VHVK E-Newsletter October 2019
October 2019
Volume III Issue 5
VHVK Law Bulletin
In this fifth issue of VHVK Law Bulletin 2019, we bring you recent developments in business and corporate law. The subjects we cover in this issue are (a) Delhi High Court restrains unauthorized resales of products (b) SEBI’s efforts to regulate resignations by auditors of listed companies (c) National Company Law Appellate Tribunal rewrites creditors’ rights in Essar Steel case (d) defamatory content in notice for director removal (e) relaxation of rules on External Commercial Borrowings (ECB) and (f) Karnataka High Court upholds rules in Companies Act, 2013 on director disqualification.
Delhi High Court intervenes to protect rights of direct sellers
In 2016, the Government of India issued guidelines to protect companies (termed “direct selling entities”) that market their products only through their authorized sellers (termed “direct sellers”).1 The structure excludes other intermediaries, in particular online portals from selling the products. In Amway India Enterprises v 1MG Enterprises,2 Delhi High Court affirmed direct selling entities’ rights and restrained e-commerce companies from selling the products of direct selling entities on unauthorized portals.
Amway Or flame and Medicare were among companies affected by the trend. They acted against the resellers that were both unauthorized and were also engaging in fraudulent practices by tampering with the products. Delhi High Court ordered an inspection of the unauthorized resellers’ warehouses and found evidence of product tampering. The court’s order restrains the e-commerce companies from offering the products of the brand owners.
The Direct Selling Guidelines (2016) issued seek to balance consumer protection with preserving the business freedom of companies to determine appropriate distribution channels for selling their products. The government of India has been active in checking market dominance and predatory practices by giant e-commerce companies (e.g. Amazon and Flipkart), and earlier this year, it came out with a regulatory framework to protect the interests of small and medium enterprises.3 The recent ruling from the Delhi High Court affirms government activism in protecting the integrity of markets and consumer interests, in the wake of the nascent challenges posed by e-commerce.
SEBI proposes regulating auditor resignation
Instances of midterm resignations by auditors of listed companies have spurred the Securities & Exchange Board of India (SEBI) to intervene.4 The usual reasons auditors state for resigning lack specificity. They make references to professional preoccupations and/or companies’ failure to provide information. Auditors’ resignation is a serious matter, more so when it occurs in the middle of a year. Present proposals from SEBI aim to streamline the process and promote some amount of continuity and greater transparency.
True disclosures and corporate transparency are foundational for the integrity and proper functioning of securities markets. Auditors provide assurance on companies’ financial disclosures companies and the importance of their position becomes topical periodically, as corporate scandals surface. This has been the trend from Enron (2001) in US to Satyam Computers (2010) in India.
The present SEBI proposal responds to a spate of midterm resignations in some high-profile companies. These include Anil Ambani-controlled Reliance Capital and Reliance Home Finance (Price Waterhouse Coopers) and Manpasand Beverages (Deloitte). Regulatory proposals from SEBI on the subject of auditor resignation are, mainly, the following.
- Auditors must complete the audit for the current quarter before resigning. In other words, they cannot abandon companies during a quarter.
- If an auditor has completed audit for all the four quarters, then it must also complete the annual audit before resignation.
- Reasons for resignation must be shared with audit committees, which must seek inputs from managements on the reasons provided by auditors.
- Companies must submit information on auditor resignation with stock exchanges.
- A template for auditor resignation is included in the proposals, to standardize the process and ensure that minimum information is provided by auditors for their decision.
SEBI has invited public comments on its proposal to regulate auditor resignation. The comment period closed on 8 Aug 2019. When a decision is made on the proposal, new rules would be implemented through amendments to the SEBI (Listing Obligations & Disclosure Requirements) Rules, 2015.
NCLAT strengthens unsecured creditors in insolvency proceedings
In a far-reaching ruling under the Insolvency & Bankruptcy Code (IBC), National Company Law Appellate Tribunal (NCLAT) granted improved recovery for operational creditors and employees of Essar Steel, thereby affecting the recovery for secured creditors.5 The scheme NCLAT upheld is based on a twofold classification of creditors – large (with dues of more than Rs. 1 crore) and small (dues of less than Rs. 1 crore). There is not much concern whether creditors are secured or unsecured. The ruling, undoubtedly, compromises the interests of secured creditors but facilitates better recovery for unsecured creditors and employees of debtor-companies.
Conventional legal rules generally favor secured creditors (usually banks and financial institutions) in insolvency situations. Secured creditors have recourse to borrowers’ assets and use them up for recovery. As a result, unsecured creditors (usually suppliers who have sold goods or provided services on credit) end up with losses.
IBC charts a new path in the area, making a distinction between financial creditors (usually, lenders with security rights over assets) and operational creditors (in general, suppliers of goods and services without any security for their dues). In the IBC regime, a nascent trend is to revisit the equation between secured and unsecured creditors – or, financial and operational creditors, to use IBC terminology. The approach can greatly improve the position of unsecured creditors. In Swiss Ribbons v Union of India (2019),6 Supreme Court of India favoured similar treatment between operational and financial creditors. In 2018, an amendment made to the Insolvency Resolution Process for Corporate Persons Regulations, 2016 also accords greater respect for operational creditors and seeks to improve their position (Regulation 38).
Relying on the Supreme Court’s observations in Swiss Ribbons (2019) and the regulatory amendment, NCLAT adopted a broad classification of creditors into the two categories noted earlier – namely, large (dues of more than Rs 1 crore) and small (dues of less than Rs. 1 crore). The scheme approved by NCLAT provides for payment of full dues to smaller creditors and partial payments to large creditors. In endorsing this structure, NCLAT more or less erased the conventional distinction between secured and unsecured creditors.
Understandably, the ruling from NCLAT invited significant uproar and the matter has been carried to the Supreme Court of India, where it is now pending.
No defamation in notice for removal of director, Bombay High Court holds
Ratan Tata v Maharashtra (2019)7 a case related to the recent leadership conflict in the Tata Group, raised the question about criminal defamation in a notice issued for the removal of a director from the board of Tata Chemicals Ltd. The Magistrate issued summons to Ratan Tata, as the accused person. On Ratan Tata’s petition, Bombay High Court quashed the case observing that the notice was only issued in compliance with requirements of the Companies Act, 2013 and was in accord with applicable standards.
Cyrus Mistry’s removal from the chairmanship and board of Tata Sons Ltd happened in Oct 2016. Subsequently, he was also removed from the board of other Tata companies, including Tata Chemicals Ltd, there was a minor rebellion in Tata Chemicals, with Nusli Wadia, an independent director, resisting the ouster of Mistry and himself from the company. Faced with this, Tata Sons Ltd requisitioned a special meeting of Tata Chemicals shareholders to remove both Nusli Wadia and Cyrus Mistry from directorship.
In compliance with the requirements under the Companies Act (sections 115 & 167), Tata Sons Ltd issued notices for the removal of Wadia and Mistry. The notice was challenged by Wadia who alleged that it was defamatory under the Indian Penal Code (section 499). The magistrate dealing with the complaint issued summons to the accused (Ratan Tata) and this was carried to Bombay High Court. Agreeing with the submission made for Ratan Tata that the notice issued for removal of Nusli Wadia from the board of Tata Chemicals Ltd was in accord with the Companies Act, the High Court also stressed that magistrates must apply their minds and find a prima facie case against accused persons, before issuing criminal summons.
Aside from its high-profile character, Ratan Tata v Maharashtra (2019) illustrates how corporate battles can become acrimonious and the individuals involved can get into “settling scores” mood. In conflict situations, balance and caution are needed in exercising corporate rights, whether as shareholder or director.
Rules on External Commercial Borrowings (ECB) relaxed
Reserve Bank of India (RBI) further relaxed the restrictions on External Commercial Borrowings (ECB) and more or less lifted the curbs on the use of ECB funds by eligible borrowers.8 There is no longer any ban on use of ECB for real estate business, investment in capital markets and equity investments. ECB funds can also be used to meet working capital requirements and for repayment of domestic loans. Importantly, both rupee-denominated and foreign currency external borrowings are placed on par and subject to the same rules.
The new structure introduced by RBI has a twofold classification of ECB, based on the Minimum Average Maturity (MAM) period. Different end-uses are permitted when the maturity period is longer (10 years or more) or shorter (7 years). Permitted end-uses for the two categories are summarized below.
- Permitted end-uses when Minimum Average Maturity is 10 years
a. Working capital
b. Repayment of rupee loans borrowed within India (not originally meant for capital expenditure)
c. General corporate purposes
- Permitted end-uses when Minimum Average Maturity is 7 years or more
a. Repayment of rupees loans onshore (initially obtained for capital expenditure)
b. Repayment of rupee loans (obtained for capital expenditure in the manufacturing and infrastructure sector)
under one-time settlement (OTS) to domestic lenders by eligible classes of borrowers
In both the above cases, Non-Banking Finance Companies (NBFCs) can use ECB for onward lending to clients, for the above permitted purposes. Permission to use longer maturity borrowings (10 years or more) for “general corporate purposes” is significant. In effect, it frees borrowers to apply the funds for any business purpose.
The new regime continues with the themes of liberalization and welcoming overseas capital. To state the obvious, the major issue for borrowers with foreign currency loans is exchange rate risk. Depending on the cost, borrowers might be able to hedge against the risk through instruments such as forward cover and permitted swaps.
Karnataka High Court upholds director disqualification rules
In Yashodhara Shroff v Union of India,9 the Karnataka High Court upheld the rules on disqualification of directors under the Companies Act, 2013. The Writ Petitions challenged automatic disqualification of individuals from holding director positions in companies, if a company in which they were directors does not file financial statements and annual returns with the Registrar of Companies for 3 years (section 164). A limited relief the court granted was to exclude periods before 1 Apr 2014 (the date when the new rules came into effect) in computing the 3 year period that triggers statutory disqualification from company directorship.
The stated objectives of Companies Act, 2013 include promoting good corporate governance and ensuring the accountability of managements. Inactive or dormant companies have been a longstanding problem and many such companies that are not actively doing business are also in default of their obligations to file financial statements and annual returns with the Registrar of Companies. Filing of documents with the Registrar assures public have access to current information on companies. It promotes transparency. The annual filing exercise is also proof that companies are active and the persons running them are diligent in complying with their legal obligations.
Companies Act, 2013 (section 164) disqualifies directors of companies in default with their filing obligations from holding corporate directorships. The rule was challenged as unconstitutional. It was assailed as arbitrary, violating Article 14 of the Constitution of India, and placed undue restriction on business rights in breach of Article 19. Referring to the accountability goals of the disqualification rules, the Karnataka High Court rejected the challenges and held the rules to be constitutional. In doing so, the court granted the petitioning directors a limited relief. In determining the 3 year period for which there was default in filing the documents triggering automatic disqualification for directors, periods prior to the effective date of the rule must be excluded. Since the disqualification rule was not retrospective in its application, earlier periods could not be considered for determining default under the rule.
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.