Recent Developments

The Companies Bill, 2011 has been introduced in the Lok Sabha. A copy of the bill is available here. Some aspects of the bill has been discussed here, here, here and here. The report of the parliamentary standing committee on finance which had carried out detailed deliberations on the Companies Bill, 2009 is available here.

SEBI has released a concept paper on regulation of investment advisors.As per the paper, the regulation intends to "regulate the activity of providing investment advisory services is various forms by a wide range of entities including independent financial advisors, banks, distributors, fund managers etc.".

On 12 October, 2011, the OECD's Centre for Tax Policy and Administration introduced a public discussion draft on proposed changes to the Commentary on Article 5 (Permanent Establishment) of the OECD Model Tax Convention. Public Comments are invited on the discussion draft before 10 February, 2012. 

Who is in Control! Is it mere shareholding that matters?

The hypothesis that a shareholder who holds a large percentage of shares in a corporation is actually in control of that corporation has been a subject matter of great discussion. The fundamental jurisprudence of company law is that a company is a separate legal entity i.e. it is distinct from its members. Further, the ownership and control does not ordinarily vest in the same hands. Whereas , it is the shareholders who  are technically the so called "owners" of the company, it is ultimately the board of directors who in essence control the day to day affairs of the company. The reasoning for the above conclusions can be deduced by examining several provisions of the Companies Act and judicial pronouncements related thereto [ which, I shall explore in a later post].

However, in the backdrop of the above, the Bombay High Court has made an interesting observation in BCCI v. Jaipur IPL Cricket Pvt. Ltd. ( Arbitartion Appeal No. 30472 of 2010). Here is the relevant extract:

 "As I observed in my judgment dated 8.3.2010 in KPH Dream Cricket Pvt. Ltd. versus Board of Control for Cricket in India, Arbitration Petition (Lodging) No.1303 of 2010, control is a matter of substance and not of form. A person can hold shares without any control over them or the voting rights in respect thereof. Conversely, a person can exercise control over shares, including the voting rights in respect thereof without being a registered holder thereof. The question therefore is whether the said owners in fact controlled the shares of the respondent at all material time (emphasis mine)."- Para. 32 

Thus it is safe to say that as per the above observation of the Bombay High Court, in essence who is in control of the company is a question of fact. I shall explore the correctness of this finding in a subsequent post.          

Constitutional Validity of the NCLT: A Brief Background

The business standard and livemint both report that the Supreme Court has upheld the constitutional validity of the National Company Law Tribunal (‘NCLT’). The judgement of the Supreme Court is not yet available. In the meantime though, it is worth recapitulating the contours of this dispute.

The legislature through the Companies (second amendment) Act, 2002 had made provisions for setting up the NCLT and the National Company Law Appellate Tribunal. The NCLT was conferred the power to hear all the matters relating to amalgamation, reconstruction of companies, winding up, reduction of share capital and other related matters. Previously these powers were conferred on the High Courts. Though the amendment to set up the NCLT was made in 2002, it has not been able to see the light of day. This reason being a pending appeal before the Supreme Court of India. The appeal was preferred by the Union of India against the judgement of the Madras High Court in R. Gandhi v. Union of India. In Gandhi the Madras High Court had held that setting up of the NCLT was Unconstitutional.

The fundamental challenge to the constitutionality of the NCLT revolves around the point, whether a complete transfer of matters from the jurisdiction of the High Court to a quasi judicial body would in principle be against the indispensable constitutional principles of independence of the judiciary and separation of powers. In the Gandhi case the madras high court had answered the question in the affirmative. Essentially two simple question needs determination insofar as the constitutionality of the NCLT is concerned:

1. Whether in principle setting up of the NCLT and excluding the jurisdiction of the High Court is constitutional?

2. Whether in its present form, the provisions relating to the appointment, tenure, qualification etc. of members of the NCLT is such that it keeps the basic constitutional principles of independence of judiciary and separation of power intact?

The first question seems to be squarely covered by the Supreme Court judgement in the L. Chandrakumar case. In the Chandrakumar case a seven judge bench of the Supreme Court had held that the power of judicial review of the high court under art. 226 cannot be excluded by the legislature through a constitutional amendment; as such a power conferred on the high court constitutes the basic structure of the constitution. In essence, the Supreme Court stated that a specialized tribunal can be set up as long as that tribunal performs a supplementary role as opposed to a substitutive role to the High courts. Simply put, if the power of judicial review is kept intact then there is no constitutional issue in setting up a specialized tribunal. On this point it seems the setting of the NCLT is clear of any constitutional hurdles or the ratio of Chandrakumar. The following paragraph from the Gandhi judgement clarifies the point:

“Parliament is thus competent to enact law with regard to the incorporation, regulation and winding up of Companies. The power of regulation would include the power to set up an adjudicatory machinery for resolving the matters litigated upon, and which concern the working of the companies in all their facets. The Law Commission, as noted by the Supreme Court in the case of Chandra Kumar, had also recommended the creation of specialist Tribunals in places of generalist Courts. Creation of National Company Law Tribunals and Appellate Tribunals and vesting in those Tribunals the powers exercised by the High Court with regard to company matters cannot be said to be unconstitutional.”- Para 57

Needless to say, the second point is the critical issue as far the constitutional validity of the NCLT is concerned. In the Gandhi case the Madras High Court after the perusal of several provisions relating to the appointment, tenure, qualification etc of the members of the NCLT. had come to this conclusion:

“In the light of foregoing discussions it is declared that until the provisions in parts 1B and 1C of the Companies Act introduced by the Companies (Amendment) Act, 2002, which have been found to be defective in as much as they are in breach of the basic constitutional scheme of separation of powers and independence of the judicial function, are duly amended, by removing the defects that have been pointed out, it would be unconstitutional to constitute a Tribunal and Appellate Tribunal to exercise the jurisdiction now excercised by the High courts or the Company Law Board.” Para 123

In light of this background what one can hope from the Supreme Court Judgement is guidelines relating to the appointment, tenure etc. of the members of the NCLT so as to make it constitutionally viable.

Right of Nominee of Shares

In a previous post on this blog Avantika had discussed a recent ruling of the Bombay High Court pertaining to the right of nominee of shares over legal heirs. The same judgement has been discussed by Somasekhar Sundaresan, Partner at J Sagar&Associates in a Business Standard article dated 10th May, 2010. The article is here.

Right of Nominee versus Right of Heir: Transmission of ownership of shares through nomination

The Bombay High Court in the case of Harsha Nitin Kokate v.The Saraswat Co Op. Bank Ltd. & Ors put to rest the debate involving inheritance of shares by heirs and the legal right over the shares through nomination in consonce with section 109A of the Companies Act,1956. The application of a widow was therefore dismissed by the Court who held that the legal right and title of the shares after the death of the shareholder( the applicants husband in this case) would be with the nominee of the shareholder and not with the heir of the shareholder.

In the instant case the applicant, the widow of the shareholder filed a suit for an interest in the shares which she claimed to have sold. The court affirmed that the foremost question in the instant case was whether the applicant had any legal right or title over such shares.
Her husband proir to his death in 2007 had made his nephew the nominee to the shares in the prescribed form of the Depository Participant. The effect of S.109A therefore results in vesting absolute rights of the nominee over the shares, notwithstanding other laws being in force. Consequent to the dematting of shares in 1996, the amendment in 1998 resulted in the inclusion of Sec.109A to govern nomination of shares. Shares being intangible movable property which can be bequeathed through word of mouth or over the internet result in transfer of rights over these with the change in holders. Therefore it became important for the inclusion of S.109A governing nomination. Furthermore in accordance with S.9.11 of the depositories Act,1996, which relates to the Transmission of Securities in the case of nomination, the shares automatically get transferred to the nominee so appointed on the death of the Nominating person.Consequently such nomination comes into effect notwithstanding anything contained in a testimentory disposition or any other nomination under any other law relating to securities at the time being in force.
The counsel for the plaintiff argued that the nominee would serve only as a trustee for the shares and thus the plaintiff being the widow of the deceased is entitiled to the right over these shares. However the Court went on to further disagree and concluded that it is the property of the shares which has been transferred along with exclusive rights of ownership. The Court further lay stress on the term 'vest' used in the statutory provision of the Companies Act as well as S.9.11 of the Depositories Act,1996 and concluded that the term has to be interpreted in the light of S. 109A to mean that the right and title over the property of the shares along with the absolute ownership belongs with the nominee. The use of the term 'vest' in other legislations as used in S.39 of the Insurance Act denotes the right to receive payment of the policy without conferring absolute ownership in the nominee.Thus the court acknowledged the right of the nominee over the property of the shares in consonance with s,109A of the Companies Act,1956 and dismissed any right of the plaintiff over such shares of the deceased husband.

The judgement has conclusively detremined the application and ambit of the S.109A of the aforementioned Act so far as a nomination has been made with regard to transmission of shares. Further it has dismissed any presumption which would prevent the nominee from absolute ownership of the shares.

Laws Relating to "Sweat Equity Shares" in India

Though it is premature to comment on the root cause of the Indian Premier League (IPL) fiasco, it would not be incorrect to assert that the term “sweat equity” has certainly been at the forefront of the initial mess. So what is “sweat equity” and what are the legal regulations surrounding it. This post attempts to answer some of these questions.

Generally at the time of incorporation, IPO or other similar instances the company issues equity shares for a certain price i.e. monetary consideration (this is subject to the company being limited by shares). The cash that is collected through such a mechanism forms the capital of the company. Contrastingly, sweat equity is issued by the company to its directors /employees at a discount or for consideration other than cash i.e. to say that the consideration is generally kind and not cash (S.79A, Explanation II). It requires no Einstein to figure out that the basic idea behind the issuance of sweat equity shares is to incentivise the employees by providing them with some direct stake in the company. Sweat equity shares are quite akin to Employee Stock Option Plans (ESOPs), but there are some differences between the two. For e.g. sweat equity shares is grant of shares at discount or without any monetary consideration whereas ESOPs are grant of an option to purchase shares at a predetermined price (Compare section 2(15A) and section 79A of the companies Act, 1956).

S. 79A of the companies act, 1956 is the primary legal provision governing the issuance of sweat equity shares. S. 79A(1) confers a right on the company to issue sweat equity shares if certain conditions as laid down in the same provision are fulfilled. The conditions are as follows:

1. Issuance of such shares is authorized by a special resolution by the company

2. The resolution specifies the number of shares, current market price, consideration (if any) and the class of employees to whom such shares are issued

3. One year has elapsed after the date of commencement of business.

4. For listed companies, other regulations of SEBI are complied with

5. For unlisted companies, the guidelines as may be prescribed by the Central Government( Generally would be the Ministry of Corporate affairs (MCA))

S. 79A seems to lay down broad guidelines for the issuance of sweat equity shares, but the provision by no means is exhaustive. I say this because clause (4) and clause (5) [please note that clause 5 is actually a proviso under s. 79A(1), but for convenience I have used it as a distinct clause since the meaning does not change at all] grants power to SEBI and MCA to issue any further regulations or guidelines.

It is in this regard the SEBI came out with a regulation in 2002 titled SEBI (Issue of Sweat Equity) Regulations, 2002. Needless to say the regulation only applies to listed companies. It would not be feasible to reconcile all the facets of the regulation here, apart from just briefly touching upon the clauses dealing with the aspect of pricing of shares and valuation of intellectual property. Clause 7 of the Regulation specifies that the minimum price of sweat equity share should be (a) the average of the weakly high and low of the related equity shares during the last six months preceding the “relevant date” or (b) the average of the weakly high and low of the related equity shares during the two weeks preceding the “relevant date”; whichever is higher. “Relevant date” is defined as the date which is thirty days prior to the date on which the general meeting is convened as per s. 79A(1) of the companies act, 1956. As for the valuation of intellectual property or know how, clause 8 of the Regulation specifies that a merchant banker shall make such valuations after consultation with industry specific experts (it is to be noted that valuations of intellectual property and know how are important as sometimes the employees are given sweat equity shares in return for any know how that the employee may provide to the company).

Similarly for unlisted companies in 2003 the MCA came out with rules titled Unlisted Companies (Issue of Sweat Equity) Rules, 2003. As per the Rules the minimum price of sweat equity shares and the valuation of intellectual property are to be determined by an independent valuer. The MCA rules also imposes a restriction on the company not to issue sweat equity shares for more than 15% of the total paid up share capital in a year or shares of the value of 5 crores; whichever is higher.

The law with regard to sweat equity shares revolves mostly around the conditions for issuance of such shares. However one may be curious to know what happens after the employee is allotted the sweat equity shares. In this regard the law only prescribes that the sweat equity shares shall be locked in for a period of three years after the date of allotment i.e. to say that the employee or the director cannot dispense of these shares within a period of three years (See clause 12 and clause 10 of the 2002 SEBI regulations and 2003 MCA Rules).

Interestingly in India which is based on a “promoter controlled model” i.e. most of the shares of a given company are owned by a family group, the issuance of sweat equity shares could be fraught with difficulties. An illustration would drive home the point. Consider a Pvt. Ltd. company X having a shareholding pattern of 80:20 held by family Y and another company Z respectively. Now, if Y inducts a family member as an employee then it can easily offer sweat equity shares to the employee at a discount or any other consideration except cash and further increase the shareholding of the family Y without actually paying the actual price of the shares. The reason why family Y can easily do that is because in case of a special resolution family Y can easily have its way considering its 80% shareholding. The law relating to issuance of sweat equity shares should be based on the basis of the corporate structure prevalent in India and not merely a legal transplant i.e. borrowed from some other countries like the UK or the US where the corporate structure is quite different(shareholding is much more dispersed in companies).

In subsequent posts I shall discuss the taxability of sweat equity shares.