The Viewpoint: Notified Sections of the Companies Act, 2013 – Analysis of Issues for M&A Transactions Introduction: After numerous drafts, delays and parliamentary debates, a new company law – the Companies Act, 2013 (‘2013 Act’) was finally enacted on 29 August 2013. The 2013 Act has been lauded by the corporates and lawyers alike for providing business friendly corporate regulations, enhanced disclosure norms, investor protection and better corporate governance amongst other things. While the 2013 Act is being appreciated by many; it also poses some practical difficulties for companies while structuring their transactions. Since only 98 sections of the 2013 Act have been notified, this Article seeks to focus on the impact of the notified sections – and in particular the issues that could be faced in the context of M&A transactions. It is pertinent to note that since the entire Act has not been notified; similar provisions of the Companies Act, 1956 (‘1956 Act’) continue to be applicable and it causes confusion regarding applicability due to parallel existence of two sets of provisions dealing with certain matters. The Ministry of Corporate Affairs is trying to clarify the matter on a case of case basis[1] but the process is not complete. We set out few significant issues that we see companies facing while undertaking and structuring M&A transactions. Loans to directors The loudest concerns heard have been about section 185 of the 2013 Act. Section 185 of the 2013 Act replaces Section 295 of the 1956 Act, governing loans/guarantees to directors by a company. It provides that a company cannot directly or indirectly advance any loan, including represented by book debt, to any directors or to any other person in whom the director is interested or give any guarantee or provide any security in connection with any loan taken by the director or such other person. The exemption provided to holding subsidiary relationship and private companies under the 1956 Act has been done away with. Explanation (e) to Section 185 of the 2013 Act inter alia defines the term ‘other person in whom the director is interested’ to include a 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 any director or directors of the lending company. This brings into the question the validity of loans and guarantees between holding and subsidiary companies irrespective of the fact that there are common directors present in the companies, since subsidiary companies may be interpreted to be accustomed to act in accordance with the directions or instructions of the board of the holding company. It is worthwhile to note that the term ‘is accustomed to act in accordance with the directions or instructions of the Board’ is also used in sections 2(30) and 295 of the 1956 Act. As per judicial precedence[2] under the 1956 Act, the term ‘is accustomed to act in accordance with the directions or instructions of the Board’ is not that same as ‘control’. To establish control, it must be shown that directors of the borrowing company did not exercise any discretion or judgment of their own, but acted in accordance with the directions of board of directors of the lending company. Additionally, the proviso (b) to Section 185(1) states that the subsection will not apply to a company which in the ordinary course of its business provides loans or gives guarantees or securities for the due repayment of any loan and in respect of such loans an interest is charged at a rate not less than the bank rate declared by the RBI. These two issues raise significant challenges to the corporate transactions currently practiced in India. Many transactions especially project and asset financing are structured in a way that the obligations of subsidiaries are secured by way of the parent guaranteeing its obligations. Without the possibility of such comfort, it may become difficult for companies to avail financing from lending institutions. The lack of a definition for the term ‘ordinary course of business’ in the 2013 Act also creates uncertainty over the scope of the interpretation allowed for the term. One can argue that holding companies are expected in their ordinary course of business to provide assistance to their subsidiaries in the form of loans or guarantees for loans obtained from financial institutions. Also, in order satisfy the above provision, it could be suggested to ensure that the memorandum of association of a company permits to provide loans/guarantees to subsidiaries as part of the main objects of the company. However, there is no certainty if this would be enough to establish ‘ordinary course of business’ and how the regulators and courts would interpret these clauses. What was initially thought to be a respite provided to the wholly owned subsidiaries and private companies by the Ministry of Corporate Affairs (‘MCA’) by its circular dated November 19, 2013, actually turned out to be a futile wish. The clarificatory circular states that section 372A of the 1956 Act is applicable till section 186 of the 2013 Act (the corresponding section to section 372A) is notified. At first blush, it may seem that wholly owned subsidiaries and private companies are not affected by the new provision, but such transactions if hit by section 185 of the 2013 Act may not be possible under the new regime. Prohibition on forward dealings in securities by any director or key managerial personnel: Section 194 of the Companies Act puts a ban on directors and key personnel of the company from dealing in securities of the company on a forward basis. In light of the recent SEBI notification which liberalises forward transactions by allowing put and call options, the intention for introducing this restrictive provision in the 2013 Act is not clear. If the rationale for introducing this section was to prevent such persons from benefiting from insider information, then the same is sufficiently captured in section 195 itself. As the section is worded right now, it creates ambiguity and conflict between the 2013 Act and the SEBI notification allowing put and call options. Even more surprising is the applicability of this section to private companies and unlisted public companies. The respite, however, is that the section appears to apply only if the option transaction is for a specified price, within a specified time and for a specified number of relevant shares or specified amount of relevant debentures. Applicability of provisions to private companies: Under the 1956 Act, private companies had been given a lot of independence to manage their corporate obligations. However, under the 2013 Companies Act, private companies are also now subject to many requirements such as restrictions on borrowing powers, prohibition on insider trading and loans to directors. Additionally, a company with any listed security will now be treated as a listed entity. This essentially means that a company which may have listed its non convertible debentures will suddenly be now burdened with series of obligations and requirements applicable to listed companies. Insider Trading The 2013 Act takes a great leap towards corporate disclosures and investor protection by introducing section 195 which deals with prohibition of insider trading. The section essentially captures the essence of Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 1992 but extends its applicability to unlisted companies. As per the section, no director or key managerial personnel of a company should engage in insider trading which would include subscribing or selling the securities or providing any price sensitive information to any person. For the purposes of insider trading under the 2013 Act, ‘securities’ has the same meaning given to it as in the Securities Contract Regulation Act, 1956 which applies only to marketable securities. It is settled position in law that securities of a private company are not marketable. In light of the definition, it is arguable that the section should not apply to private limited companies – albeit the restriction is with respect to trading in securities of a ‘company’. A clarification by the MCA on this issue would at least remove the ambiguity around the applicability of this provision with respect to private limited companies. Transfer of an undertaking: The lack of definition of the term “undertaking” under section 293 of the 1956 Act has led to ambiguity in transactions, and reliance on judgments to define what can be constituted as an undertaking. With the notification of section 180 of the 2013 Act, it was expected that the clarity with respect to what an undertaking of a company constitute of, would be provided. However, in attempting to define an “undertaking”, the 2013 Act has only managed to restrict the scope of the same by introducing an additional restriction of a minimum threshold, which ought not be read independently of the primary requirement – i.e. that the transfer in question is indeed the transfer of an ‘undertaking’, and not merely certain specified assets which do not constitute an undertaking. Under the new legal regime, companies will still have to rely on interpretations of the term ‘undertaking’ – for example, judicial precedents such as case of International Cotton Corporation v. Bank of Maharashtra[3] which defined an undertaking to mean ‘any business or any work or project which one engages in or attempts as an enterprise analogous to business or trade’ and Yellamma Cotton and Silk Mills Co. Ltd[4] where it was held that an undertaking was not in its real meaning, anything which may be described as tangible piece of property like land, machinery and equipment, and that it was an activity which in commercial or in business parlance meant an activity engaged in the view to earn profit. The section broadly states that an ‘undertaking’ will mean an ‘undertaking’ in which the investment of the company exceeds twenty per cent of its net worth or which generates twenty per cent of the total income of the company, and provides that a special resolution would be required for the transfer of an undertaking or ‘substantially the whole of the undertaking’. In this context, it is indeed unfortunate that the term ‘substantially the whole of the undertaking’ has been defined purely as twenty percent or more of the ‘value’ of the undertaking. On a technical and literal reading, this would mean that if assets worth more than twenty percent of the value of an undertaking are being transferred, the company would be regarded as having transferred ‘substantially the whole of the undertaking’, thereby mandating the requirement of a special resolution of its shareholders. Section 4 (7) of the 1956 Act: The partial notification of the 2013 Act has also led to ambiguity regarding the validity of Section 4(7) of the 1956 Act. Section 4 (7) of the 1956 Act sets out that a private company which is a subsidiary of any foreign company, which if incorporated in India would have been a public company under the 1956 Act, would be considered as private company that is a subsidiary of a public company and subject to the same regulatory compliance standard. Section 2 of the 2013 Act, through various subsections, primarily subsections (27), (46) and (87), attempts to incorporate section 4 of the 1956 Act. They however, do not completely capture what was provided for in corresponding section of the 1956 Act, which not only defined holding and subsidiary companies, but also clearly defines the status of subsidiaries of foreign companies in India. The same was captured in Section 4(6) and Section 4(7) of the 1956 Act. As per the MCA general circular No. 16/2013 the entire Section 4 stands repealed. This is a matter which needs clarification as it can hamper structuring of various foreign investments in India. Compliance of various regulations by the subsidiaries will be left unanswered until a clarification with respect to Section 4(7) is brought out. Conclusion: Whilst the 2013 Act is certainly a step in the right direction for corporate India, it may be worthwhile for the regulators to pay heed to concerns being voiced by the lawyers and corporates alike and incorporate them while notifying the rules and issuing clarifications. The 2013 Act leaves a lot to interpretation but there is a hope that the notification of rules and clarifications by the MCA may address and solve some of these challenges.
Posted on: Fri, 31 Jan 2014 17:59:41 +0000
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