The Firm

Show Timings:

Friday: 10.30 pm, Saturday: 11.30 am

Sunday: 9:30am & 11.00pm

CNBC TV18
Network18

Cos Act Ep#6: Inter-Corporate Loans & Investments & RPTs

Published on Fri, May 30,2014 | 23:05, Updated at Thu, Jun 05 at 16:20Source : CNBC-TV18 |   Watch Video :

Are Audit Committees equipped to be the new watchdogs? Will parent companies be able to fund their subsidiaries? Will new restrictions on Related Party Transactions lead to better governance or more paperwork? On the 6th episode of this special series on the Companies Act, 2013 we analyse the impact on Board Committees, Inter-Corporate Loans & Investments and Related Party Transactions with Y M Deosthalee, Chairman & MD of L&T Finance Holdings, well know independent director Nawshir Mirza, Cyril Shroff - Managing Partner, Amarchand Mangaldas and Bharat Vasani -Chief General Counsel, Tata Group. 

Last week we discussed the new responsibilities and liabilities of independent directors.

This week we continue our analysis of Chapters XI & XII by focusing on board committees, inter-corporate loans and investments and related party transactions.

The 2013 Act introduces, for the first, time a stakeholders relationship committee for all companies with more than 1000 shareholders, debenture holders or deposit holders. It also, for the first time, makes mandatory the constitution of a nomination and remuneration committee for all listed companies and for public companies with a paid up capital of Rs 100 crore or more or a turnover of Rs 100 crore or more or Rs 50 crore or more in outstanding debt.

BOARD COMMITTEES
Stakeholders Relationship Committee
Company with > 1000 Shareholders
>1000 Debentureholders
>1000 Depositholders

BOARD COMMITTEES
Nomination & Remuneration Committee
All Listed Companies                     
All Public Companies                    
                |                                              
Paid Up Capital >= Rs 100 cr                        
Turnover >= Rs 100 cr                 
Borrowings/Debentures/Deposits >= Rs 50cr

A nomination and remuneration committee must constitute three or more non-executive directors of which at least half should be independent. Its job is to identify talent for senior management and directorial positions and evaluate director performance as well as set remuneration polices for key managerial personnel and directors.

BOARD COMMITTEES
Nomination & Remuneration Committee
Section 178
- Atleast 3 Non-Executive Directors
- Atleast 50% members to be Independent Directors
BOARD COMMITTEES
Nomination & Remuneration Committee
Section 178
- Identify Talent for Senior Management & Directorial Positions
- Evaluate Director Performance  
- Set Remuneration Policies for KMP & Directors

Compared to 1956 Act, the 2013 Act mandates audit committees for a smaller universe of companies. But, while the 1956 Act made no reference to independent directors, the 2013 Act says an audit committee must have a minimum three directors with independent directors in majority. Most of them, including the chairperson, should be able to understand financial statements.

BOARD COMMITTEES
Audit Committee
1956 Act
- Every Public Company with paid up capital of not less than Rs 5cr

2013 Act
- All Listed Companies                     
- All Public Companies                    
                |                                              
Paid Up Capital >= Rs 10 cr                        
Turnover >= Rs 100 cr                 
Borrowings/Debentures/Deposits >= Rs 50cr

BOARD COMMITTEES
Audit Committee
1956 Act
- Minimum 3 Directors
- 2/3rd should be Directors other than MD or WTD

2013 Act
- Minimum 3 Directors
- ½ should be Independent Directors

The responsibilities of an audit committee now include to recommend auditor, review and monitor auditor independence, examine financial statements, approve related party transactions, evaluate internal financial controls and monitor the end use of public funds raised.

BOARD COMMITTEES
Audit Committee
Section 177
- Recommend appointment, remuneration and terms of appointment of Auditors
- Review and monitor Auditor’s independence and performance
- Examination of financial statement
- Approval of Related Party Transactions
- Evaluation of Internal Financial Controls
- Monitor end use of Funds raised via Public Offers

Vasani: The major issue is not the composition of the committee but the charter of the audit committee because now the responsibility which is cast on the audit committee for the first time they are made responsible to approve all related party transactions completely. It is not the approval of the Board- if only they come to a view that it is not in the ordinary course of business and it is not at arms length pricing, then only it goes to Board and then to the shareholders.  However, audit committee having primary responsibility, some of the audit committee members have told that if you look at all my responsibilities my role which was essentially an independent director's role of exercising supervision is seemed to have become more of an operating role. If you see the kind of duties which have been entrusted to them under Section 177(4) if you read it with the SEBI’s Clause 49 it makes it so onerous in terms of day-to-day operations. I am still not able to figure out how it will work in practice if it is a prior approval.

BOARD RESTRICTIONS
- Under the 2013 Act a company needs approval via a special resolution to sell/lease an undertaking > 20% of networth/total income of company
- Under the 2013 Act a company needs approval via a special resolution to sanction borrowings exceeding the aggregate of paid up share capital + free reserves

Deosthalee: It is a fact that lot of time will have to be spent by audit committees on many of the issues which have been listed; their duties have increased.

Doshi: They are the first screening process for a lot of important financial situations. So, isn't it a good thing that they have to spend more time?

Deosthalee: I agree with you but ultimately you must also understand that independent directors join a company and they also join a management. So, ultimately what we are saying is there has to be some trust and faith in the management also.

Mirza: There are two other concerns. The audit committee should never have an executive role because it must maintain objectivity.

Doshi: But its not- the words used here are review and monitor the auditors independence and performance, examine the financial statement, scrutiny of inter-corporate loans and even related parties, it says approval of transactions.   

Mirza: What is the concern- now the promoter directors are no longer involved with the approval. In fact they are the people who might well have instigated an improper transaction and they will now be scot-free because they will say we never were party to this whole thing; nobody asked us.

Vasani: The point which he is canvassing, if a proposal comes to the audit committee and the management would just make a bland statement that in our opinion it’s a transaction in the ordinary course of business and at arms length. Now, what should the audit committee do, how do they go about evaluating?

Shroff: I don’t agree with that. I think audit committee is probably the right place for it to be seen because they will probably have that specialist knowledge and the financial literacy to ask more detailed question. I agree with Bharat that it has increased the workload.

Mirza: Why not in the Board where everybody then is responsible for that transaction?

Shroff: Because time is a constraint.

Mirza: But audit committee has much more work than the board.

Shroff: But they are more expert as a body.

Vasani: But even then they will depend on super experts which are some external advisors now.

Doshi: But this is what it is.

Deosthalee: But then if this is what it is, we should not discuss.

Doshi: We are discussing impact. We can’t do anything else but discuss the impact of this because this is what it is.

Mirza: Impact means a lot of money for transfer pricing experts who will be asked to give opinions to justify the price.

Doshi: That is what audit committees will rely on- all the external consultants and say please give me an opinion on all of this.

Shroff: It has made the process more cumbersome and therefore there will be one sort of bundle of transaction which will probably not make it through this and then we stay out.

Deosthalee: But we can’t say that this is what it is because there are representations which have been made and what we find now is that many of the things which should be in the Act, through Rules, they are changing and amending. So, there is a hope that some of these things will be heard.

Doshi: Also listed under Section 177 is the need for every listed company and the company which accepts public deposits or has loans of Rs 50 crore or more to establish a vigil mechanism with adequate safeguards against the victimisation of whistleblowers. This also must be overseen by the audit committee.

VIGIL MECHANISM
Section 177
All Listed Companies
All Companies with Public Deposits/Loans >= Rs 50 cr

- Provide for adequate safeguards against victimisation of complainant
- Make provision for direct access to the chairperson of the Audit Committee

There are several other new provisions in the Companies Act 2013. It restricts the director from acquiring or selling assets to the company for a non-cash consideration without shareholder approval. It prohibits directors and key managerial personnel from forward dealings in securities of the company. It also, rather unusually, covers unlisted companies in its insiders trading prohibition.

DIRECTOR DEALINGS
Section 192
- Any non-cash transactions involving Directors
- Need prior approval of shareholders
FORWARD DEALINGS IN SECURITIES
Section 194
No Director/Key Managerial Personnel
Shall buy in the company (or holding/subsidiary/associate)
- a right to call for delivery/make delivery at a specified price and within a specified time, of a specified number of relevant shares/debentures; or
- a right, as he may elect, to call for delivery/make delivery at a specified price and within a specified time, of a specified number of relevant shares/debentures

INSIDER TRADING
Section 195
‘No person including any director or key managerial personnel of a company
shall enter into insider trading’

Punishment
- Imprisonment for upto 5 years
- Fine of minimum Rs 5 lakhs extending to Rs 25cr or 3 times the profit whichever is higher  

Doshi: Though Call and Put contracts are not supposed to have specified prices under the new RBI, SBI requirements- could this end up hurting Call and Put contracts, would that be your legal opinion?

Shroff: Yes, as far as KMPs are concerned.

Doshi: As far as KMPs are concerned, not for the independent directors, etc this is only for promoters?

Shroff: That is right.

Doshi: Insider trading- now these provisions or prohibitions apply not just to listed companies but unlisted public companies as well?

Vasani: I don't know how it will work first of all? Where is the price, unpublished price sensitive information in an unlisted public company - where there is no market price where is the question of how the mechanism will work?

Doshi: I don't know, I couldn't understand why they have applied to unlisted companies.

Vasani: I would like to rely on the landmark judgement of the Supreme Court in 2006, the mill land matter- Bombay Dyeing versus Bombay Environmental Action Group- where Supreme Court says that where you find new provisions lead to absurdity, you have to apply a commonsensical approach; then it applies to listed companies.

Shroff: The common sense approach could be what is the real purpose of insider trading? It is to ensure information symmetry between both parties and other sort of people like other shareholders.

Vasani: You have to read it down.

Doshi: There might be several unlisted companies in your group. While you are following all the requirements that you need to with regards to protecting information in the listed companies, you now need to duplicate those for some of the unlisted intermediate companies in your group as well.

Deosthalee: I am not clear about this provision at all because it talks about insider trading.

Vasani: In my opinion it should be read down to apply to publicly listed companies.   

Deosthalee: I don't know how trading is going to happen in unlisted company.

Shroff: It will make a difference for strategic or private equity transaction in unlisted company.

Doshi: At the holding company level?

Shroff: How will you do diligence, what information will you share – I think this is a practical transactional impact it will have on any company; not just the holding company.

Doshi: How it will work legally is my question. You have X company which is the holding company.

Shroff: Why holding company; it could apply to any unlisted company.

Doshi: Yes any unlisted company.

Deosthalee: I only made the reference of holding because I thought there will be some relevance. But if you have 15 listed subsidiaries and let’s say somebody is investing in the holding company, the management of the holding company is now further restricted in being able to talk about what any of its listed subsidiaries maybe doing, not doing and any of that could then amount to insider trading?

Vasani: This Act has raised a very peculiar situation. Large number of concepts which are essentially governed by SEBI’s Clause 49 and have been brought as part of the Companies Act -  there are separate punishments prescribed under both the Acts. Securities Law there is separate punishment; Companies Act there is separate punishment. The larger question is the Constitution, under Article 23, gives a categorical guarantee there cannot be a double jeopardy for a person for the same offence.

Doshi: Mirza’s question was which punishment would apply- Companies Act punishment or SEBI punishment?

Mirza: And who will prosecute?

Shroff: Both prosecute theoretically.
 
Doshi: So who will punish?

Shroff: For listed companies, it will be SEBI and for an unlisted companies, it would be the Companies Act; that is their understanding as well.

Time now for the toughest Sections in Chapter XII- Section 185, 186 and 188. Section 185 says no company can give a loan, guarantee or security directly or indirectly to its director or to any other person in whom the director is interested.

The Act defines any other person in whom the director is interested to also include any body corporate, the board of directors, managing director or manager whereof is accustomed to act in accordance with the directions or instructions of the board or of any director or directors of the lending company. Now, this effectively blocks the ability of a holding company to extend loans, securities or guarantees to its subsidiaries; an activity that was exempted under the earlier law.

The anomaly has now been corrected via the Rules but only partially. So, loans, guarantees or securities to a wholly owned subsidiary or guarantees or securities to a subsidiary are exempt as long as they are used by the subsidiary for its principle business activities.

LOANS TO A DIRECTOR
Section 185
No Company shall directly or indirectly
Provide Loan/Guarantee/Security
To any of its Directors or to “any other person in whom the director is interested”*

* means  -
 (e) any body corporate, the Board of directors, managing director or manager, whereof is accustomed to act in accordance with the directions or instructions of the Board, or of any director or directors, of the lending company.

1956 Act exempted Loan/Guarantee/Security to subsidiary
LOANS TO A DIRECTOR
Rules
Exempts Loan/Guarantee/Security by Holding Company to Wholly Owned Subsidiary
Exempts Guarantee/Security by Holding Company to Subsidiary

Provided such loans utilised by the subsidiary company for its principle business activities

Section 186 poses a similar problem. It too places restrictions on loans, guarantees or securities provided by a company.

If a company wants to extend loans, guarantees or securities exceeding 60 percent of its networth or 100 percent of the aggregate of its free reserves and securities premium account to any body corporate it needs approval via a special resolution. The threshold and the approval also apply to acquiring securities of another body corporate.

The 1956 Act exempted loans, guarantees or securities to a wholly owned subsidiary from such threshold limits. The 2013 Act now seeks to do the same via the rules. So, the special resolution requirement has been relaxed in the case of wholly owned subsidiaries and joint ventures.

However, that is only partial relief as such loans, guarantees or securities will still be counted towards the threshold limits.

LOAN & INVESTMENT BY COMPANY
Section 186
No company shall directly or indirectly
Give Loan/Guarantee/Security to or Acquire Securities of Any Body Corporate

Exceeding 60% of paid up share capital + free reserves + securities premium a/c
or
Exceeding 100% of free reserves + securities premium a/c
Without approval via Special Resolution

1956 Act exempted Loan/Guarantee/Security to + Acquisition of Share s of WoS

LOAN & INVESTMENT BY COMPANY
Rules
A company does not require Special Resolution approval for
Loan/Guarantee/Security to WoS or JV
Acquisition of Shares of WoS

But such loans will count towards threshold!

Vasani: The major problem here is that holding subsidiary exemption which was taken out in the Act, they have reintroduced through the Rules. Otherwise it would have been a big chaos. The exemption is given from loans, investments and guarantees by holding company to its wholly owned subsidiary but they have introduced one more in fact. Not only they have introduced the exemption for wholly owned subsidiaries they also introduced exemption from joint ventures.   

Doshi: Are you happy with the way the Rules have rectified what 185 and 186 seek to do?

Deosthalee: So long as nobody challenges the Rules and there is no reversal, it is fine.

Vasani: It should have been done through using power under Section 462 that is power to exempt. They have put a restriction that they can issue an exemption notification only after 30 days it was laid before the table of both the houses of parliament. Today we don’t have a Lok Sabha; so they could not have done it. So they have used the Rule route. In my opinion, it is an incorrect way of doing the thing. It was a Statute - after a lot of debate in the Parliamentary Standing Committee took out this exemption; they have reintroduced the exemption through the Rules. Corporates are happy but I don’t know how long the happiness will last.

Mirza: Or under 470 because they have taken a power to remove any difficulty.

Vasani: So long as it is not inconsistent with the Act.   

Shroff: I don’t think it is a complete fix what they have done through the Rules. It is only wholly owned subsidiaries that have been exempted.

Doshi: It is joint ventures as well, right?

Vasani: Joint venture is not defined. Suppose if I have only 20 percent equity in a joint venture still it’s carved out.  

Shroff: You can have a company which is not a wholly owned subsidiary and not a joint venture and still have this problem.

Vasani: In fact you have created a very big loophole through the joint venture route. Joint venture is not defined, you can have a 5 percent investment and still it is your joint venture and you can give the loans, investments and guarantees.

Shroff: So, I don’t think it has been completely plugged.

Deosthalee: Joint venture is under the accounting standards, isn’t it the definition of joint venture?

Vasani: There is definition under the FDI policy which is 3 percent investment.

Doshi: So you could pretty much give a loan, guarantee or a security to anybody and claim that they are a joint venture?

Vasani: Any company which has got more than 3 percent it is a joint venture and you are out.

Shroff: I think you need to meet a slightly higher qualitative test. You can’t just say passive 3 percent.

Dohi: Are you worried about the fact that the Rules are attempting to fix what the Act has attempted to disallow?

Shroff: There is an issue of overreach by the Rules- that is a legal issue and until that Rules are struck down or somebody challenges it, it is useful to have. So, leave that aside for a second. Even if you take the Rules as they stand today, it does not fix the essential problem that 185 was posing which is the overreach in terms of applying it to companies within the group- your subsidiaries and affiliate companies in the group simply which became affiliated because of common directorships. They have alleviated the problem only as far as wholly owned subsidiary is concerned. The joint venture exception has got very limited use; I think you still have a problem and we are actually seeing this in terms of company which are wanting to make this kind of facility- bankers are worried about it. The problem is why are lenders uncomfortable with this?
The lenders are the recipients of guarantees or parent supports that are given and when they receive that kind of support they want to know that it is lawful and in compliance with Section 185. They are taking this just now on a tenuous basis with all this ambiguity that is involved. So, that is why lenders are unhappy.

Mirza: To only clarify one thing, in the definition of an associate company which is 20 percent or more, they have said includes joint ventures implying therefore that even a 20 percent holding would make it a joint venture. I am not saying the 3 percent but here in the Companies Act there is a definition.

Shroff: What they should have done is applied to all subsidiaries; not necessarily resting it to wholly owned subsidiaries.

Doshi: Which brings us to one final point which is related party transactions.

The Rules to the 2013 Act require extensive disclosures for all related party transaction including particulars of contract pricing and commercial terms including those outside the contract, barring those related party transaction entered into by a company in its ordinary course of business and at arms length. All other related party transactions pertaining to the sale or purchase of goods, materials, property services, agency services and the like need board approval. All related party transactions not in the ordinary course of business or at arms length require special resolution approval in the case of a company with a paid of share capital of Rs 10 crore or more. In the case of other companies, for all transactions that exceed prescribed limits. For the first time in Indian company law, a shareholder who is a related party cannot vote on the special resolution.

RELATED PARTY TRANSACTIONS
Rules
DISCLOSURES include
- Nature, duration of the contract and particulars of the contract or arrangement
- Material terms of the contract or arrangement including value
- Manner of determining pricing and other commercial terms, both included as part of contract and not considered as part of the contract;

RELATED PARTY TRANSACTIONS
Section 188
Except when in ordinary course of business or at arm’s length
Need Board approval for
- Sale/purchase/supply of goods or materials
- Selling/disposing/buying/leasing property
- Availing/rendering of services
- Appointment of any agent for purchase/sale of goods, materials, services or property

RELATED PARTY TRANSACTIONS
Section 188 & Rules
Need Special Resolution approval for all RPTs

- Company with paid share capital of >= Rs 10 cr
- Exceeding specified transaction thresholds
eg: Sale/purchase/supply of goods or material exceeding 25% of turnover

RELATED PARTY TRANSACTIONS
Section 188
‘'no member of the company shall vote on such special resolution, to approve any contract or arrangement which may be entered into by the company, if such member is a related party’

Vasani: Effectively, from a plain reading of the language, if the company has a paid up capital of more than Rs 10 crore the entire regulatory regime applies to you; iIrrespective of the fact that the transaction thresholds are not met.

Doshi: Which means that you need audit committee pre-approval, board approval, special resolution approval from shareholders and in the case of any interested share holder, that share holder is barred from voting.

Deosthalee: The only thing is that if it is not in ordinary course of business.

Doshi: Not at arms length.  

Deosthalee: Those two things are important.

Vasani: Only the Companies Act is not giving any guidance on how do you determine the pricing unlike Income Tax Act where there is a specific method prescribed.

Deosthalee: You need to have policies approved by the board on some of these issues and independent directors will have to approve those policies.

Doshi: There is one more interesting thing which we have touched upon briefly here which is that the interested shareholder cannot vote when a special resolution approval is being sought which effectively means wherever a promoter is involved in a related party transaction.

Mirza: No related party can vote; not just the promoter

Doshi: No related party; so any interested party.

Mirza: Not just the party who is interested in the transaction.

Vasani: The party which is related for that transaction only.

Doshi: No that's not right; he is right the language is not clear.

Vasani: The language is very clear that the related party- if there are three related parties but only one is interested in that transaction…(Interrupted by Guest)

Shroff: It is based on the conflict of interest.

Doshi: It should be but Nawshir Mirza is right; it doesn't say that, that particular related party should not vote, it says the related should not vote.

Vasani: The larger problem which people have not touched upon and that is the issue with regard to who is the related party. One category which is in the definition of the related party that is to sub- section 76 sub clause 5, which is there is one common director between two public companies that also makes the two companies related parties. If there is an independent director of company A and independent director of company B, it is a related party. There is also a word or if he holds two percent capital. They are planning to issue removal of difficulties order which is on the website of Ministry but yet not notified or signed by the Minister.

RELATED PARTY TRANSACTIONS
Section 188
Proviso: No member of the company shall vote on such special resolution, to approve any contract or arrangement which may be entered into by the company, if such member is a related party

RELATED PARTY TRANSACTIONS
Section 2 (76): Definition of ‘Related Party’
- (v) a public company in which a director or manager is a director or holds along with his relatives, more than two per cent. of its paid-up share capital;
IMPACT
- If 2 public companies share a common Independent director, they will be considered Related Parties!

Doshi: So all the company you are on the board of; they are all related?

Mirza: Yes I know; according to Bharat Vasani's clarification. I am waiting to see how general meetings of shareholders are going to approve these transactions, because these are simple straight forward commercial things and you got housewives there who come in with plastic bags to carry away the mithai.

Doshi: Why would you underestimate the ability of a housewife?

Mirza: The ability to comprehend the issue, I don't know how this is going to get approved.

Doshi: Good shareholder will grow up, become more mature.

Vasani: The minority will become the new majority now.

Shroff: Apart from the entire psyche of independent that has changed, another profound impact has happened on the psyche of the promoter director as well to now deal with this whole concept of majority or minority. So it is no longer enough to say that I own 51 percent of this company or 75 percent of the company; so I can do what I want with it. You could find yourselves and promoters coming to term with this new reality that on several important things they have no voice at all and decision making in the company would be made by this minority; with them just standing on the sidelines watching how this performs. From an ethical perspective, it is a good thing. From a practicality of doing business perspective, there is an over reach. Simply because this applies even in cases where there is no specific benefit even if the terms are fair, even then you have to go through this rigor. You don't know whether the minority has enough a business judgment or assessment to take a proper call.

Deosthalee: From a long term, this is a good provision. However there is a process we need to have much more enlightened, knowledgeable shareholders to do this.

Shroff: I have a slightly different problem with this and more intellectual and conceptual one which is firstly as an owner of property, namely the shares, I am entitled to act in self interest. The rule for acting in the fiduciary responsibility applies to the board. We are effectively now applying fiduciary principles at the ownership level and you are saying that you shall not act in self interest. This could have been dealt with a disclosure regime as well. You could have had disclosures, you could have had principles in which you will sort of deal with it. So why would a disclosure regime, a strong disclosure regime with a requirement of approval but without conflicting me from voting not have been enough?

Doshi: How has life for board changed?

Deosthalee: It's a process. According to me boards will learn to live with this situation. Ultimately with all these things, if the efficiency of boards improves then that's a good thing to happen for companies in India. However if it is going to result in something else in terms of looking over the shoulder continuously than asking more questions just for satisfying the requirements of this Act, then we would achieve nothing.     

Shroff: It is all of the above. I think certainly boards have become far more active. The nature of the discourse has changed. Independent directors have found a sort of a new voice and most boards of independent directors are seeing themselves as a power center by themselves as Bharat was pointing out sometime ago. So it is certainly a milestone in terms of a new era of corporate governance. I can see that and it really comes to roost on important decisions like M&A transactions or a capital raising or something which significantly changes the nature of the company. The level of discussion and the level of caution, sometimes even little bit of paranoia, is significantly higher.

Vasani: Certainly the Act has created an architecture for better corporate governance but the only question which Mr Deosthalee has raised that is the focus going to shift from business issues to more compliance issues; that is a worrying part.

Mirza: Last month I was lecturing to a group of people who are aspiring independent directors.

Doshi: There are still that kind left after this Act?

Mirza: There are and my message to them was when you do receive an offer to be a director, don’t think of all the reasons why you should accept the offer but of all the reasons why should refuse it. Only if you can, even in spite of that, convince yourself that it is an offer worth taking only then should you take it.

Doshi: Be very selective of the boards you are going to join, of the managements you trust and of the promoters you hobnob with.

Mirza: Correct, because the problem is that SEBI has opened the doors to all sorts of promoters who should never have been permitted to list. Having permitted them now, they make these rules and regulations and the government does the same. The problem is there – you should never allow these people to take money from the public. Once you allow them there is no matter how many bandores you try to slam shut, the horse has bolted.

Vasani: The major issue is not the composition of the committee but the charter of the audit committee because now the responsibility which is cast on the audit committee for the first time they are made responsible to approve all related party transactions completely. It is not the approval of the Board- if only they come to a view that it is not in the ordinary course of business and it is not at arms length pricing, then only it goes to Board and then to the shareholders.  However, audit committee having primary responsibility, some of the audit committee members have told that if you look at all my responsibilities my role which was essentially an independent director's role of exercising supervision is seemed to have become more of an operating role. If you see the kind of duties which have been entrusted to them under Section 177(4) if you read it with the SEBI’s Clause 49 it makes it so onerous in terms of day-to-day operations. I am still not able to figure out how it will work in practice if it is a prior approval.

BOARD RESTRICTIONS
- Under the 2013 Act a company needs approval via a special resolution to sell/lease an undertaking > 20% of networth/total income of company
- Under the 2013 Act a company needs approval via a special resolution to sanction borrowings exceeding the aggregate of paid up share capital + free reserves

Deosthalee: It is a fact that lot of time will have to be spent by audit committees on many of the issues which have been listed; their duties have increased.

Doshi: They are the first screening process for a lot of important financial situations. So, isn't it a good thing that they have to spend more time?

Deosthalee: I agree with you but ultimately you must also understand that independent directors join a company and they also join a management. So, ultimately what we are saying is there has to be some trust and faith in the management also.
   
Mirza: There are two other concerns. The audit committee should never have an executive role because it must maintain objectivity.

Doshi: But its not- the words used here are review and monitor the auditors independence and performance, examine the financial statement, scrutiny of inter-corporate loans and even related parties, it says approval of transactions.   

Mirza: What is the concern- now the promoter directors are no longer involved with the approval. In fact they are the people who might well have instigated an improper transaction and they will now be scot-free because they will say we never were party to this whole thing; nobody asked us.

Vasani: The point which he is canvassing, if a proposal comes to the audit committee and the management would just make a bland statement that in our opinion it’s a transaction in the ordinary course of business and at arms length. Now, what should the audit committee do, how do they go about evaluating?

Shroff: I don’t agree with that. I think audit committee is probably the right place for it to be seen because they will probably have that specialist knowledge and the financial literacy to ask more detailed question. I agree with Bharat that it has increased the workload.

Mirza: Why not in the Board where everybody then is responsible for that transaction?

Shroff: Because time is a constraint.

Mirza: But audit committee has much more work than the board.

Shroff: But they are more expert as a body.

Vasani: But even then they will depend on super experts which are some external advisors now.

Doshi: But this is what it is.

Deosthalee: But then if this is what it is, we should not discuss.

Doshi: We are discussing impact. We can’t do anything else but discuss the impact of this because this is what it is.

Mirza: Impact means a lot of money for transfer pricing experts who will be asked to give opinions to justify the price.

Doshi: That is what audit committees will rely on- all the external consultants and say please give me an opinion on all of this.

Shroff: It has made the process more cumbersome and therefore there will be one sort of bundle of transaction which will probably not make it through this and then we stay out.

Deosthalee: But we can’t say that this is what it is because there are representations which have been made and what we find now is that many of the things which should be in the Act, through Rules, they are changing and amending. So, there is a hope that some of these things will be heard.

Doshi: Also listed under Section 177 is the need for every listed company and the company which accepts public deposits or has loans of Rs 50 crore or more to establish a vigil mechanism with adequate safeguards against the victimisation of whistleblowers. This also must be overseen by the audit committee.

VIGIL MECHANISM
Section 177
All Listed Companies
All Companies with Public Deposits/Loans >= Rs 50 cr

- Provide for adequate safeguards against victimisation of complainant
- Make provision for direct access to the chairperson of the Audit Committee

There are several other new provisions in the Companies Act 2013. It restricts the director from acquiring or selling assets to the company for a non-cash consideration without shareholder approval. It prohibits directors and key managerial personnel from forward dealings in securities of the company. It also, rather unusually, covers unlisted companies in its insiders trading prohibition.

DIRECTOR DEALINGS
Section 192
- Any non-cash transactions involving Directors
- Need prior approval of shareholders
FORWARD DEALINGS IN SECURITIES
Section 194
No Director/Key Managerial Personnel
Shall buy in the company (or holding/subsidiary/associate)
- a right to call for delivery/make delivery at a specified price and within a specified time, of a specified number of relevant shares/debentures; or
- a right, as he may elect, to call for delivery/make delivery at a specified price and within a specified time, of a specified number of relevant shares/debentures

INSIDER TRADING
Section 195
‘No person including any director or key managerial personnel of a company
shall enter into insider trading’

Punishment
- Imprisonment for upto 5 years
- Fine of minimum Rs 5 lakhs extending to Rs 25cr or 3 times the profit whichever is higher  

Doshi: Though Call and Put contracts are not supposed to have specified prices under the new RBI, SBI requirements- could this end up hurting Call and Put contracts, would that be your legal opinion?

Shroff: Yes, as far as KMPs are concerned.

Doshi: As far as KMPs are concerned, not for the independent directors, etc this is only for promoters?

Shroff: That is right.

Doshi: Insider trading- now these provisions or prohibitions apply not just to listed companies but unlisted public companies as well?

Vasani: I don't know how it will work first of all? Where is the price, unpublished price sensitive information in an unlisted public company - where there is no market price where is the question of how the mechanism will work?

Doshi: I don't know, I couldn't understand why they have applied to unlisted companies.

Vasani: I would like to rely on the landmark judgement of the Supreme Court in 2006, the mill land matter- Bombay Dyeing versus Bombay Environmental Action Group- where Supreme Court says that where you find new provisions lead to absurdity, you have to apply a commonsensical approach; then it applies to listed companies.

Shroff: The common sense approach could be what is the real purpose of insider trading? It is to ensure information symmetry between both parties and other sort of people like other shareholders.

Vasani: You have to read it down.

Doshi: There might be several unlisted companies in your group. While you are following all the requirements that you need to with regards to protecting information in the listed companies, you now need to duplicate those for some of the unlisted intermediate companies in your group as well.

Deosthalee: I am not clear about this provision at all because it talks about insider trading.

Vasani: In my opinion it should be read down to apply to publicly listed companies.   

Deosthalee: I don't know how trading is going to happen in unlisted company.

Shroff: It will make a difference for strategic or private equity transaction in unlisted company.

Doshi: At the holding company level?

Shroff: How will you do diligence, what information will you share – I think this is a practical transactional impact it will have on any company; not just the holding company.

Doshi: How it will work legally is my question. You have X company which is the holding company.

Shroff: Why holding company; it could apply to any unlisted company.

Doshi: Yes any unlisted company.

Deosthalee: I only made the reference of holding because I thought there will be some relevance. But if you have 15 listed subsidiaries and let’s say somebody is investing in the holding company, the management of the holding company is now further restricted in being able to talk about what any of its listed subsidiaries maybe doing, not doing and any of that could then amount to insider trading?

Vasani: This Act has raised a very peculiar situation. Large number of concepts which are essentially governed by SEBI’s Clause 49 and have been brought as part of the Companies Act -  there are separate punishments prescribed under both the Acts. Securities Law there is separate punishment; Companies Act there is separate punishment. The larger question is the Constitution, under Article 23, gives a categorical guarantee there cannot be a double jeopardy for a person for the same offence.

Doshi: Mirza’s question was which punishment would apply- Companies Act punishment or SEBI punishment?

Mirza: And who will prosecute?

Shroff: Both prosecute theoretically.
 
Doshi: So who will punish?

Shroff: For listed companies, it will be SEBI and for an unlisted companies, it would be the Companies Act; that is their understanding as well.

Time now for the toughest Sections in Chapter XII- Section 185, 186 and 188. Section 185 says no company can give a loan, guarantee or security directly or indirectly to its director or to any other person in whom the director is interested.

The Act defines any other person in whom the director is interested to also include any body corporate, the board of directors, managing director or manager whereof is accustomed to act in accordance with the directions or instructions of the board or of any director or directors of the lending company. Now, this effectively blocks the ability of a holding company to extend loans, securities or guarantees to its subsidiaries; an activity that was exempted under the earlier law.

The anomaly has now been corrected via the Rules but only partially. So, loans, guarantees or securities to a wholly owned subsidiary or guarantees or securities to a subsidiary are exempt as long as they are used by the subsidiary for its principle business activities.

LOANS TO A DIRECTOR
Section 185
No Company shall directly or indirectly
Provide Loan/Guarantee/Security
To any of its Directors or to “any other person in whom the director is interested”*

* means  -
 (e) any body corporate, the Board of directors, managing director or manager, whereof is accustomed to act in accordance with the directions or instructions of the Board, or of any director or directors, of the lending company.

1956 Act exempted Loan/Guarantee/Security to subsidiary
LOANS TO A DIRECTOR
Rules
Exempts Loan/Guarantee/Security by Holding Company to Wholly Owned Subsidiary
Exempts Guarantee/Security by Holding Company to Subsidiary

Provided such loans utilised by the subsidiary company for its principle business activities
Section 186 poses a similar problem. It too places restrictions on loans, guarantees or securities provided by a company.

If a company wants to extend loans, guarantees or securities exceeding 60 percent of its networth or 100 percent of the aggregate of its free reserves and securities premium account to any body corporate it needs approval via a special resolution. The threshold and the approval also apply to acquiring securities of another body corporate.

The 1956 Act exempted loans, guarantees or securities to a wholly owned subsidiary from such threshold limits. The 2013 Act now seeks to do the same via the rules. So, the special resolution requirement has been relaxed in the case of wholly owned subsidiaries and joint ventures.

However, that is only partial relief as such loans, guarantees or securities will still be counted towards the threshold limits.

LOAN & INVESTMENT BY COMPANY
Section 186
No company shall directly or indirectly
Give Loan/Guarantee/Security to or Acquire Securities of Any Body Corporate

Exceeding 60% of paid up share capital + free reserves + securities premium a/c
or
Exceeding 100% of free reserves + securities premium a/c
Without approval via Special Resolution

1956 Act exempted Loan/Guarantee/Security to + Acquisition of Share s of WoS

LOAN & INVESTMENT BY COMPANY
Rules
A company does not require Special Resolution approval for
Loan/Guarantee/Security to WoS or JV
Acquisition of Shares of WoS

But such loans will count towards threshold!

Vasani: The major problem here is that holding subsidiary exemption which was taken out in the Act, they have reintroduced through the Rules. Otherwise it would have been a big chaos. The exemption is given from loans, investments and guarantees by holding company to its wholly owned subsidiary but they have introduced one more in fact. Not only they have introduced the exemption for wholly owned subsidiaries they also introduced exemption from joint ventures.   

Doshi: Are you happy with the way the Rules have rectified what 185 and 186 seek to do?

Deosthalee: So long as nobody challenges the Rules and there is no reversal, it is fine.

Vasani: It should have been done through using power under Section 462 that is power to exempt. They have put a restriction that they can issue an exemption notification only after 30 days it was laid before the table of both the houses of parliament. Today we don’t have a Lok Sabha; so they could not have done it. So they have used the Rule route. In my opinion, it is an incorrect way of doing the thing. It was a Statute - after a lot of debate in the Parliamentary Standing Committee took out this exemption; they have reintroduced the exemption through the Rules. Corporates are happy but I don’t know how long the happiness will last.

Mirza: Or under 470 because they have taken a power to remove any difficulty.

Vasani: So long as it is not inconsistent with the Act.   

Shroff: I don’t think it is a complete fix what they have done through the Rules. It is only wholly owned subsidiaries that have been exempted.

Doshi: It is joint ventures as well, right?

Vasani: Joint venture is not defined. Suppose if I have only 20 percent equity in a joint venture still it’s carved out.  

Shroff: You can have a company which is not a wholly owned subsidiary and not a joint venture and still have this problem.

Vasani: In fact you have created a very big loophole through the joint venture route. Joint venture is not defined, you can have a 5 percent investment and still it is your joint venture and you can give the loans, investments and guarantees.

Shroff: So, I don’t think it has been completely plugged.

Deosthalee: Joint venture is under the accounting standards, isn’t it the definition of joint venture?

Vasani: There is definition under the FDI policy which is 3 percent investment.

Doshi: So you could pretty much give a loan, guarantee or a security to anybody and claim that they are a joint venture?

Vasani: Any company which has got more than 3 percent it is a joint venture and you are out.

Shroff: I think you need to meet a slightly higher qualitative test. You can’t just say passive 3 percent.

Dohi: Are you worried about the fact that the Rules are attempting to fix what the Act has attempted to disallow?

Shroff: There is an issue of overreach by the Rules- that is a legal issue and until that Rules are struck down or somebody challenges it, it is useful to have. So, leave that aside for a second. Even if you take the Rules as they stand today, it does not fix the essential problem that 185 was posing which is the overreach in terms of applying it to companies within the group- your subsidiaries and affiliate companies in the group simply which became affiliated because of common directorships. They have alleviated the problem only as far as wholly owned subsidiary is concerned. The joint venture exception has got very limited use; I think you still have a problem and we are actually seeing this in terms of company which are wanting to make this kind of facility- bankers are worried about it. The problem is why are lenders uncomfortable with this?
The lenders are the recipients of guarantees or parent supports that are given and when they receive that kind of support they want to know that it is lawful and in compliance with Section 185. They are taking this just now on a tenuous basis with all this ambiguity that is involved. So, that is why lenders are unhappy.

Mirza: To only clarify one thing, in the definition of an associate company which is 20 percent or more, they have said includes joint ventures implying therefore that even a 20 percent holding would make it a joint venture. I am not saying the 3 percent but here in the Companies Act there is a definition.

Shroff: What they should have done is applied to all subsidiaries; not necessarily resting it to wholly owned subsidiaries.

Doshi: Which brings us to one final point which is related party transactions.

The Rules to the 2013 Act require extensive disclosures for all related party transaction including particulars of contract pricing and commercial terms including those outside the contract, barring those related party transaction entered into by a company in its ordinary course of business and at arms length. All other related party transactions pertaining to the sale or purchase of goods, materials, property services, agency services and the like need board approval. All related party transactions not in the ordinary course of business or at arms length require special resolution approval in the case of a company with a paid of share capital of Rs 10 crore or more. In the case of other companies, for all transactions that exceed prescribed limits. For the first time in Indian company law, a shareholder who is a related party cannot vote on the special resolution.

RELATED PARTY TRANSACTIONS
Rules
DISCLOSURES include
- Nature, duration of the contract and particulars of the contract or arrangement
- Material terms of the contract or arrangement including value
- Manner of determining pricing and other commercial terms, both included as part of contract and not considered as part of the contract;

RELATED PARTY TRANSACTIONS
Section 188
Except when in ordinary course of business or at arm’s length
Need Board approval for
- Sale/purchase/supply of goods or materials
- Selling/disposing/buying/leasing property
- Availing/rendering of services
- Appointment of any agent for purchase/sale of goods, materials, services or property

RELATED PARTY TRANSACTIONS
Section 188 & Rules
Need Special Resolution approval for all RPTs

- Company with paid share capital of >= Rs 10 cr
- Exceeding specified transaction thresholds
eg: Sale/purchase/supply of goods or material exceeding 25% of turnover

RELATED PARTY TRANSACTIONS
Section 188
‘…no member of the company shall vote on such special resolution, to approve any contract or arrangement which may be entered into by the company, if such member is a related party’

Vasani: Effectively, from a plain reading of the language, if the company has a paid up capital of more than Rs 10 crore the entire regulatory regime applies to you; iIrrespective of the fact that the transaction thresholds are not met.

Doshi: Which means that you need audit committee pre-approval, board approval, special resolution approval from shareholders and in the case of any interested share holder, that share holder is barred from voting.

Deosthalee: The only thing is that if it is not in ordinary course of business.

Doshi: Not at arms length.  

Deosthalee: Those two things are important.

Vasani: Only the Companies Act is not giving any guidance on how do you determine the pricing unlike Income Tax Act where there is a specific method prescribed.

Deosthalee: You need to have policies approved by the board on some of these issues and independent directors will have to approve those policies.

Doshi: There is one more interesting thing which we have touched upon briefly here which is that the interested shareholder cannot vote when a special resolution approval is being sought which effectively means wherever a promoter is involved in a related party transaction.

Mirza: No related party can vote; not just the promoter

Doshi: No related party; so any interested party.

Mirza: Not just the party who is interested in the transaction.

Vasani: The party which is related for that transaction only.

Doshi: No that's not right; he is right the language is not clear.

Vasani: The language is very clear that the related party- if there are three related parties but only one is interested in that transaction…(Interrupted by Guest)

Shroff: It is based on the conflict of interest.

Doshi: It should be but Nawshir Mirza is right; it doesn't say that, that particular related party should not vote, it says the related should not vote.

Vasani: The larger problem which people have not touched upon and that is the issue with regard to who is the related party. One category which is in the definition of the related party that is to sub- section 76 sub clause 5, which is there is one common director between two public companies that also makes the two companies related parties. If there is an independent director of company A and independent director of company B, it is a related party. There is also a word or if he holds two percent capital. They are planning to issue removal of difficulties order which is on the website of Ministry but yet not notified or signed by the Minister.

RELATED PARTY TRANSACTIONS
Section 188
Proviso: No member of the company shall vote on such special resolution, to approve any contract or arrangement which may be entered into by the company, if such member is a related party

RELATED PARTY TRANSACTIONS
Section 2 (76): Definition of ‘Related Party’
- (v) a public company in which a director or manager is a director or holds along with his relatives, more than two per cent. of its paid-up share capital;
IMPACT
- If 2 public companies share a common Independent director, they will be considered Related Parties!

Doshi: So all the company you are on the board of; they are all related?

Mirza: Yes I know; according to Bharat Vasani's clarification. I am waiting to see how general meetings of shareholders are going to approve these transactions, because these are simple straight forward commercial things and you got housewives there who come in with plastic bags to carry away the mithai.

Doshi: Why would you underestimate the ability of a housewife?

Mirza: The ability to comprehend the issue, I don't know how this is going to get approved.

Doshi: Good shareholder will grow up, become more mature.

Vasani: The minority will become the new majority now.

Shroff: Apart from the entire psyche of independent that has changed, another profound impact has happened on the psyche of the promoter director as well to now deal with this whole concept of majority or minority. So it is no longer enough to say that I own 51 percent of this company or 75 percent of the company; so I can do what I want with it. You could find yourselves and promoters coming to term with this new reality that on several important things they have no voice at all and decision making in the company would be made by this minority; with them just standing on the sidelines watching how this performs. From an ethical perspective, it is a good thing. From a practicality of doing business perspective, there is an over reach. Simply because this applies even in cases where there is no specific benefit even if the terms are fair, even then you have to go through this rigor. You don't know whether the minority has enough a business judgment or assessment to take a proper call.

Deosthalee: From a long term, this is a good provision. However there is a process we need to have much more enlightened, knowledgeable shareholders to do this.

Shroff: I have a slightly different problem with this and more intellectual and conceptual one which is firstly as an owner of property, namely the shares, I am entitled to act in self interest. The rule for acting in the fiduciary responsibility applies to the board. We are effectively now applying fiduciary principles at the ownership level and you are saying that you shall not act in self interest. This could have been dealt with a disclosure regime as well. You could have had disclosures, you could have had principles in which you will sort of deal with it. So why would a disclosure regime, a strong disclosure regime with a requirement of approval but without conflicting me from voting not have been enough?

Doshi: How has life for board changed?

Deosthalee: It's a process. According to me boards will learn to live with this situation. Ultimately with all these things, if the efficiency of boards improves then that's a good thing to happen for companies in India. However if it is going to result in something else in terms of looking over the shoulder continuously than asking more questions just for satisfying the requirements of this Act, then we would achieve nothing.     

Shroff: It is all of the above. I think certainly boards have become far more active. The nature of the discourse has changed. Independent directors have found a sort of a new voice and most boards of independent directors are seeing themselves as a power center by themselves as Bharat was pointing out sometime ago. So it is certainly a milestone in terms of a new era of corporate governance. I can see that and it really comes to roost on important decisions like M&A transactions or a capital raising or something which significantly changes the nature of the company. The level of discussion and the level of caution, sometimes even little bit of paranoia, is significantly higher.

Vasani: Certainly the Act has created an architecture for better corporate governance but the only question which Mr Deosthalee has raised that is the focus going to shift from business issues to more compliance issues; that is a worrying part.

Mirza: Last month I was lecturing to a group of people who are aspiring independent directors.

Doshi: There are still that kind left after this Act?

Mirza: There are and my message to them was when you do receive an offer to be a director, don’t think of all the reasons why you should accept the offer but of all the reasons why should refuse it. Only if you can, even in spite of that, convince yourself that it is an offer worth taking only then should you take it.

Doshi: Be very selective of the boards you are going to join, of the managements you trust and of the promoters you hobnob with.

Mirza: Correct, because the problem is that SEBI has opened the doors to all sorts of promoters who should never have been permitted to list. Having permitted them now, they make these rules and regulations and the government does the same. The problem is there – you should never allow these people to take money from the public. Once you allow them there is no matter how many barn doors you try to slam shut, the horse has bolted.

 
Twitter


 
Copyright © e-Eighteen.com Ltd. All rights reserved. Reproduction of news articles, photos, videos or any other content in whole or in part in any form or medium without express written permission of moneycontrol.com is prohibited.