13 August 2015

Letter and Spirit of the Law

by Vijaya Sampath

The universal complaint against lawyers is that they have five different and contradictory interpretations of the same sentence, each fully justified. Some of our laws are centuries old and the language is so archaic that the original intent of the then legislature is obfuscated by time and technology advances. But the same can also be said of an important and recent  legislation like the Companies Act 2013.   Some of these sections are delightfully vague and at times give even contra indications, this may well open a Pandora’s box with un-intended consequences with companies adopting different practices and interpretations on the same subject matter.

The confusion commences from one missing word in the definition in Section 2(52) of a “listed company meaning a company which has any of its securities listed on any recognized stock exchange”, seemingly straightforward at first glance. As is well known, the disclosure, governance and compliance requirements of a ‘listed company’ are way higher than that of a closely held non listed entity.  Even the composition of the Board, requirements for independent directors, manner of holding meetings, voting, etc., are different. The term listed company is used liberally at least 21 times in various sections in the Act setting out mandatory requirements for such companies to fulfil.  Many companies list their issue of debt securities on the stock exchanges and until date, none of these companies are regarded as “listed” and hence not subject to the additional requirements of the Act. However, since listing as defined is not confined to equity securities, it is not clear whether all these companies will now fall within the purview of “listed” and hence have to comply with all the sections that were originally meant for publicly listed equity securities.

The definition of a foreign company in Section 2(42) presents an interesting dilemma and means any company or body corporate incorporated outside India which

  1. Has a place of business in India whether by themselves or through an agent, physically or through electronic means and
  2. Conducts any business activity in India in any manner.

This brings within its ambit companies that have appointed agents or distributors in India, e-commerce entities whose web site is accessible to Indians, who are now deemed to conduct business in India though they do not have any entity in India and even liaison offices of universities and non profit associations would now be covered. An entire chapter XXII is devoted to compliance requirements by such companies with respect to inter alia filing a balance sheet, details of its directors and secretary, naming a person who is authorized to receive a notice, etc., with the Registrar of Companies. Section 379 states that if not less than 50% of the capital (equity and/or preference) of a foreign company is held by Indian citizens/ bodies corporate or companies incorporated in India, then it would be required to comply with all the provisions of the Act as if it were an Indian company even though it is incorporated overseas and is subject to another jurisdiction and may have very nominal “business activity” in India. Section 393 goes a step further in iterating that a foreign company will not be able to file any legal proceedings or enforce agreements/transactions until it complies with all the requirements set out in Chapter XXII though all contracts signed by it will be valid. This implies that the other party can sue for enforcement of such documents but this right is denied to the ‘foreign company’.

Section 68(1) on buy back of securities allows companies to purchase its own shares out of (a) free reserves (b) securities premium account or (c) proceeds of the issue of any shares of other specified securities. The proviso states that no buy back can be made out of the proceeds of an earlier issue of the same kind of shares or securities. While clearly permitting amounts in the securities premium account to be used for buy back as per the sub section, the explanation indicates the contrary by prohibiting proceeds from any earlier issue of the same kind of security that had an element of share premium from being used for the buy back.

Further, share premium account may include amounts credited from multiple earlier issues and there is no segregation of the amount received for each issue. Since proceeds of an earlier issue cannot be used, companies have to establish/prove that the share premium used for buy back is not from the proceeds of an earlier ‘same kind of security’ issue in order to comply with the proviso. Penalty for non compliance is stringent with fines ranging from INR 100,000 to INR 300,000 and every officer in default shall be punishable with imprisonment up to 3 years and an additional fine.

The Act has introduced for the first time in Section 195, prohibition of Insider trading of securities. While the SEBI code on insider trading for publicly listed entities has been in force for a long time, this is the first time that even closely held, whether public or private, companies are covered within the ambit of “insider trading”. Since there are only a few shareholders in these companies, who at most times will be in possession of ‘unpublished price sensitive information’ it would be difficult to transfer shares amongst themselves;  Shareholder agreements of joint venture companies  that have right of first offer clauses will also face a similar problem. Surely, the authorities could not have intended to include this restriction on non listed entities but the absence of the words “listed company” in this section leaves the reader in doubt as to the real intent and meaning of this section. In any case, insiders and connected persons of  listed companies have been subject to stringent restrictions on insider trading under SEBI new regulations, hence the presence of this section in the Act, particularly as worded currently  only creates confusion. 

Section 184 envisages the disclosure of interest by every director in companies, bodies corporate etc., as well as in any contract or arrangement whether direct or indirect. The objective is laudable and necessary to ensure that there is no conflict of interest. Towards this end, a director is required to also inform a company of his/her shareholding in any entity. However, sub section 5(b) clarifies that nothing in this section shall be applicable to any contract or arrangement between two companies where a director or two or more of them hold more than 2% in the other company.  This in practice means that compliance officers of companies would have to constantly keep a watch on the individual and aggregate shareholding of all the directors to ensure that compliance when it crosses 2%. Failure by one director to disclose his/her shareholding may unwittingly make another compliant director liable to fine up to INR 100,000 and/or even imprisonment up to one year. It is only reasonable to make directors individually liable, principle of collective responsibility is clearly wrong in this case.  Further, for directors who are active participants in the equity market, are now obliged to inform companies of their daily/weekly trading activity.

Section 135 (1) has introduced the new concept of the formation of a CSR committee of three or more directors by every company that fulfils any of the following criteria

  1. a net worth of INR five hundred rupees or more or
  2. net profit of INR 5 crores or more or
  3. turnover of INR 1000 crores or more 

This section has been dissected and subject to numerous debates on each of its provisions. CSR rules excludes dividend received from other companies in India or any profit arising from an overseas branch from the definition of net profit. However, companies that have only dividend income and those that have a turnover of INR 1000 crores without any profit have to constitute a committee, hold meetings and also have a CSR policy even though they will not have to spend on CSR, making the entire exercise futile and meaningless.  Additionally, no set off or adjustment is permitted in the next year if a company spend more or less in a year. Since it is almost impossible to spend the exact amount as required under the Act, every annual report will have an explanation for spending more or less than required unless the exact amount is contributed to the Prime Ministers Relief Fund for which even a tax deduction is permissible under income tax and may actually be more beneficial for companies from the tax and monitoring perspective.

There are other sections of the Act with similar issues of what may be described as ‘form over substance’ but that is for another time.  The government has issued a number of notifications and clarifications post implementation of the Act and even an amendment Act has been notified.  The Ministry of Corporate Affairs has sought comments from the public on further amendments to be made and it is hoped that a comprehensive review will address all these issues and truly make the Act in line with its objective of ease of doing business.

 [The author is a Senior Partner and Country Head, Corporate Practice, Lakshmikumaran & Sridharan

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