MEMORANDUM I. Background & Purpose: • National Spot Exchange Limited (“NSEL”) is 99.99% owned by Financial Technologies (India) Limited (“FTIL”). • We understand that several independent reports have confirmed that the affairs of NSEL were conducted in a manner that was misleading and defrauded the interests of third parties dealing with NSEL with the active management and support of Mr Jignesh Shah who, in turn, was the Managing Director of FTIL and was also a Director /KMP in NSEL. • The purpose of this note is to outline the legal basis and precedents warranting the intervention of the Government of India into the affairs of NSEL and ordering the amalgamation of NSEL into FTIL in accordance with Section 396 of the Companies Act 1956 (“the Amalgamation”). • The unquestionable necessity for ordering the Amalgamation is evident from the following key arguments: Firstly, FTIL was the controlling shareholder and the directing mind of NSEL. The affairs of NSEL were conducted in a manner which is manifestly fraudulent. Therefore, if the unpaid creditors of NSEL purport to make claims against FTIL (or seek the winding up of FTIL), it cannot now stand behind the principle of “limited liability” and escape responsibility for the actions of NSEL. It is a well-established legal principle that if fraud has been perpetrated by a subsidiary company (i.e. NSEL), then its holding company (i.e. FTIL) should be held liable – particularly, in this case, as NSEL is a wholly owned subsidiary of FTIL and functioned as the alter ego of FTIL. Secondly, the power to order an amalgamation under Section 396 must be exercised where it is “essential in public interest”. If the Government fails to order the Amalgamation, apart from the fact that FTIL and its management would be rewarded for the fraudulent conduct of their wholly owned subsidiary, the reputation of Indian markets & regulators to see through corporate charades would be severely dented. This could result in contagion into other securities markets and lead to a crisis (akin to 2008) in India. Lastly, as the Satyam Case, and certain global precedents demonstrate (e.g. American International Group Inc in USA and Northern Rock in UK), Governments routinely taken over failing assets where interests of depositors or other counterparties are to be protected. In this case, rather than making taxpayers responsible for the actions of NSEL, it would be appropriate for the Government to order the Amalgamation and let the obligations come home to roost at the FTIL level, since NSEL is effectively a wholly owned subsidiary of FTIL. II. Legal Analysis: Lifting the Corporate Veil 2.1. The principle that a company has a separate legal existence and the law recognising it as a legal person, separate and distinct from its members / shareholders, was recognised by the law in Saloman v. Saloman & Co Ltd. When a company is incorporated it is treated as a separate legal entity distinct from its promoters, directors, members, and employees, and hence, the concept of the corporate veil, separating those parties from the corporate body, has arisen. 2.2. However, in India, under certain exceptional circumstances and where it is in the interest of the members or in public interest, Indian law allows lifting of the corporate veil in order to identify and punish the persons who misuse the medium of separate legal identity. 2.3. The circumstances under which Indian courts may lift the corporate veil can be broadly categorised under the following heads: 2.3.1. Under statutory provisions: The corporate veil may, for example, be pierced under some special circumstances as expressly provided under a statute. These include: i. reduction of number of shareholders beyond the minimum statutory threshold; ii. misrepresentation in prospectus; iii. fraudulent conduct – carrying on the business of the company with the intent to defraud creditors; iv. Consolidated Accounting mandate; and v. liability for acts which are ultra vires the company; 2.3.2. Under judicial interpretations: Apart from the special circumstances as specifically provided under statutes, the Indian courts have, from time to time and on the facts of each case, set out precedents where the corporate veil may be pierced. These include: i. prevention of fraud or improper conduct; ii. protection of revenue; iii. determination of enemy character of a company (during war); iv. in cases of economic offences; v. cases where company is used for illegal or improper purposes. 2.3.3. In the matter of issuance of optionally fully convertible debentures by Sahara India real Estate Corporation Limited and Sahara Housing Investment Corporation Limited, the Securities Exchange Board of India (India’s Capital markets watchdog) held that, in the interest of the investors, there is a clear imperative to lift the corporate veil and identify the individuals, behind this solicitation of funds. This decision of Securities Exchange Board of India in lifting the corporate veil was further confirmed by the Hon’ble Supreme Court of India (India’s apex court) in Sahara India Real Estate Corporation Limited & Ors v. The Securities Exchange Board of India. 2.3.4. LIC v. Escorts Ltd. had emphasised that the corporate veil should be lifted where the associated companies are inextricably connected as to be, in reality, part of one concern. Even though holding company and subsidiary company are two separate and juristic persons, lifting the veil, holding company can be held responsible on behalf of subsidiary only in four situations: i. Where the statute itself contemplates lifting of veil; ii. Where fraud or improper conduct is to be prevented; iii. Where taxing statute or benefitting tax is sought to be evaded; and iv. Where group companies are inextricably connected as to be part of one concern. 2.3.5. In State of Uttar Pradesh v. Renusagar Power Co., the Supreme Court lifted the veil to hold that Hindalco, the holding company, and Renusagar Power Co., its subsidiary should be treated as one concern and the power plant of Renusagar must be treated as the own source of generation of Hindalco and Hindalco would be liable to payment of electricity duty on that basis. 2.3.6. In Vodafone International Holdings BV v. Union of India, it was held that in a Holding-Subsidiary relation the test will be whether the persons conducting the business were “guided by the same head and brain” and whether the parent decided what the subsidiary should do. In order to find out whether a given transaction evidences a preordained transaction in the sense indicated above to evade taxes or investment to participate, one has to take into account the factors enumerated hereinabove, namely, duration of time during which the holding structure existed, the period of business operations in India, generation of taxable revenue in India during the period of business operations in India, the timing of the exit, the continuity of business on such exit, etc. Courts, however, will not allow the separate corporate entities to be used as a means to carry out fraud or to evade tax. 2.3.7. In DHN Food Distribution ltd. v. Tower Hamlets LBC the holding company was held entitled to compensation for disturbance of business, even though the land that had been compulsorily acquired belonged to the subsidiary company. In another case of Revlon Inc. v. Cripps & lee Ltd., a trademark owned by a Swiss subsidiary of an international group was regarded as an asset of the group as a whole. The two cases reinforces the concept where a subsidiary company will be treated as an alter ego / shadow of the parent entity. 2.3.8. Further, where a company is subsequently used to perpetrate fraud or to conceal illegal activities the courts will disregard the personality of the company in order to render its controller liable under the criminal law and subject to fines, confiscation orders and the like. For instance in the case of R v. Omar (Basam) where the company was used by the defendant to perpetrate fraud and any benefit ostensibly accruing to such company were treated by the court as a benefit accruing to the defendant, notwithstanding that 50% shares of the company were owned by his wife. Also, in R v. K assets of a number of companies were properly treated as assets of the defendants where those companies had been used as a device to conceal illegal activities. 2.4. In view of the aforementioned rulings, it is eminently clear that the Indian Courts and regulatory bodies (like SEBI for example) are actively piercing the corporate veil to ascertain the actual offenders and the nature of transactions behind the veil of the company. 2.5. In the present case, it is clear that the corporate veil established by FTIL (between NSEL and itself as its sole beneficial shareholder), was abused for an unjust and inequitable purpose. Since NSEL and FTIL has significant common directors and the management of NSEL reported to directors of FTIL, in essence, NSEL operated as the alter ego of FTIL. Accordingly, if any claims are made against FTIL, the central government and the courts must not hesitate to lift the veil and order that FTIL, the holding company and the directing mind of NSEL, is liable to each of the secured and unsecured creditors and other claimants of NSEL on a Rupee for Rupee basis and require such amounts to be provisioned by FTIL in its books of account or paid to the relevant claimants. Amalgamation is essential in public interest 2.6. In accordance with sub-section (1) of section 396 of the Companies Act, the Central Government may, upon being satisfied that it is “essential in public interest” that two or more companies should amalgamate, issue an order notified in the Official Gazette providing for the amalgamation of those companies into a single company, with such constitution, property, powers, rights, interest, authorities and privileges; and with such liabilities, duties, and obligations; as may be specified in such order. Sub-section (1) of section 396 as above enjoys overriding effect over anything contained in Sections 394 and 395 of the Companies Act. 2.7. We understand that the management of FTIL is opposed to the Amalgamation and to change the management of NSEL. It is the case of FTIL that the Amalgamation will irreparably prejudice and harm FTIL. 2.8. It is submitted that FTIL’s arguments are baseless and hold no water for the following reasons: (i) FTIL already holds 99.99% of the shareholding of NSEL; (ii) several of the directors and KMPs of NEIL were employees or directors of FTIL and, as such, responsible for implementation of the overall strategy and plans laid out by FTIL’s management and board; and (iii) FTIL would, in any event, be required to consolidate NSEL (in accordance with Indian law) in its books of accounts. Since, NSEL is a wholly-owned subsidiary of FTIL (for all practical purposes) and not a company with distinct shareholding, the sole purpose of FTIL resisting the Amalgamation is to deprive bone fide creditors and other claimants the right to recover the amounts due and payable to them. Given the manifest fraud, such technical arguments by FTIL should be struck down by the Court and the Government. 2.9. The purpose of the Amalgamation is to salvage NSEL and to allow it to emerge from the difficulties that it is facing. The Amalgamation will enable both NSEL and FTIL to pool together their respective human, material and financial resources; in particular since the transferor-company is a wholly-owned subsidiary of the transferee-company. 2.10. With reference to Section 396, the question arises, what is meant by “public interest”? The Supreme Court of India has observed that the expression public interest cannot be put in a straitjacket. Public interest takes into its fold several factors. There cannot be any hard-and-fast rule to determine what public interest is. The circumstances in each case would determine whether government action was taken in public interest or was taken to uphold probity in governance. 2.11. In Re: Wood Polymer Limited; In Re: Bengal Hotels Pvt. Ltd.[1] the court held that the expression “public interest” must take its colour and content from the context in which it is used. The context in which the expression public interest is used should permit the court to find out why the transferor-company came into existence, for what purpose it was set up, who were its promoters, who were controlling it, what object was sought to be achieved through creation of the transferor-company and why it is now being dissolved by merging it with another company. All these aspects will have to be examined in the context of the satisfaction of the court whether its affairs have not been carried on in a manner prejudicial to public interest. 2.12. In Bareja Automobiles Pvt. Ltd. v. State of Haryana fraud was considered as a ground to violate public interest, but under the particular facts of the case the court held that as there is no fraud and therefore there is no loss to public interest. 2.13. In the present case, NSEL was established as a wholly owned subsidiary of FTIL. The affairs of NSEL were conducted on a fraudulent basis. The directing mind of NSEL is FTIL and its KMPs. By allowing the Amalgamation, the Government would create a single entity which would have the financial resources to mitigate or compensate for the prejudice that has been suffered by public on account of the activities of NSEL. The equity interests of the shareholders of FTIL would not change since no shares would be issued to any third parties. Therefore, this would be an appropriate case for the Government to order the Amalgamation under section 396. Conversely, it is completely erroneous and misleading to claim that the Amalgamation in the present case is not “essential in the public interest” as envisaged under Section 396 of the Companies Act, 1956. 2.14. It is a settled position under common law that any fraud or crime is against ‘public interest’. Therefore, by ordering the Amalgamation and thereby mitigating / curing the ‘fraud’ would per se be in the public interest. 2.15. Should the contrary view prevail, FTIL would, in effect, be permitted to escape liability for fraud perpetrated by its wholly owned subsidiary, NSEL, by relying on a technical argument of a distinct corporate veil or the investigations prevailing against it and thereby benefit by its own unethical behaviour. Such inaction on the part of the Government will also have a negative effect on Indian bourses and lead to a loss in confidence of the market as a whole. As positions would be unwound, there is a contagion risk for other markets such as the FX market or the equity market as witnessed during the 2008 US Economic crash. Satyam and Other Precedents 2.16. During the 2008 Economic Crisis, the U.S. government seized control of American International Group Inc (“AIG”) to effectively acquire a 79.9% equity stake in AIG in the form of warrants. In 2008/09 the U.S. stepped in to buy preferred equity stakes in Goldman Sachs Group Inc., Morgan Stanley, J.P. Morgan Chase & Co., Bank of America Corp including the soon to be acquired Merrill Lynch -- Citigroup Inc., Wells Fargo & Co., Bank of New York Mellon and State Street Corp. Each of th 2.17. ese investments was to restore confidence in public markets. 2.18. Closer home, once the Satyam Scandal broke out, the Government immediately reconstituted the board of Satyam under Section 408 of the Companies Act, 1956. Since in the instant case the crisis is at the NSEL level, simply ordering the Amalgamation shall help resolve several matters, and no change in shareholding at the FTIL level would be involved.
Posted on: Mon, 27 Oct 2014 04:00:13 +0000
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