Saturday, August 30, 2008

An Exotic Precedent in Partnership Law

Straying beyond Indian borders and also into partnership law territory, here is a link in a lighter vein to a post on Ideoblog:

“We don’t usually think of Jerry Seinfeld as an authority on partnership law, but a very recent Maryland case reveals this other side.”
Enjoy that post.

Speedier Enforcement of Large Contracts on the Anvil

Business Standard reports that the Government is considering a new law for the faster enforcement of high-value business contracts. This is to enhance the environment in India for business transactions. The principal driver behind this move is stated to be the low scores India has received on this count in the Doing Business Report published annually by the World Bank. The Business Standard states:

“The Centre had taken notice of the World Bank’s Doing Business Report 2007, which said that it takes as many as 1,420 days in India to implement a financial contract. The report had given India an overall ranking of 177 in the report, a rank that remained unchanged in 2008.

Three indicators — the number of procedures, time taken to settle commercial disputes and the cost of litigation — determine how efficient a country’s commercial contract enforcement is. On all three counts, India scored poorly when compared with China and even Pakistan.

The cost of settling a financial dispute between buyers and sellers in a commercial transaction is nearly 40 per cent of the disputed claim, with a large portion of this amount going into paying legal fees.”
This is not the first time that specialised processes have been set up for enforcement of specific types of contracts. Other examples include the Recovery of Debts Due to Banks & Financial Institutions Act, 1993 and the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002. If precedent is anything to go by, we can only expect the proposed new law to have a long short-title – no pun intended!

Precedent also reveals that such legislations are susceptible to constitutional challenges as we have seen with the previous two. Hence, care must be taken by the lawmakers to ensure that the provisions are designed and drafted in a manner that withstands scrutiny against the backdrop of the Constitution in order to further the legislative goal.

Reforming Indian Company Law

After a prolonged wait, far-reaching reforms are finally underway in relation to the Companies Act, 1956. The Union Cabinet yesterday gave its approval to the Companies Bill, 2008 which is set to introduce a comprehensive revision of the Companies Act. Though the Companies Act (enacted in 1956) essentially tracked the then existing English company law, and although the Act has undergone a great number of amendments over the years, it has failed to keep up with developments in the corporate sector globally. For instance, the United Kingdom itself has amended its company law in the meanwhile, including in 1985 (with a new company law) and more recently with the Companies Act, 2006 (which is being brought into effect in stages). Other jurisdictions in the Commonwealth which similarly borrowed from English company law, such as Australia, New Zealand, South Africa and Singapore have also constantly amended their laws to meet with dynamic business situations. On the other hand, Indian company law still carries several archaic concepts which have long been shunned by other jurisdictions. Given this background, the latest initiative of the Government in simplifying and modernising Indian company law is a welcome move. But, as is always the case, the devil lies in the detail.

A Press Release of the Government encapsulates some of the salient features of the Bill. These are:

- The Bill provides basic principles for all aspects of internal governance of corporate entities and a framework for their regulation;

- Articulation of shareholders democracy with protection of the rights of minority stakeholders, responsible self-regulation with disclosures and accountability, substitution of government control over internal corporate processes and decisions by shareholder control;

- Easy transition of companies operating under the Companies Act, 1956, to the new framework as also from one type of company to another;

- Introduction of a one-person company (OPC);

- E-governance initiatives; also, ability to satisfy meeting requirements (of board of directors, etc.) through electronic mode (such as video-conferencing);

- Facilitation of joint ventures; increase in maximum number of partners in partnerships from 20 to 100;

- Companies to have a minimum of 33% of the board strength consisting of independent directors;

- Separate framework for determination of fair valuations in companies for various purposes;

- Facilitation of shareholder actions in case of fraudulent conduct of companies, such as through class actions;

- Revised insolvency framework that covers rehabilitation and winding-up of companies;

- Comprehensive dispute resolution framework, through the establishment of the National Company Law Tribunal;

As a copy of the Bill does not appear to be available yet in the public domain, it is perhaps premature to attempt a detailed analysis of the provisions. At a general level however, some of the efforts are laudatory in terms of simplifying company law. These including the setting up of one-person companies, reduction in governmental control in management and operation of companies, and e-governance initiatives. However, there are several areas where reforms seem to be inadequate, and there are a number of them at that. Just to explore a few –

(i) obliteration of the concept of par value of shares, which has largely lost its significance in modern company law; similarly, the concept of a minimum authorised share capital. There is no apparent effort to address these matters in the Bill;

(ii) abolition of the doctrine of ultra vires. Indian company law still requires an “objects clause” to be contained in the memorandum of association. It is well-known that drafters of memoranda follow the “kitchen-sink” approach in drafting objects, making them look inelegant at the very least. Considering that other economies are moving away from the need for companies to have objects clause at all (as they have lost their relevance in modern company), efforts in this direction would help to simplify company law;

(iii) changes to the doctrine of ‘financial assistance’ contained in Section 77 of the Companies Act, 1956 in the light of the emergence of leveraged acquisition as a popular form of M&A transaction.

This list could go on. Since the Companies Act is currently undergoing a comprehensive revision, it would help for all these other aspects to be considered in detail so that they are incorporated in an appropriate manner precluding the need for further changes on an ongoing basis.

Further, it appears that in some cases the changes have been retrograde. For instance, the summary of the provisions indicate that the Bill proposes to do away with the concept of shares with differential voting rights. This sends confusing signals to the market. When the concept was introduced only recently in the first place (in 2001) and when companies are yet to implement this facility largely due to the excessive restrictions placed in this behalf, it may not augur well to then withdraw this facility altogether rather than to streamline it.

Lastly, the Bill does not seem to fully address a quagmire that company law and regulation often finds itself in, and that is the issue of multiplicity of regulation and multiplicity of regulators. The Department of Company Affairs (DCA), SEBI and RBI would continue to exercise regulatory powers and influence over different types of companies. For instance, while the DCA is expected to regulate all companies, SEBI’s powers extend to securities regulation in respect of listed companies and RBI’s in respect of banking companies. It is necessary for the legislation to clearly demarcate the powers of these authorities so that there are no loopholes left in regulation and enforcement of the law.

These are only some initial thoughts, and we can expect a greater discussion on the Bill at various fora once the detailed provisions become available.

(Press Reports are available in The Economic Times and The Indian Express)

Wednesday, August 27, 2008

Indian stock markets

I just came across an interesting article in MoneyLife, where Debashis Basu traces the ups and downs of the Indian stock markets - He states that during the boom in 1994-95, there were 1400 IPOs in a year! That sounds absolutely unbelievable now - considering 2007 was the big hit year with just 90 IPOs!

The gist of the article is reflected in this paragraph of the article:

"Of the 177 IPOs made in the past three years, only 68 are trading higher than their issue price. Of these, 24 are still showing a price appreciation of 100% or more (as of 21st August) while over 45 stocks are trading at less than half their issue price. Since we now know that investment bankers operate like a herd and are only focused on their fees, we need to ask if the regulator did enough to ensure strict accountability that goes beyond gathering due diligence certificates. The picture only gets worse. The regulator did precious little when investors were being ripped-off but media reports suggest that it was conducting a ponderous investigation that could lead to penalties after the market is all but dead."

Governance Trends Among Indian Conglomerates

In a column in the Financial Express, Rajesh Chakrabarti sets out some observations regarding corporate governance trends that are affecting Indian companies (particularly conglomerates), based on academic research. These include concentrated ownership (even among large listed companies), lower than desired levels of board supervision, earnings management and the skewed nature of executive compensation. While this column focuses on the Indian situation, it is important to note that most emerging and developing economies are largely faced with similar issues relating to corporate governance as their ownership structures as well as institutional matters pertaining to corporate governance tend to be somewhat similar in nature.

Monday, August 25, 2008

Endemic Delays with Takeover Offers

The Hindu Business Line has published an interesting news story in its edition dated August 24, 2008 about delays in clearing open offers made under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 (“Takeover Regulations”).

Chronic delays in clearance of open offers are leading to M&A activity in India in the listed space being rendered unpredictable. Worse, technically, the Securities and Exchange Board of India claims in courts that it does not “clear” letters of offer and only issues letters of observations and comments. Courts have held the directions contained in such letters are “orders” for purposes of the appellate jurisdiction under the SEBI Act, 1992, and it is high time this ostensible stance is given up by SEBI.

SEBI is required to give its comments on letters of offers within 21 days of the document being filed by the merchant banker. However, there is no known case in recent years of the letter of offer being cleared by SEBI for circulation to shareholders within this deadline. I wrote about this situation last year in the Business Standard (edition dated September 24, 2007 – Without Contempt), and I have reproduced below:-
Last week, at a private training session, when I extolled the virtues of the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 (“Takeover Regulations”), an outspoken participant drove home a strong argument. His grouse was that the Takeover Regulations have failed to meet their fundamental stated objective – of giving public shareholders a timely exit opportunity.

While at first blush, one could dismiss such an accusation as unduly provocative, further reflection suggests that the point is very pertinent. At the core of the Takeover Regulations is the intent of the law to provide the minority non-controlling shareholders a timely opportunity to exit the target company in the wake of a substantial change in shareholding or control. In fact, the law has been regularly amended to prune the time gap between the announcement of the open offer and the receipt of funds in the hands of the shareholders participating in the offer.

However, the practical reality is that the time gap between the announcement of an open offer and the completion of the open offer formalities has only widened. Increasingly, one comes across transactions where this time gap extends to well over six months. This is a sore PR point with SEBI, and has been subject matter of many letters to editors of newspapers that have carried reports of allegedly unduly long delays. However, a dispassionate and scientific review of some of the reasons for the delay would not hurt.

The Takeover Regulations require the acquirer to file the draft letter of offer with SEBI for review. However, once a draft letter of offer is filed, SEBI checks whether there has been any violation of the Takeover Regulations by any other acquirer in the history of the target company. Often, past acquisitions that would seem to have triggered an open offer obligation are discovered. SEBI then demands the acquirer who has filed the letter of offer in compliance with the law, to prove that the past acquisitions were indeed in compliance with the Takeover Regulations.

Checking the entire history of the target company for past violations could entail immense expenditure of time and energy, and substantially delays the clearance of the letter of offer. While such a review may be laudable in principle, it can in no manner justify holding up today’s compliant acquirer, it penalizes the acquirer who is compliant with the law today, for suspected past wrong-doings by others in the past. The past violator could well be a person who is selling his shares today, triggering the open offer by the purchaser, but even that is no reason to hold up the compliant acquirer, or to penalize the public shareholder.

The law has adequate teeth to penalize contraveners, and past breaches should be pursued separately by SEBI, leaving the acquirer who has filed the letter of offer free to proceed with his offer, and helping the public shareholder to get his funds quickly. An obvious import of such a delay is of course the unfair imposition of an enormous cost on the compliant acquirer since the acquirer has to lock up substantial resources in escrow. However, in reality, it is the public shareholder who is harmed.

First, once an open offer is announced, the “offer period” starts and the Takeover Regulations impose significant restrictions on the target company during the offer period. For many important decisions, the target company would need to take shareholder approval, and every general meeting or postal ballot would cost even a mid-sized company at least a million rupees. The economic impact of such avoidable administrative costs is obviously to the account of all shareholders.

Second, the public shareholder’s access to the open offer gets delayed, and thereby his receipt of funds is delayed. During this delay, the market price could move. If the market price goes up, the open offer becomes academic since the public shareholder could well sell his shares in the market instead of selling them to the acquirer. If the market price goes down, the public shareholder’s ability to have all his shares purchased would get further diluted since all shareholders would tender, and therefore, the shares tendered would only get accepted on a pro rata basis.

Third, once an open offer is announced, no other open offer for the same target company can be announced after 21 days. This is a very important rule that regulates competitive bids. If the open offer itself takes ages to be completed, no competitive bid can ever be made on the target company, taking away the prospect of public shareholders even being presented with another open offer. In fact, one interpretation of this rule would mean that after the first 21 days of announcement of the open offer, the target company’s M&A prospects get seriously curtailed.

Besides, SEBI now charges acquirers fees linked to the size of the open offer to review draft letter of offer. At 0.5% for most offers, with a graded scale, SEBI’s income from a single open offer could go up to as high as Rs. 10 crores. Surely, the scale of accountability for a rapid turnaround of documents should be commensurate with the size of these fees.

Acquirers making open offers are equally investors in the securities market who need protection.

Another important factor to be borne in mind is that unless an open offer is fully completed and the public shareholders are paid for their shares, the agreement for the substantial acquisition that triggered the open offer cannot be closed. Therefore, once an acquirer agrees to acquire shares of a size that triggers an open offer, he is completely at the mercy of how well SEBI process the letter of offer for the open offer.

Administration of the Takeover Regulations needs to change urgently. Takeover activity is not akin to raising money in the primary market. It cuts at the core of the M&A environment in India.

Sunday, August 24, 2008

Legal Practices and Public Ownership

We have previously discussed on this blog (here and here) the phenomenon whereby law firms could undertake transactions such as public offering of securities and buyouts. The current issue of The Economist carries a column on this topic. Here is an extract:

“Investing in law firms is more than just a pipe dream. A change in British law, introduced last year, enables law firms to use business structures other than private partnerships, and allows for external investment and initial public offerings (IPOs). Law firms will have to wait for a new regulator, the Legal Services Board, but everything is due to be in place by 2011.

Listing could have a dramatic effect on law firms’ behaviour. Slater & Gordon, an Australian law firm that went public in May 2007, used the proceeds to go on an acquisition spree, swallowing up six smaller rivals within a year. The firm’s share price has risen 50% since the IPO. Companies could also use the money from a flotation to expand abroad more rapidly, or to poach talented lawyers from rivals.”
As far as India is concerned, the necessary legal structures are not in place to enable Indian professional services firms (such as lawyers, chartered accountants, company secretaries and the like) to undertake such transactions. As The Economist states, the existence of a public market for securities of professional services firms presupposes the availability of corporate structures other than partnerships.

However, in India, these professional services firms are restricted to the use of the traditional general partnership firms. Even the intermediate step of converting to limited liability partnerships (LLPs) is not yet an available option. Although most other leading jurisdictions such as the US, UK and Singapore as well as emerging economies such as China permit the use of LLPs (or similar vehicles) for professional services firms, their Indian counterparts are left with the traditional general partnership vehicle only. There have already been two Bills that have been drafted for LLPs in India (see previous discussion on the blog - here and here), but it does not appear that legislative change is set to occur immediately. This is not a desirable position – while the professional practice reforms at an international level are witnessing a debate on possible corporate structures for such firms, the debate in India still lags far behind on the question as to whether LLPs should be allowed instead of the current general partnerships.

Wednesday, August 20, 2008

The Impact of Status Quo on Participatory Notes

Last week, there was expectation that SEBI would make some announcements regarding issuance of participatory notes (P-notes) by foreign institutional investors, particularly that curbs on P-notes will be removed. However, no decision was taken by SEBI and it was decided to defer the matter.

In an editorial, the Financial Express comes out very strongly in favour of removal of all restrictions against offshore derivative instruments such as P-notes. It says:

“Sebi and the government continue to dither on the problem of participatory notes (PNs). PNs are over-the-counter (OTC) derivatives (i.e. bilaterally negotiated derivatives) on Indian equity that are transacted offshore. Restrictions on PNs are supposedly motivated by the need to do supervision of the stock market. This is a canard. All over the world, there are enormous OTC derivatives markets that thrive alongside exchange-traded markets. The managers and supervisors of the London Stock Exchange, New York Stock Exchange, etc., seem to be very comfortable with delivering on their supervisory responsibilities on these exchanges, despite the OTC derivatives market that flourishes alongside.

India has reaped enormous benefits by a highly limited opening of a closed economy. That process of opening must go on. The way forward consists of moving on with the removal of capital controls, and not going back to having more of them. The FII framework was an appropriate idea in 1992. Its utility needs to be increasingly questioned. What does India gain by having a foreign company come to Sebi and register itself? Would it not be better for India to remove the FII framework altogether, and only ask foreign investors to have direct depository accounts with NSDL or CDSL? This way, an entire layer of a permission raj would be eliminated. In addition, the possibility of policy mistakes—such as the restrictions on PNs—would also be removed.”
There is need for caution here. The success of free market regulation (that this editorial advocates) is, and continues to be, a debatable issue. Recent events and the ongoing financial crisis that emanated in the US have questioned the success of market regulation even in advanced economies such as the US, what with collateralized debt obligations (CDOs) and other unregulated instruments wreaking havoc in the financial markets. In this background, it is not entirely certain whether such a prescription will work at all in an emerging economy like India. The relaxation of capital controls necessarily has to be a progressive and controlled process.

Requiring foreign portfolio investors to register with SEBI directly (through the “front door”) rather than resort to indirect routes such as participatory notes has several advantages: it would subject these entities to supervision by the Indian regulators, enhance transparency in the markets and ensure that the capital markets are not exported offshore through indirect (and derivative) instruments. What is important though is that there is a proper, streamlined and timely process followed by SEBI for registration for FIIs, failing which the registration method would not function effectively.

These views are lent some support in today’s editorial in the Economic Times, which finds merit in SEBI’s decision to continue with status quo, and also sets out some data to indicate the lack of any adverse effect to the markets because of the prevailing position:

“SEBI has done well not to rush through any change in its present regimen governing promissory notes (PNs), offshore derivative instruments that allow foreign investors to invest indirectly in a country’s stock markets without disclosing their identity. The restrictions on foreign institutional investors (FIIs) and their sub-accounts, prohibiting them from issuing or renewing PNs with underlying as derivatives and directing them to unwind their positions within 18 months are based on sound logic. They are driven by the need to bring transparency into the market and ensure that beneficial interest is known so that suspect or tainted money does not enter the stock market. Any policy reversal must, therefore, be preceded by thorough examination of the imperatives that led to the imposition of restrictions in the first place.

To the extent FIIs resorted to PNs only because Sebi’s registration processes were cumbersome, the right remedy is to ease the process. This is precisely what Sebi has done; the number of FIIs has gone up from 1,219 in December 2007 to 1,457 in July 2008. But if the fear is that business being is being driven out of India to places like Singapore, where the volume of trading on Nifty futures and options has surged in recent times, the remedy is to improve procedures and product offers on our exchanges, not to reinstate a bad idea; which is what PNs are, a bad idea ab initio.”

Monday, August 18, 2008

Reverse Burden upon Exporters under FERA

(The following post has been contributed by Venugopal Mahapatra and Gautam Bhatia)

A recent judgment of the Supreme Court addressed a few important questions with regard to the imposition of reverse burden under the Foreign Exchange Regulation Act (FERA). In the case of Seema Silk and Sarees and Anr. v. Directorate of Enforcement and Ors., decided in June 2008, the constitutional validity of Sections 18(2) and 18(3) of the FERA was challenged as being discriminatory and violative of Article 14 of the Constitution.

Seema Silk and Sarees, a garment-exporting firm, failed to repatriate the full export value of goods to the tune of Rs. 16.5 crores. Accordingly, a notice was issued by the Directorate of Enforcement under Sections 18(2) and 18(3) of the FERA. In the proceedings initiated by the authorized dealer, Canara Bank, before the Debt Recovery Tribunal, the Enforcement Director imposed penalties upon the firm for violation of the aforementioned provisions. The appellants then preferred an appeal before the Supreme Court. The impugned provision was Section 18 of the FERA.

Section 18(1) of the FERA imposes a mandatory precondition on the exporter to furnish a declaration of the ‘full export value’ of the goods notified by the Central Government. It also requires an affirmation to repatriate the proceeds of the exports, if the exporter directly or indirectly wants to export the specified goods. It further provides a mechanism for grant of exemption by the Reserve Bank of India, the prescribed authority, to export such goods.

Section 18(2) lays down certain procedural requirements pertaining to the mode and method of the payment for goods, the timing of such payment, and the permissibility of deductions in the export value. Section 18(3) states that where in relation to any of the goods notified Clause (a) of Sub-Section (1) applies, and when the prescribed period has expired and the payment not been made, it shall be presumed that the requirements of Section 18(2) have not been complied. The Appellants contended, inter alia, that his provision was harsh inasmuch as it imposed a reverse burden upon the exporter, and also violative of Article 14, as it discriminated against exporters as opposed to domestic traders.

Responding to the Article 14 argument, the Court observed, first, that the Act in question was placed in the Ninth Schedule of the Constitution, and therefore could not be held to be ultra vires even if it did abridge or abrogate fundamental rights under Part III. The Court did not refer to the judgment in I.R.S. Coelho; however, this part of the judgment is relatively less important, as the Court decided to go into the substance of the contention in any event.

The Court referred to the cases of Ajoy Kumar Banerjee v. Union of India and Southern Petrochemical Industries Co. Ltd. v. Electricity Inspector & ETIO to extract the principle that a factual foundation must exist to prove the ground of inequality. No such factual foundation had been demonstrated in the instant case. The Court then went on to make a very important observation: it held that a domestic trader and an exporter stand on different footings. Going into the legislative intent behind the Section, the Court observed further that these provisions were made at the time of a “severe foreign exchange crunch,” with the objective of preventing fraud. In this manner, both the intelligible differentia and the rational nexus tests under Article 14 were satisfied, and the provisions in question were constitutionally valid.

A contention was also raised that the validity of the Act must be judged “on the touchstone of commercial considerations inasmuch as whether an exporter may not be able to repatriate the export proceeds.” Reference to the Income Tax Act and the provisions for a bad debt were also made. The Court held, however, that commercial expediency or auditing of books of accounts could not be a ground for striking down a statute as constitutionally invalid.

It was contended, lastly, that Sections 18(2) and 18(3), which placed the burden of proof upon the accused, were of a ‘draconian nature’ and hence unconstitutional. Rejecting this submission, the Court observed that a ‘legal provision does not become unconstitutional only because it provides for a reverse burden.’ Moreover, the reverse burden only establishes a rebuttable presumption, which can be refuted by the accused if he establishes that the provisions of the Act have not been violated. The Court cited the examples of statutes such as the Negotiable Instruments Act, Prevention of Corruption Act etc. to buttress its holding that an imposition of reverse burden could not, in itself, render a statute unconstitutional.

This case, therefore, provides authority for the proposition that exporters under the FERA form a separate and unique class, upon whom reverse burden can and may be imposed.

Sunday, August 17, 2008

Revisiting the Foreign Venture Capital Regime

In a previous post on this blog about four months ago, we had extolled the virtues of an economy possessing a favourable venture capital regime. We had also highlighted some of the progressive developments in the Indian venture capital market that were induced by favourable regulations issued by SEBI and RBI.

However, the perception of regulators in respect of venture capital firms (especially the foreign venture capital investors) has taken a drastic turn lately, and the picture is beginning to look somewhat gloomy. Over a week ago, we wrote about the possibility that the foreign venture capital route is likely to be restricted to a few sectors only, following pressure from the RBI. The fear on RBI’s part is likely to have been triggered due to the fact that foreign direct investments (FDI) is coming into certain sectors as foreign venture capital investment (FVCI) thereby not only taking advantage of the more benevolent FVCI regime but also overcoming some of the obstacles posed by the FDI regime. The bone of contention here is the real estate sector, where FDI is subject to greater regulation than in other sectors.

A recent column by Richie Sancheti and Vikram Shroff in the Economic Times notes:

“… RBI has been uncomfortable with FVCIs having low-capital base, circumventing takeover guidelines and round-tripping of investments, and has therefore also suggested that SEBI set up screening mechanism for all FVCI applications. In the interim, most of the applications have been kept on hold without any clarity on the time frame.

The intention behind introducing the FVCI regime in 2000 was to provide FVCIs a favourable environment with respect to their investments in India compared with foreign direct investment (FDI) and create a level-playing field between domestic and overseas venture funds.

FVCIs are accordingly entitled to certain benefits, including exemption from entry and exit pricing norms, exemption from any lock-up restriction, post-IPO (subject to certain conditions), and exemption from applicability of the takeover code in the event of sale of shares back to Indian promoters (and not generally). RBI seems to have developed some concerns on the nature of the applications received and investments under the FVCI regulations. …”
The column then goes on to discuss each of these concerns separately, and seeks to allay the fears of the regulator.

Ajay Shah deals with this issue from a broader perspective of financial market regulation and “rule of law”. He says:

“I am worried that there is a problem of rule of law here. What appears to be going on is that applications are not being cleared even though they are compatible with the existing policy framework. If the policy framework is a problem, it should be changed. But at all times, the letter of the law must define how government agencies operate. Similar problems seem to have arisen earlier with RBI's treatment of external commercial borrowing (ECB) also.

Running any system of capital controls, in the modern world, is messy. There will inevitably be a arms race where the bureaucrats will come up with new controls and the private sector will use technological and financial sophistication to evade these controls. Good countries wake up and understand that this spy vs. spy contest is pointless, and shift over to full convertibility. While we are in the process of getting there, the least we should aspire to is to not do violence to the idea of rule of law.”
I couldn’t agree more. Even when capital controls operate in India as they do now, certainty of the law and clarity (to the extent possible) in its interpretation serve important roles in furthering economic development. The regulatory effort ought to be to preserve certainty and clarity, and to avoid ambivalence and nebulousness in policy for foreign investment.

Thursday, August 14, 2008

Simplifying Qualified Institutional Placements and Rights Issues

(In the following post, Shantanu Naravane examines recent changes to the SEBI DIP Guidelines made with a view to promoting qualified institutional placements and rights issues)

The concept of Qualified Institutional Placements [“QIP”] was introduced in India, with effect from May 8, 2006, by virtue of an amendment to the SEBI (Disclosure & Investor Protection [“DIP”] Guidelines, 2000. [Economic Times, May 23, 2006] The object of this amendment was to prevent the ‘export of domestic equity markets’, and encourage on-shore investment. Chapter XIIIA, which was introduced, allowed QIPs to be made for securities which could be issued as equity shares or other specified securities. The primary advantages of this introduction were saving on time, avoiding regulatory hassles, and also cost efficiency. However, one drawback of the system was the requirement that in determining the price of offering, the higher of the average previous six months’ or 15 days’ price had to be taken. In comparison to the global practice, which fixes prices as on the date of issue, this requirement resulted in a false price being used as the price of issue.

This issue became particularly important due to the recent market meltdown, which made it increasingly difficult for companies to sell their issues since the floor price was way higher than the prevailing market price. Surveys indicated that up to 35-40 QIP issues were stuck due to pricing issues. However, on Wednesday, SEBI has relaxed these norms and reduced the timeline of rights issues. As opposed to the earlier position, QIP issues can now be priced on the basis of the average price of two weeks before the issue. This serves the purpose of ensuring greater congruence between the floor price and actual market price. Among other measures related to the segregation of unlisted assets and the submission of consolidated results, SEBI has also decided to reduce the time taken to complete rights issues to 43 days against the current 109 days.

Given the numerous debates as to the propriety of recent Government measures to accommodate and address economic concerns, this amendment seems to provide another ripe issue for policy and business analysts to mull over.

While this is a welcome move in an overall sense, it still leaves some matters open for interpretation. For example, while the SEBI DIP Guidelines have now been amended, the Reserve Bank will have to amend the relevant regulations under the Foreign Exchange Management Act, 1999 to reflect the revised pricing norms for QIP transactions. Unless that is effected promptly, there may be incongruity in the norms issued by SEBI and the RBI thereby introducing uncertainty in the offering of shares to non-resident investors in a QIP, and leaving the reform process only partly accomplished. RBI would have to amend its pricing norms (for non-resident investors in QIPs) to bring it in tune with the revised SEBI Guidelines.

For a detailed discussion of the changes introduced, see the report in Business Standard, August 14, 2008 and a discussion among experts on

(Note: Some of the problems arising out of minimum pricing norms prescribed by SEBI have been discussed in a previous post on this blog)

Wednesday, August 13, 2008

Official Liquidator and Misfeasance Proceedings

(The following post has been contributed by V. Niranjan)

Under s. 457 of the Companies Act, a liquidator has wide powers to ensure fair and equitable distribution of its assets. These powers are general in nature, and their scope and extent are well known. In addition, the Official Liquidator also has the power to compel a director or an officer to restore any wrongful benefit arising out of misfeasance in the course of winding up. Under s. 543, the Liquidator can exercise this power by making an application to the Tribunal. However, that application has to be made, according to s. 543(2), within five years from the date of the order of winding up, or of the first appointment of the liquidator, or of the misfeasance, whichever is the longest. The question that recently arose is whether the Official Liquidator can resort to certain exclusionary provisions in the Companies Act in order to mitigate the effect of s. 543(2) (Ajay G. Podar v. Official Liquidator of J.S. and W.M., CA 4597 of 2008, decided on 22 July 2008).

It was argued before the Supreme Court that the benefit of the general exclusion provision in s. 458A of the Companies Act should not be considered available to an Official Liquidator. S. 458A provides that the period from the date of commencement of the winding to the date on which the winding up order is passed, and one year thereafter, shall be excluded in computing the limitation period. Two other aspects are significant. The provision applies only in respect of a “suit or application in the name of and on behalf of a company”, and applies “notwithstanding anything contained in the Limitation Act, 1963, or any other law for the time being in force”. It was argued that since s. 543(2) is a specific provision that prescribes a specific limitation period, it should not artificially be extended by resorting to s. 458A.

The Court rejected this contention, by distinguishing between ‘extension’ of a limitation period, and ‘exclusion’ of a certain period from its computation. The Court referred to analogous provisions in the Limitation Act permitting exclusion under certain circumstances, and concluded that those provisions do not have the legal effect of ‘extending’ the period of limitation applicable in the first place, but merely alter the period of computation. The Court also found that a misfeasance application filed by the Official Liquidator with the Court or the Tribunal counts as a “suit or application instituted in the name of and on behalf of the company”. An Official Liquidator is typically authorised by the company court’s winding up order to take steps to recover assets. The Court held that this power includes the power to institute misfeasance proceedings against a director or an officer. Consequently, exercising that power will be in the name and on behalf of the company. The Court also came to the conclusion that such an application was more in the nature of a ‘plaint’, making the exclusionary provision applicable. According to the Court, since the object of extending the limitation period is to enable the Official Liquidator to take charge of the affairs of the company, to examine records etc., and collect the assets, actually doing so is always on behalf of the company.

Interestingly, although the Court distinguished between ‘extension’ and ‘exclusion’, the effect of the decision for an Official Liquidator is that an application is maintainable even after five years have passed in fact, because a certain portion of that period is excluded for the purpose of computing the period of limitation. Whether this is the correct view or not is another question entirely, and arguments that it is not may point out that since the period of limitation prescribed in s. 543(2) is in any case the longest of three factual possibilities, there is no need to resort to the general provision. However, what is clear today is that the time period for instituting a misfeasance proceeding has substantially increased in fact, although its legal status has not changed.

Tuesday, August 12, 2008

Inconsistency in Accounting Norms

There have been news reports lately that bring to the fore the inconsistency between the accounting standards issued by the Institute of Chartered Accountants of India (ICAI) and the requirements in Schedule VI of the Companies Act, 1956 in relation to exchange losses incurred by companies on foreign currency-denominated transactions (see here and here).

A Business Standard editorial goes beyond the technicalities of law and accounting and takes matters into the realm of corporate governance:

“The discovery that many large companies are using a contradiction between two sets of rules (one on accounting standards, and another provided under company law) to improve the profits that they report, should come as a wake-up call to all those who believe that India now has good governance standards in companies. The clear intention of the companies which have parked foreign exchange losses on capital assets in the balance sheet, without booking them in the profit and loss account, is to boost the bottom line — in some cases, by substantial margins (as reported in this newspaper yesterday). All the companies involved have quoted legal opinion in their favour, and therefore have provided themselves with some cover for their actions. The question, though, is what is the correct thing to do, not what might pass muster in a legal dispute. And it seems clear enough that these losses should be booked in the profit and loss account. That is what India’s accounting standards ask you to do. That is what the US accounting standards ask you to do. And that is what the international accounting standards ask you to do.”
This episode also touches upon an important aspect of corporate governance. It is not sufficient for good governance to be legislated upon. Corporate governance does not merely revolve around complying with rules and codes, but it ought to be a “way of life” for corporates. Governance principles are to be followed both in form and in substance, and both in letter and in spirit. Unless this is truly practised, no economy can pride itself in having a well developed corporate governance regime.

Monday, August 11, 2008

The Breakdown of the Doha Round

(The following post has been contributed by Mihir Naniwadekar)

Trade talks at the WTO over the Doha Round (now in its seventh year) broke down late last month in Geneva after intense negotiations failed to resolve a deadlock between India and China on the one hand and the US and EU on the other. This short note will look at the differences which led to the breakdown, and the implications of the failure to reach consensus.

Differences arose on the second day of the talks on the issue of capping of farm subsidies granted by the US to its farmers. Developing nations insisted that the US cap its annual subsidies at a level much lesser that what the US agreed to. The US insisted that the annual subsidy cap could be no lesser than US$ 15 billion. This limit was far more than it actually spent last year, but less than it spent in four of the last seven years, when prices of farm products were noticeably lower. Developing countries refused to accept that the US was making any genuine concession. They pointed out that the figure of US $ 15 billion proposed by the US was quite excessive; and the fact that in some years a larger subsidy had been granted could not in itself make an excessive figure justifiable.

Attempts at reaching a consensus were also defied by the issue of a ‘special safeguards mechanism’ designed to protect small farmers in developing countries by allowing such countries to impose a tariff on imports of certain agricultural products if the level of imports surged beyond a particular level. There was disagreement on the threshold level of imports at which the tariffs would kick in, with the United States arguing that the threshold level was too low; and India wanting to reduce it further.

The American and Indian delegations traded allegations blaming each other for the failure of the talks, with the US trade representative alleging that India was the only country at the negotiating table which was absolutely inflexible. Indian Commerce Minister Mr. Kamal Nath in turn stated that the United States was promoting commercial interests of large farmers and agri-business corporations at the cost of the livelihoods of subsistence farmers. China strongly supported the Indian line, with EU Trade Commissioner Peter Mendelson preferring to blame a ‘collective failure’. Other than the purely political fallout of the breakdown of negotiations, two issues merit discussion. First, what are the implications of a failure to reach a consensus on the tricky question of farm subsidies? Secondly, from the point of view of India, what is the significance of the failure to conclude the negotiations successfully?

An Economic Times editorial points out that the failure to reach an agreement on farm trade reforms gives developing countries which are also agricultural exporters (such as Brazil) a new incentive to challenge US farm programmes as being in violation of international trade rules. Successful challenges could force the United States to make cuts in its farm subsidy programmes without developing countries opening their markets in return. In this context, it is worth noting that the US recently (in June) lost a WTO appeal against Brazil on the issue of subsidies for cotton farmers, and also faces cases in several other sectors in which the farm subsidies are being challenged. Thus, it is possible that the failure of negotiations could hurt US interests without allowing the US a free entry into developing markets in return. Of course, this prediction is far from being a certainty, and is perhaps more easily achievable by consensus rather than contest. Also of note is the fact that the US failed to “buy up” several developing nations by offering sops, with developing countries remaining united.

From the perspective of India specifically, it is arguable that the insistence on a low threshold for triggering the tariff mechanism is out of tune with economic realities. Presently, India is witnessing extremely high levels of inflation (with the figures crossing the 12% mark last week) driven by increasing oil and food prices. There might be an arguable case for welcoming a surge in imports. Also, perhaps by refusing to compromise on the issue of the special safeguards mechanism, India threw away a chance to get the developed world to firmly commit to a cap on farm subsidies, which is essential for India if its farmers are to export their products profitably instead of accepting low prices in cases of surplus production. On the other hand, one might take the view that “no agreement is better than a bad agreement”; and India is not really losing out on as much as it would have under an unfavorable agreement. Whichever view one prefers, one thing is clear – the greatest loss would be for India to be disallowed from using special safety mechanisms without a tangible benefit in the form of a cap on developed country farm subsidies. Several interesting perspectives on the breakdown of the Doha round are found in the Economic Times and the Financial Times.

Thursday, August 7, 2008

Trading in Currency Futures permitted on Indian Stock Exchanges

The RBI and SEBI have jointly published guidelines for trading in currency futures on Indian stock exchanges yesterday. This would help further widen the derivative markets in India - While currently only trading in INR-USD futures is permitted, it may be further expanded at a later stage.

A currency future is a standardised foreign exchange derivative contract traded on a recognized stock exchange to buy or sell one currency against another on a specified future date, at a price specified on the date of contract. It does not include a forward contract. For more details, see the notification at the RBI website (

Wednesday, August 6, 2008

Employment Restrictions on PSU Executives: How Valid Are They?

One of our regular readers points us to this news report:

“Top level public sector executives, including directors and chief executives, will not be able to join private firms after retirement or resignation unless they get go-ahead from the government.

If they decide to join, they may have to pay damages to the government for violation as per the bond or agreement signed with the department concerned, says a circular issued by the Ministry of Heavy Industries and Public Enterprises.

"No functional director of the company, including chief executive who has retired/ resigned from the service of the company shall accept any appointment or post in any company, whether Indian or foreign, with which the company has or had business relations within one year from the date of retirement without prior approval of the government," the circular said.”
I will leave you with two valid questions the reader poses:

(i) Is this restriction reasonable in the context of Section 27 of the Indian Contract Act, which invalidates contracts that are in restraint of trade?

(ii) Is this restriction reasonable in the context of Article 19(1)(g) of the Indian Constitution (freedom to practice profession, or to carry on any occupation)?

When Can Directors be Held Responsible for Offences Committed by Their Companies?

(The following post contributed by Gautam Bhatia, a III Year B.A., LL.B (Hons.) student at the National Law School of India University, Bangalore deals with an important, but often controversial, issue of whether directors should be held criminally liable for offences by companies)

The case of Maksud Saiyed v. State of Gujarat, decided by a two judge bench of the Supreme Court in September 2007, is an important judgment dealing with the criminal responsibility of directors for offences committed by their companies.

In Maksud Saiyed, Dena Bank had published certain false and misleading information in its prospectus with regard to the sanction limits, and dues and export bills of Nagamai Nicotine Pvt. Ltd. It was alleged that the Bank was liable under Sections 120B, 425, 191, 192, 177 and 181 of the Indian Penal Code (IPC). It is important to note that the allegations in question were directed at the Bank, and the identity of the person who had acted on behalf of the Bank was not disclosed.

The Court held that while the acts or omissions on part of the Bank may give rise to a statutory violation on its part, that does not imply that its directors could be held personally liable. It cited the case of Saroj Kumar Poddar v. State (NCT) of Delhi and Anr., wherein it could not be shown that the director of a company (who had since resigned) was responsible for the conduct or business of the company. The Court then held that the IPC did not contain any provision for attaching vicarious liability on the part of the Managing Director or the directors of the Company when the accused is the Company. Therefore, in order to hold the directors responsible, it must be shown that they are personally responsible for the offence in question. The allegations in the instant case did not show that the directors had “anything to deal with personally either in discharge of their statutory or official duty.”

While analyzing the judgment in this case, we must distinguish the case of Avnish Bajaj v. State, decided by the Delhi High Court in May 2008. The relevant question that arose in Avnish Bajaj was whether the Managing Director of a company could be held liable for the fact that pornographic material was displayed on a website maintained by the company. It was held that the Managing Director could be proceeded against under Section 85 of the Information Technology Act (IT Act). Section 85(2) of the IT Act clearly states that “where a contravention… has been committed by a company, and it has been proved that the contravention has taken place with the consent or connivance of, or is attributable to any neglect on the part of any director… such director shall also be deemed guilty of the contravention and shall be liable to be proceeded against and punished accordingly.”

Thus, Avnish Bajaj dealt with a situation where the governing statute itself allowed for holding company directors liable. Indeed, at Para. 13 of Maksud Saiyed, the Court states: “vicarious liability of the Managing Director and Director would arise provided any provision exists in that behalf in the statute. Statutes indisputably must contain provision fixing such vicarious liabilities.”

Thus, it may be said that the ratio of Maksud Saiyed is limited to the proposition that Directors can be held liable for offences committed by their companies only where the governing statute permits that by way of an express provision. It may, of course, be argued that the lack of such provision in the IPC is simply a lacuna on the part of the drafters, and so should be ignored. However, addressing this specific point, Avnish Bajaj pointed out that other statutes such as the IT Act and the Negotiable Instruments Act incorporated such provisions; and even more importantly, the Parliament had chosen not to amend the IPC to insert director’s liability. This, coupled with the requirement that criminal statutes must be construed strictly, meant that director’s liability could not possibly be read into the IPC. In the words of Avnish Bajaj, “if and when a statute contemplates creation of such a legal fiction, it provides specifically therefore.”

Lastly, it may be noticed that the decisions in Everest Advertising Pvt. Ltd. v. State (Govt. of NCT of Delhi and Ors.) and S.M.S. Pharmaceuticals Ltd. v. Neeta Bhalla, both Supreme Court judgments of 2007, have imposed liability upon directors only under the express provisions of Sections 138 and 141 of the Negotiable Instruments Act, thus lending implicit support to the decision in Maksud Saiyed. Furthermore, Maksud Saiyed has been affirmed in the cases of Ashok Sikka v. State and R.C. Gupta and Ors. v. State and Anr. (two 2008 judgments where the Delhi High Court expressly held that there mere statement that certain persons were directors of a company would not be enough to attach liability), and the 2008 Supreme Court case of S.K. Alagh v. State of UP and Ors. The current position of law, therefore, does not admit of much doubt.

Miscellaneous: Commodities Trading; Venture Capital, etc.

1. Commodities Futures Trading

A few papers and columns have recently appeared in this area. In a paper titled Futures Trading in Agricultural Commodities, Sandhya Srinivasan finds that the ban on futures trading on 4 agricultural commodities in May this year has not been effecting in bringing down the price of all these commodities. Here is the abstract:

“On 7 May, 2008, the Indian Government announced the ban futures trading in four agricultural commodities - chickpea, potato, rubber and soy oil. The purpose of this paper is to examine the rationale behind the ban and study how logical the decision to impose it is. The stated purpose of the ban was to control inflation. However, of the four banned commodities, only the price of potato declined after the ban due to the bumper crop.

The rising inflation rate, pegged at 11.42% for the week ended 14 June, 2008, has been attributed to a number of factors, including the 56% increase in global food prices over the past year, record crude oil prices (over $140 a barrel), the diversion of land for bio-fuel production, loose monetary policy in emerging economies, and the adoption of an expansionary fiscal policy by the Government.

An analysis of spot and futures prices of the four banned commodities shows a high degree of positive correlation in the prices of the two markets. The prices are interdependent: the futures markets give signals to the spot markets on the direction in which prices will move in the future and the futures prices are determined on the basis of the conditions in the spot markets. Speculation may drive prices further up, but a speculator expects prices to rise due to the market conditions, and doesn't arbitrarily bet on a price rise. The extent to which two markets influence each other depends on the level of integration of the two markets. Developing the spot markets along with the futures markets and ensuring higher participation from the farmers is essential to integrate the futures and spot markets. When the participation by consumers and producers of agricultural commodities in the futures market is low, the debate over the futures ban becomes irrelevant.”
However, in spite of such findings, which are in tune with the Abhijit Sen committee report which found no correlation between futures trading and the price rise, news reports indicate that the ban on futures trading on these essential agricultural commodities is likely to continue. Despite the ban, commodity exchanges appear to be witnessing a surge in trading, mostly in metals and energy (see Business Times Online: India News – subscription required).

The impending introduction of the commodities transaction tax may act as a dampener. In a recent column, MR Mayya argues that the “imposition of commodities tranaction tax will add to the cost of transactions in all these commodities, including those having a modicum of liquidity, with serious adverse consequences.”

2. Possible Restrictions on Venture Capital Funds

There seems to be a proposal to restrict the sectors in which venture capital funds can invest. Here is a report:

“Reserve Bank of India (RBI) has asked the Union finance ministry to prevent foreign investors from side-stepping foreign investment norms by taking recourse to the venture capital (VC) route.

With increasing concerns of foreign capital driving up real estate prices, RBI has recommended that foreign venture capital investments (FVCIs) be restricted to nine sectors (investment in other sectors being treated as foreign direct investment). It has suggested that capital market regulator SEBI set up a screening mechanism for all pending and future FVCI proposals.”
Today Economic Times carries a column by TK Arun who forcefully argues against any such restrictions. Here is an extract:

“The vision that only investment in technology-intensive sectors constitutes venture investment is to grossly misconstrue venture investment and to forgo the venture capital industry’s truly revolutionary potential to nourish entrepreneurship in the country.

VC funds make entrepreneurship more democratic, by taking it away from the preserve of the wealthy. Policy should promote rather than discourage such evolution of financial intermediation. Limiting venture funds to particular sectors is to hold back social progress.”

3. Financial Market Regulation

The recent credit crisis has brought about calls for revamping the entire system of regulation of financial markets. In this column in the Financial Times, Henry Kaufman sets out eight precepts of sound financial regulation that should be considered while drafting new rules and eliminating old ones.

Stock Options for Nominee Directors

Nominee directors on Indian corporate boards are a unique category of directors. They are usually are nominated by a bank, financial institution or other large investor to be a director on companies in which such nominating entities have invested. Sometimes, nominee directors also find themselves in an unenviable position – in case of a conflict between the interests of the nominating institution and the company, whose interests are they required to protect? Although there is no definitive guidance on this aspect of the law, one thing is fairly clear. All directors (whether nominated or otherwise) owe fiduciary duties to the companies on whose boards they sit. Such duties are non-derogable and, to that extent, in case of a real conflict, a nominee director may be required to put the interests of the company before the interests of the nominating entity.

Nominee directors need to be paid for their services, as in the case of other directors. Often, certain institutions follow the practice where nominee directors are required to turn their fees received from companies over to the nominating entities as they are only on those boards at the will of these nominators. This arrangement would not truly reflect the return for the personal services (such as advisory and monitoring role performed) of these directors.

As regards the availability of stock options as a form of remunerating their services, the position was somewhat unclear. This has been put to rest by a circular issued by SEBI this week amending the SEBI (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines, 1999. The changes introduced are briefly described in the circular as follows:

“(a) Presently, as per SEBI (ESOS & ESPS) Guidelines, an employee (including a director of a company / its holding company / its subsidiary, whether such director is a whole-time director or not) is eligible to participate in the ESOS of the company, if such employee is not a promoter, does not belong to the promoter group and is not a director, who, either by himself or through his relative or through any body corporate, directly or indirectly holds more than 10% of the outstanding equity shares of the company.

(b) It has been decided to clarify that a director, nominated by an institution as its representative on the Board of Directors of a company, is eligible to participate in the ESOS of the company, if the contract / agreement entered into between the nominating institution and the director so appointed specifically provides for acceptance of ESOS of the company by such director and a copy thereof is filed with the company.”
An important aspect of this amendment is that the “options granted to a director, who is an employee of an institution and has been nominated by the said institution, shall not be renounced in favour of the institution nominating him”. This structure places emphasis on the role of the nominee director towards the company as such director is being remunerated for services performed to the company, and thereby buttresses the position that nominee directors owe their duties to the company. As regards stock options, the new amendments also proscribe the practice of nominee directors turning over their fees or remuneration to the nominating institutions. In that sense, the nominating institutions exercise their powers at the time of nomination (in terms of determining which individual they nominate on boards). After such appointment, the principal legal relationship is that between the nominee director and the company.

While the position of the nominee director continues to be a matter of debate, this amendment introduced by SEBI resolves the matter at least so far as grant of stock options to such directors is concerned.

(Note: The recent amendments also bring the accounting treatment prescribed by SEBI, for options granted under graded vesting, in line with the accounting treatment provided by the Institute of Chartered Accountants of India (ICAI) in this regards.)

Tuesday, August 5, 2008

A Recent Pronouncement on Enforcement of Foreign Arbitral Awards

(Arbitration clauses have attained ubiquity in international commercial contracts, such as joint venture agreements, involving Indian companies. However, considering the short span of time that the Indian Arbitration and Conciliation Act, 1996 has been in existence, these provisions have not been fully tested in practice.

In this following post, Venugopal Mahapatra, a III Year B.A., LL.B (Hons.) student at the National Law School of India University, Bangalore, identifies one instance of difficulties that parties could possibly face in the implementation of this relatively new piece of legislation. The following is Venugopal’s analysis of a recent case)

The recent Supreme Court judgment Venture Global Engineering v. Satyam Computer Services [AIR 2008 SC 1061] has exposed the enforcement of foreign awards to a challenge on the grounds of domestic public policy. This pronouncement has deep ramifications for international commerce as it poses a significant threat to achieving uniformity and consistency in international commercial arbitration. A short analysis of the case follows.

Satyam Computer Services Limited (SCS), an Indian Company entered into an agreement with Venture Global Engineering (VGE) to create a JV company by the name of Satyam Venture Engineering Services Ltd. An arbitration clause was inserted in the shareholder agreement (SHA) executed by the companies, providing that the state law of Michigan would be the governing law of the contract.

SCS alleged that the VGE had committed an event of default under the SHA and thereby, it had exercised its option of purchasing VGE’s share in the JV company at its book value. On the failure of the parties to resolve the dispute amicably, the matter was referred to arbitration. The arbitrator directed VGE to transfer the shares to SCS and consequently, SCS filed for enforcement of the award before the US District Court, Michigan. VGE objected to the enforcement, arguing that it was in violation of FEMA regulations in India.

‘Patent illegality’ or an award contrary to substantive provisions of law had been interpreted by the apex court in ONGC [(2003) 5 S.C.C. 705] to be contrary to public policy and consequently, a ground for setting aside the award under Section 34 of the Arbitration and Conciliation Act, 1996. VGE controversially argued that as the award was against the provisions of FEMA, it would be open to challenge under Section 34. The submission was controversial because s. 34 is found in Part I of the Arbitration Act, which deals only with domestic awards, while Part II covers enforcement of foreign awards

The Supreme Court’s consideration was limited to this important question of law. In Bhatia International [(2002) 4 SCC 105], the Court had categorically erased the distinction between Part I & Part II of the Arbitration Act, stating that provisions under Part I would apply to all arbitrations and to all related proceedings. For arbitrations held in India, the provisions would be compulsorily applicable and only the derogable provisions of Part I could be deviated from. In international commercial arbitrations, held outside India, the provisions of Part I would apply by default unless the parties expressly or impliedly, excluded all or any of its provisions through agreement.

Relying on this pronouncement, the Court held that the judgment debtor cannot be deprived of his right under Section 34, Part I to invoke the bar of public policy to set aside an award, although it is not a domestic award, and although there is a specific part of the Arbitration Act devoted to such awards. The Court further held that the non-obstante clause contained in Section 11.05 (c) of the Shareholders Agreement which provided that the shareholders should, at all material times act in accordance with the Companies Act and other applicable rules in India overrode the specific arbitration agreements. The Court held that the enforcement must, therefore, be in India. The Court further remarked that as the award, its enforcement, the concerned companies and the entire transaction had a ‘close nexus’ with India, SCS cannot evade the laws of India by taking the award to foreign courts.

The above observations made by the Court impose significant limitation on the extent of contractual freedom available to the parties. The liberty available to the parties in selecting the law, the forum, and the arbitrator is the most alluring aspect of arbitration. Therefore, the UNCITRAL Model Law and general international opinion is strictly against judicial interference in arbitral agreement. Hence, in this light, the judgment deserves careful scrutiny.

The Court also held that there is no difference between Section 48 which deals with enforcement and Section 34 which deals with a challenge to the Award. This seems to be in direct conflict with its opinion in RenuSagar [1994 Supp. (1) SCC 644] which had advocated an extremely narrow scope of public policy while laying a challenge to the enforcement of foreign awards. In light of the expanded scope of public policy as laid down in the ONGC case, this judgment threatens to hinder the requirements of uniformity and consistency that UNCITRAL Model laws seek to promote.

In ONGC, the Supreme Court took the bold step of incorporating ‘patent illegality’ under the scope of ‘public policy’ under Section 34. While doing so, it had relied significantly on the distinction between enforcement of foreign awards and domestic awards to give an expansionary ambit to public policy in case of the latter. However, the Court may have undone a lot of that with this judgment.

A concept, as vague as ‘public policy’, can indeed prove to be an unruly horse, leading arbitration into unknown and undesirable territories. How far, this judgment proves detrimental to the cause of arbitration and international commerce is a question that only time can reveal.

Monday, August 4, 2008

China’s Anti-Monopoly Law

China’s new Anti-Monopoly Law took effect on August 1, 2008.

Financial Times, in a news report published last week (July 28, 2008), has a brief comparison between the Indian and Chinese positions on antitrust. The report observes:

“Tough antitrust laws that take effect in China this week and India later this year could delay or thwart high-profile cross-border mergers and acquisitions, lawyers and business executives have warned.

From [August 1, 2008], companies will have to notify Chinese enforcement agencies about any planned M&A that meets designated thresholds for filings – then await clearance before completing the deal.

China and India are implementing regimes based on the European Union model, covering anti-competitive agreements, abuses of dominance and merger control – with the potential effect on M&A causing concern among multinational companies.

Lawyers and business executives believe China and India’s thresholds for merger filings are too low, and likely to ensnare global deals that will have little effect on competition locally. They also fear enforcement agencies in each country will lack the resources and expertise to deal quickly with complex merger cases.”
Commentators on Chinese law are lamenting about the lack of adequate guidance and resources in implementing the new complex law. See China Law Blog and Chinese Law Prof Blog.

However, an interesting comment has been made on China Hearsay blog as follows:

“Yes, I’m aware of all the breathless press reports on the looming Anti-monopoly Law. I’ve read several articles, including this one from the FT.

Why no blogging? Essentially, there is nothing to blog about here. The law was passed some time ago, we have no implementing regulations (i.e. no regulatory guidance), and obviously we have no cases yet to ponder over and try to determine what position the government will take.”
There appears to be a great deal of similarity (at least at a general level) in the development of competition laws in India and China – the agonizingly slow pace of reforms. In both cases, new laws on competition (or anti-monopoly) have been passed a while ago, but took time to be given effect to, and would perhaps take a lot more time in future to be meaningfully implemented.

Sunday, August 3, 2008

Commercial Disparagement as a Tool in Corporate Battles

(In the following post V. Niranjan, a B.A., LL.B (Hons.) student at the National Law School of India University, Bangalore and Editor, National Law School of India Review, analyses recent court rulings on the issue of ‘comparative’ advertising and commercial disparagement)

The Delhi High Court very recently disposed of two cases relating to commercial disparagement, on the same day. This practice – of using ‘comparative’ advertisement to subtly deprecate a competitor’s product - has become increasingly common in corporate India. Interestingly, although the law has ever since 1895 recognised that this could constitute a tortious act, the practice was nearly non-existent in India, until about 2003. Since then, a spate of such cases has arisen across the country, and today there are more than 15 reported judgments of various High Courts.

The Delhi High Court (Reckitt Benckiser v. Hindustan Lever, CS 1359/2007, decided on 7 July 2008) was required to determine whether an advertisement promoting the Lifebuoy soap indirectly disparaged Dettol, its main competing brand. The advertisement cleverly showed a lady using an ‘orange’ bar of soap, only to be told by a doctor that ‘ordinary antiseptic soaps make the skin dry, allowing germs to enter the cracks’. This culminates in the suggestion that the Lifebuoy Skin Guard is free of these defects, as it contains Glycerine and Vitamin E. The ingenuity of this campaign allowed HLL to claim that its advertisement could not have been directed at Dettol, as there was not so much as a single mention of that brand in the entire advertisement. The High Court rejected this argument, confirming that the test to be applied is the perception an ‘average person with imperfect recollection’ would have had of it. Such an ‘average person’, the Court said, must be picked from the ‘target group of users of the product sought to be slandered’, thus making it far easier for a plaintiff to establish disparagement, since a customer familiar with the specificities of a product will invariably make the association that the advertisement intends him to make. The Court awarded punitive damages of Rs. 5 lakh.

On the same day, the Court (Reckitt Benckiser v. Hindustan Unilever, IA 994/2008 in CS 136/2008) also declined to issue an injunction restraining HLL from telecasting its advertisement disparaging Reckitt’s product Harpic Power. This was another ingenious advertisement where a ‘blue, thin’ toilet cleaning liquid was said to have no germ killing capacity, as compared to Domex, the competitor’s product. The Court applied the same test of ‘average person with imperfect recollection’, this time concluding that the target group would not associate the advertisement with Harpic, since Harpic is not a ‘thin’ toilet cleaner.

More significant than these decisions are two questions that need answers. First, to what extent are Courts willing to allow the market resolve these disputes, and secondly, under what circumstances will disparagement be inferred, especially when the advertisement in question makes references to a class of products, as opposed to a particular product? This has assumed importance because some of these advertisements are thought to be extremely effective commercially.

Developments over the past five years or so indicate that there are very few comparative advertisements that the Court will allow. There is no better example than the 2003 Cola Wars. Coca Cola famously telecast an advertisement claiming that ‘PAPPI’ was a ‘sweet’ drink meant for ‘children’, as opposed to ‘Thums Up’, that ‘grown up people’ would prefer. Although this is probably no more than commonplace advertising in a competitive market, a Division Bench of the Delhi High Court (Pepsi Co v. Hindustan Coca Cola Ltd., (2003) 27 PTC 305) issued a permanent injunction restraining its broadcast, holding that the advertisement depicted a Pepsi product in a ‘derogatory and mocking’ manner. The Court specifically said that the marketplace is no ‘substitute’ for an injunction.

Furthermore, the concept of ‘generic disparagement’ has made the range of permissible advertisement still narrower. Not only can an advertisement not be ‘derogatory’, it now cannot make negative references to a class of products, or to a characteristic of a product, should an average person of imperfect recollection associate that class or characteristic with a specific brand. Eureka Forbes was therefore able to prevent Pentair from advertising that a water purifier system based on ultra-violet technology fails to detect invisible contaminants, although the advertisement did not refer to Aquaguard itself (Eureka Forbes v. Pentair Water India, (2007) 4 Kar LJ 122). The Delhi High Court’s decision in Dettol and Harpic also confirm this theory, as do several other decisions of various High Courts involving Dabur, Emami, Colgate Palmolive, Reckitt and Wipro etc. The merits of these tests apart, the question is whether the growing significance of using injunctions to block damaging advertisement will continue.

Supreme Court on Fringe Benefit Taxes

(In the following post Shantanu Naravane, a 4th Year B.A., LL.B (Hons.) student at the National Law School of India University, Bangalore, examines one of the first Supreme Court decisions on fringe benefit taxes)

Ever since its introduction by the 2005 Finance Act, the concept of Fringe Benefit Taxes [“FBT”] has spawned several controversies. However, the first judicial consideration of its provisions is the recent decision of the Supreme Court in R & B Falcon (A) Pty. Ltd. v. CIT (Appeal (civil) 3326 of 2008).

The Appellant was a company incorporated in Australia, and was engaged in the business of providing mobile offshore drilling rig (MODR) along with crew on a day rate charter hire basis to drill offshore wells. By virtue of an agreement with ONGC for supplying MODR along with equipment and offshore crew, the employees of the Appellant were to work on the MODR on commuter basis. An employee worked on MODR for 28 days, (on-days) alternated by a 28 days field break, (off-days) when he stayed at the place of his residence. The members of the crew were residents of various countries and were transported from their home country to the MODR in two laps: (i) from the nearest designated base city at the place of residence in the home country to a designated city in India; and (ii) from that city in India to MODR through helicopter especially hired by the applicant for this purpose. On the completion of 28 days they were transported back from MODR to the designated base city in their home country in the same manner. The Appellant provided free air tickets of economy class for lap (i) of the journey, and the corresponding return leg, while not paying any conveyance/transportation allowance. The question was whether this provision of free transport was liable to taxation under the FBT regime.

U/s. 115WB(1)(a), a fringe benefit means a consideration for employment provided by way of any ‘privilege, service, facility or amenity … provided by an employer, whether by way of reimbursement or otherwise, to his employees’. S. 115WB(1)(b) also includes ‘any free or concessional ticket provided by the employer for private journeys of his employees of their family members’ as a fringe benefit. S. 115WB(2) deems certain expenditures to be fringe benefits, of which two expenditures relevant for the purposes of this issue are ‘conveyance’ and ‘tour and travel (including foreign travel)’. Finally, s. 115WB(3) provides that for the purposes of sub-section (1), privilege, service, facility or amenity shall not include any allowance provided by the employer ‘for journeys by their employees from their residence to the place of work, or such place of work to the place of residence’.

The crux of the issue was whether the exemption to FBT provided under sub-section (3) could be availed of in this case. Before the Authority for Advance Rulings [“AAR”], the Respondents (Tax Department) contended that:

(a) the exemption under sub-section (3) was only in respect of sub-section (1) and since the tickets here fell within sub-section (2), no exemption could be claimed;

(b) in any event, for the purposes of the section, the ‘residence’ would be the residence on the rig, and not their actual residence; and

(c) the provision applied only to employees resident in India, and since the employees here lived abroad, the exemption could not be claimed by them.

The AAR held that ‘residence’ would not include residence on the rig, and refers to the actual residence. However, they upheld contentions (a) & (c), and held that FBT could be charged. This decision was reversed in appeal by the Supreme Court.

The Court upheld contention (a), holding that sub-section (3) was an exception only to sub-section (1) and not (2). However, they also pointed out that this holding should not be interpreted in such a way as to render sub-section (3) nugatory. If the only expenditures on transport formed part of sub-section (2), sub-section (3) would be denuded of all meaning, since there would be no taxable benefit under sub-section (1), which was being exempted under sub-section (3). Thus, in order to give effect to sub-section (3), they held that all expenditures other than ‘conveyance’ and ‘tour and travel’ would be included under the term ‘or otherwise’ used in sub-section (1). Thus, although the Court agreed with the decision of the AAR on the scope of sub-section (3), they re-interpreted sub-section (1) to include the tickets provided within its ambit. The Court also reversed the decision of the AAR that the employees needed to be Indian residents for the exemption to apply, on the grounds that such an interpretation would be iniquitous and did not follow from the section.

However, one additional contention was also raised before the Supreme Court, i.e. for the purpose of falling within the exemption under sub-section (3), the allowance has to be for regular journeys, and not for periodical journeys like the ones being undertaken here. The Court chose not to answer the question since the argument had not been raised before the AAR and no evidence was on record as to the nature of the payments made. However, an examination of the AAR decision seems to suggest that if this issue were to arise in the future, the argument would be rejected. Sub-section (3) only talks about a journey from ‘residence’ to ‘place of work’. The AAR categorically stated that the term connotes a permanent residence and “not a place where a person is required to stay for a short duration in connection with his duties like the stay at the rig”. Thus, it decided that in the facts at hand here, the homes of the employees, wherever situated, would be their ‘residence’ for the purposes of sub-section (3). Now, if that is accepted, there seems no rationale for allowing an exemption if the transport from the residence is daily, and not allowing it if it is on a bi-monthly basis. At best, a requirement of periodicity can be imposed, given the object of the section. But that requirement too, had been satisfied here. Thus, it seems highly probable that the requirement of daily commuting is not required under sub-section (3).

In arriving at its decision, the Court repeatedly asserted the object of introducing the FBT, and reiterated the importance of using that object as a guiding principle in interpreting the relevant provisions. Thus, apart from the obvious precendential value of the decision, it also assumes significance as laying down some of the guiding principles for future decisions on FBT-related issues.

Saturday, August 2, 2008

Supreme Court on Winding-up Petition by a Contributory

Usually, in a merger, the resulting company becomes entitled to all the rights (and subject to all the liabilities) of the merging company. This includes the exercise of rights in respect of shares in other companies (which we shall call target companies) held by the merging company, as the resulting company would become the owner of those shares. However, it appears that would not be true in all cases, unless the procedure for registration of the transfer of these shares from the merging company to the resulting company has been completed.

In a post contributed by Mihir Naniwadekar, a 4th Year B.A., LL.B (Hons.) student at the National Law School of India University, Bangalore, he analyses a case where the resulting company found itself in a position where it was unable to exercise rights as a shareholder (that it inherited from the merging company) as the shares were not registered in its name in the books of the target company. Mihir’s post is set out below:

Recently, the Supreme Court of India in Severn Trent Inc. v. Chloro Controls (India) Pvt. Ltd. [(2008) 4 SCC 130] dealt with an interesting point of law related to the locus standi of a contributory to file a petition for winding up.

The facts of the case are clear. Chloro Controls (India) Private Limited and Capital Controls Delaware Company, Inc. set up joint venture company, Capital Controls India Private Ltd. Later on, Capital Controls Delaware merged into Severn Trent Water Purification Co. Inc., and pursuant to the merger agreement, Capital Controls (Delaware) went out of existence. The authorised capital of the Indian joint venture company was Rs. 75,00,000 divided into 7,50,000 equity shares of Rs. 10/- each. Capital Controls Delaware (now Severn Trent) held 50% of the equity share capital of the company. The other 50% of the shareholding of the company was held by Chloro Controls (India) Private Limited. Even after the merger between Severn Trent and Capital Controls Delaware, the name of Severn Trent was not entered into the register of Capital Controls (India). Severn Trent terminated the Joint Venture Agreement vide its letter dated July 21, 2004 due to alleged breaches committed by Chloro Controls (India) Private Limited. In the termination notice, Severn Trent called upon the other shareholder to take steps for winding up of the company. When no such steps were taken, Severn Trent filed a petition for winding up on just and equitable grounds. This petition was contested by Capital Controls (India) as well as by Chloro Controls (India). Among various other grounds, the respondents also objected to the maintainability of the petition.

It was contended that Severn Trent was not a shareholder on the company’s register and, therefore, had no standing to maintain the petition for winding up. It was further contended that at no point of time was any application for transfer of share certificates and/or substitution of the name of Severn Trent made. Severn Trent, on the other hand, asserted that it had stepped into the shoes of Capital Control (Delaware), and was entitled to file a petition for winding up. The Company Judge allowed the petition, and an appeal was preferred before the Division Bench of the Bombay High Court. The Division Bench held that the petition was not maintainable on the grounds of Severn Trent being a contributory, but remanded the matter to the Company Judge to decide whether Severn Trent could file the petition on the grounds of its being a creditor. Appeals were filed against this order before the Supreme Court. In the Supreme Court, it was argued that although Severn Trent was a contributory, it was still not entitled to bring a petition for winding up because certain essential conditions were not complied with.

The issue before the Supreme Court called for an interpretation of Section 439(4)(b) of the Companies Act, 1956. Under this Section, a contributory is not entitled to present a petition for winding up unless the shares in respect of which he is a contributory, or some of them, (a) were originally allotted to him; or (b) were held by him and registered in his name for a certain period; or (c) devolved on him through the death of a former holder. Severn Trent did not dispute that category (a) was inapplicable in the case; but argued that it should be held to have conformed to categories (b) and (c). Essentially, the contention was that the requirement of the shares having to be “registered in his name” was not a mandatory requirement, and could be waived in certain circumstances. Otherwise, a company (particularly in cases where two groups of shareholders are severely hostile to each other) could prevent a contributory from bringing a petition for winding up by simply refusing to register the shares in the name of the contributory. Alternatively, Severn Trent argued that the shares could be deemed to have devolved upon it through the “death” of the former holder. After the merger between Capital Control (Delaware) and Severn Trent, the former had effectively met its “civil death”, and its shares had then devolved upon the latter.

The Court relied on a string of English decision beginning from In Re a Company [(1894) 2 Ch. 394] to negate these contentions. The Court held that the plain language of Section 439 could not be modified or read down; and to come under category (b), it was essential that the shares should be held by the contributory and registered in his name. Section 439(4) was held to be a complete code in this respect, leaving no room for equitable considerations to be used to allow a petition in cases where a strict reading of the provisions would not allow one. Adverting to Severn Trent’s contention that the company could simply refuse to register the shares in the name of the contributory, the Court stated, “… if there is omission, default or illegal action on the part of the Company in not registering the name of the contributory even though he/it can be said to be a contributory by holding the shares… the law provides a remedy.” And as Severn Trent had not availed of any such remedy, the Court held that the maxim ‘in equity, what ought to have been done must be taken as having been done’ was inapplicable. The Court also held that the category (c) listed above – “devolved on him through the death of former holder” – would be applicable only to personal representative in his individual capacity and not to corporate entity or juristic personality. Further, it was stated that the word ‘death’ normally applies to the death of a natural person. Severn Trent’s appeal was accordingly dismissed. As to the issue of its locus standi as a creditor, the matter was sent back to the Company Judge.

This case is significant because it is perhaps the only clear Supreme Court decision on the issue of locus standi of a contributory to bring a petition for winding up. The case now conclusively settles that Section 439(4) is an exhaustive code on the subject of winding up by contributories; and in order to present a petition for winding up, a contributory must be able to bring itself within the wordings of the categories mentioned in Section 439(4)(b); with all the categories being construed according to a strict literal meaning.