Cos Act Ep#13: Private Companies
The one big distinction between the new Companies Act and the old one is the inclusion of private companies. The Companies Act, 1956 exempted private companies from many provisions. The Companies Act, 2013 covers private companies in most provisions. The new private placement norms apply to private companies. The restriction on inter-corporate loans and investments apply to private companies as well! Private companies with a paid up share capital of Rs 20 crore and more must rotate their auditors. And the extensive disclosures on related party transactions and the restrictions on RPTs that apply to public and public listed companies, apply to private companies as well. At the time of designing the law, the Ministry Of Corporate Affairs, in its reasoning with the Parliamentary Standing Committee, said it preferred to rely on the power to exempt to provide future exemptions than exempt private companies at the start. Well, it's been barely 3 months of the law going live and a long list of exemptions is on the anvil! Will they offer substantial relief to private companies or not? On Companies, Act this week, Menaka Doshi speaks to Ashwath Rau of Amarchand Mangaldas and Sai Venkateshwaran of KPMG.
PRIVATE COMPANIES: PUBLIC PAIN
Restrictions on accepting deposits & private placement apply
Restrictions on loans to directors & inter-corporate loans apply
Rotation of auditor applies
Restrictions & provisions on related party transactions apply
PRIVATE COMPANIES: PUBLIC PAIN
‘…it was felt that exemptions to class of companies (including private companies) can be given through notifications after due deliberations with concerned stakeholders and through laying in draft form in the Parliament. Clause 462 provides for such powers/procedure. It is submitted that this approach is more conducive to deal with all possible eventualities…’
- MCA’s response to Parliamentary Standing Committee
Doshi: I am going to go back to the reasoning that the Ministry provided to the parliamentary standing committee for your opening comments on the impact of this Act on private companies. They have said we would rather use the power to exempt to give relief to private companies in certain situations as opposed to exempt them right at the beginning in the law itself. Would you say that was the right approach when it came to private companies because we are now three months into the law and many private companies are weeping.
Rau: Purely from a legislative perspective, I think it would have been better had they done what they did in the 1956 Act which is looked at it provision by provision and decided what was the public purpose that was sought to be achieved by each provision and decided whether it needed to apply to private companies or not.
The certain class of companies provision that is there was there in the previous statute as well. The intention for that particular provision is entirely different from basically exempting the primary classes of companies. It is meant to be sick companies and various categories of companies.
Doshi: And also in extraordinary situations or circumstances where you realize something is having an unintended impact, you can exempt the companies from that?
Sec 462: Govt may direct that any provision may not apply to a class of companies or may apply with modifications
Rau: Absolutely and the fact that that was not the way to do it, is only being proven by the current exercise that is underway to try and now clawback and restore some of the benefits that were hitherto there; many things are getting missed out and we will talk about it.
Doshi: It is weird because it gives them flexibility that they can use the power to exempt now to exempt classes though that may not have been the intention. But it also creates a lot of flux. Like even as we go through this conversation there will be so much of it if this becomes the law or if this changes. And this could continuously change as we have seen in the last three months. There are circulars out everyday changing positions on provisions.
Venkateshwaran: Private companies are struggling since April 1 when these Sections became effective and today we are sitting on a draft circular which has been tabled in both the houses of parliament but I doubt it will see light of the day in the current session or next month and it will probably get finalised only when the parliament meets again probably in the winter session.
So that means for another six-eight months, private companies will have to deal with all of the challenges.
Doshi: So half a year, actually a fiscal year, a fiscal year would have passed before we get certainty on what applies to them and what doesn’t?
Venkateshwaran: Absolutely and ideally they should have thought through what are the issues that private companies will face and before they made it effective, come out with these exemptions rather than having them go through all of this pain and uncertainty for a number of months and then withdraw some of these.
Doshi: Let us look at the various areas of impact and try and understand what this means for private companies. Fund raising for private companies has become tougher on account of two-three different things; some of which has been attempted to be rectified in the draft notification. For instance the raising of deposits - there are new restrictions, issuing shares with differential voting rights you need to have a profit track record that would be very difficult for a young startup company to have. Thirdly when it comes to private placements, the restrictions that apply on private placements and preferential allotments for public listed companies applies to private companies as well. Why is this painful for private companies and will it mean that they are not able to raise capital with the ease that they were able to under the 1956 Act?
Rau: As far as deposits is concerned my own view is that it is probably more relevant for the bigger public companies. Now in the rules or rather the notification they have eased it for private companies as well subject to certain limits. So they have addressed that partially.
PRIVATE COMPANIES: DEPOSITS
1956: Loans from shareholders exempted from deposit restrictions
2013: All restrictions & conditions on acceptance of deposits apply
Draft: Exempted if 50 or less members & if deposits < threshold
Revised: Exempted if deposits < 100% of paid up share capital + free reserves
Doshi: So only companies with 50 members and less can avail.
Rau: And that will be modified in the July version.
Doshi: So there is yet another version out there which is the version that has been placed in front of parliament and nobody is sure whether it is there or not.
In June MCA issued Draft Notification listing several exemptions for private companies.
In July a news website published a revised version of draft notification sourced from RS office
Rau: And they have removed the 50 member limit there.
Doshi: So all private companies have then been exempted from the restrictions on deposits?
Rau: Subject to certain limits which is basically twice the capital or Rs 50 crore whichever is lower. But the two other points that you raised are the critical ones. The fact that the 2013 Act effectively made it impossible for a private company to issue shares with differential rights was something that actually impeded a lot of structures - both domestic and foreign- because you had waterfall mechanisms in terms of promoter structures etc where economics were differently shared between different shareholders in the company and there was no reason why you needed to restrict that in the context of a private limited company. The June draft itself eases that. So differential rights are possible; so that is a positive.
PRIVATE COMPANIES: DVRs
1956: Private companies exempted
2013: Need to meet all conditions including dividend track record
Draft: Private companies exempted
Revised: Exempted if AoA/MoA so provides
I think the problem with the 2013 Act which applies to all companies and is particularly onerous in the context of private companies because the rationale for applying this set of restrictions is a little more unclear than in the context of public companies. It is basically this whole confusion about whether every preferential allotment has to follow private placement rules. Now it is very clear conceptually that every private placement of shares will result ultimately in a preferential allotment for the issuance to take place but not every preferential allotment need necessarily follow a private placement process. The whole concept of a private placement - this is obviously to address the entire Sahara problem - is to basically to say that look don’t try and overcome limitations on publicly raising money by using the private placement route and converting what is effectively a private exercise into a backdoor public fund raising exercise. So they have come out with rightly limits on what you can and cannot do in a private placement.
Doshi: Naturally they have been fairly lauded for those limits because they have put in some well thought-through safeguards so to speak.
Rau: Absolutely but now you should take a situation where there is an existing shareholder of the company who wants to contribute capital and they are not doing it through a rights issuance or there is a single private equity investor that you are talking to and you are going to make a private preferential allotment of shares to that particular investor. The confusion now is as to whether you need to comply with the private placement norms even though it is a one-on-one arrangement. You are not clearly going out in the market place and talking to 50 people as the case maybe. Even then now, because of the language of this Statute as it stands right now, the safer view which a lot of the market is following is to follow the private placement norms.
PRIVATE COMPANIES: PRIVATE PLACEMENT
1956: Private companies exempted
2013: To comply with all provisions and extensive rules
Draft: No exemption
Revised: No exemption
Doshi: But those are fairly extensive norms.
Rau: Extensive norms and the whole idea of having a private company is to do things privately and things like confidentiality etc are protected. Now you are in a situation where even in a private company, you have to disclose the identity of the investor, the number of shares that the investor is subscribing, most importantly the price per share therefore divulging details of valuation. There is no logical policy reason for wanting to have all of that in the public domain and unfortunately misuse is a reality in this particular market and that is a big concern; a big dampener.
Sec 42: Private Placement rules include advance identification of investors, special resolution approval, minimum investment size, filing & returns…
Venkateshwaran: I think they should probably just exempt private companies from some of these requirements.
Doshi: That is not available in the draft notification at least from what I understood, is it?
Venkateshwaran: I don’t think - there is no relief specifically on these provisions and maybe that is something that they should consider in the next round.
Doshi: Without which what happens?
Rau: Earlier private company, through a Board approval, could go and do a preferential allotment to a new investor coming in. Now they have to go and take shareholder approval and take a special resolution from the shareholders.
Doshi: Is this a deal breaker? My point is that yes, it is a little bit more painful but is any of this a deal breaker in that sense?
Rau: The resolution is paperwork but having to follow private placement norms to my mind is clearly a deal breaker.
Doshi: Anything outside of the confidentiality issues that you have raised?
Rau: Which is a big deal.
Doshi: All those gets filed with the RoC- who is going to be able to get the information out?
Rau: From experience, a lot of people.
Doshi: You are saying that is a deal breaker for sure?
Rau: Of course it is a deal breaker.
Doshi: The other key talking point seems to be the new governance requirements which seemingly are to onerous for private companies. The sub-points to that are, for instance, auditor rotation applies to all companies including private companies of a certain size and more. Sections 185 and 186 which are restrictions on the loans that you can give to directors or to other companies, they apply to private companies. Section 188 which is the dreaded related party transaction section, that applies to private companies and then the insider trading section also applies to private companies, which is the most befuddling of them all because there is no public traded price in this, so why would it apply to private companies. All of this is making life very difficult, what would you pick amongst these as the most material negative impacts on private companies?
PRIVATE COMPANIES: PUBLIC PAIN
Sec 139: Auditor Rotation applies to all private companies with paid up share capital of Rs 20 cr and more
Sec 185 & 186: Interest rates on loans to directors/corporates cannot be lower than RBI/Gsec rates
Sec 185: Restrictions on loans to directors applies to private companies too
Sec 188: RPTs of all companies need extensive disclosures, board approval, special resolution approval & interested party cannot vote…
Sec 194: Prohibits Director, KMP of all companies from forward dealings in securities
Sec 195: Prohibition of insider trading provisions apply to all companies including private companies
Venkateshwaran: Each one of these has its own set of impact. So if you look at Section 185 and Section 186, just the ability of funding within their own corporate structure that has kind of almost come to a standstill, although there are now limited exemptions that are available.
Doshi: In the draft notification? What exactly have they suggested in Section 185- they have said that if there is no body corporate shareholder in that private company, then section 185 does not apply; is that correct?
PRIVATE COMPANIES: LOANS
1956: Private companies exempted
2013: Restrictions on Loans to Directors
Draft: Exempted if no body corporate as investor & borrowings below threshold
Revised: Exempted if body corporate is investor & borrowings below threshold
Venkateshwaran: Yeah, and again I think they have put a limit.
Rau: Take your pick. June says what just you said, but the July draft if you don’t know (interrupted)
Venkateshwaran: The July says exactly the opposite.
Doshi: The July draft is the question mark draft because there is one website that has this draft and it is not been put out by the Ministry of Corporate Affairs (MCA) in any fashion.
Venkateshwaran: No, it hasn’t.
Rau: So effectively, if you look at what the July draft says, which is the more recent one, and let’s go over it as a later version for a second. Basically it says that if you don’t have loans from banks which is in excess of two times of your capital or Rs 50 crore whichever is lower. You have a body corporate shareholder that is a change from the June draft.
Doshi: You have to meet both these conditions?
Rau: And you are not in default of your debt,
Doshi: Then Section 185 and Section 186 don’t apply or only Section 185?
Venkateshwaran: Only Section 185 doesn’t apply.
Doshi: So Section 186 continues to apply on all private companies. So the ability to extend loans within that group becomes painful or even outside the group?
Venkateshwaran: Section 186 is again a question of getting a resolution done to exceed your 60 percent or 100 percent limit. So that is not so much of an issue, but the challenge that lot of companies are facing is that even under Section 186 you still got to charge your bank rate of interest; that becomes a challenge . Especially when you are funding another entity which is not doing so well or maybe a start up etc to then be expecting them to charge interest and you are booking interest here.
Doshi: So that is Section 7 or something which says, if you are putting out on a loan under this position, it must be at a rate that is above the bank rate for that comparable tenure or something. The government rate actually, the government security.
Venkateshwaran: Section 185 talks about bank rate and Section 186 talks of the Gsec rates.
Doshi: So that is going to be the key pain point for private companies?
Venkateshwaran: That is one pain point. The related party transaction is another one which if you go by the June notification, they are giving total exemption which is good. This July one also brings in some relief- it makes two changes- one is it narrows down the definition of related party in the context of a private company by saying that other entities in the group that is your holding company, subsidiary, associate all of those entities are no more considered your related party, that’s one.
Doshi: But that only applies to a private company?
Venkateshwaran: Only to a private company and second is in terms of the members who are allowed to vote on a transaction that needs to be taken to shareholders. It is for companies in general like an interested shareholder cannot vote, but private companies even an interested shareholder can vote on it.
PRIVATE COMPANIES: RPTs
1956: Provisions milder in previous section
2013: To comply with all provisions and extensive rules
Draft: Private companies exempted
Revised: Exempted from restriction on interest party vote
Holding, subsidiary, associate not included in Related Party
Doshi: Those are the only two reliefs in the July; not very sure about this notification, and the June notification full exemption, Section 188 does not apply to private companies at all.
Venkateshwaran: Does not apply to private companies at all.
Rau: Actually the June position, as far as related party transactions is concerned, is actually the better position, if you really look at it from a governance point perspective.
Doshi: Wouldn’t you prefer a complete exemption?
Rau: Depends on which perspective you’re looking at- if you are a promoter of an Indian private company, you would clearly prefer the June draft. But if you were to say, for example, look at it from a private equity perspective -private equity is paranoid particularly in our country about this particular category more than anything else- they are really worried about related party transactions.
Look at what Sai said. There are two relaxations that have come through in the July draft, one they have said group companies- if it is in the same group no problem which is helpful and the second is they have given the related party a right to vote. They have said that the related party can still vote. So, the promoters have got less reason to complain and there is some degree of protection given to a third party investor even in a private company because it says that you have to go through that particular governance process. So I won’t rate the Related Party Transactions (RPT) provision as cumbersome or obstructive as for example the Section 185 and Section 186 probably.
Doshi: Insider trading applies to private companies and how in heavens is anybody going to sort of enforce that?
Rau: As with many other provisions of the Companies Act, this is not free from doubt but at least the view I hold is that the insider trading provision 195 does not apply to private companies. It comes out of the fact that the reference in 195 is to securities and securities is the definition under the Securities Contracts Regulation Act (SCRA). An SCRA ultimately it’s this case law to clarify that the shares of a private company is not a security for the purposes of the SCRA, because it is not marketable. So insider trading I don’t think is the problem. For private companies the much bigger problem is 194 which is the prohibition on forward dealing. We have had sessions on this very show in relation to put call options etc and Securities and Exchange Board of India (SEBI) and Reserve Bank of India (RBI) have been really good in clearing the doubts and clearing the ambiguity, but the Companies Act has done us a bad turn there because the ambiguity continues; thanks to the fact that 194 actually applies to even private companies. If the person who is party to your put or call is the promoter of the company who also happens to be a director, which is not at all unusual, then he potentially faces imprisonment.
PRIVATE COMPANIES: CALL/PUT OPTIONS
(1) No director of a company or any of its key managerial personnel shall buy in the company, or in its holding, subsidiary or associate company—
(a) a right to call for delivery or a right to make delivery at a specified price and within a specified time, of a specified number of relevant shares or a specified amount
of relevant debentures…
Doshi: If he was to enter that put and call option?
Rau: And as we were discussing earlier this was not the objective at all. The idea was to prevent people/employees of the company or managers of the company from taking positions in the stock market.
Doshi: The listed derivates markets so to speak so. So is this hurting the ability of let’s say, promoters because it is a very common instance, if I have understood it correctly, in private companies where you have private equity investments and the promoter does sign these option agreements to give the private equity investor some sort of assurance that look at some point of time if you want to exit and you can’t go public or we can’t go public etc I am willing to buyback your share. He can no longer enter that kind of an agreement?
Rau: There are interpretations around this. One of those interpretations are that if you look at the way the forward dealing prohibition is written it also speaks of a fixed price. So in any event fixed price returns are illegal for a different set of reasons particularly in cross border context. So one way that people are getting out of it or at least believe that they are getting out of it is to have a fair market value (FMV) related put out call.
Doshi: Which is exactly what anyway SEBI and RBI want in the case of listed and in public companies for that matter.
Rau: That is right.
Doshi: So you just follow that same principle for all companies, whether it is private, public, public listed and you are probably safe.
Rau: Yes, you are probably safe.
Doshi: I want to talk about wrap up comments because we are at the end of the show. What does all of this mean for private companies? Does it become almost purposeless for you to be a private company as opposed to being a public company because you stand to gain nothing? There are no exemptions; you are doing pretty much everything that a public company has to do in terms of compliance etc?
Venkateshwaran: In fact a lot of private companies that I have interacted with in the last few months, several of them have realistically started considering moving to an LLP structure simply because they don’t see an advantage being a private limited company and having to go through all of these cumbersome compliances and at the same time the increased risk and the penalties etc that they are exposed to. So realistically a lot of them are evaluating moving to a LLP structure. The only thing that they want clarity on is tax neutrality when they do that. In fact one of the recommendations that went to the finance ministry before the Budget was to actually allow tax neutral transfer from a private limited company into an LLP.
Doshi: And that has not yet come through?
Venkateshwaran: That has not yet come through.
Rau: The current position from a tax perspective any which way favors an LLP but that is not the reason why you haven’t had entire migration from private companies to LLPs. Why hasn’t it happened and it is worth thinking about that. Firstly I am a lot more optimistic about the fact that you are not going to have any mad rush simply because of the fact that, whether it is June or July notification, one will have to wait and see has eased some of the problems that came with the 2013 Act. They haven’t cured all the problems by any such imaginations but they have done a decent job. So client’s are going to be a little happier for that but please understand what the impediment is to actually move to an LLP. An LLP is untested. Ultimately an entity which does business has to interact with the whole set of laws. It can’t function in isolation and if those laws don’t recognise an LLP, for example you go for a Non-bank financial companies (NBFC) registration and the Reserve Bank of India (RBI) says what LLP or for that matter if you have for an example foreign investment and foreign investment and foreign investment is under the automatic route only for companies it is just a lot of effort that goes into getting the attendant statutes to actually change to recognise an LLP and then the cost of doing business in between. I mean we have had real estate clients actually consider it and basically saying we see it as a serious problem because there are a number of municipalities and other regulations that don’t recognise in any way.
Doshi: So you are saying you might not see the rush to LLPs happen. Then my final question is to you is not whether there will be a rush but what else is left to deal with besides what has been dealt with by the draft notification of June and the so called final notification of July. If the MCA is listening, what would you tell them to fix?
Rau: What they did was they looked at what exemptions are available under the 1956 Act which were not given in the 2013 Act and then they have come out with this exemption list under the notification trying to plug part of what was missed out but what they haven’t realised is that the 2013 Act actually has a lot of new concepts that have been either advertently or inadvertently applied to private companies. For example the definition of a listed company under the 2013 Act is any company which has got its security listed. So any private company which has issued non-convertible debentures (NCDs) is going to be treated as a listed company on par from a Companies Act point of view to a company which has got its equity shares listed on a stock exchange and all those onerous requirements would apply. CSR is a concept, the two layer limit on investment layers. The requirement for resident directors of private companies is going to be a problem for a lot of our foreign clients who actually have private company operations over here.
PRIVATE COMPANIES: PUBLIC PAIN
Private company = Listed company if NCDs are listed
CSR requirements apply to all companies above a certain size
Restriction of 2 layers of investment companies applies to all companies
All companies to have atleast one Resident director
Venkateshwaran: You also need to look at lot of the additional governance and reporting requirements that actually now become applicable to private companies as a result of these. So be it on the internal financial controls or be it on the directors’ responsibilities around compliance with all laws and regulations and demonstrating a process for all of that. One of the points which the MCA, in their drafting of this June’s notification, on the auditor’s appointment- they have tried to deal with the 20 company limit but I don’t think they have got that fix right and the reason being this notification will only be read in the context of a private company. So when the private company is looking to appoint auditors he can disregard the limit of 20 companies.
PRIVATE COMPANIES: AUDITOR
1956: Private companies exempted
2013: Audit client limit of 20 includes private companies
Draft: Audit limit shall not include private companies
Revised: Shall not include private companies with paid up share capital < Rs 100 cr
Doshi: But the auditor can’t disregard, because in the auditor’s Section it has not been relaxed.
Doshi: But that is a pain point for auditors and not for private companies.
Venkateshwaran: For a public company when they are looking to appoint auditors they only get to see that if that auditor is holding appointment of 20 companies, then he can’t appoint them and there could be 20 private companies that he is holding upon.
Rau: July 1 makes it worse as well because they have not, any which way, said it’s exempt from the 20 limit if it is a private company. It has to be a private company and it has to have a share capital of less than Rs 100 crore.
Doshi: They have put in a new size requirement then.