Wednesday, April 27, 2011

Parent Company's duty to employees of its Subsidiary

In an interesting judgment delivered earlier this month, Chandler v. Cape Plc. [2011] EWHC 951 (dt. 14/4/2011), it has been held that a parent company owes a duty of care to employees of its subsidiary. The decision contains a detailed analysis of the scope of the duty of care in such situations; and provides some indication that the existence of the corporate veil between the parent and its subsidiary (which was not pierced in the case) may not prevent a direct duty of care between the parties.

The Claimant, Chandler, was employed between 1959 and 1962 by a company – Cape Products. In 2007, the Claimant discovered that he was suffering from asbestosis which was caused due to exposure to asbestos in the course of his employment. Further, this exposure was caused in turn by negligence on the part of Cape Products. Cape Products, however, had long ceased to exist; and the Claimant framed his claim by alleging that at the relevant times, a duty of care was owed to him by Cape Plc., the parent of Cape Products. In effect, the claim was that Cape Products (subsidiary) and Cape Plc. (parent) were joint tortfeasors, jointly and severally liable to pay damages to the Claimant.

The Court began its analysis by noting:
the fact that the Claimant was owed a duty of care by Cape Products does not prevent such a duty arising between the Claimant and other parties.  No doubt, the fact that a duty situation exists between the Claimant and his employer is a factor to be taken into account when deciding whether another party owes the Claimant such a duty.  But, to repeat, the existence of the duty between the Claimant and his employer cannot preclude another person being fixed with a duty of care.  Second, the fact that Cape Products was a subsidiary of the Defendant or part of a group of companies of which the Defendant was the parent cannot mean by itself that the Defendant owes a duty to the employees of Cape Products.  So much is clear from Adams and others v Cape Industries plc & another [1991] 1 AER 929.  Equally, the fact that Cape Products was a separate legal entity from the Defendant cannot preclude the duty arising.  Third, this case has not been presented on the basis that Cape Products as a sham – nothing more than a veil for the activities of the Defendant.  Accordingly, this is not a case in which it would be appropriate to “pierce the corporate veil.”

The Court also accepted (on the authority of Smith v. Littlewoods Organisation Ltd [1987] A.C. 241) that in general, the law imposes no duty of care upon a party to prevent a third party from causing injury to another. However, the Court held (on the basis of Caparo v. Dickman) that this statement was subject to some exceptions. The exceptions were: “… a) where there was a special relationship between the Defendant and Claimant based on an assumption of responsibility by the Defendant; b) where there is a special relationship between the Defendant and the third party based on control by the Defendant; c) where the Defendant is responsible for a state of danger which may be exploited by a third party; and d) where the Defendant is responsible for property which may be used by a third party to cause damage…”

On the facts, it was held that Cape plc. had actual knowledge of the working conditions of the claimant – and this was “no failure in day-to-management; this was a systemic failure of which the Defendant was fully aware.” In such circumstances, the Claimant’s injury should have been foreseen by Cape plc. Further, “At any stage [Cape plc] could have intervened and Cape Products would have bowed to its intervention…” In view of this, it was held that the there was enough proximity between the Claimant and the Defendant to impute a duty of care on the defendant.

The Court did note that merely because there was a parent subsidiary relationship, it did not follow that the parent had a duty of care to the subsidiary’s employees. But besides the normal incidents of a parent-subsidiary relationship (such as the potential to address ‘systemic failures’), the only fact which the Court highlighted was that Cape plc. was itself medical officers who were given the responsibility of looking at the health and safety issues of all group employees.

This fact would of course be insufficient for piercing the veil of the subsidiary; but the Court has held that the absence of a factual foundation strong enough to pierce the veil need not mean that an independent duty of care cannot be established. On the facts, as Cape plc. retained the potential to alter the policies of its subsidiary, a duty of care was held to exist. In the context of a parent-subsidiary relationship, however, it would appear that such potential control would almost always exist. It is not clear when, on the Court’s analysis, the parent company would not have a duty of care to third parties which it knows are dealing with its subsidiary.The decision is an illustration of how the corporate veil may not always be an adequate protection for shareholders.

Globalisation: Myth and Reality

A new study asserts that the importance and virtues of globalization, including cross-border trade and foreign investment, may have been overplayed. The Economist has a column discussing Pankaj Ghemawat’s book World 3.0: Global Prosperity and How to Achieve It. It points to some astonishing data and conclusions that emerge from the book:
Mr Ghemawat points out that many indicators of global integration are surprisingly low. Only 2% of students are at universities outside their home countries; and only 3% of people live outside their country of birth. Only 7% of rice is traded across borders. Only 7% of directors of S&P 500 companies are foreigners—and, according to a study a few years ago, less than 1% of all American companies have any foreign operations. Exports are equivalent to only 20% of global GDP. Some of the most vital arteries of globalisation are badly clogged: air travel is restricted by bilateral treaties and ocean shipping is dominated by cartels.

Far from “ripping through people’s lives”, as Arundhati Roy, an Indian writer, claims, globalisation is shaped by familiar things, such as distance and cultural ties. Mr Ghemawat argues that two otherwise identical countries will engage in 42% more trade if they share a common language than if they do not, 47% more if both belong to a trading block, 114% more if they have a common currency and 188% more if they have a common colonial past.

What about the “new economy” of free-flowing capital and borderless information? Here Mr Ghemawat’s figures are even more striking. Foreign direct investment (FDI) accounts for only 9% of all fixed investment. Less than 20% of venture capital is deployed outside the fund’s home country. Only 20% of shares traded on stockmarkets are owned by foreign investors. Less than 20% of internet traffic crosses national borders.

UDF at Mumbai and Delhi airports

A Division Bench of the Supreme Court today declared that the User Development Fee [“UDF”] charged by the private operators of the Mumbai and Delhi airports is ultra vires. The judgment, reported as Consumer Online Foundation v Union of India, contains several observations that are crucial in ascertaining the proper scope of the public-private model [“PP”] in the aviation sector. This post set out two entirely distinct issues the Court considered, one of which is likely to prove important in subsequent disputes.

The structure of aviation regulation in India is found in the Airports Authority of India Act, 1994 [“AAI Act”]¸ which created the AAI, and provides in s. 12 that it is to exercise a variety of functions, such as planning runways, air safety services, facilities at airports etc. When the Government decided to adopt the PP Model in developing the Bombay and Delhi airports, two amendments were made to the AII Act. In 2003, s. 12A was added to provide that the AAI may “in the public interest or interest of better management of airports” make a lease of the premises of an airport and assign to the lessee some of its functions under s. 12. S. 22A was also added, and provided in gist that the AAI could, with the approval of the Central Government, levy development fees. This provision was amended in 2008 when the Airports Economic Regulatory Authority Act, 2008 [“AERA Act”] was enacted, to provide that AREA would determine the rates of the UDF. In 2006, the AAI, acting under s. 12, leased out the Delhi and Bombay airports to DIAL and MIAL respectively. On 9 February, 2009, the Government of India conveyed its approval of UDF rates to DIAL and MIAL, and UDF has been levied ever since. The Delhi High Court rejected a challenge to the legality of the levy.

The dispute before the Supreme Court turned on a close analysis of statutory language, which it is necessary to set out before the issues can be described. The relevant provisions are s. 12A(4) and s. 22A. Both versions of s. 22A are set out, for the minor differences in language potentially produce a different construction altogether.

12A. Lease by the authority.--(1) Notwithstanding anything contained in this Act, the Authority may, in the public interest or in the interest of better management of airports, make a lease of the premises of an airport (including buildings and structures thereon and appertaining thereto) to carry out some of its functions under section 12 as the Authority may deem fit:

Provided that such lease shall not affect the functions of the Authority under section 12 which relates to air traffic service or watch and ward at airports and civil enclaves

(4) The lessee, who has been assigned any function of the Authority under sub-section (1), shall have all the powers of the Authority necessary for the performance of such function in terms of the lease.

S. 22A before 2008 amendment

S. 22A as amended in 2008

22A. Power of Authority to levy development fees at airports. -- The Authority may, after the previous approval of the Central Government in this behalf, levy on, and collect from, the embarking passengers at an airport, the development fees at the rate as may be prescribed and such fees shall be credited to the Authority and shall be regulated and utilized in the prescribed manner, for the purposes of-

(a) funding or financing the costs of upgradation, expansion or development of the airport at which the fees is collected; or

(b) establishment or development of a new airport in lieu of the airport referred to in clause (a); or

(c) investment in the equity in respect of shares to be subscribed by the Authority in companies engaged in establishing, owning, developing, operating or maintaining a private airport in lieu of the…

22A. Power of Authority to levy development fees at airports.-- The Authority may,--

(i) after the previous approval of the Central Government in this behalf, levy on, and collect from, the embarking passengers at an airport other than the major airports referred to in clause (h) of section 2 of the Airports Economic Regulatory Authority of India Act, 3 2008 the development fees at the rate as may be prescribed;

(ii) levy on, and collect from, the embarking passengers at major airports referred to in clause (h) of section 2 of the Airports Economic Regulatory Authority of India Act, 2008 the development fees at the rate as may be determined under clause (b) of sub-section (1) of Section 13 of the Airports Economic Regulatory Authority of India Act, 2008, and such fees shall be credited to the Authority and shall be regulated and utilized in the prescribed manner, for the purposes of--

Two issues arose – first, is a private operator, as a matter of law competent under s. 12A(4) to levy UDF and secondly, in any event, can UDF be levied before rates are prescribed by the competent authority. It is convenient to begin with the second issue. The Court held that the levy of UDF is not consideration for services provided, but a “compulsory exaction of money by the Government” with the result that the requirements of Art. 265 had to be complied with. A powerful reason the Court gave for this conclusion is s. 22 of the AAI Act, which provides that the AAI may collect “charges and rent” from inter alia passengers for facilities offered to them. The Court said that the power in s. 22A to levy UDF is over and above the charges and rent, indicating that it was not intended to be levied for consideration, but was “really in the nature of a cess or tax for generating revenue for the specific purposes mentioned in … s. 22A”. It is for this reason, the Court held, that Parliament had to enact legislation specifically authorising the AAI to levy UDF, and therefore UDF could not be levied except strictly in accordance with the condition laid down in s. 22A. S. 22A, as the extract above indicates, requires that UDF must be levied “at such rates as may be determined” by AERA. The Court found that a letter by the Ministry of Civil Aviation giving approval to DIAL and MIAL is therefore insufficient, and that the levy was ultra vires because it preceded the determination of the rate by AREA. It distinguished judgments cited by MIAL and DIAL holding that while the existence of a power is not affected by the failure to make rules, that conclusion is displaced when the statute makes it a precondition for the exercise of the power, and that taxing statutes must be construed strictly. Since AERA had subsequently determined rates for the Delhi airport, DIAL has been permitted to continue to levy UDF but has been directed to place its collections prior to the determination with AAI.

The first issue – whether private operators are competent to levy the fee - is considerably more difficult. The Supreme Court’s reasoning on this aspect of the case rests crucially on its finding that UDF must not only be utilised for the purposes indicated in s. 22A above, but may not be levied or collected for any other purpose. It is convenient to refer to the three purposes in s. 22A as Purpose A, B and C. The Union of India’s case was that s. 12A(4) provides that the lessee is entitled to exercise “all” the powers of the AAI necessary to discharge the functions assigned to it, of which management, upgradation and modernisation were part. Since AAI had the power to levy UDF under s. 22A, it was said to follow that the private operators have it too. The Supreme Court rejected this contention on the basis that while the AAI may use the UDF collected for any of the purposes in s. 22A, it can assign only the power to collect UDF for Purpose A above to the private operators. The Court held that Purpose B (establishing a new airport in lieu of the existing airport) and Purpose C (investment…) cannot be assigned to the operators because:

… the function of establishment and development of a new airport in lieu of an existing airport and the function of establishing a private airport are exclusive functions of the Airports Authority under the 2004 Act, and these statutory functions cannot be assigned by the Airports Authority under lease to a lessee under Section 12A of the Act, the lease agreements, namely, the OMDA and the State Support agreement could not make a provision conferring the right on the lessee to levy and collect development fees for the purpose of discharging these statutory functions of the Airports Authority

While the Court’s construction of s. 22A is certainly a plausible one, it is submitted, with respect, that it is not clear that the “purposes” enumerated in s. 22A qualify levy and collection as well as utilisation. Although a comma precedes the words “for the purpose of” which may therefore be taken to qualify both utilisation and collection, it is significant that those words follow the expression “such fees shall be credited to…and utilised in the prescribed manner…” It is possible that the legislature only intended to provide that UDF, collected with the approval of the Centre and at the rates determined, shall be regulated and utilised for the enumerated purposes. Not adopting this construction leads to the curious result that the lessee who operates the airport is not empowered to collect UDF even on behalf of the AAI to be held for those purposes. Moreover, a comparison of s. 22A prior to 2008 with the present version reinforces the impression that the purposes only govern utilisation.

More significantly, it is difficult, with respect, to completely reconcile the Court’s conclusion on the two issues. If, as it held on the first issue, private operators have no power whatsoever to levy UDF since Purposes B and Purpose C cannot be assigned to them, the fact that AERA determined rates cannot change the result. The Court appears to reconcile the two conclusions by suggesting that the UDF now levied by DIAL is traceable not to s. 12(4) but has been “assigned” to it by the AAI under s. 22A - and that it is generally confined to Purpose A. Yet, the language of ss. 12 and 22 indicate, with respect, that the AAI can only assign a “function” it is required to discharge under s. 12, and that any power the private operator needs to discharge it will have to be traced to s. 12(4).

Some of these uncertainties may be addressed when AERA makes a rate determination for MIAL. Reports on the case are available here and here.

Tuesday, April 26, 2011

Lifting the Corporate Veil for Tax Purposes

The judgment of the Bombay High Court rendered last year in the Vodafone Case favours the revenue when it comes to imposition of tax by the Indian authorities on sale of shares in an offshore company that has a substantial stake in an Indian company. While an appeal in the Vodafone Case is pending before the Supreme Court, the Karnataka High Court recently had the opportunity to pronounce a judgment in Richter Holding v. The Assistant Director of Income Tax on a similar fact situation. Although the Karnataka High Court too sided the revenue, the reasoning substantially deviates from Vodafone.

Richter Holding (a Cyprus company) and West Globe Limited acquired 100% shares in Finsider International Company Limited (registered in the UK). Finsider in turn held 51% shares in Sesa Goa Limited, an Indian company. The Indian tax authorities sought to tax the transaction under the head of capital gains, and sought further information from the parties. In turn, Richter Holding filed a writ petition before the Karnataka High Court.

Richter Holding relied on the Vodafone Case to argue that acquisition of shares in an offshore company does not amount to acquisition of immovable property or control of management in an Indian company, and “it is only an incident of ownership of the shares in a company which flows out of holding of shares”. Moreover, it was argued that controlling interest in a company is not identifiable as a distinct asset capable of being held. The tax authorities, on the other hand, argued that the transaction resulted in an indirect transfer of 51% interest held by Finsider in Sesa Goa, which is subject to Indian taxation.

In its judgment, the Karnataka High Court refused to be drawn into the merits of the taxation dispute. The court left it to Richter Holding to urge contentions on the merit of taxation before the authorities. It also found that the agreement produced before the court was insufficient to determine the exact nature of the transaction. Most importantly, the court allowed the tax authority to lift the corporate veil to ascertain the true transaction:
It may be necessary for the fact finding authority to lift the corporate veil to look into the real nature of [the] transaction to ascertain virtual facts. It is also to be ascertained whether [the] petitioner, as a majority share holder, enjoys the power by way of interest and capital gains in the assets of the company and whether transfer of shares in the case on hand includes indirect transfer of assets and interest in the company.
There has been a great amount of discussion regarding the Richter judgment by commentators (here, here and here).

The aspect that deserves greater attention is that the Karnataka High Court demonstrates a keen interest in lifting the corporate veil. This has a number of implications. First, the Richter Holding Case extends even further the scope of the principles laid down in the Vodafone Case. For example, in Vodafone the Bombay High Court did not consider lifting the corporate veil to impose taxation in case of indirect transfers, as we have previously noted. In that sense, the Richter Holding Case arguably provides an additional ground to the tax authorities to tax indirect transfers. Second, it is not clear from the judgment itself whether the tax authorities advanced the argument regarding lifting the corporate veil and, if so, how it was countered by Richter Holding. Third, the Karnataka High Court appears to have readily permitted lifting the corporate veil without at all alluding to the jurisprudence on the subject-matter. Generally, courts defer to the sanctity of the corporate form as a separate legal personality and are slow to lift the corporate veil, as evidenced by Adams v. Cape Industries, unless one of the established grounds exist.

From a macro-perspective, the legal position seems to have been confounded even further, as a column on MoneyControl notes:
… While, the intention of the legislature to tax such transactions is clear, the implications under the current income tax law become critical for completed transactions and existing structures. Notices alleging liability to tax on such indirect transfers have already been issued to Sanofi, Tata, Vedanta, SABmiller, Cadbury etc. and appear to be a growing trend.

The changed approach of the tax department and the consequent uncertainty of taxation is creating apprehensions in the minds of the investors. Tax risks are increasingly being discussed at the time of concluding deals and are a cause of great concern. In the meantime, deal makers are opting for mechanisms like escrow accounts, insurance policy, etc. to conclude transactions already in pipeline.

However the prevailing tax uncertainty coupled with aggressive tax approach adopted by revenue authorities does not augur well for new investments into India. The actual impact of aggressive tax policies on inbound investment will need assessment and perhaps a relook, given the huge investment needs particularly in infrastructure sector.

As one moves ahead, the next hurdle to be crossed is the mechanism and basis of computing gains arising as a result of the transaction being taxable in India. This is going to be the next bout of litigation in case the tax authorities view is eventually upheld by the Courts.

Monday, April 25, 2011

Attracting Sovereign Wealth Funds

Although there had been a great amount of discussion a couple of years ago regarding soverign wealth funds (SWFs), both in terms of their investments in the Indian markets and to to whether India should create one for itself, that seemed to have died down. This was largely because SWFs were expressly recognized in 2008 as foreign institutional investors (FIIs) under the SEBI FII Regulations, and many SWFs indeed registered themselves as FIIs.

Now there is a proposal (reported here and here) to provide some relaxations to SWFs both under the FII Regulations as well as the Takeover Regulations. While this is expected to increase the flow of funds from SWFs into India, there are also questions raised as to the need for separate treatment of SWFs as a category of foreign investors, as this debate suggests.

Saturday, April 23, 2011

Offering of Securities: Public or Private?

Today’s Economic Times carries a newsreport about a company that has 2.6 million shareholders, but nevertheless continues to be unlisted. If true, this oddity of circumstances calls into question section 67 of the Companies Act. That section provides any offer of shares or debentures made to 50 persons or more will be considered a public offering, which will require listing of the securities on a recognized stock exchange. The only way a company can stay out of the purview of this provision is if it makes distinct offerings, with each such offering being made to less than 50 persons. In a company with millions of shareholders, it is unlikely that such an approach is practicable, given the enormous number of separate offerings the company would have to make to invoke the private placement provision. The only other possibility is where the company is a non-banking finance company, as the 50-offeree restriction does not apply so long as the offer is made in accordance with guidelines prescribed by SEBI for the purpose in consultation with the RBI.
In order to prevent abuse of section 67, it may be necessary to consider the inclusion of an absolute limit on number of shareholders in order that a company may continue to be unlisted. This would be in addition to the limit on number of offerees per securities offering. The overall limit on number of shareholders would be akin to requirements in the US where a company with 500 shareholders becomes subject to reporting obligations, which would lead to companies to list anyway. Google went down the path of listing for this reason, and Facebook is expected to follow soon. Such a limit on number of shareholders would be clearer to companies to follow and easier for regulators to implement that the current provisions of section 67 which continue to reveal uncertainties and loopholes.

Friday, April 22, 2011

The Romalpa Clause and Bankruptcy Protection

To a supplier or, more generally, to any commercial entity involved in the initial stages of a supply chain, protecting itself in the event of the bankruptcy or change in constitution of its principal buyers is a matter of great importance. It is therefore commonplace to find clauses in a contract creating, for example, a unilateral right to terminate in the event of change of control. Similarly, several devices are used to try to gain an advantage over other creditors in the event of bankruptcy, especially in a business that involves a substantial level of supply on credit. Of these, the most well-known mechanism is the “Romalpa clause” – a retention of title clause that provides that property in the goods does not pass until full payment is received. The recent decision of the UK Court of Appeal in Bulbinder Singh v Jet Star Retail demonstrates some of the limitations of such clause, particularly because of the buyer's implied authority to dispose of the goods.

Mr. Singh was engaged in the business of manufacturing clothing under the trade name of Isher Fashions UK [“Isher”] and was also in time the sole shareholder of Jet Star, a retailer of fashion garments. Isher supplied a large quantity of clothing to Jet Star until 2008, when Jet Star found itself unable to pay many of its suppliers. A winding-up petition was filed by some of its other creditors, and it was placed in administration on November 19, 2008. Nevertheless, it continued to trade between 20 and 24 November, and sold in that period a significant quantity of stock supplied by Isher Fashions. The contract between Isher Fashions and Jet Star contained a retention of title clause, which it is useful to set out in full:

6.2 Isher Fashions shall retain property, title and ownership of the Products until it has received payment in full in cash or cleared funds of all sums due and/or owing for all Products supplied to the Customer by Isher Fashions under this Contract and any other agreement between Isher Fashions and the Customer.


If the Customer

. . .

7.1.4 . . . has a bankruptcy petition presented against it, has appointed in respect of it or any of its assets a liquidator, . . . receiver, administrative receiver, administrator or similar officer . . . then Isher Fashions shall have the right, without prejudice to any other remedies, to exercise any or all of the following rights:

. . .

7.1.9 Isher Fashions may require the customer not to re‑sell or part with the possession of any Products owned by Isher Fashions until the Customer has paid in full all sums due to Isher Fashions under this Contract or any other agreement with the Customer

Isher Fashions had not exercised its right under Clause 7.1.4. at the relevant time. Nevertheless, it brought a claim against Jet Star for conversion. It had to be conceded that a buyer, in these circumstances, has implied authority to dispose of the goods although title has not passed – the nature of the relationship between a supplier and a buyer makes that conclusion inevitable. Isher Fashions suggested, however, that a retention of title clause is analogous to an agreement for a floating charge. If this premise is established, it would follow that that implied authority to dispose of goods automatically terminates when the buyer is placed in administration, for it is well established that an instrument that creates a floating charge prevents a company from disposing of its assets “outside the ordinary course of its business.” A detailed analysis of the scope of this expression is available in Etherton J.’s judgment in Ashborder BV v Green Gas, in which it was accepted that a transaction by a company that is intended to or has the effect of bringing its business to an end is outside the ordinary course of its business. Thus, this suggestion, if well-founded, would have considerably strengthened the effectiveness of a retention of title clause.

In Bulbinder Singh, Moore-Bick LJ agreed that the ordinary course of business test has been correctly formulated but held that there is no effective analogy between a retention of title clause and a floating charge. For one, the scope of a retention of title clause depends, in the ultimate analysis, on the intention of the parties as manifest in the particular contractual context, and it is misleading to suggest that every such clause has the same effect. For example, the provision in clause 7.1.4 (extracted above) that the seller is entitled to withdraw the buyer’s authority to sell is itself a conclusive indication that the buyer, in the absence of the seller taking such action, does have that authority. In other words, if it is the case that insolvency automatically terminates implied authority, clause 7.1.4 would have been unnecessary. Moore-Bick LJ held that this is the reason the analogy between a floating charge and a retention of title clause breaks down:

The parties clearly had in mind, therefore, that the buyer might be permitted to continue to deal with the goods even after it had become insolvent or (as here) had gone into administration. In my view that is an important distinction between this contract and a debenture creating a simple floating charge and one which has significant implications for the scope of the buyer’s authority to dispose of the goods. It is an important feature of a floating charge that it crystallises on the insolvency of the debtor and thereby provides the creditor with the protection he seeks. Under this contract, by contrast, the protection provided by the retention of title clause is contingent on the decision of Isher Fashions to withdraw the buyer’s authority to deal with the goods. I do not think, therefore, that one can draw a direct analogy between the two [emphasis mine].

It followed in Bulbinder Singh that the buyer’s authority to dispose of goods was not limited by the ordinary course of business test.

This decision is an important reminder that the step from a Romalpa clause to automatic limitations on implied authority to dispose is often one too many. The result may be different if the retention of title clause, unlike in Bulbinder Singh, provides not only that title is retained, but that authority to re-sell or dispose is terminated in advance of a seller's notice to that effect, on the event of administration.

Thursday, April 21, 2011

Territorial Nexus Revisited: GVK Industries v. Union of India

We have previously discussed issues surrounding the application of the “territorial nexus” doctrine to income tax law in several posts (here, here, here and here). In its recent decision in GVK Industries v. Union of India, a Constitution Bench of the Supreme Court has confirmed that the doctrine applies to Parliamentary laws. The precise question of the constitutionality of Section 9(1)(vii) of the Income Tax Act, 1961 was not answered by the Constitution bench.

In GVK, the following questions were referred to the Constitution bench:
(1) Is the Parliament constitutionally restricted from enacting legislation with respect to extra-territorial aspects or causes that do not have, nor expected to have any, direct or indirect, tangible or intangible impact(s) on, or effect(s) in, or consequences for: (a) the territory of India, or any part of India; or (b) the interests of, welfare of, wellbeing of, or security of inhabitants of India, and Indians?
(2) Does the Parliament have the powers to legislate "for" any territory, other than the territory of India or any part of it?

The Court explained the constitutional scheme by holding, “The grant of the power to legislate, to the Parliament, in Clause (1) of Article 245 comes with a limitation that arises out of the very purpose for which it has been constituted. That purpose is to continuously, and forever be acting in the interests of the people of India. It is a primordial condition and limitation… Clause (2) of Article 245 carves out a specific exception that a law made by Parliament, pursuant to Clause (1) of Article 245, for the whole or any part of the territory of India may not be invalidated on the ground that such a law may need to be operated extraterritorially. Nothing more.” It was specifically held that any laws enacted by Parliament with respect to “extra- territorial aspects or causes” which have “no impact on or nexus with India” would be ultra vires Article 245 of the Constitution of India.

In a few Tribunal decisions such as Ashapura Minichem (discussed here and here), there were remarks that the doctrine of territorial nexus may not necessarily be relevant in tax laws (“It is thus fallacious to proceed on the basis that territorial nexus to a tax jurisdiction being sine qua non to taxability in a jurisdiction is a normal international practice in all systems. This school of thought is now specifically supported by the retrospective amendment to section 9”). GVK impliedly confirms that those observations must be read in their context. The issue of whether in particular Section 9(1)(vii) especially after the recent amendments satisfies the nexus requirements, is still unanswered. As Ashapur Minichem held, the “render + utilize” formula of Ishikawajima and Clifford Chance is now statutorily overridden by the Finance Act, 2010. Perhaps, Courts may now again insist on a factual “live link” to be established before the provisions of S. 9(1)(vii) can be invoked.

SEBI on Put and Call Options

The Vedanta/Cairn Energy deal brings the issue of put and call options back into the spotlight as SEBI has sought removal of those clauses from the agreement regarding sale of shares in Cairn India. Curiously enough, SEBI has adopted a strict stance on an issue that is far from being clear under Indian law. As we have discussed earlier, the enforceability of put and call options hinges upon a number of statutory provisions and subsidiary legislation to regulate forward contracts (and speculation in securities) that date several decades.

There has been an extensive debate on this issue lately:
Discussion on The Firm – Corporate Law in India;

A column by Ashwin Mathew on The Firm – Corporate Law in India; and

Comments by Sandeep Parekh.
SEBI’s view is consistent with the approach it previously adopted in the order pertaining to the MCX Exchange where it found buyback arrangements in securities of a company to be unenforceable under law (although options do carry certain material differences with plain-vanilla forward contracts). In that case, SEBI went into a fairly detailed analysis of the law on the topic.

The immediate question is whether the Cairn Energy case would represent a precedent as far as SEBI’s regulatory opinion is concerned. If so, similar directives can be expected in other cases where agreements contain put and call options and pre-emption clauses. The position is likely to be resolved only when there is a definitive ruling from an appellate body if SEBI’s stance were to be challenged. A similar saga played out in the past when SEBI adopted a stringent stance on the meaning of “control” under the Takeover Regulations, and the matter appears to have been resolved, at least temporarily, after the judgment of the Securities Appellate Tribunal (SAT) in the Subhkam Case.

Wednesday, April 20, 2011

Caution in Whistle Blowing

Whistle blowing is one of the key tools used in corporate governance to act as a check on managerial actions. It is also recognised in India as a non-mandatory requirement under Clause 49 of the listing agreement. While whistle blowing is useful in enhancing governance standards, the recent episode at Renault suggests that it is also capable of abuse. Lessons from that episode include the need for more robust investigations into allegations made and for restraint to be exercised by the company before the matter is publicly announced.

Thursday, April 14, 2011

Corporate Criminal Liability for Securities Offerings

Mihir and I had previously discussed (here and here) the Supreme Court’s judgment in the Iridium Motorola case rendered in October 2010. We have now posted a more detailed analysis in a case note titled “Corporate Criminal Liability and Securities Offerings: Rationalizing the Iridium-Motorola Case” that is scheduled to be published in the National Law School of India Review. The abstract is as follows:
This case note analyzes the decision of the Supreme Court of India in Iridium India Telecom Ltd. v. Motorola Incorporated & Ors (AIR 2011 SC 20, [2010] 160 Comp Cas 147). The decision is momentous as it clarifies the position under Indian law that a legal person such as a company is capable of having mens rea. It is an important step in promoting the use of criminal sanctions to regulate corporate behavior.

At the same time, it is crucial to note that the Supreme Court stops short of ruling convincingly on the methods by which mens rea of a company can be proved. It places reliance on the anthropomorphic approach of the English courts in Tesco Supermarkets Ltd. v. Nattrass ([1972] AC 153 (HL)) without in any way considering the subsequent crucial development in the form of the more flexible approach in Meridian Global Funds Management Asia Ltd. v. Securities Commission ([1995] 2 AC 500 (PC)). Similarly, the Supreme Court does not conclusively deal with the effect of Risk Factors in determining the existence of ‘deception’ as an ingredient of an offence of cheating due to misrepresentation in a private placement offering document. Of course, the Supreme Court was concerned only with an appeal on preliminary aspects relating to an order of quashing under section 482 of the Code of Criminal Procedure, 1973.

In this note, the authors argue that while Iridium must hold the field on the ability of a company to have mens rea, its rulings on the other aspects must be accepted in measured terms only as possible guidance for further specific judicial determination.

Allahabad High Court’s Order Vacating Stay in the Sahara Case

We have previously discussed SEBI’s order restraining two entities of the Sahara group as well as certain promoters and directors from accessing the capital markets. The order was subsequently stayed by the Allahabad High Court.

On April 7, 2011, the Allahabad High Court vacated its stay, and this order is now accessible through eLegalix (Writ Petition No.11702 (MB) of 2010). While vacating the stay, the High Court has not ruled on any questions of law, particularly relating to the scope of a public offering of securities as compared to a private placement. The decision has been based largely on the conduct of Sahara in evading the requests of SEBI for providing further information regarding the names and addresses of investors to whom securities have been issued. The court offers some guidance regarding the types of information that can be sought by SEBI, and rules that the information needs to be provided within a reasonable time frame.

A report in today’s Mint discussed the impact (or lack thereof) of the High Court order on the offering of securities by the entities involved.

Tuesday, April 12, 2011

MCA Circular on Prosecution of Directors

One of the disincentives that operate against directors, particularly non-executive directors, is that they are often susceptible to prosecution for offences committed by the company that it not within their knowledge. Occasionally, innocent directors have been subject to victimization by requiring to answer allegations that are often frivolous in nature. This concern has now been addressed, at least partially, by a Circular issued on March 25, 2011 by the Ministry of Corporate Affairs to all Regional Directors, Registrars of Companies (ROC) and Official Liquidators.
The Circular relates primarily to independent directors and nominee directors, who are not in charge of the day-to-day affairs of the company. It calls upon the ROC to take extra care in examining the cases where such directors are identified as “officers in default” for the purposes of actions to be taken under the relevant penal provisions of the Companies Act. The Circular further states:
No such Directors as indicated above shall be held liable for any act of omission or commission by the company or by any officers of the company which constitute a breach or violation of any provision of the Companies Act, 1956, and which occurred without his knowledge attributable through Board process and without his consent or connivance or where he has acted diligently in the Board process. The Board process includes meeting of any committee of the Board and any information which the Director was authorised to receive as Director of the Board as per the decision of the Board.
The Circular imposes greater obligations on the ROC to verify relevant information and records before initiating prosecution against independent or nominee directors. These include the status of the director and timing of resignation relative to the commission of the offence by the company. Special provisions have been made for identification of the appropriate “officer in default” in connection with violation of the provisions relating to accounting and financial statements. In sum, the Circular moves away from the erstwhile regime where ROC could potentially adopt a trigger-happy approach while initiating criminal prosecution of directors to one where the ROC is compelled to exercise “proper application of mind”. 

This is a welcome move as it prevents harassment of innocent directors who have been kept in the dark by managements. The Circular, however, does not go as far as proposals discussed in the context of the Companies Bill, 2009 that call for complete immunity to independent directors from prosecution. By conferring discretion on the ROC (to be exercised in an informed manner), the Circular adopts a principles-based approached by avoiding the rigidity involved in complete immunity. This would continue to spur non-executive directors to perform their role diligently, but at the same time protect them against prosecution risks in the event of their innocence.

Monday, April 11, 2011

Scheme of Arrangement: Role of Tax Authorities

The role of the tax authorities in challenging a scheme of arrangement under sections 391 to 394 of the Companies Act, 1956 has been called in question in the demerger of the passive infrastructure assets of various Vodafone Essar entities into Vodafone Essar Infrastructure Limited. This was an intra-group transaction as all companies enjoyed a wholly owned subsidiary relationship with one of the transferor companies. Accordingly, the demerger of the passive infrastructure business was effected at nil consideration, whereby the transferee company was not required to issue any shares or pay cash for receiving the assets.

Since companies were situated in various states, the scheme required the approval of the High Courts at Bombay, Calcutta, Madras, Gujarat and Delhi. While the Gujarat High Court refused to bless the scheme, all the other High Courts sanctioned it, with the Delhi High Court’s order being issued a few days ago, on March 29, 2011. The purpose of this post is to highlight the different approaches adopted by the Gujarat and Delhi High Courts on the same scheme.

In December 2010, the Gujarat High Court delivered its judgment refusing to sanction the scheme. Specifically, the court found that the transaction did not fall within the scope of “arrangement” within the provisions of the Companies Act as the transaction was considered to be a gift due to the lack of consideration. The court found the existence of a number of other grounds to reject the scheme, primarily because the transaction would result in a loss to the revenue. The memos from KPMG and Ernst & Young contain a discussion of the arguments put forth by the parties and the decision of the Gujarat High Court.

The decision of the Gujarat High Court appears to have taken the M&A fraternity by surprise as the court not only provided a restrictive interpretation to a scheme of arrangement under section 391, but also seemed to confers immense powers to tax authorities to object to the scheme at the outset. This was a setback of sorts because sections 391 to 394 of the Companies Act provide sufficient flexibility to companies to carry out mergers, demergers, reconstructions and other similar forms of transaction albeit with shareholder (and sometimes creditor) approvals and under the supervision of the court. In fact, court schemes have become quite popular in India to implement restructurings, and more so than in other Commonwealth jurisdictions such as the U.K. and Singapore where similar statutory provisions exist. It is no surprise, therefore, that Vodafone Essar preferred an appeal from the decision of the single judge of the Gujarat High Court to a division bench, which is understood to be pending.

On the other hand, the Delhi High Court was concerned with the same scheme, but approved it despite objections by the tax authorities. At the same time, the court reserved certain powers to the revenue that therefore operates as a midway path adopted by the Court. In its decision, the Delhi High Court accepted the wide amplitude of the expression “arrangement”. The Court examined the lexicographic scope of the expression by noting that the expression “arrangement” is not defined in the Companies Act. [Note: However, section 390 does define “arrangement”, although only in inclusive and illustrative terms.] Even a transaction that does not involve payment of consideration can fall within the scope of an arrangement, and it does not matter that the transferor companies are effectively giving up the assets for free. The Court had this to say:
The Income Tax Department cannot conceivably have the same interest in the company proposing the scheme as the shareholders of that company. And, to my mind, the Income Tax Department is also not in any sort of loco parentis to the shareholders of the transferor companies who have unanimously agreed to transfer their assts without recompense, nor are they the guardians of their interests, and therefore, the Income Tax Department cannot be heard to plead that the scheme must be thrown out because, in its opinion, the Scheme operates as a confiscation of the transferor shareholders rights. The essence of the idea of confiscation is the taking away or abstraction of something from someone without his consent. Once there is consent, there can be no confiscation.
Furthermore, the court did not accept the arguments of the tax authorities regarding the accounting and tax matters pertaining to the scheme. It found that the object of the scheme was not merely to avoid tax. The Delhi High Court, however, clarified that it was only concerned with sanction of the scheme and was not ruling on the merits of accounting and taxation of the scheme. The via media adopted by the court was to accord sanction to the Scheme of Arrangement under Section 391 and 394 of the Companies Act, 1956 while reserving the right of the income tax authorities to determine any tax liability.

The Gujarat and Delhi High Courts have adopted somewhat contrasting approaches. The Gujarat High Court examined the taxability of the demerger transaction in detail and also whether the transaction was effected as a matter of tax planning. The Delhi High Court, on the other hand, merely confined the scope of its jurisdiction to an examination of the typical factors considered in schemes, including public interest, but reserved powers to the tax authorities to subsequently pursue their tax determination. In that sense, parties seeking sanction of the scheme will necessarily have to assume the risk of adverse determination by the tax authorities. The Delhi High Court’s approach introduces greater predictability in schemes of arrangement by more closely circumscribing the court’s jurisdiction.

Given the varying approaches, it is natural to expect some level of clarity on the issue. Perhaps when the Gujarat High Court is considering the matter on appeal, it will have the benefit of the Delhi High Court judgment and will have the opportunity to consider both approaches before deciding the issue.

Sunday, April 10, 2011

India’s Contribution to the Global IPO Activity

Since economic liberalization in 1991 and following SEBI’s efforts in spearheading the primary capital markets, IPO activity of Indian companies has witnessed significant growth. A recent study that compares global IPO activity with the US domestic markets provides key comparative data that help assess India’s performance. In a paper titled “The U.S. left behind: The rise of IPO activity around the world”, Craig Dodge, Andrew Karolyi and Rene M. Stultz find, from a “comprehensive sample of 29,361 IPOs from 89 countries constituting almost $2.6 trillion (constant 2007 U.S. dollars) of capital raised over 1990 to 2007”, that there has been a steady growth of IPOs around the world in comparison with a decline in IPO activity in the U.S.
A few key findings from the paper are extracted below:
Some of the decrease in the importance of U.S. IPO activity compared to worldwide IPO activity is due to lower IPO activity by U.S. firms, but much of it is explained by the considerable growth of IPOs in other countries that occurs throughout the sample period. To a large extent, this growth is fueled by the emergence of global IPOs, which include both IPOs in which some of the shares are sold outside the home country of the firm going public, and foreign IPOs in which of all the shares are sold outside the home country. … U.S. firms have never been active participants in the global IPO marketplace. This newer global IPO phenomenon is an important tool linked to the globalization of capital markets.
This paper documents dramatic changes in the IPO landscape around the world. U.S. IPOs and IPOs from other common law countries have become less important, whether one looks at counts or at proceeds. In fact, U.S. IPO activity has generally not kept pace with the economic importance of the U.S.
Global IPOs have played a critical role in increasing the importance of IPOs by non-U.S. firms. Though firms in countries with weaker institutions are less likely to go public with a domestic IPO, they are more likely to go public in a global IPO. That is, global IPOs enable firms to overcome poor institutions in their country of origin. Perhaps as a result, the laws and institutions of a firm’s country of origin have become significantly less important in affecting the rate and pace of IPO activity in a country.
There are important global drivers in domestic IPO activity. Higher levels of worldwide IPO activity outside a country are strongly and positively related to the level of IPO activity in that country. However, IPO activity is also related to domestic market conditions. Firms are more likely to choose to go public at home when valuations are higher in the home market.
The data analyzed in the paper provides some interesting insights into IPOs by Indian companies. In terms of number of IPOs, India stands in 2nd place (behind the U.S.) with 4,867 IPOs during the period of study, of which 4,777 are domestic IPOs and 90 are global IPOs. This signifies not only a high number of IPOs in absolute terms, but also demonstrates the overwhelming contribution made by domestic IPOs where securities are listed on Indian stock exchanges. Global IPOs (which presumably, in the Indian context, refer to ADR/GDR offerings listed on foreign exchanges) pale in number. The data indicate the strong attraction of domestic markets in luring Indian companies to list rather than to look overseas. This may also be explained by the fact that even when Indian companies embark on domestic IPOs and list on Indian exchanges, a substantial portion of the capital nevertheless comes from foreign investors. In that sense, foreign investors find comfort in investing in domestic Indian IPOs without requiring issuer companies to activity scout for overseas listings.
The analysis of proceeds raised in IPOs, however, presents a different picture. On that count, India stands in 18th place with total a capital-raising of $32.2 billion, of which $17.8 billion is from domestic IPOs and $14.4 billion from global IPOs. The leading countries on this parameter are the U.S. ($647.7 billion) followed by China $254.6 billion). At first blush, this may suggest lack of depth in the Indian capital markets in the overall scheme of things. But, the correlation between the number of IPOs and the proceeds raised is also an indicator of one important factor. That is, there appear to be a large number of Indian IPOs with relatively small amounts of capital raised. This could be read to mean that a larger proportion of India’s companies have access to the public capital markets even while raising small amounts of capital. This makes the capital markets regime beneficial not just for large companies, but also for small and medium sized companies.
Of course, several other factors have a role to play in assessing the contribution of IPO markets as the paper suggests, including the quality of the country’s institutions such as corporate governance norms and the availability of sophisticated intermediaries and advisors such as investment bankers, lawyers and accountants.