following post is contributed by Vinod Kothari of Vinod Kothari & Co. He may be contacted at]

The issue of ownership and control of insurance companies in India has been in a state of flux since early this year. While the intent of the Government was clear – to permit FDI up to 49% in the insurance sector – the Rules framed by the Ministry of Finance in February 2015 created a flutter with confusion about the manner of computation of foreign ownership of Indian insurance companies. There was an attempt to clarify the issue by an amendment carried out in early July 2015. Now, the regulator, the Insurance Development and Regulatory Authority of India (IRDA), has brought a new set of rules to define “Indian control” of insurance companies. These rules, framed as Guidelines for “Indian Owned and Controlled” insurance companies, were notified by IRDA on October 19, 2015 (Control Guidelines).

In the opinion of the author, the language of the Control Guidelines is far from clear. The Control Guidelines may lead to several changes in the manner of nomination of directors to boards and quorum requirements for board meetings. That the present articles of association may not have quorum requirement matching with the Control Guidelines may actually drive several insurance companies to change their articles of association. In addition, changes in shareholders’ agreements may also be required because existing shareholders’ agreements may run counter to the requirements of the Control Guidelines.  All these changes are expected to be given effect to within 3 months from the date of notification of the Control Guidelines, and are to be supported by an undertaking of the Chief Executive Officer and Chief Compliance Officer, supported by a board resolution, as also amended copy of the shareholders’ agreement, where applicable. If at all companies are advised to implement the changes by appropriate amendment of articles of association, the time frame of 3 months may be grossly insufficient. In short, the Control Guidelines may create yet another flutter in the insurance fraternity.

Indian Ownership

The genesis of the Control Guidelines is in section 2(7A) in the Insurance Act, 1938 inserted by the 2015 amendment. This section defines an Indian insurance company as follows:

“Indian insurance company” means any insurer, being a company which is limited by shares, and, -

(a) which is formed and registered under the Companies Act, 2013 as a public company or is converted into such a company within one year of the commencement of Insurance Laws (Amendment) Act, 2015;

(b) in which the aggregate holdings of equity shares by foreign investors, including portfolio investors, do not exceed forty-nine per cent of the paid up equity capital of such Indian insurance company, which is Indian owned and controlled, in such manner as may be prescribed.
Explanation – For the purpose of this sub-clause, the expression “control” shall include the right to appoint a majority of the directors or to control the management or policy decisions including by virtue of their shareholding or management rights or shareholders agreement or voting agreements;

(c) whose sole purpose is to carry on life insurance business or general insurance business or re-insurance business or health insurance business.

As is evident, there are twin conditions of ownership and control in the definition above.

Indian ownership is defined by way of Indian Insurance Companies (Foreign Investment) Rules, 2015. Rule 2(l) of the said Rules requires more than 50% ownership either by Indian residents, or Indian companies which are in turn beneficially owned by Indian residents. Apparently, there is a need to look at the second layer of investors above an Indian company owning shares in an insurance company.  Rule 2 (l) was subsequently amended by way an amendment dated July 3, 2015 to seemingly provide that the manner of computation of indirect foreign investment in case of insurance companies will not be the same as in usual cases of foreign direct investment. Irrespective of such intent, the confusion about reckoning indirect foreign investment in case of insurance companies survives.

In the meantime, IRDA has come up with Control Guidelines.

Indian Control

The overarching theme of the Control Guidelines seems to be the same as laid down in the Explanation to section 2(7A)(b). However, given the fact that IRDA has gone about micro-regulating the issue of board control, particularly laying down a peculiar requirement as to quorum, the Control Guidelines may lead to substantial difficulties in implementation. The language of the Control Guidelines is also suboptimal, leaving scope for interpretation issues.

Scope of Applicability

The interpretation difficulties start from the very clause pertaining to scope of applicability.

Clause 1 lists out three cases where the Control Guidelines apply, which are connected by a conjunctive “and”. Generally speaking, “and” is used in conjunctive sense – that is, each of the elements specified in clause 1 must be satisfied in order to attract the scope of applicability.

However, a basic analysis of the three sub-clauses of clause 1 will indicate that the “and” is actually an “or”. However, the three sub-clauses of clause 1 will possibly include the entire universe of Indian insurance companies.

Board composition

The Control Guidelines stipulate that a majority of directors, excluding independent directors, shall be “nominated” by the Indian promoter/Indian investor.

Black’s Law Dictionary defines a nominee thus: “One who has been nominated or proposed for an office. One designated to act for another in his or her place.”

Reference to “nomination” in the Control Guidelines cannot to be taken to mean a “nominee director” as commonly used in corporate parlance. A nominee director is one who is placed on the board at the discretion of the nominator. The nominator is the one who decides who will be a director, and for how long. Any resignation of such nominee is placed before the nominator, and removal of such nominee is also effected by the nominator. 

Note that an insurance company has to be a public company. In case of public companies, section 152(6) of the Companies Act, 2013 mandates at least two-thirds of the directors be appointed by the company in general meeting; therefore, the question of “nomination” of a majority of directors by either the Indian investor or the foreign shareholder, does not arise at all. The only meaning of “nomination” in the context of the Control Guidelines is that the proposal for the appointment of a majority of the directors will come from Indian promoters. The actual appointment will still have to be undertaken through the regular process of the Companies Act and Listing Regulations, including recommendation by the Nomination and Remuneration Committee (where applicable), and approval by shareholders.

There is yet another difficulty. If the number of directors on the board of a company, excluding independent directors, is an even number, the test of control on appointment of a majority will fail. Therefore, companies will need to ensure that their board strength is so fixed, that the number, excluding independent directors, is an odd number.

The Control Guidelines are completely silent about the nomination of independent directors (IDs). Insurance companies, being substantially capitalised public companies, are most likely to need at least two IDs. Foreign JV partners may not be well placed to nominate IDs: therefore, IDs will most likely be identified by the Indian investor. While IDs are expected to be independent, coupled with the majority control over the ex-IDs board by the Indian promoter, this gives the Indian promoter significant board strength.

Appointment of CEOs and other KMPs

The Control Guidelines provide that the appointment of the CEO/Managing Director or Principal Officer will be done by either the Indian promoter or by the Board. Note that by virtue of section 179(3) of the Companies Act, 2013, appointment of key managerial personnel (KMPs) will necessarily require board approval. However, the Control Guidelines seem to be indicating that the nomination of the CEO must be done by the Indian partner.

The Control Guidelines go on further to state that the nomination of KMPs other than that the CEO – for example, the CFO, may be done by the foreign partner. The next requirement – that such appointment will need to be approved by the Board – is superfluous because that is anyways the requirement of the law in section 179(3).


The most curious part of the Control Guidelines is the requirement pertaining to quorum. It is notable that special provisions with regard to quorum are a common feature of all shareholders’ agreements (SHAs). SHAs typically provide that in any meeting of the board, at least one representative of either side must be present to constitute valid quorum. There are typically requirements for affirmative votes on specific matters, irrespective of whether the matter comes before a board meeting or not. However, it is not common for SHAs to provide the requirement of a majority from either side.

The Control Guidelines say: “Quorum shall mean and include presence of majority of the Indian directors irrespective of whether a foreign investor’s nominee is present or not.”

Several aspects about the provision are unclear:

- First, it does not state what sort of meeting is being referred to. It might only be inferred that the meeting is a meeting of the board. But then, given that several significant decisions are taken at committees of boards, can it be that there is absolutely no rule applicable to meetings of committees of boards? In many cases, decisions of a committee virtually bind the board – for example, audit committee decisions [See section 177(8) of the Companies Act, 2013].

- The expression “Indian director” is an example of inappropriate language. It should mean “directors nominated by the Indian promoter/investor”. It may be alright for a quorum requirement to stipulate the presence of at least one director from either side, but it will be quite challenging to require “majority” of Indian investors’ nominees. Once again, if, excluding the independent directors, the number of directors present from both sides is equal, it does not satisfy the requirement of the Control Guidelines. It is mostly difficult to ensure presence of the full board in most board meetings – so, if the board of a company has two IDs, four Indian investor nominees, and three foreign investor nominees, the meeting will fail the quorum if even one of the Indian investor nominees fails to attend the board meeting, assuming that all the three foreign investor nominees either make it to the meeting, or attend by video-conferencing. It seems odd to require one of the foreign investor nominees to also be absent from a meeting, if one from the Indian side is absent.

- It is a well-established rule of board meetings that quorum is required not only to commence a meeting, but at all times. Assuming that before the conclusion of the business, one of the Indian investor nominees has to leave the meeting, this may cause the quorum requirement to fail. It is also a canonical rule that an interested director on a particular business is not counted for the purpose of quorum. It is quite likely that one or more of the Indian investor nominees are not to be counted for quorum for some particular matter –which breach their majority in the board. This will be an impossible situation to handle, as even adjournment of the board meeting otherwise required by the Control Guidelines will not redeem the situation.

- The biggest issue is – in what way are the requirements as to quorum are to be enforced? Section 174(1) of the Companies Act, 2013 lays down the requirement for quorum. In case of insurance joint ventures, there will obviously be a provision in the articles of association which will reflect the clause of the SHA. No SHA would have ever envisaged what the Control Guidelines provide. Hence, most articles of association of insurance companies will not be explicitly providing what the Control Guidelines stipulate. The question, therefore, is – is the quorum requirement of the Control Guidelines applicable sans any amendment of the articles of association? Or, will it be necessary or desirable to amend the articles of association in line with the provisions of the Control Guidelines?

Obviously, there is no answer to any of these questions.  As a matter of stating the policy, having laid down a rule about composition of board of directors, requiring the actual majority presence in board meeting is a very curious case by itself. Control is a question of ability, and not necessarily actual exercise. If the Indian investor has a majority, that is sufficient control, as the ability to control is established. Whether the Indian investor actually ensures sufficient board presence in board meetings is like insisting upon a routine demonstration of strength, which is unnecessary.

Confirmation of Compliance and Time Limits

In order to ensure that the Indian insurance companies are in compliance with the Control Guidelines, IRDA has come out with an additional requirement of filing an undertaking duly signed by CEO and COO. Such undertaking needs to be appended with a certified true copy of board resolution and amended certified copy of agreement/ JV agreement, if applicable.

Companies existing prior to issuance of Control Guidelines: comply within a period of 3 months;

Companies existing post issuance of Control Guidelines: before grant of certificate of registration.


The Control Guidelines are a step towards micro-regulation. The insurance sector is quite a sensitive sector, and in the opinion of the author the Control Guidelines barely give out a signal of the ease of doing business in India.

- Vinod Kothari

Exclusive and Non-Exclusive Jurisdiction

We have discussed the judgment of the Supreme Court in Swastik Gases on the construction of jurisdiction clauses. Its conclusion there is no rule of law that a clause cannot confer exclusive jurisdiction unless it uses words of exclusion (“only”, “exclusive” etc) is plainly correct. But this gives rise to a further question: how should the courts actually decide whether a particular clause does or does not confer exclusive jurisdiction? This is, of course, a question of construction, but there is a large body of case law on this topic that is of assistance. These cases were reviewed by the Court of Appeal earlier this year in its important judgment in Hin-Pro v Compania Sud Americana De Vapores SA.

Hin-Pro was a freight forwarder registered in Hong Kong. The respondent (‘CSAV’) was an international shipping company. Bills of lading issued by CSAV contained the following jurisdiction clause:

23      Law and jurisdiction

This Bill of Lading and any claim or dispute arising hereunder shall be subject to English law and the jurisdiction of the English High Court of Justice in London. If, notwithstanding the foregoing, any proceedings are commenced in another jurisdiction, such proceeding shall be referred to ordinary courts of law.

Notably, clause 23 did not say that the English High Court was to have exclusive jurisdiction.

In 2012, Hin-Pro commenced a number of actions in the Chinese courts for damages alleging that CSAV had released its cargo without the production of the original bills of lading. CSAV commenced an action in the English court. A number of orders restraining Hin-Pro from continuing the Chinese proceedings were passed but these were ignored. Andrew Smith J found Hin-Pro to be in contempt and committed its sole director to prison. Evidently not deterred by this, Hin-Pro commenced a further 23 actions in China; CSAV then sought a declaration in the English court that Hin-Pro was bound by the jurisdiction clause in the bills of lading to sue in England only. Cooke J made this declaration and granted a permanent injunction restraining Hin-Pro from pursuing the Chinese litigation. In the Court of Appeal, Hin-Pro argued that Cooke J was wrong to have made this order because clause 23 of the bills of lading was a non-exclusive jurisdiction clause; so Hin-Pro was not in breach of contract in commencing proceedings in China.

In the English case law on this point, a distinction has been drawn between ‘transitive’ and ‘intransitive’ jurisdiction clauses: this is the difference between saying “the parties agree to submit to the jurisdiction of the English courts” and that “the parties agree to submit disputes to the jurisdiction of the English courts”. It was suggested that the latter (transitive) clause was obligatory while the former (intransitive) was non-obligatory, that is, the agreement was merely that English jurisdiction would be recognised if proceedings were started there, not that proceedings had to be started there. This distinction may strike those attracted by Lord Hoffmann’s approach in Fiona Trust as uncommercial; there is, however, a substantial body of case law that draws it. In Hin-Pro, Christopher Clarke LJ came the conclusion that clause 23 of the bill of lading was an exclusive jurisdiction clause partly for this reason. He also gave six other reasons, some of which are of general importance. First, he rejected Hin-Pro’s submission that the clause should be construed in the light of the fact that a recipient of the bill of lading was unlikely to be English: “[i]n agreeing in English to an English law contract the parties must be taken to have agreed that it shall be interpreted with all the nuances of the English language and in the way that a speaker whose first or only language was English would do so.”

Second, Christopher Clarke LJ thought it significant that clause 23 clearly provided for a mandatory choice of law: English law. Although not conclusive, this makes it more likely that the parties intended the English court’s jurisdiction to be exclusive, because not all foreign courts would necessarily apply English law in accordance with the choice of law clause.

Third, the phrase ‘notwithstanding the foregoing’ in the second sentence only made sense on the basis that the first sentence created an obligation to sue in England rather than merely an option to do so. As a matter of ordinary language, saying “if C does X despite Y...” suggests that the effect of Y is that “X should not be done”.

Fourth, Christopher Clarke LJ rejected Hin-Pro’s attempt to invoke the contra proferentem rule, that is, the argument that any ambiguity in the bill of lading should be resolved against CSAV as the proferens of the clause. The usual consequence of applying this rule is to choose a construction of a clause that is adverse to the proferens (eg pay more, accept less) compared to an alternative construction (eg pay less, accept more). Christopher Clarke LJ made the important point that, even if the rule applies, it is impossible to tell at the time the contract is made which construction of a jurisdiction clause is adverse to one party. How could either CSAV or Hin-Pro have known in 2010 whether it would be to their advantage to sue in England or in China with respect to disputes that had not yet arisen? Which jurisdiction was advantageous would depend entirely on the nature of the dispute, the applicable limitation period, and many other factors that could have had no purchase on the date of conclusion of the contract. As a Canadian judge put it in a passage that Christopher Clarke LJ cites with approval, “[t]he proper interpretation of the contract must exist at the time it is made, and not change. It cannot come and go as the parties' fortunes wax and wane. It cannot be unknowable and shrouded in fog until after the event. For example one interprets an insurance contract the same way before and after a fire, and it has meaning before any fire”.

The upshot of this analysis is not just that a jurisdiction clause can be exclusive even if it does not use words of exclusion: it is that it usually will be exclusive as a matter of construction. One interesting difference between English and Indian law is, however, this: if a contract is governed by English law or contains an English jurisdiction clause (whether exclusive or non-exclusive), an English court has jurisdiction under the CPR even if no part of the cause of action arose in England. Contrary to what has been suggested in some cases, an Indian court does not: the Indian CPC does not recognise jurisdiction by agreement alone. This means that there is always a logically prior question to be answered in this country before turning to the jurisdiction clause: does the Indian court have jurisdiction under its own procedural rules? But the construction of the clause may still matter: for example, if a small part of the cause of action arose in India or the property is located in India (so that the Indian court has jurisdiction under the CPC/Letters Patent), and one of the parties seeks an anti-suit injunction in the Indian court restraining the other party from pursuing English proceedings, it is important to decide whether the jurisdiction clause in favour of the Indian court is exclusive or non-exclusive. So the question of construction is just as important in this country although one must be careful to not overlook these differences relating to underlying jurisdiction.

Saturday, October 24, 2015

The Growth of Unsponsored American Depository Receipts of Indian Companies

[The following guest post is contributed by Dhanush. M, a 5th year student at the Jindal Global Law School]

On October 10, 2008, amendments to section 12g3-2(b) of the Securities Exchange Act of 1934 became effective. The amendment allowed a foreign private issuer to have its equity securities traded in the U.S. over-the-counter market without registration under Section 12(g) of the Act,  thereby indirectly paving the way for the for the unprecedented growth in Unsponsored  American Depository Receipts Programs (UADR).

Following the amendment, a depository bank could independently make the determination that a foreign issuer meets the exemption for purpose of establishing an UADR, so long as the depository represents that it has a “reasonable, good faith belief after exercising reasonable diligence” that the issuer electronically publishes the information required by Rule 12g3-2(b) of the Act.

In the past, issuers had to apply for exemption under Rule 12g3-3(b) of the Act. Under the new rules the exemption became automatic, conditional on the electronic publication of the information. The exemption did not have any material effect on Indian companies as the Depository Receipts Scheme of 1993 allowed companies to issue only sponsored depository receipts (DRs).

However, the 2014 Depository Receipts Scheme envisaged that DRs could either be sponsored by the issuer company or even unsponsored. Unsponsored DRs mean DRs issued without specific approval of the issuer of the underlying securities. Unsponsored DRs can be issued on the back of listed eligible securities only if such DRs give the holder the right to issue voting instruction and are listed on international stock exchange.

The aforementioned change in the depository scheme led to the establishment of several UADR programs of Indian companies without the knowledge or consent of the Indian companies. UADR programs was advantageous from the investor’s viewpoint as it allowed existing investors to have a viable exit option along with access to alternate foreign capital markets. For example, private equity and venture capital funds could exit through an UADR in case the Indian company delays or resists going public.

However, with regard to the Indian Companies, the UADR could be cumbersome from the reporting and compliance standpoint. Indian companies with UADR should be cautious to determine that the existing UADR has not increased interest in the issuer’s securities in the US market and resulted in the issuer having more than 300 holders of a class of its equity securities in the United States, as such a scenario would trigger the requirement that the issuer register the class of securities with the SEC under Section 12(g) of the Securities Exchange Act of 1934 which could be stringent and burdensome.

Why Indian companies must set up a Sponsored Level 1 Depository Receipt program

A Sponsored Level 1 ADR program refers to a program where, ADRs are non-capital raising and not listed on a US stock exchange but are traded in the US Over-the-Counter (OTC) market, mainly on the Pink Sheets market.

An Indian company can foreclose the establishment of an unsponsored ADR program by setting up its own sponsored Level I ADR program. The SEC has stated (in response to Question 105.04) that a sponsored program cannot coexist with an unsponsored program. Therefore, depository banks will be forced to disband the UADR and negotiate with investors for the settlement of the terms a UADR program, if the issuer company establishes a sponsored level 1 ADR program.

The benefits of a sponsored program over an unsponsored program are numerous. The issuer could directly negotiate the appropriate share to ADR ratio with the depository and exercise more control over the voting, dividend payment and other provisions through a deposit agreement under a sponsored program, in contrast to a UADR, where multiple depositories could establish numerous depository programs, where the terms of the agreement could be unknown to the market, creating a market perception and corporate governance problems.

UADR programs, created without the consent of the company could be disadvantageous to the shareholders as depository banks could create multiple UADR, with DRs having multiple ratios for the company’s shares, increasing the liquidity concerns in a company’s shares, in the event of a disbanding an UADR by a depository. Furthermore, multiple depositories could create confusion among investors by offering ADRs at different prices and ratios.

In an UADR program, the level of visibility and the investor awareness of the issuer`s shares is minimal as the DRs are not traded on any recognised exchange, in contrast to a Level I ADR program, which is traded on the “Pink sheet market”, where  the company is more likely to experience better visibility and liquidity. The issuer could leverage the support received by investors in the “Pink sheet market” to raise its profile in the US market with a view towards raising overall US share ownership.

UADR programs may also be of concern if the issuer’s lack of control over one or more UADR programs may lead to market perception problems arising from investors who may draw negative conclusions in respect of the issuer’s securities, particularly if the investor is unaware that an ADR program is unsponsored.

With regard to the liability concerns between a Sponsored Level 1 program and an UADR from the company’s viewpoint, the level of risk in a sponsored program could be minimized, and potentially reduced below that which exists in an unsponsored program, through the use of exculpatory provisions inserted into the deposit agreement that can be designed to protect the Indian issuer.

For instance, since the ADR holders in a Sponsored Level 1 program are deemed to be parties to the deposit agreement and are bound by its terms, the investors’ ability to assert claims against the issuer can be contractually limited under the deposit agreement, in contrast to the UADR program where the issuer has no legal relationship with ADR holders, and therefore no ability to control its risk with respect to such holders.

With regard to the fears of Indian issuers of secondary claims liability for criminal or tort actions a sponsored level 1 ADR program entails, the U.S supreme court in the case  Morrison v. National Australia Bank  highlighted that sponsored level 1  ADRs were not traded on an official exchange-such as New York Stock Exchange or NASDAQ, but were rather traded over the counter, and therefore section  10(b) of the Securities Exchange Act of 1934 would not apply to what the court considered a “predominantly foreign securities transaction”. The Court also stated that Level I ADRs are characterized by their trading in the over-the-counter market, reduced reporting requirements, and inability to raise new capital in the U.S. and therefore should not attract liability under rule 10-b-(5) of the Act.

In respect of civil liability through a sponsored Level 1 ADR program for an Indian issuer, the likelihood of liability is minimal as proving civil securities fraud involving securities that do not trade on the markets can be very difficult, as the plaintiff cannot rely on the “fraud-on-the-market theory”, which is a common ground for securities fraud claims in the United States.

It is necessary to assess whether an Indian issuer on setting up a Sponsored Level 1 ADR program would be liable under the  U.S Foreign Corrupt Practices Act, 1977 (FCPA)  exposing the Indian issuer to potential fines, costly compliance measures, loss of sources of business revenue and reputational harm. The FCPA exposes Indian issuers to the risk of criminal and civil penalties that U.S. enforcement authorities can obtain for violations. Corporations can face criminal fines of up to $25 million for a violation of the FCPA’s accounting provisions and a maximum of $2 million for a violation of the FCPA’s anti-bribery provisions.

It is pertinent to note that in a legal dispute for an FCPA violation by BAE Systems plc, which has a Sponsored Level 1 ADR program and  traded under the symbol BAESY on the Pink Sheets market, the U.S. District Court in the District of Columbia stated that because Level 1 ADRs do not trigger Exchange Act registration or reporting, foreign issuers whose securities underlie these ADRs do not expose themselves to U.S FCPA jurisdiction.

With regard to the tax liability on conversion or transfer of a DR into a share, the Finance Act, 2015 has stated that tax benefits would to be available to only sponsored global depository receipts (GDRs) issued by listed companies, which could dampen the investor sentiment  for the company’s shares globally through the UADR route. Indian companies could take advantage of this favourable tax regime to gain by setting up a sponsored Level 1 ADR program as the investor sentiment would be favourable in regards to a Sponsored Level 1 program.

I conclude, stating that Indian companies could avail the opportunity of market visibility, widened investor base in the U.S markets with minimal legal liabilities by setting up a Sponsored Level 1 ADR program.

- Dhanush. M

Monday, October 19, 2015

Report of the High Level Committee on CSR

[The following guest post is contributed by Suprotik Das, a 4th year law student at the Jindal Global Law School, Sonepat, Haryana.]

This post is with regard to the Report of the High Level Committee to suggest measures for improved monitoring of the implementation of Corporate Social Responsibility policies.

The Committee has suggested a number of measures and steps to bring out clarity to the erstwhile CSR regime of India. However, there remains no data on the implementation and impact of the new CSR rules in India. This should be made public around December or so. The Report does a good job of summarising the recommendations in Chapter IV on page 26.

At this juncture, it becomes pertinent to shed light on clause 4.7 of the recommendation dealing with penalty:

“As regards penalty for non-compliance with CSR provisions of the Companies Act, the present provisions in the law appear to be sufficient. However, the Committee is of the view that the leniency may be shown against the companies for non-compliance in [the] initial two/three years to enable them to graduate to a culture of compliance. This is being recommended because [the] initial three years will be a period of learning for all the stakeholders. This liberal view can at least be taken for smaller companies, which become eligible at the margin to take up CSR programme[s] under Section 135(1) of the Act.”

At present, India has adopted the oft-talked about ‘comply or explain’ approach and the present provisions are by no means sufficient or clear. Let us explore the current regime with regard to penalties and reporting under the Companies Act, 2013 (the “Act”) and The Companies (Corporate Social Responsibility Policy) Rules, 2014 (the “CSR Rules”).

1.         A company which is eligible to invest in CSR Activities does so and discloses the same in the Board’s Report under Section 134(3)(o) read with the second proviso to Section 135 and Rule 8 of the CSR Rules, the details about the policy developed and implemented by the company on corporate social responsibility initiatives taken during the year

This is the ideal situation that any company would want.

2.         A company does not invest in CSR Activities and discloses the reasons in the Board’s Report. Prima facie, the company will not incur any liability.

3.         A company neither invests in CSR Activities nor discloses the same in the Board’s Report. Section 134(8) will be made applicable –a fine shall be levied which shall not be less than Rs. 50,000 but which may extend to Rs. 25,00,000 and every officer of the company who is in default shall be punishable with imprisonment for a term which may extend to 3 years or with fine which shall not be less than Rs. 50,000 but which may extend to Rs. 5,00,000 or with both.

At the first blush, these provisions seem conclusive, as the Committee, in its report has suggested. However, consider the following scenarios:

4.         A company invests in CSR Activities but does not disclose this in the Board’s Report. Should the penalty clause in section 134(8) be made applicable? Section 134(8) starts with the words “If a company contravenes the provisions of this section…” This shows that it may be made applicable but has not been done till now.

Would a penalty in this scenario be a fair? The above 4 points assume that the company adheres to the 2% limit envisaged in Section 135(5).

5.         Suppose a company invests >2% of its average net profits of the last 3 financial years. Some observations arise:

(a)        As per item 6 of the Annexure in the Rules, the company, in the Board’s Report, will have to provide reasons for not spending the amount. If it does this, it seems by virtue of the current provisions, that the company will not be penalised.

(b)        However, if the company still does not disclose the fact that it spent lesser than the 2% limit, will it be liable? The answer seems to be yes, on the basis of the wordings of Section 135(5) read with Section 134(8). This is because the phrase ‘fails to spend such amount’ includes the range from 0 to 1.9%.

Now, taking scenarios 2, 3, 4 and 5 into account [where money has not been invested in CSR Activities or money lesser than 2% has been invested], the general penalty provision in Section 450 may be made applicable. Section 450 prescribes a fine which may extend to Rs. 10,000 and where the contravention is continuing, a further fine which may extend to Rs. 1,000 for every day the contravention continues. There has been no discussion on this matter till date.

Again, considering scenarios 2, 3, 4 and 5: can the Parliament consider this leniency aspect and somehow exonerate the company from liability by clarifying that Section 450 will not be made applicable if a company does not invest in CSR Activities and/or disclose the same in the Board’s Report? We will need to await further clarification.

One can see the various permutations and combinations that can occur with regard to the CSR structure of India – which in no way is sufficient. The Committee needs to further clarify several aspects. First, what is the ambit of this leniency to small companies? Second, why does this dichotomy exist for smaller companies? Third, will Section 450 be made applicable under any circumstance for not investing in CSR activities?

- Suprotik Das