Thursday, January 27, 2011

Constitutional Challenge to IPAB and Copyright Board

Spicy IP reports that two writ petitions have been admitted by the Madras High Court challenging the constitutionality of the Intellectual Property Appellate Board (IPAB) [Shamnad Basheer v. Union of India] and the Copyright Board [SIMCA v. Union of India]. The challenge is based on separation of powers grounds; and if one were to apply the principles laid down by the Supreme Court in the NCLT case [R. Gandhi v. Union of India] which we have previously discussed here, it would seem that the Petitioners have an extremely strong case. A Spicy IP post discussing the two petitions is available here.

Procedural leniency under the Negotiable Instruments Act

Over the past few years, the Supreme Court has gone a long way towards reducing the use of section 138 of the Negotiable Instruments Act (“Act”) as the basis for the vicarious liability of directors. In February last year, National Small Industries v. Harmeet Singh Pantial, the Supreme Court emphasised the high standards required in order to invoke vicarious liability of creditors under section 141 of the Act. As discussed earlier, this is a stance which has been adopted by the Supreme Court in K.K. Ahuja v. V.K. Vora. Hence, under section 141 of the Act, being ‘in charge of, and was responsible to, the company for the conduct of the business of the company’ has been held to contain two independent requirements of both being legally in charge of, and factually responsible for the day-to-day affairs of the company. Further, the Court has held that the complaint needs to have a specific averment of the role played by the director in the particular case. While this may be unexceptional, a decision of the single judge of the Kerala High Court in TGN Kumar v. State of Kerala, was much more far-reaching. The Court had issued a set of directions to Magistrates to treat ‘technical’ offences like section 138, involving ‘no moral turpitude’ to be treated differently from other offences.

The case involved an application by an accused to dispense with personal appearance at trial for an offence under section 138. The High Court judge allowed the application, and held that there was a “great need for rationalising, humanising and simplifying the procedure in criminal courts with particular emphasis on the attitude to the "criminal with no moral turpitude" or the criminal allegedly guilty of only a technical offence, including an offence under Section 138 of the N.I. Act”. For this purpose, the High Court had provided detailed guidelines to the trial courts, which exempted all accused of offences under section 138 of the Act from personal appearance at any stage of the trial, and also provided that only bailable warrants may be issued in such cases. Although the High Court did provide for this procedure to be departed from in exceptional cases, the guidelines were quite wide-ranging and significantly impinged on the discretion of the trial court.

These guidelines were appealed against to the Supreme Court, which reversed the decision of the High Court. It held that the discretion of the trial judge must be left untrammelled, and that the Supreme Court in Bhaskar Industries Ltd. v. Bhiwani Denim & Apparels Ltd. was right in saying that “it is within the powers of a Magistrate and in his judicial discretion to dispense with the personal appearance of an accused either throughout or at any particular stage of such proceedings in a summons case, if the Magistrate finds that insistence of his personal presence would itself inflict enormous suffering or tribulations on him, and the comparative advantage would be less. Such discretion need be exercised only in rare instances where due to the far distance at which the accused resides or carries on business or on account of any physical or other good reasons the Magistrate feels that dispensing with the personal attendance of the accused would only be in the interests of justice”. To this dictum, the Court only adds that the order of the Magistrate should be such which does not result in unnecessary harassment to the accused and at the same time does not cause any prejudice to the complainant. The Court must ensure that the exemption from personal appearance granted to an accused is not abused to delay the trial”.

Thus, it is clear that the Supreme Court has firmly set its face against allowing a greater degree of leniency in cases involving section 141 of the Act, even when dealing with matters of criminal procedure. Given the language of the Code of Criminal Procedure, and the scope of appellate interference permitted into the exercise of discretion by the trial court, the decision is based firmly on statutory language and past precedent. Equally however, given the proactiviness of the Supreme Court in laying down guidelines for the exercise of discretion in other areas of the law, a watered down version of the High Court’s recommendations would not have been unjustified. The requirement that personal presence should be done away with only when it inflicts “enormous suffering or tribulations” or when it is justified “due to the far distance at which the accused resides or carries on business or on account of any physical or other good reasons” is surely setting the bar too high, especially when dealing with offences under the provisions like section 138 or section 141 of the Act. However, as the law stands today, it appears that barring the satisfaction of the detailed requirements of section 141, there are no other procedural safeguards for persons accused of offences under the Act.

Wednesday, January 26, 2011

Balco Arbitration Award: Section 111A of the Companies Act

A CNBC-TV 18 report and interview indicate that an arbitration panel has rejected Sterlite’s right to acquire the balance 49% in Balco by way of exercise of a call option. The report states:
The arbitration panel comprised of two former chief justices of India and a third senior judge. When Sterlite acquired Balco’s 51% stake for Rs 550 crore in 2001 it was all fine, it had a call option to buy the remaining 49% but things changed for the company and they changed politically.

In May 2004 after the UPA came to power it referred the call option, which is the right to buy the governments balance shareholding to the attorney general who said that the call option was not legal under the companies act and that it violated Section 111A of the Companies Act …
Although it is possible to embark upon an analysis of the legal position adopted the arbitrators only when the details of the award are available, several questions and concerns do arise at this stage.

First, the award seems to put to rest the initial euphoria generated by the Bombay High Court judgment in the Messer Holdings case, which provided some recognition to arrangements such as transfer restrictions among shareholders of a company. It is not clear if the Messer Holdings judgment was considered by the arbitrators, but the award goes against the approach adopted by the Bombay High Court.

Second, issues involving put and call options need to be tested against the provisions of the Securities Contracts (Regulation) Act, 1956 (SCRA) (particularly section 16) and notifications issued thereunder. It would be interesting to see if the award throws light on the enforceability of options under SCRA, which continues to be a vexed issue. A SEBI order involving the MCX Stock Exchange examined these issues in a fair amount of detail, although that case involved buyback arrangements or forward contracts, and not options.

Third, in terms of concerns, the award tends to muddy the waters further regarding enforceability of shareholders agreements (and similar arrangements) under Indian law rather than to lend clarity and certainty.

Tuesday, January 25, 2011

General Anti-Avoidance Rule - UK Committee

Developments in Indian tax law over the last five years or so have brought to the fore the contentious issue of whether it is desirable to enact a General Anti-Avoidance Rule [“GAAR”] in India, and, if so, whether it is likely to be effective. As we have noted, the Direct Taxes Code proposes to introduce a significantly broad GAAR in India, with limited guidance as to its application.

In this context, it may be of interest to note that the UK Treasury has recently constituted a high-powered committee of which Lord Hoffmann and other distinguished jurists are members, to consider tax avoidance techniques in other jurisdictions, “what a UK GAAR can usefully achieve” and the “basic approach of a GAAR”. A list of the topics the Committee proposes to examine is available here. Of particular relevance to us are questions about the relationship between a GAAR and the existing tax code, the burden of proof and scope of application.

Sunday, January 23, 2011

RBI Sub-Committee on Microfinance

With several legal and regulatory issues affecting the microfinance sector lately, more so in the state of Andhra Pradesh, the Reserve Bank of India (RBI) had appointed a sub-committee under the chairmanship of Mr. Y.H. Malegam to “study issues and concerns in the microfinance sector in so far as they related to the entities regulated by the [RBI]”. The keenly awaited report, which was expected to resolve a number of the issues, was published by the RBI a few days ago (and is summarised by Ramesh S. Arunachalam).

While the report clarifies several regulatory matters pertaining to the microfinance sector, it has also invited a number of comments on the specific recommendations (e.g. this critique in the Mint). The purpose of this post, however, is to highlight the recommendations of the committee on corporate governance and financing in microfinance institutions.

By way of background, the idea of microfinance was initially spearheaded by self-help groups and other non-profit institutions. However, with the need to create a scalable model, the sector began attracting private capital through market-based mechanisms that required the creation of for-profit enterprises. This witnessed the emergence of the traditional corporate set up where companies were incorporated to carry on microfinance business. This business is financed through traditional means of corporate finance: bank loans, investments from private equity or venture capital investors, and increasingly through securities offerings to the public.

The prevalence of for-profit companies raising finance from the markets gives rise to a peculiar corporate governance issue: a dichotomy of objectives in the microfinance sector. On the one hand, microfinance institutions are established with social goals, i.e. the reduction of poverty, and in that sense need to cater to the interests of their stakeholders, who are the poorer and less-privileged sections of society that avail of their services as customers. On the other hand, raising finances from the financial markets imposes pressures to constantly deliver returns to the markets, thereby incentivizing managements to earn profits. A delicate balancing exercise is involved in this addressing this dichotomy. Apart from mandatory norms imposed by regulators as to the manner in which microfinance companies carry on business, the nature of management and governance of these companies does have a significant role to play. Unfortunately, the governance issues are difficult to grapple with, and there is no direction is sight yet.

In this context, the Malegam committee recognises the importance of corporate governance in the microfinance sector, and makes recommendations. The relevant portion of the report is extracted below:
16. Corporate Governance

16.1 MFIs have twin objectives, namely to act as the vehicle through which the poor can work their way out of poverty and to provide reasonable profits to their investors. These twin objectives can conflict unless a fair balance is maintained between both objectives. This makes it essential that MFIs have good systems of Corporate Governance.

16.2 Some of the areas in which good corporate governance can be mandated would be:-
a) the composition of the board with provision for independent directors

b) the responsibility of the board to put in place and monitor organisation level policies for:-
(i) the growth of the loan portfolio including its dispersal in different regions
(ii) the identification and formation of joint liability groups
(iii) borrower training and education programmes
(iv) credit and assessment procedures
(v) recovery methods
(vi) employee code of conduct
(vii) employee quality enhancement programmes
(viii) compensation system for employees including limits on variable pay and the limit therein on weightage for business development and collection efficiency
(ix) customer grievance procedures
(x) internal audit and inspection
(xi) whistle blowing
(xii) sharing of information with industry bodies
c) disclosures to be made in the financial statements including:
(i) the geographic distribution of the loan portfolio, both in terms of number of borrowers and outstanding loans
(ii) analysis of overdues
(iii) the average effective rate of interest, the average cost of funds and the average margin earned
(iv) analysis of the outstanding loans by nature of purpose for which loans were granted
(v) composition of shareholding including percentage shareholding held by private equity
16.3 We would, therefore, recommend that every MFI be required to have a system of Corporate Governance in accordance with rules to be specified by the Regulator.
While the recommendations do well in identifying the dichotomy between social and financial objectives of microfinance companies, they are somewhat cursory in nature in the absence of a detailed conceptual discussion and analysis of the issues involved. That is perhaps understandable because the committee was operating within the aegis of the RBI as a financial regulator. Since corporate affairs fall within the purview of the Ministry of Corporate Affairs (for unlisted companies) and SEBI (for listed companies), a more detailed consideration may have to await their intervention. Since microfinance activity has witnessed exponential growth in India in the last few years, this is an opportune time to consider corporate governance of microfinance through a different paradigm (especially for companies that are accessing the public markets), and it is not sufficient to rely on conventional models of corporate governance.

Apart from microfinance companies, the investors and financiers of such companies also have a significant role to play in this debate. If finance is provided on conventional terms, it is not too much for the investors and financiers to expect market-based returns, which skew the social objectives. Hence, there is need for socially responsible investments in this sector. The Malegam committee does take note of this issue and suggests measures as follows:
21 Funding of MFIs

21.1 It has been suggested that the entry of private equity in the microfinance sector has resulted in a demand for higher profits by MFIs with consequent high interest rates and the emergence of some of the areas of concern which have been discussed earlier.

21.2 Without expressing any opinion on the matter, it is necessary to understand the circumstances in which private equity has entered the sector. On the one hand, there was a huge unsatisfied demand for microfinance credit and on the other, there was a limitation on the capacity of not-for-profit entities to meet this demand. When for-profit entities emerged, microfinance was seen as a high-risk entity but venture capital funds are not allowed to invest in MFIs and private equity rushed in to fill this vacuum.

21.3 We believe it is necessary to widen the base from which MFIs are funded in respect of the Net Owned Funds needed for Capital Adequacy and for that purpose the following need to be examined.
a) It has been suggested that a "Domestic Social Capital Fund" may be permitted to be established. This fund will be targeted towards "Social Investors" who are willing to accept "muted" returns, say, 10% to 12%. This fund could then invest in MFIs which satisfy social performance norms laid down by the Fund and measured in accordance with internationally recognized measurement tools.

b) MFIs should be encouraged to issue preference capital which carries a coupon rate not exceeding 10% to 12% and this can be considered as Tier II capital in accordance with norms applicable to banks.
21.4 We would, therefore, recommend that:

a) The creation of one or more "Domestic Social Capital Funds" may be examined in consultation with SEBI.
b) MFIs should be encouraged to issue preference capital with a ceiling on the coupon rate and this can be treated as part of Tier II capital subject to capital adequacy norms.
Although there has been some momentum in the past with socially responsible investment methods, it is not clear whether it has attained sufficient size and robustness so as to make a difference in the Indian context, particularly with reference to the microfinance sector.

Thursday, January 20, 2011

A Case For Mandatory Dematerialisation of Securities

In yesterday’s Financial Express, Prof. Jayanth Varma makes a compelling case for abolition of physical share certificates and for mandatory dematerialisation of all shares.

To supplement the arguments he makes, dematerialisation also impacts the manner in which transfers of shares are recognised in law. In the case of physical shares, a transfer obtains legal effect only if it is registered by the company (an act usually performed by the board or a special committee constituted for the purpose) in accordance with Section 108 of the Companies Act, 1956. This perpetuates a circumstance where shares may be held in street names – sellers hand over share certificates and transfer forms but the purchaser does not tender them to the company for registration. Due to this, there is a separation of legal and beneficial ownership of shares. In the case of dematerialised shares, however, the transfer is made effective through the depository system and does not require any involvement on the part of the company. This makes recording of share ownership more straight-forward and lends greater transparency to the system than physical certificates.

Sunday, January 16, 2011

To Indemnify or Not?

One of the key considerations while drafting or negotiating a contract is how to deal with consequences of violation of the contract by one of the parties. There are two possibilities. One is a simple claim for breach of contract. The other is the inclusion of a specific clause for indemnification. Of the two, the use of the indemnification clause has gained popularity, especially in large commercial contracts, such that it is almost viewed as heresy if one were to draft a contract without an indemnification clause. But, is such a clause always necessary?
The Koncision Blog has an interesting discussion on indemnification in the context of a confidentiality agreement. Here is some background:
Indemnification can be helpful in two ways. First, it allows you to replace a regime of contract claims with something more customized. For example, indemnification can help a party more likely to be subject to a claim by allowing it to specify time limits for bringing claims and put caps on liability. Second, indemnification can help a party more likely to bring a claim by, among other things, allowing it to bring in deep pockets and allowing it to provide a remedy for losses caused by nonparties.

I discussed the role of indemnification in this August 2009 AdamsDrafting blog post. What prompted me to write that post was the sense that drafters are too quick to throw indemnification provisions into a contract without considering whether a contract cause of action would be adequate.

That excessive use of indemnification may be what has prompted the resistance to indemnification that I’m now encountering. But I think we’re at risk of throwing the baby out with the bathwater. For example, it’s perhaps unhelpful to say that indemnification provisions don’t belong in confidentiality agreements. That’s like saying that representations don’t belong in confidentiality agreements. Instead, you have to look at how indemnification provisions are used.

On a separate note, the Koncision Blog also has a useful discussion on use of the expression “shall cause” in contracts, again set in the context of confidentiality agreements. It has some practical advice on where such obligations work, and in what circumstances they might not. A good read for transactional lawyers.

SEBI’s Consent Order in the Reliance ADAG Case

On January 14, 2011, SEBI passed a consent order in the matter relating to shares of Reliance Communications Limited (RCL). SEBI had earlier initiated investigations into transactions entered into by two companies within the ADA group of companies, being Reliance Infrastructure Limited (RIL) and Reliance Natural Resources Limited (RNRL), and some of their officers on the ground that loans taken by them through external commercial borrowings (ECB) were used to invest in the shares of RCL. The investigations were initiated to examine possible violations of the SEBI Act and relevant Regulations (including those pertaining to fraudulent and unfair trade practices in securities).
The latest consent order has been passed on the basis of an offer made by the companies and their officers to whom notices had been issued by SEBI. The noticees have paid a settlement amount of Rs. 50 crores (approx. USD 11 million), which is billed as the largest settlement amount in actions of violation of securities laws in India. In addition, the companies and officers are barred from investing in the stock markets for certain periods of time, and the companies are required to implement a policy of rotation of statutory auditors (an aspect that is not generally mandatory for listed companies in India).
From the regulator’s perspective, the consent order provides a timely outcome to a matter where investigation is likely to have prolonged for an extended period of time and where the regulator may not necessarily foresee high chances of success. In this regard, offences in the secondary markets such as insider trading and market manipulation are indeed onerous to establish. However, the downside of such a settlement is an inherent lack of transparency because it eliminates the opportunity to the regulator to delve into the detailed appreciation of the facts and circumstances of the case. In this case too, SEBI’s order is devoid of any detailed discussion of the allegations or the manner in which it arrived at the terms of the order. In that sense, it is impossible to say with precision whether the measure of sanctions imposed in a consent or settlement order is commensurate with the violations involved. In some jurisdictions, this difficulty is dealt with by having a court of law examining the terms of settlement independently to determine its fairness in the circumstances, and courts have on occasion rejected terms of settlements by regulators. However, in the context of consent orders of SEBI, there is no such automatic independent determination, unless the order is separately challenged.

The Red Jaguar: Apparent Authority and Tortious Liability

Ironically, many significant propositions in private law have been advanced in the course of a court’s attempt to unravel a transaction or scheme engineered by a rogue with considerable ingenuity – so much so that judges not infrequently ask the question “which of two innocent parties should bear the loss caused by a rogue” (See, for example, Re Jones [1926] All ER Rep 36). The immediate context for this observation is the decision of the Court of Appeal on 16 December, 2010, in Quinn v CC Automobile – where yet another rogue left one of two innocent parties to bear a loss of some £11,000.

In Quinn, a Mr and Mrs Quinn, who had a Silver Jaguar through a hire-purchase agreement with Black Horse Ltd., approached Car Craft, an automobile dealer, with the intention of purchasing a Red Jaguar in time for their daughter’s wedding, scheduled for 22 July, 2005. There they had the misfortune to meet a Mr. Khan, at the time employed by Car Craft as a car salesman, from whom they agreed to purchase a Blue Jaguar for £7500 plus the Silver Jaguar, with Car Craft to clear their remaining obligations under the hire purchase agreement with Black Horse. The next day, Mr. Khan told the Quinns that he had found a Red Jaguar after all, and, ten days later, met them at a service station on a motorway to cancel the Blue Jaguar agreement. At this meeting, it was agreed that the Red Jaguar would be sold on the same terms - £7500 plus Silver Jaguar plus hire purchase obligations – and the judge found at first instance that the Quinns did not subjectively find it odd or unusual to meet Car Craft’s agent at a service station or to conclude an agreement in this manner. On 20 July, two days before the wedding, Mr. Khan demanded an extra £700 to deliver the car, but settled for £400 when he was told that this was all the Quinns could afford, delivered the car and took possession of the Silver Jaguar. Mr. Quinn, happy with the transaction, was aghast when he subsequently received a letter from Black Horse informing him that the dues under the hire-purchase agreement had not been paid, and investigation revealed that Mr. Khan had sold the Silver Jaguar to an innocent third party, and had failed to clear the dues with Black Horse. It also transpired that the Red Jaguar never belonged to Car Craft. Mr. Quinn brought an action against Car Craft contending that it was vicariously liable for the tort of deceit committed by its agent.

Before considering the result in the case, it is useful to briefly describe certain basic propositions in the law of agency. It is well known that a principal is bound to a third party for the acts of an agent within either his actual or apparent authority. However, actual authority not only refers to the obvious case where a principal specifically authorises an agent to perform the act in question, but also to “implied actual authority”. The third party is said to be a stranger to actual authority, which is a relationship between the principal and the agent, and it follows that his knowledge or lack thereof is irrelevant. It is therefore important to distinguish implied actual authority from apparent authority, because apparent authority is a relationship to which the agent is a stranger, arising as it does on principles analogous to estoppel. Apparent authority prevents a principal from setting up the agent’s lack of actual authority because of his representation to the third party to the contrary. The representation may be specific, either by word or conduct or a state of dealing (“genuine apparent authority”) or general, where the apparent authority is said to arise from the position in which the principal has placed the agent. It follows that the third party cannot rely on apparent authority when he is aware of lack of actual authority. In all these cases, the principal is liable directly, not vicariously. This description is essentially a summary of the masterly analysis of the subject in Bowstead and Reynolds on the Law of Agency, especially Chapter 3, Section 1 and Chapter 8, Section 1.

In cases like Quinn, there are two additional complications – the principal is a company with limited legal power, and the claimant seeks to hold the principal vicariously liable in tort, not directly liable in contract. The reason the first of these matters is that it is possible for the company to resort to the doctrine of constructive notice to defeat a claim of apparent authority, subject to the doctrine of indoor management. While this difficulty did not arise on the facts of Quinn (it was found that Mr. Khan undoubtedly had apparent authority to sell the Red Jaguar and that there was no constructive notice), it is often a contentious point. A more detailed analysis is available in Mihir’s article, ‘The Law of Agency as Applied in Company Transactions’ 3 ECFR 280 (2008).

The second point – that liability is tortious – proved to be a source of controversy. The traditional approach to this question was to say that the principal/master is liable for tortious acts committed by the agent/servant in the course of his employment, which was understood to cover any wrongful act actually authorised, and any authorised act committed in a wrongful manner. In Lister v Hesley Hall, the House of Lords formulated a wider test, holding that the principal is liable for a tortious act when that is fair and just on the basis of the “close connection” between the act and the employment. However, Lister was not a case of deceit, and the House had held in Armagas v Mundogas that a principal is liable in such cases only if the representation is itself within apparent authority. The rationale is said to be that the torts of misrepresentation, deceit, and negligence (in statements) necessarily involve an element of reliance by the third party, which cannot reasonably arise when the representation is not apparently authorised (Bowstead and Reynolds, Chapter 8, Section 3).

In Quinn, the question for the Court was to identify the proper doctrine of authority that applies in defining “course of employment” for deceit purposes. The judge at first instance had held that although the Quinns subjectively believed that Mr. Khan was authorised to sell the Red Jaguar, they were “put on enquiry” by his sudden demand of an extra £700 and his unexplained willingness to accept a lower sum. The Court of Appeal (Gross LJ), after referring to Armagas and Lister, rejected this finding, in a crucial passage:

To my mind, an analysis founded on reliance and belief leaves little room for any consideration of whether the third party was “put on enquiry”. If there is proper scope for such consideration, it would seem to arise as an aspect of whether the third party turned a “blind eye” to his suspicions as to the employee’s apparent authority; possibly too, there could be debate as to whether the third party was put on enquiry if the employee was acting outside of the usual authority of a person holding the position he holds: see Bowstead and Reynolds on Agency (19th ed.), at paras. 8-054 – 8-055. But on no view can it be said that the third party is put on enquiry because of mere unreasonableness in failing to see through the employee’s deceit; a fortiori, if the transaction is within the class of acts that an employee in the position of the rogue is usually authorised to do [emphasis mine].

Although Court did not resolve the controversy over the scope of Lister in relation to deceit, the clarification that a third party cannot (save the “blind eye” case) be “put on enquiry” when the agent acts within his apparent authority is an important one, with potential ramifications for some areas of company law as well.

Sunday, January 9, 2011

Dealing With the Anti-IPO Sentiment

We usually come across reports of companies preparing or filing for IPOs in order to take advantage of listings on stock exchanges. On the other hand, companies also often display resistance for undertaking IPOs as they are accompanied by costs such as full-blown regulatory oversight and public scrutiny. This is so even when the companies have grown to a significant size and there is a vibrant private market created for their securities. In this post, we will examine this issue in the context of a high profile U.S. company and an Indian company that are testing the borders of securities regulation by staying outside the purview of public listing. 
In the U.S., speculation is rife as to whether Facebook will go down the route of offering its shares to the public. Apart from a private market having been created in its shares, Facebook recently raised monies from a special purpose vehicle of Goldman Sachs that in turn allows various Goldman clients to take indirect interest in Facebook shares. Steven Davidoff has an analysis of the implications of this transaction under U.S. securities regulation: 
Goldman Sachs’s investment in Facebook once again raises the issue of whether the Securities and Exchange Commission will force the social networking company into an initial public offering. In particular, this issue arises because of the special purpose vehicle that Goldman plans to create in order to allow its clients to invest up to $1.5 billion in Facebook. 
The reason lies on the technical shores of the federal securities laws. The Securities Exchange Act of 1934 sets forth certain requirements for companies to register their shares with the S.E.C. 
Specifically, Section 12(g) requires that a company register its securities with the S.E.C. if it “has total assets exceeding $1,000,000 and a class of equity security … held of record by five hundred or more … persons…”
The issue comes with the 500-person requirement. This speaks only of shareholder-of-record ownership. Shares can be held “of record” or “beneficially,” but the rule is only set off based on the number of shareholders who hold shares “of record.” 
The S.E.C. defines “of record” for these purposes to mean securities held “by each person who is identified as the owner of such securities on records of security holders maintained by or on behalf of the issuer.” 
Record ownership is thus clear. It is the shareholders who are recorded as such on the books of the company that issued the securities.
We do not know the number of record holders of Facebook shares, but in the case of Facebook, this appears to be how Goldman is planning to get around the S.E.C.’s reporting rule. Goldman will form a special purpose investment vehicle for its super-wealthy clients to invest in Facebook. 
Technically, there would then be only one shareholder of record here, the investment vehicle. … 
Davidoff argues, however, that the use of such special purpose vehicles to overcome the 500-person rule “certainly appear[s] to be cutting it close”. Separately, Larry Ribstein comments on the underlying rationale for such structures and the factors that drive companies to maintain private markets for securities rather than public listings. 
Note that the key principle in U.S. securities regulation is the number of shareholders on record in a company. Once the threshold (set at 500) is breached, companies need to report their financial and other information to the SEC. Although companies are not compelled to do an IPO at this point, it nevertheless makes eminent sense for them to make a public offering as they are subject to the reporting requirements in any case and there is no merit in remaining as an unlisted company. 
The contemporaneous example in India relates to the Sahara group of companies, which has witnessed a number of legal developments within a short span of time (as discussed earlier - 1, 2, 3 and 4). The current position is that SEBI has issued a public notice to investors of two Sahara companies advising them to make their own decisions (and at their own risk) while investing in securities issued by those companies and cautioning that SEBI would not be able to provide any redressal if grievances do arise. 
The underlying legal principle in India for private markets is somewhat different. First, there is no concept of companies merely reporting their financial results to a regulator or the public without undertaking an IPO. In other words, companies which breach the limits are faced with only one consequence: to make an IPO. Second, the threshold for an IPO is defined differently from the U.S. The reference point is the proviso to Section 67(3) of the Companies Act, 1956 which reads: 
“Provided that nothing contained in this sub-section shall apply in a case where the offer or invitation to subscribe for shares or debentures is made to fifty persons or more.” 
The obligation to do an IPO arises when an “offer” is made to 50 persons or more. Under this method of reckoning, companies may make separate offers so long as each offer is made to less than 50 persons. Questions have been raised in the past whether this method can be subject to abuse because it is not entirely clearly as to what distinguishes one offer of securities from another when they are made by the same company. Is it the type of securities issued, the time-gap between two offers or involvement of separate processes? The answers are not readily available. Although it does not appear that Sahara has advanced the argument of separate offers (with each being to less than 50 persons), that could potentially be used as an escape to stay outside the purview of public offer requirements. 
That leaves us with the question as to whether the simple threshold of absolute number of shareholders (as in the U.S.) or a threshold based on the number of persons to whom each offer of securities is made (as in India) is more rationale and practical and therefore desirable. Both have their share of deficiencies. The rule involving absolute number of shareholders appears simple at first blush. However, it is capable of circumvention as we have seen in the Facebook case. Nevertheless, one way of addressing this would be to provide that the number of shareholders to be taken into account would include holders of record (i.e. legal shareholders) as well as those holding beneficial interests. As far as the scenario in India is concerned, far more clarity is required as to what constitutes an “offer” for purposes of Section 67(3), failing which there would be less certainty for companies issuing securities without public listings and also for investors taking up those securities.

Wednesday, January 5, 2011

Use Ex Parte Powers Abstemiously

An “ad interim, ex parte” order passed by SEBI, directing companies in the Sahara Group not to raise funds by way of placement of their debentures, led to a debate here over interim reliefs granted by courts, after the Allahabad High Court stayed SEBI’s order. The Supreme Court has now refused to stay the stay granted by the Allahabad High Court.

Sections 11 and 11B of the SEBI Act, 1992 confer extraordinary powers on SEBI to issue orders without hearing the parties that would be affected by the order – an exception to the general rule of natural justice. Courts have indeed held that a post-decisional hearing would remedy what would otherwise be considered to be a deviation from the settled principle of natural justice i.e. of hearing a party before condemning it. Therefore, these provisions in the SEBI Act should indeed be read as conferring on SEBI the power to step in and take urgent action.

Therefore, the key issue is: When would circumstances justify a bending of the principle of natural justice, and permit an ex parte regulatory intervention, to be remedied by a post-decisional hearing? In my view, putting a person out of the market, or asking him not to deal in securities, or not to carry on business of a certain nature, until further notice, is a serious intervention and therefore should not be lightly invoked.

These are interventions that may be well-intentioned, but whether they are necessary, is an issue that one should have to answer every single time. Over the past ten years, the practice of SEBI restricting a person’s constitutional right to carry on business and to lead life by way of ex parte orders has gained currency. For example, a few years ago, a fund manager was asked not to deal in securities until further notice. The reason used to justify the intervention was that the media reported that he had plans to start a mutual fund – an activity that in any case cannot be conducted without a license from SEBI, which itself entails a huge process of scrutiny by SEBI. Another example is the repeated assertion by SEBI that a particular depository was “complicit”, “negligent”, “fraudulent” and part of a “device” in the occurrence of what is called the “IPO scam”. Even requests for a hearing were ignored and more and more “ad interim” orders were passed. (Disclosure: both these examples are of clients represented by me).

Emergency powers are not unheard of. Even preventive detention of a person (impeding his constitutional right to move about the nation) has been upheld as constitutional but always subject to stringent safeguards. An economic equivalent of such detention, equally, ought to be subject to serious safeguards, and such powers should be used more as an exception to deal with exceptional cases, rather than as a norm, to be used routinely in all cases.

Any regulator or policeman or arm of the State should have very good reasons to put a person out of freedom without even hearing his side of the story. Ideally, regulators such as SEBI (other regulators too have similar powers – it is only SEBI that is thankfully subject to quasi-judicial review of its orders) should develop a transparent and publicly known policy on the parameters within which it would inflict a serious intervention into a person’s life.

Such power should be used in rarest of rare cases, and the regulator should demonstrate what harm would be caused to its regulatory constituency but for such intervention.

Tuesday, January 4, 2011

Supreme Court on the Sahara Case

While the earlier post analyzing the judgment of the Allahabad High Court generated an interesting debate, it has been reported today (here, here and here) that the Supreme Court refused to interfere with the High Court’s order.

Monday, January 3, 2011

Public Offering of Securities: Liability of Investment Bank

In order to ensure accuracy of disclosures in offering documents pertaining to public issue of securities, regulators tend to impose liabilities for misstatements on issuers as well as intermediaries. The intermediaries, referred to as “gatekeepers” perform an important role in the securities markets. In his book, Gatekeepers: The Professions and Corporate Governance, Professor John Coffee notes (on pp. 1-2):
What Are Gatekeepers? The term ‘gatekeeper’ has been used in many different settings across the social sciences usually in ways that are more metaphorical than precise. Typically, the term connotes some form of outside or independent watchdog or monitor—someone who screens out flaws or defects or who verifies compliance with standards or procedures.

Within the corporate context, the prior academic commentary has usually used the term ‘gatekeeper’ to mean an independent professional who plays one of two distinct roles, which tend to overlap in practice. First, the gatekeeper may be a professional who is positioned so as to be able to prevent wrongdoing by withholding necessary cooperation or consent. For example, an investment banking firm can refuse to underwrite the issuer’s securities if it finds that the issuer’s disclosures are materially deficient; similarly, an auditor or an attorney who discovers a serious problem with a corporate client’s financial statements or disclosures can prevent a merger from closing by declining to deliver an opinion that is a necessary precondition for that transaction in this first sense, the gatekeeper is a private policeman who has been structured into the process to prevent wrongdoing. By withholding its approval, it closes the gate, typically denying the issuer access to the capital markets. …

However, defining gatekeepers simply in terms of their capacity to veto or withhold consent misses what is most distinctive about the professionals who serve investors in the corporate context. Inherently, they are repeat players who provide certification or verification services to investors, vouching for someone else who has a greater incentive than they to deceive. Thus, a second and superior definition of the gatekeeper is an agent who acts as a reputational intermediary to assure investors as to the quality of the ‘signal’ sent by the corporate issuer. The reputational intermediary does so by lending or ‘pledging’ its reputational capital to the corporation, thus enabling investors or the market to rely on the corporation’s own disclosures or assurances where they otherwise might not. The gatekeeper has such reputational capital because it is a repeat player who has served many clients over many years. …
Consistent with theory, SEBI imposes liability for violation of securities laws directly on the issuers on the one hand, and also on various intermediaries (or gatekeepers) on the other hand. Among these intermediaries, investment banks are subject to immediate oversight by SEBI as they are registered with SEBI. In the context of public offering of shares, investment banks have a duty to conduct due diligence in order to ensure accuracy of disclosures in the offering document.

In this background, SEBI has recently issued an adjudication order imposing a penalty of Rs. 25,00,000/- on Enam Securities Pvt. Ltd., an investment bank, primarily in connection with the IPO of Yes Bank. The bone of contention of contention relates to whether the offering document should have disclosed Rabobank International Holding B.V. as the promoter of Yes Bank. The adjudicating officer found that the investment bank was in breach of its due diligence obligations in not disclosing Rabobank as the promoter in the offering document.

While the order is representative of SEBI’s initiatives in imposing liability on intermediaries as a means to ensure adequate disclosure, it also highlights difficulties in certain matters of interpretation under the disclosure guidelines. More specifically, the term ‘promoter’ has hitherto been defined differently in various regulations of SEBI (such as those relating to disclosures in offer documents, takeover regulations, etc.), although efforts have been made more recently to streamline those definitions. Nevertheless, this case highlights difficulties in nailing down entities as promoters for the purposes of offer documents.

On a separate note, SEBI’s efforts to impose liability on intermediaries are not confined to those registered with it. It has previously sought to exercise jurisdiction on auditors in the Satyam case, which approach has received concurrence of the Bombay High Court.