VHVK E-Newsletter June 2018
June 2018
Volume II Issue 3
VHVK Law Bulletin
In this third issue of VHVK Law Bulletin 2018, we bring you recent developments in business and corporate law. The subjects we cover include arbitration (stay of award when appeal is pending), judicial intervention in director disqualification, corporate governance (SEBI accepts many recommendations of Kotak Committee), capital markets (directors’ debarred for for diversion of funds, but no disgorgement) and Value Added Tax (permissibility of input tax credit beyond the period specified in the VAT Act).
Stay of award during appeal, Supreme Court streamlines position
In Board of Control for Cricket in India v Kochi Cricket Pvt Ltd1, the Supreme Court resolved an important issue on stay of arbitration awards when appeals against the award are pending. The amendments that were made under the Arbitration and Conciliation Amendment Act, 2015 eliminated a longstanding problem – namely, automatic stay of awards when they are challenged in appeal (Arbitration and Conciliation Act, 1996, section 36). The 2015 amendment did away with automatic stay of awards, but there was no clarity on whether the amendment would apply to appeals filed before the new rules came into force on 23 October 2015. This issue is now resolved by the Supreme Court with the ruling that there would be no automatic stay of awards even if the appeals were filed before the amendment.
Arbitration and Conciliation Act, 1996 was introduced over 20 years ago with a number of goals – to promote alternate dispute resolution, reduce the burden on courts, and provide an efficient private remedy for conflicts. A major roadblock in arbitration was section 36 of the original Act under which awards were stayed by operation of law when they were challenged in courts. Stay would continue till the court decided the appeal. This effectively stymied the rights of litigants who had succeeded in arbitration. Finally almost 20 years later, the problematic legal position was set right by the 2015 amendment. Under the new rule, there would be no automatic stay when an award is carried in appeal. Courts could grant stay, conditional or unconditional, in individual cases. This would be on the application of parties and after hearing the other side.
However, even after the 2015 amendment, a lingering problem was the lack of clarity about appeals filed before the new rule came into force. Rejecting the argument made by some appellants that they had a “vested right” to stay under the old rule, the Supreme Court ruled that there would be no automatic stay in any pending appeal. If an appellant wanted stay of the award, it would be necessary to seek orders from the court where the appeal is pending. The ruling is consistent with the legislative goal, which to promote arbitration as an efficient method of dispute resolution and enhances the efficiency of arbitration as an alternative method of adjudication.
Judicial intervention in director disqualification
With the stepping up of enforcement of company law rules, disputes regarding disqualification of directors and termination of companies have surfaced. They also indicate some of the difficulties in applying the broad disqualification rules in the Companies Act, 2013 (section 164). When individuals are directors in more than one company, default by one of the companies can disqualify them from all company directorships. In Atul Kholsa & Others v Union of India,2 Delhi High Court intervened to provide interim relief to directors affected by the broad orders of disqualification.
To improve compliance and the quality of governance, Companies Act, 2013 disqualifies directors for a variety of reasons. These include non-filing of financial statements and annual returns with the Registrar of Companies and default in repayment of fixed deposits taken from the public (section 164). Difficulties can arise when an individual is a director of more than one company and one of the companies is non-compliant with the more formal requirement of filing financial statements and annual returns. This was the situation for a number of directors who approached the Delhi High Court to question their disqualification. In passing interim orders permitting the petitioners to continue as directors, the Delhi High Court directed them to make belated compliance with the filing requirement under the Condonation of Delay Scheme, 2018 recently introduced by the Government of India.
The remedial approach adopted by the Delhi High Court eases the rigour of the disqualification rules in the Companies Act, 2013, which are quite sweeping though well-intended. A welcome development is, realizing the seriousness of the problem, the Government recently amended section 164 to provide a window of six months for incoming directors to set right the defaults in companies. The amendment is yet to be notified.
SEBI accepts several recommendations of Kotak Committee on Corporate Governance
SEBI approved many of the recommendations made by the Kotak Committee on Corporate Governance. New rules are introduced through amendment regulations notified on 9 May 2018.3 The effective dates differ for individual rules, reflecting the need for companies to make the transition and adapt to the new regime. Some of the Kotak Committee recommendations were approved “as made” while some others are adopted with modifications. New norms include cap on directorships, measures to strengthen the “independence” of independent directors, requiring disclosures on use of funds from private placements, and secretarial audit.
After a wide-ranging review, the Kotak Committee submitted its report in October 2017 with several important recommendations. The following are among those SEBI accepted with no modification.
- Cap on directorship in listed companies reduced from 10 to 8, effective April 2019, and to 7 by April 2020
- Eligibility norms for independent directors are expanded/strengthened. Members of “promoter groups,” as defined, are ineligible and others must provide a declaration of independence. A check on “board interlocks” is implemented. It restricts individuals from sitting on different boards in two capacities – independent and non-independent directors. If X is an independent director of A Co and but non-independent director of B Co, then no independent director from A Co be on the board of B Co. This rule would check a collegial group of individuals from sitting on boards of different companies wearing different hats (independent/non-independent directors).
- Audit committee functions to include review of transactions with subsidiaries through loans, advances, or investments in excess of ₹ 100 crores or 10 percent of the subsidiary’s assets.
- Listed companies must provide a matrix of skills considered necessary/appropriate for their boards and explain how their board members’ skills match the specified criteria.
- Additional disclosures are required for auditors, both fresh appointments and reappointments. Annual General Meeting (AGM) notices should provide information on the credentials of the audit firm, the audit fee proposed, and the reasons for resignations when auditors step down.
- Quarterly financial disclosures must include consolidated quarterly results from 2019-20.
- Secretarial audit is made mandatory for listed companies and their material subsidiaries (defined as representing more than 20 percent of the consolidated income or net worth of a listed holding company).
The recommendations of the Kotak Committee are numerous and detailed, and we hope to present some more in our coming issues.
SEBI raps directors on the knuckles for fraudulent conduct, refrains from disgorgement order
Zenith Infotech Ltd, once a major IT company, went into a death spiral since late 2000s. Zenith defaulted in repaying the Foreign Currency Convertible Bonds (FCCBs) due for redemption in 2011. To raise the funds needed meet the commitments, the company obtained shareholder approval for further borrowings and sale of a division of its business. At the end of proceedings that lasted 5 years, SEBI found diversion of funds from the sale of business and has passed orders restraining the promoters, for 2 years, from accessing the capital markets and from acting as directors of listed companies.4
The story of Zenith’s downfall is tainted with instances of questionable corporate governance. From a preliminary investigation of a sudden slide in the share price of Zenith, SEBI initiated proceedings in March 2013 against the promoters of the company. Zenith promoters actively defended themselves, going all the way to the Supreme Court to challenge the notice. The current action of SEBI is with regards to the US$ 48 million Zenith received from sale of a business division held through a subsidiary. Upon investigation, SEBI found that a major part of the proceeds had been channeled to various overseas subsidiaries of Zenith. SEBI also charged Zenith with not providing material, price-sensitive information to investors about the default in FCCB redemption and also with making misleading representations to investors without the intention to perform.
At the end of proceedings that lasted 5 years, SEBI stopped with debarring the errant individuals from (a) acting as directors of listed companies, and (b) accessing the capital markets, both for 2 years. This is certainly a rap on the knuckle, but hardly a death blow. Importantly, SEBI also refrained from ordering disgorgement of illegal gains from the promoters, which it can under the SEBI Act (section 11B). In not ordering disgorgement, the reasons SEBI stated are lack of evidence and the effort and time required for tracing the funds. The reasons, though valid in themselves, point to the difficulties in implementing an important deterrent in securities laws against corporate misconduct and affording compensation to investors.
IBC Review Committee submits report on law revamp
The Insolvency Law Committee chaired by Injeti Srinivas submitted its report in March 2018.5 The 90-page report makes a number of recommendations for changes from the experience gained with the Insolvency & Bankruptcy Code, 2016 (IBC) since its recent inception. The major recommendations include (a) placing home buyers in real estate projects on par with commercial lenders, (b) excluding sureties from moratorium, (c) empowering the National Company Law Tribunal (NCLT) to permit additional categories of essential goods and services for supply to corporate debtors, (d) fine-tuning the rules on disqualifications for Committees of Creditors in their application to related parties, (e) clarifying the function of creditors’ representatives, (f) requiring NCLT’s satisfaction about implementation before approving insolvency resolution plans, and (g) reduction in voting thresholds applicable to creditors for some decisions.
- Recognizing the substantial stake homebuyers have in real estate companies in advancing funds for property purchase, a recommendation is made to place homebuyers on par with financial creditors for the purpose of insolvency law. This would strengthen homebuyers by enabling them to participate in insolvency and restructuring proceedings (amendment to IBC, section 5).
- The judicial trend has been to extend the moratorium available under IBC to companies in credit restructuring also to sureties.6 Stating an apprehension about sureties filing “frivolous applications to merely take advantage of the stay and guard their assets,” a recommendation is made for clarifying that the statutory moratorium would not cover sureties (amendment to IBC, section 14).
- Presently, there is a restrictive definition of essential goods and services required for the ongoing operations of corporate debtors in restructuring proceedings. It only includes power, water, telecom and IT services.7 To make the provision meaningful and to provide support to companies to run their business while they are restructuring, NCLT to be empowered to recognize any other goods/services as essential for the operations of debtors. This would enable NCLT to ensure supply of critical materials to debtor companies when the restructuring is in process (amendment to IBC, section 14).
- IBC excludes related parties, defined to include shareholders, from participating in committees of creditors to check conflicts of interest. This provision restricts banks and financial institutions, which are pure-play lenders from effectively participating in the restructuring process if they also happen to hold shares in their clients. To overcome this difficulty and in recognition of the predominant character of banks and financial institutions as lenders, it is proposed to exclude them from the definition of related parties (amendment to IBC, section 21).
- Clarity to be given to the role and function of the authorized representatives of financial creditors. Essentially, authorized representatives must act in accordance with documented instructions from their principals and must also share the instructions with the respective committees of creditors (new provision in IBC, section 25A)
- To provide greater flexibility, the voting threshold for creditors is proposed to be reduced for some decisions. For the insolvency resolution process to continue beyond 180 days and for appointment of resolution professionals, minimum creditors’ vote to be 66 instead of 75 percent. Except where a higher minimum is provided, committee of creditors will make decisions by a simple majority vote.
The above are only a portion of the changes – some formal, some substantive – proposed by the Review Committee. It remains to be seen how the Government deals with the recommendations that have been made.
Substantive claim for Input Tax Credit to prevail over procedural limitations
In Kirloskar Electric Co v Karnataka,8 Karnataka High Court had to consider the admissibility of Input Tax Credit for purchases made by dealers prior to the period for which they claimed the credit. It is normal in business that dealers make regular purchases of materials and pay tax on them, and materials are used at a later point in the future. The question was whether the input tax credit can be claimed only in the same period in which a purchase is made or can be claimed at a future date as well. Karnataka High Court upheld the action of the dealers in claiming input tax credit at a later point.
A foundational principle of the Value Added Tax regime, which was in place until recently, was that selling dealers will receive credit for the taxes paid on the materials purchased by them (Karnataka Value Added Tax Act, 2003, section 10). The section was amended in 2015 to lay down a time limit of 6 months within which credit could be claimed for input tax. However even for periods prior to the amendment, assessing officers disallowed input tax credit claimed by dealers, by applying the time limit of 6 months. This was questioned by a group of dealers through writ petitions that bypassed the remedy of appeal available to them.
Karnataka High Court accepted the argument that input tax credit was substantive in character and dealers had a vested right to the credit. With the reasoning that stipulating time limits for claiming the credit can defeat the substantive right to the credit, the High Court allowed the claims of the petitioning dealers. The High Court also directed the Commissioner of Commercial Taxes, Karnataka to issue a clarificatory circular to assessing officers to prevent recurring denial of input tax credit in such circumstances.
VHVK Law Bulletin is issued for information purposes only and does not constitute legal advice. For more information on any of the material covered here and/or their implications for your situation, please obtain competent legal advice.