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Key Implications of the Companies Act 2013 on Board Room Decision Making

A simplified look at the key changes in the Act which will make corporate social responsibility binding for firms among other things

Published: Jul 10, 2014 06:02:05 AM IST
Updated: Jul 10, 2014 02:34:23 PM IST
Key Implications of the Companies Act 2013 on Board Room Decision Making
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The Indian Companies Act, 2013 (“2013 Act”) marks a paradigm shift in India’s corporate law regime, and has far reaching implications for both domestic Indian companies and overseas investors with a presence in India. This article provides a brief analysis of some of the key changes that have been brought about by the 2013 Act which became largely effective on April 1, 2014. Some provisions, however, continue to remain inoperative and are likely to be made effective by the Indian government in due course. This piece makes it easier to understand the changes in the 2013 Act that affect multinational corporations having Indian companies or those looking to make investments in India.

Constitution of the Board
The 2013 Act has made a significant change in the manner in which boards of companies must be constituted. It is mandatory that at least one director must be a resident in India for a minimum period of 182 days during the preceding calendar year. Moreover, all listed companies and certain other classes of companies as prescribed under delegated legislation would also need to have at least one woman director on their boards.

All listed Indian companies and unlisted companies satisfying certain conditions are now required to have at least one third of their board comprising of “independent directors”. In this context, the 2013 Act prescribes stringent criteria for qualification of persons as independent directors and makes it explicitly clear that a nominee director would not be considered “independent”. In the context of legal responsibility, the 2013 Act has enlarged the scope of the expression “officer in default”, which now includes directors of boards who do not object to decisions taken at board meetings. Therefore, existing and potential foreign investors would need to significantly restructure their board compositions and bring about a higher degree of care in order to comply with provisions of the 2013 Act.

Decision-Making Power of the Board
Unlike under the Indian Companies Act 1956 (“1956 Act”), where an ordinary resolution (requiring a simple majority of shareholders) was sufficient, under the 2013 Act, certain powers of the board of directors can now only be exercised subject to a favourable special resolution (requiring a three-fourth majority of shareholders) being passed. These include important subjects such as the right to sell a substantial part of the undertaking or borrow money above certain specified thresholds. Special resolutions may also include conditions and the applicability of the provision has been extended to private companies as well. Further, there have been several important additions to the list of powers which are to be exercised by board of directors only at a meeting of the board, and cannot therefore be delegated. These include things such as the approval of financial statements, diversification of business and the approval of mergers and takeovers. Additionally, although the 2013 Act recognises and permits board meetings to be conducted via video conference, certain decisions, including those relating to the approval of financial statements and mergers, cannot be made via video conference. Foreign investors ought to be wary of these changes, as they significantly curtail the decision-making power of the board and require increased shareholder support for positive company outcomes.

Related Party Transactions

The range of related party transactions under the 2013 Act has been significantly widened compared to the provisions of the 1956 Act. Under the 2013 Act, a shareholder of the company, who is a related party vis-à-vis a counter party in such a transaction, is not permitted to vote while approving the transaction. However, “arm’s length transactions” entered into by the company in its “ordinary course of business” are exempt from the related party rule. “Arm’s length transaction” is defined to mean “a transaction between two related parties that is conducted as if they were unrelated, so that there is no conflict of interest”.

The expression “ordinary course of business” has not been defined in the 2013 Act, and will have to be determined on a case-to-case basis. The 2013 Act importantly now includes an “associate company” within the ambit of the term related party. An associate company in relation to a company is a company, other than a subsidiary, in which the first mentioned company has “significant influence”, i.e., controls at least 20 percent of the share capital or business decisions under an agreement, and it specifically includes a joint venture company. Given that the 2013 Act mandates that no related party can vote on several important company resolutions, it is possible that in certain cases, the “majority” related party shareholders could be prevented from voting and minority shareholders would in effect get decision-making power. An interested director cannot be present at the company’s board meeting when a related party transaction is under discussion and vote. Further, the exemption under the 1956 Act for interested directors of private companies has been done away with, thereby extending the application of the provision to all private companies as well.

The 2013 Act also specifically prohibits forward contracts and put or call options between the directors/key managerial personnel of a company and the company or any holding, subsidiary or associate company.

Corporate Social Responsibility
The 2013 Act has ushered in certain innovative provisions relating to corporate social responsibility. A company that has a net worth of at least Rs 5 billion or a turnover of at least Rs 10 billion or a net profit of at least Rs 50 million during any financial year will be required to constitute a “Corporate Social Responsibility Committee” with three or more directors to frame and oversee the company’s general policy and specific corporate social responsibility activities.

The 2013 Act mandates that every such company must spend at least two percent of its average net profits in every financial year on corporate social responsibility activities.  However, any profits arising from overseas operations conducted through foreign branches or subsidiaries and dividend received from other companies in India will be excluded. In the event that a company does not comply with its corporate social responsibility, the board of directors of the company will be required to explain their reasons for this along with the company’s yearly financial statements.

The law does not prescribe any sanctions for non-compliance with the obligation to spend the two percent as long as the board records reasons for this. For foreign companies present in India, the corporate social responsibility obligations become directly relevant, because delegated legislation under the 2013 Act has mandated that the provisions will also apply to foreign companies having a place of business in India or having any business connection with India in any form. While it is unlikely that this would include foreign companies other than those in which more than 50 percent of the total paid up share capital is held by Indian citizens or Indian companies, in the absence of a clarification, all foreign companies with any presence in India would be required to comply.

Inter-Corporate Loans
The 2013 Act has imposed several onerous conditions for inter-corporate loans. Under the 2013 Act, a special resolution (requiring a three-fourth majority of shareholders) is required for a loan exceeding the prescribed threshold of 60 percent of the paid-up share capital, free reserves and securities premium account of the company, or 100 percent of free reserves and securities premium account of the company, whichever is higher. Further, now unanimous approval of all directors present at the board meeting is required. This will apply to private companies as well, and therefore, make it more cumbersome for a private company to give loans to its affiliate companies. The 2013 Act also prescribes some enhanced disclosure requirements for loans, investments, guarantees and securities.

Capital Raising

For new businesses in India, private companies used to be the preferred business vehicle due to a lesser compliance burden. However, several of those advantages have been obliterated by the 2013 Act. For instance, there were no restrictions on private companies issuing shares with differential rights and creating multiple classes. However, under the 2013 Act, they must now comply with certain statutory requirements. Further, in the earlier regime, as long as there was enough headroom in the authorised share capital, private companies' boards could themselves issue shares (regardless of whether it was a rights’ issue or a preferential allotment). However, now other processes have been prescribed.

Under the 1956 Act, in the case of preferential allotment, unlisted public companies needed shareholder sanction and private companies needed board sanction, and there were scant other compliances. However, under the 2013 Act, these companies must also prepare an offer letter which will require some financial and other information to be included. In the context of the rights issue process, the pricing of resultant securities would need to be determined upfront even in the case of private companies. There is ambiguity over this pricing, which appears to be in conflict with current Indian foreign exchange laws.  

Insider Trading

Foreign investors must be cautious that the 2013 Act introduces a fresh provision relating to insider trading, a concept that was previously dealt with by a separate regulation for listed Indian companies enacted by the Securities and Exchange Board of India and not under the 1956 Act. Under the 2013 Act, all persons, including any director or key managerial personnel of a company, are prohibited from indulging in insider trading. “Insider trading” has been broadly defined to include the acts of subscribing, buying, selling or dealing in securities, or procuring or communicating non-public price sensitive information. Punishment for contravention includes imprisonment for up to five years, with or without a fine.

The provision also proscribes communication of unpublished price sensitive information. However, the enactment provides a carve-out for communication required in the ordinary course of business or profession or employment or under any law. Despite the prior existence of a specific regulation on insider trading, the new provision has been inserted in the 2013 Act for completeness. However, this has led to some confusion as expressions used in the provision such as “insider trading” are defined differently from those seen in the specific regulation. Moreover, unlike the specific regulation for listed Indian companies, under the 2013 Act, the provision extends to public unlisted companies as well.

Buy-Back of Shares
Under the 1956 Act, companies could do multiple buy-backs of shares in the same financial year except in certain specific facts where there was a cooling off period of one year. However, now the 2013 Act requires a mandatory one-year time period between any type of buy-back, even if the buy-back was achieved through a scheme approved by an Indian court. The 2013 Act also stipulates that a buy-back is not possible if the company has made any default in the repayment of deposits or interest, or redemption of debentures, or preference shares, or payment of dividend, or in the repayment of a term loan to a bank or financial institution. However, the buy-back may be possible if the defect is remedied, and a three-year time period has elapsed.  

The earlier common practice of a back-to-back shareholder-approved buy-back following a board mandated buy-back is no longer possible under the 2013 Act, and this is likely to significantly delay and adversely impact investor exit options. It is noteworthy that with the introduction of a non-creditable tax on buy-back distributions under tax law, this route had already become less attractive.

Minority Squeeze-Out

The 2013 Act now explicitly deals with the issue of buying out the minority shareholders of a company. In a situation where an acquisition results in the acquirer holding 90 percent of the issued share capital of the company, it shall be obliged to inform the company of its desire to purchase the minority shareholding of that company at a price determined according to the provisions of the 2013 Act. This is a key change and significant departure from the 1956 Act, which did not have such a provision. From a minority protection perspective, it is welcome that the minority buy out is not limited to the dissenting shareholders, but available to the minority as a whole. This means that a minority might be able to share the upside of a deal and the entire process of squeeze out could take place without intervention by the court. Further, the 2013 Act also makes the formula to determine the exit price clear and removes the ambiguity that existed under the 1956 Act. 

Layered Investments Through Subsidiaries

The 2013 Act makes a significant departure from the 1956 Act by specifically mandating that investments can no longer be made through more than two layers of investment companies, except in certain specified circumstances. Although this appears to have been enacted with a view to prevent convoluted structures and diversion of financial assets, this provision is likely to affect complex cross border merger and acquisition activity. Two specific exemptions have been provided in the 2013 Act, i.e.,

(i) an offshore acquisition is possible if the offshore target has investment subsidiaries of more than two levels as per the local laws of such foreign country; and

(ii) an investment subsidiary may exist in order to comply with regulatory  requirements or other laws in force at the time.

An “investment company” has been defined as a company whose principal business is the acquisition of shares, debentures or other securities, and it remains unclear whether or not the two layer restriction is meant to apply only to investment “subsidiaries”. The two layer restriction takes away some structuring flexibility and genuine special purpose vehicles for a large corporation’s varying business interests may become a thing of the past. Compliance costs of ensuring the existence of operating companies between investment companies is also expected to be weighty.   

The 2013 Act significantly alters the manner in which mergers may be effected, with an objective of making them less time-consuming and providing more flexibility. In this context, the 2013 Act has introduced two concepts novel to Indian law, i.e., “fast track mergers” and “cross border mergers”. A fast track procedure for mergers involving certain types of companies is now possible. For instance, this would apply in a merger between a holding company and its wholly-owned subsidiary, subject to certain conditions such as approval of 90 percent of the shareholders of the company and no objections being raised by the Registrar of Companies and other authorities.

The 1956 Act permitted the mergers of foreign companies into Indian companies, but did not allow the converse. The 2013 Act now permits “cross border mergers”, i.e., both mergers of foreign companies into Indian companies and mergers of Indian companies into foreign companies; however, the practical utility will depend on yet-to-be-enacted Reserve Bank of India (“RBI”) regulations on this topic and necessary changes to India’s foreign direct investment policy. Currently, such a merger would require prior RBI approval. In the case of a company listed on an Indian stock exchange that seeks to merge with an unlisted Indian company, the transferee company can elect to remain unlisted, providing the shareholders of the listed company a consequent right to receive the value of their shares and then elect to stay out of the transferee company.

Class Action Suits
Though arguments have been made in the past that class action suits have always been permissible under India’s Code of Civil Procedure, 1908, the 2013 Act now specifically provides for class action suits brought by: (i) members; or (ii) depositors of a company, where they are of the opinion that the management or conduct of the affairs of the company is being conducted in a manner prejudicial to the interests of the company or its members or depositors. The Indian understanding still appears to be narrower than a US view on class action where groups of similarly aggrieved persons institute suits with a primary objective of recovering damages from a defendant. However, foreign investors will still be required to play a more active day-to-day role in their Indian investments to ensure Indian companies do not violate corporate governance norms and respect member and depositor interests alike.

Enforcement of Shareholders Agreement and Entrenchment
Under the 1956 Act, the articles of association of a company could only be altered by a resolution passed by three-fourth of its shareholders. In practice, however, in order to attract foreign investors, existing Indian shareholders would still grant investors higher rights in the form of veto rights for amending important provisions in a company’s articles. The 2013 Act has now specifically validated the idea of entrenchment, and therefore, all such contractual agreements by shareholders now have legislative recognition. This will provide much-needed flexibility for investors to specify that certain provisions of the articles of a company may only be altered if special conditions or procedures are complied with.

Similarly, while under the 1956 Act share transfer restrictions in investor agreements between shareholders of a public company were not expressly permitted, the 2013 Act has now legitimatised arrangements in respect of the transfer of securities, which shall be enforceable as a contract. The change finally settles the position on enforceability of agreements with investors providing for pre-emptive rights inter-se shareholders of a public company such as the lock-in period, right of first refusal and tag-along and drag-along rights. This importantly takes these issues out of potential litigation in Indian courts.

(Rishi Shroff is an Associate at law firm Khaitan & Co.)


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  • S.m.sheth

    Pre-emptive Rights /ROFRs..etc all are tools that are designed to favor only the promoters. In other way they create a pre-arrangement to suit their future requirements. This in fact goes against the interest of non-promoter shareholders. By ROFR applicability, promoters\' stake can be exchanged at a future date as per the terms between agreement. The transfer term & price may have significant mismatch but the legality of ROFR has made the way very clear for promoters. An interesting case was recently judged at Bombay High Court. WMDC & BAJAJ group both have 27 & 24 % stakes respectively in a jt. venture called msl-MAHARASHTRA SCOOTERS LTD.An agreement for each other\'s stake was made as ROFR. But the pecularity of the matter revolves around a weird term. The term was: Whenever any stakeholder made offer to sell the stake and the other party accepted the same, it would be treated as a SALE even if the price factor remained disputed. It raises a serious question about the wisdom of the legal experts who allows such terms to be a part of any agreement. A common sense would mean that to fulfill a SALE all the terms need to completed and the PRICE remained the most important factor of it. Even the sitting Hon\'ble Judge did not pay serious attention to this imp. point and for this reason only the desicion went against the majority of [76%] shareholders of MSL. This clearly gives an impression that it is not necessary that all those sitting at the helm have an important organ called BRAIN in the uppermost part of their body !!!!!!!!!!

    on Jul 9, 2015
  • Tushar

    It is given very nicely, but about the "forward dealing" please post.

    on Mar 4, 2015
  • Law Person

    Hello Amruta, If I may answer your query, I think the answer to your question lies in Sec. 188(3). Since a special resolution will not be possible in the case where all the directors (I presume that you meant that they were members as well) are related parties under the second proviso to Sec. 188(1), this will attract Sec. 188(3). Hence, the contract will be voidable and the directors will have to indemnify the company for the loss, if any. I would hardly imagine that these director-members will exercise the option of voidability. If there is loss, they will have to indemnify the company. Hence, the requirement of indemnification will ensure self-regulation by the director-members. Kindly let me know if you need further clarifications.

    on Jan 9, 2015
  • Charlette Machado

    Of all the Companies Act 2013 implications, I think the most needed mandate for listed company and public company is induction of atleast 1 women director on their board. But at the same time it is very important to ensue that these women are prepared to handle this responsibility. I have come across a workshop that helps women prepare themselves to become a board member. You should have a look at it, sounds informative & interesting ey.com/WomenOnBoard

    on Aug 12, 2014
  • Amruta

    Dear sir With regard to section 188 of co. act 2013, can you explain how would we form a quorum in case of family managed private company having all the directors or two out of three directors related?

    on Jul 31, 2014
    • Law Person

      Hello Amruta, If I may answer your query, I think the answer to your question lies in Sec. 188(3). Since a special resolution will not be possible in the case where all the directors (I presume that you meant that they were members as well) are related parties under the second proviso to Sec. 188(1), this will attract Sec. 188(3). Hence, the contract will be voidable and the directors will have to indemnify the company for the loss, if any. I would hardly imagine that these director-members will exercise the option of voidability. If there is loss, they will have to indemnify the company. Hence, the requirement of indemnification will ensure self-regulation by the director-members. Kindly let me know if you need further clarifications.

      on Jan 15, 2015