The Corporate & Commercial Law Society Blog, HNLU

Author: HNLU CCLS

  • Mandatory Dematerialisation of Securities: Unveiling the new MCA Amendment

    Mandatory Dematerialisation of Securities: Unveiling the new MCA Amendment

    BY TARUN THAKUR, A SECOND-YEAR STUDENT AT NLUO, CUTTACK

    Introduction

    In an interesting move recently, the Ministry of Corporate Affairs (MCA) vide notification on 27 October 2023 introduced the Companies (Prospectus and Allotment of Securities) Second Amendment Rules, 2023. Now, this amendment has inserted Rule 9B which stipulates that securities issued by private companies must be in a dematerialised form, and further mandates that both issue and facilitation of its existing securities should necessarily be in dematerialised form. This is a major leap as now securities can now only be in dematerialised form. After this amendment, with effect from 30 September 2024, a private company has to comply with the new rules.

    This amendment does not come as a huge surprise to the private companies as there were already discussions in the market from a long time that soon it will become mandatory that securities must be held in dematerialised form. Securities and Exchange Board of India (SEBI) in its report titled – Report of the Group on Reduction of Demat Charges that was released in early 2004 highlighted the risks involved when dealing with physical shares and SEBI also stated that it is playing an important role in in nurturing the growth of dematerialisation of securities in the country. So, from the report it is very coherent that even SEBI was in favour of dematerialisation at that time and was also working to achieve it. Moreover, the CLC working committee report was released last year in March 2022 which also hinted towards the new amendment that has been done to the Companies (Prospectus and Allotment of Securities) Rules, 2014 (PAS rules), as it noted the advantages of dematerialisation and also proposed that the Companies Act, 2013 (CA) should be amended and issue, transfer and facilitation of securities should be done only in dematerialised form.

    Tracing the origins of dematerialization

    Now before moving forward with the intricacies and challenges that this amendment poses it is crucial to know about dematerialisation and its inception. The term “dematerialisation” simply means converting physical shares and securities into electronic form and it was first introduced in the Depository Act, 1996 (DA 1996), as section 9(1) of the Act states that all securities pertaining to a depository shall be dematerialised.

    This was the inception point when securities facilitation and storage started in dematerialised form.  It is also noteworthy that Section- 29 of the CA broadened the scope of dematerilization as it mandates that the issuance of securities should only be in dematerialized form, thus complimenting the DA.  

     Understanding the rationale behind mandatory dematerilisation

    The main contention revolves around the rationale behind making dematerilisation mandatory for the private companies  Earlier in 2018, MCA amended the PAS Rules (2018 Amendment) which inserted Rule 9A and made it mandatory for the public companies to issue and facilitate existing securities in dematerialised form. The same Rules have been applied to the private companies via the new amendment with minor differences.

    Dematerialization combats back-dated transactions and improves transparency of the system. Backdating is the practice of changing a document’s date to an earlier one but when the documents pertaining to shares will be in an electronic form than backdating cannot be done, hence transparency will get bolstered.  Furthermore, dematerialization assists in real-time monitoring of any non-compliance of rules that has been done by any company due to its electronic nature and strict regulatory oversight.

    Challenges Ahead: Examining the Transition to Dematerialisation

    The current amendment exempts only small and government companies from mandatory dematerilisation in contrast to its previous 2018 Amendment, which in addition to small and government companies, also exempted Nidhi companies and wholly owned subsidiaries from mandatory dematerilisation. The reason cited for this was that these type of companies have limited number of shareholders. This gives rise to a pertinent question – why is there a diversion from the previous 2018 amendment, and what is the rationale behind not exempting Nidhi companies and wholly owned subsidiaries in the current amendment?

    One justification for non-exemption might be to fill in the gaps that existed in the 2018 amendment. An additional and more convincing rationale could be that the government is rapidly approaching dematerialization and any exemption granted to any company will eventually run its course. As a result, soon there will be no company that will be exempted from dematerialization. To maintain a cohesive framework, MCA must address the concerns of the stakeholders.

    Further, while extension of the dematerialized realm to private companies seems like a bold move, the compliance timeline given to the private companies is only 18 months i.e. till 30 September 2024, after which issuance and transfer of securities can only happen in demat form.  In India, there are 24,61,937 private companies that are currently registered. . All of these companies will be filing applications in the NSDL and CSDL for the conversion of securities. Consequently, the main concern is whether both these systems have the requisite digital infrastructure and technology to not only facilitate this conversion of securities, but also facilitate them in a fast and smoother way as massive amount of applications may pose operational challenges to both of them.

    Another  obstacle is that a private subsidiary company cannot qualify as a small company.  In case of subsidiaries of private foreign companies, they will also need to adhere to the new rules that have been notified. This will be cumbersome for both, the government and private foreign companies, as they will need to open a demat account with SEBI which requires them to complete a comprehensive Know Your Customer (KYC) process and also obtain a permanent account number (PAN).  This will be taxing for the government as there will be an influx of foreign entities trying to obtain PAN. Moreover, the private foreign companies will also face a challenge as even after obtaining PAN after a comprehensive process, they will have to incur a recurring cost to maintain their demat account.

    Course of Action for Private companies

    In order to comply with the new regulations, private enterprises will need to take a few steps as a result of this amendment. Initially, in order to facilitate the dematerialisation of securities, a private company must get the International Securities Identification Number (ISIN) for each security. Subsequently, the company must notify its shareholders of this information. A private company’s securities should only be issued and transferred in dematerialised form once its share capital has been dematerialised. Additionally, the dematerialisation of the securities held by the company’s directors and promoters should be required. The amendment does not provide for any penal sanctions for non-compliance but on non-compliance a private company will not be able to facilitate transfer of securities and if a there is any grievance a security holder has then it will be resolved by the Investor Education and Protection Fund Authority (IEPFA).

    Concluding thoughts

    This amendment though has some issues but this is a major transformation from the conventional system where the transfer and issuance of securities was done in physical form. Dematerialization shall help in  bringing more efficiency and transparency into the system. Further, from the regulators point of view, this will help them in tackling and mitigating benami transactions and theft by incorporating this new technology driven digital system. It is still debatable whether there is adequate infrastructure to sustain this paradigm shift. The government has to ensure that intact systems are placed so as to regulate and facilitate changes that this new amendment will bring.

    Electronic form of securities also helps in tracking real time market movements and see if there is any suspicious activity which cannot be done in the case of physical securities. While a company has to bear printing expense in case of physical securities, a much lower cost is involved in managing electronic securities. Also, the stringent KYC norms posed by this amendment give an overriding benefit to the government as it will help them to maintain a comprehensive database which would further help in bringing more transparency in the system and make it more robust.

    In the end, it can be stated that this is a major progressive reform but there are some concerns that needs to be addressed by the MCA.

  • Regulating Through Litigating: Quandary of SEBI

    Regulating Through Litigating: Quandary of SEBI

    BY ANSH CHAURASIA, A THIRD-YEAR AT RMLNLU, LUCKNOW

    Introduction

    Recently, the securities market regulator Securities and Exchange Board of India (‘SEBI’), equipped with broad powers, had difficulty defending its quasi-judicial orders. For instance, the Supreme Court (‘SC’) rejected SEBI’s appeal against the order of the Securities Appellate Tribunal (‘SAT’) in the matter of Apollo Tyres. SEBI was reprimanded by the SC for imposing a penalty for violation of SEBI (Buy Back of Securities) Regulations, 1998, but only after the show cause notice was issued to the respondent after more than a decade in 2014 for a cause of action that arose way back in 2003. SEBI passed the order imposing the maximum penalty in 2016, which was set aside by the SAT on grounds that it was not justified in imposing the maximum penalty. Subsequently, the revised penalty was quashed by SAT, against which SEBI approached the apex court. The SC affirmed the decision of SAT on the grounds of inordinate delay, a point of law entirely overlooked by the SEBI during the whole proceedings, right from the commencement of the investigation in 2014 to its appeal before the court on 4 December 2023. Although the SEBI Act has no limitation period per se for the issuance of show cause notice or the completion of the adjudication proceedings, the court’s earlier decision settled the position that such exercise of power must be done within a reasonable time.

    The aforementioned failure of SEBI in appealing before SC is part of a larger trend. At the heart of this regulatory struggle lies the legally untenable orders of SEBI and consequential litigation before SAT and SC. The redundancy of SEBI’s regulatory role resulting from such orders being litigated and decided against affects its credibility and has far-reaching implications for the key market regulator.

    The detrimental litigation

    The legislative history and precedent of the SC lucidly point to the cases appropriate for the appeal. The unamended Section 15Z, the appellate remedy to the High Court, was provided on any question of law or fact. After the amendment in 2002, the appellate court was changed from the High Court to the Supreme Court, and the grounds for appeal were limited to only questions of law, making it the current position. The SC interpreted the phrase ‘question of law’ in the backdrop of Section 15Z to arise when there is either erroneous construction or interpretation of the legal provisions of the statute or the general principles of law. The court also held that the power under Section 15Z has to be exercised while keeping in mind the sectorial laws and policy evolved by the tribunal acting under Section 15T through its interpretation of the Acts, Rules and Regulations. Therefore, the scope of the appeal and criteria of the cases appropriate for appeal are settled propositions of law.

    In its attempt to enforce its order, SEBI has appealed multiple times to the apex court despite a clear scope. In WhatsApp leaks case, SEBI imposed a penalty upon noticees for forwarding messages containing information about financial results. However, the order lacked any finding with respect to the originator of the message. SEBI’s order completely overlooked the fact that noticees merely forwarded the messages with sensitive information, which resulted in SAT overturning the order and vindicating SAT’s finding by the SC.

    In Tata Steel case, SEBI appealed to SC after its order to impose a penalty was set aside by SAT. SC refused to interfere because the order of SAT clearly established that the show-cause notice did not impute any charge upon the noticees. Consequently, the penalty was set aside. SC also remarked whether SEBI appealed only because their ‘ego was hurt’.

    In NSE Dark fibre case, SEBI appealed to SC after a setback from SAT when the disgorgement order for Rs 625 crore with interest was quashed due to a lack of nexus between the disgorgement order and the wrongdoing as required under Section 11B. Another order of fine was set aside by SAT in this case due to inadequate reasons to impose a maximum fine under Section 15J. Consequently, SAT reduced the quantum of the penalty. The move of SEBI demanding a stay on SAT’s order delineates an approach centred on recourses to enforce its orders rather than introspecting on its quasi-judicial adjudication process. Frequent dismissals in appeals whose fate could have been easily determined pinpoints the obdurate nature of the regulator.

    The ramifications of SEBI donning a litigator’s mantle

    The inefficiency of the adjudicatory process becomes apparent when shortcomings in SEBI’s order are pointed out by SAT and vindicated by SC. This directly dents the investor confidence that SC regards to be directly dependent upon the effectiveness of the regulatory mechanism. In SEC v Zandford, investor confidence was held to be the key objective behind the introduction of the Securities Exchange Act. Investors should not perceive the market as a system stacked against them. The Sisyphean undertones in SEBI’s approach to taking the case to the apex court, which has now been frequently falling to the ground, negate the fundamental credibility that the legislature intended to imbibe in the eyes of the investors.

    The SC interpreted the statutory right of appeal incorporated under Section 15T as scrutiny of SEBI’s broad power and emphasised the crucial role of the tribunal in the structural and consistent evolution of sectorial laws. Overlooking the shortcomings pinpointed by the order of SAT or requesting a ‘stay’ on its order before the apex court erodes the parliamentary intent and development of sectorial law.

    Against this backdrop, the problem of complying with basic technicalities is also a glaring issue. A lackadaisical approach in passing orders without providing adequate and sound reasons and bypassing the jurisprudence enunciated by SAT decisions is concerning.

    However, at the outset, SEBI incurs a financial burden every time it decides to go against an order of SAT, and the imposition of a similar burden on the opposite party is problematic. Justice Madan B. Lokur lamented this approach of government agencies litigating for the sake of litigating in a 2018 judgment. SEBI itself passed a proposal in 2019 mandating the appellants before SAT to deposit 10 per cent of the penalty so it could curb the appeals solely aimed at delaying the execution of its order. Therefore, SEBI does acknowledge the hardened mindset to resort to appeal, if not within itself yet among the parties aggrieved by its order, and it rightly points to the consequences of such an approach.

    The ripple impact of this approach is now perceptible as affecting institutional integrity. The SC reprimanded SEBI in the Suzlon case, asking the regulator to ‘regulate rather than litigate’. Although the SC granted the relief to SEBI, clarifying that the contested order would not be treated as precedent, it proceeded to remark. In Apollo Tyres case, SEBI was criticised for appealing against every order that went against them and directed to submit an affidavit of appeals they have filed.

    Conclusion

    The SEBI is a unique statutory body that has the role of regulating, investigating, adjudicating, and deterring the offender. We see an amalgamation of executive, legislative, and quasi-judicial functions within the SEBI. The broad powers conferred upon it have to be exercised to protect the interest of the investors and inspire confidence among the public. SEBI ought to weigh the above considerations before moving to the apex court. SEBI brought itself into this position where it has been reprimanded multiple times for ascertaining the cases only to meet the on-paper requirements. However, the situation requires adherence in spirit. This obstinacy on the part of SEBI is a Faustian bargain where it is giving up institutional credibility for no change in consequences and further losing an opportunity to look into regulatory mechanisms. Any decision to appeal must pass the muster of the requirements of appeal irrespective of the fact that SEBI has been aggrieved at the hands of the SAT.

    The striking similarity in all cases challenged before SC and quashed before SAT is SEBI’s failure to substantiate its allegations and insistence on enforcing its order. Changes in its regulatory and investigatory mechanism can lower the recurrence of these defects. Recently, the SC expert committee constituted to investigate the Adani-Hindenburg made significant suggestions for the prudent and effective exercise of the broad power at SEBI’s disposal. It suggested an ‘effective enforcement policy’ to lay down criteria by which SEBI must decide whether to initiate the proceeding either to impose a monetary penalty, to take a remedial action, or to take a punitive action. Such criteria should be clear and non-arbitrary. Laying down criteria would delineate an objective requirement of specific conditions to initiate proceedings, consequently leading to a proportionate exercise of regulatory powers.

  • SEBI’s Instantaneous Trade Settlement: Evaluating the Implications on Foreign Investors

    SEBI’s Instantaneous Trade Settlement: Evaluating the Implications on Foreign Investors

    BY PARV JAIN, A THIRD-YEAR STUDENT AT INSTITUTE OF LAW, NIRMA UNIVERSITY, GUJARAT

    Introduction

    According to SEBI’s annual report, the year 2022–23 faced a foreign portfolio investors (“FPIs”) outflow of Rs 40,936 crore. This was the third highest sell-off by FPIs during a financial year. This FPI pull-out could be driven by the opening of China post-lockdown, the Russia-Ukraine crisis, and a series of rate hikes due to inflationary pressures. But now, it is the need of the hour to ensure not to give offshore investors any reason to pull out of India, given the huge contemporary capital requirements.

    In September 2023, Securities and Exchange Board of India (“SEBI”) announced the plan for the implementation of instantaneous trade settlements, which has caused a plethora of debate regarding the future implications of such a move. SEBI Chairperson Madhabi Buch had expressed her enthusiasm for instant trade settlement, which will become a game-changer for the Indian stock market and will benefit investors greatly by making trading faster, safer, and cheaper. According to her, it will also enhance India’s position as a leading financial market in the world. This implies that the instant trade settlement plan might roll out very soon, but it is still unclear whether the regulator would resolve the potential challenges for foreign investors from such a change beforehand or not. SEBI now aims to achieve a same-day i.e. T+0 settlement system by March 2024, and then aspires to move towards a method of instantaneous settlement of trades.

    As the discussions increase, people are anticipating a withdrawal of offshore investors from the market, who fear that the settlement of equity market trade on the same day will eventually fragment the liquidity of the market. In this regard, I discuss how the instant trade settlement affects foreign investors. I argue that the demerits of such a change could outweigh its merits. Lastly, I propose certain additions and changes in the framework to ensure the inflow of foreign investment. 

    Addressing the Lacunae

    From a practical standpoint, achieving instant trade settlement might be impossible within the current financial framework.  In 2020, the Asia Securities Industry and Financial Markets Association (ASIFMA) also highlighted the difficulties for foreign investors if the settlement cycle is reduced, as this may result in inefficiencies for trade matching and end of day reconciliations. This is because the settlement of securities transactions requires a multi-faceted procedure, demanding seamless coordination and communication among a diverse array of stakeholders. Adequate time must be allocated post agreement on a trade for the underlying securities to undergo the necessary transfers and for the corresponding funds to be transferred. At the core of the settlement process, time must be allowed to guarantee legitimacy, accuracy, and adherence to regulatory standards. 

    These conceptual issues might be solved through technological alterations and mutual agreements, but the core issue would lie in the fact that such a move would require an alteration of the whole financial system. This includes the configuration of the Indian payment system as well as the framework governing pivotal banking functions, such as the facilitation of deposit accounts and the extension of credit. To achieve instant trade settlement, a substantial restructuring of the current clearing, payment, and settlement infrastructure within the Indian market would be required.

    Demystifying the Implications on Foreign Investors

    Currently, there is a set procedure followed by foreign investors to deal in the Indian stock market. For instance, if a Germany-based foreign investor wants to buy shares in India, he has to first send euros to the custodians, who will then book the forex, convert the euros into Indian rupees, and deposit the funds into the FPI’s cash account in India. By the time settlement occurs, the funds are deposited with the custodians. Currently, there is a set window of time for transferring the funds and converting them to Indian rupees, subject to market fluctuations which almost occur within a day. But the instantaneous trade settlement will reduce this time, which means foreign exchange transactions will have to be expedited as well to fast track the conversion of currency into Indian rupees. The foreign investors will have to face a lot of challenges, and this might cause a lot of unexplored issues.

    The core issue with instantaneous trade settlement arises from the time difference between Indian and foreign jurisdictions. As a result, foreign investors would need to predict the entry price of a stock in advance, and the price may also fluctuate before they make a purchase. To mitigate this, offshore investors would be compelled to prefund the transaction. Consequently, in the case of SEBI’s instant settlement plan, the law of diminishing returns applies, as the shortened time frame introduces more risk without generating additional benefits for widespread adoption across the market. This could potentially lead to a situation where capital is underinvested, making the delivery of securities more complex, fraught with increased risk and escalation of costs. Thus, the implementation of this measure could make the Indian financial markets less appealing to global investors. 

    The Way Ahead

    Ms. Madhabi Buch has said that FPI would not face any problems as they would be given the choice to opt out of instantaneous settlement if they prefer not to use it. She ensured that SEBI had ascertained the data that shows which trades are matched with each other. Based on this data, they believe that choosing not to opt for instantaneous settlement will not create any issues or problems for anyone involved. In essence, they are reassuring that the traditional settlement process will still be accommodated and will not cause any difficulties for those who prefer it. However, this optimistic model would fail when the foreign investors would be left with no option but to opt for instant trade settlement if a large share of retail volume does so. This is because, with two distinct trade settlement cycles, the liquidity could be divided in the two-way transaction. Most of the domestic investors are likely to prefer instant trade settlement creating a risk of fragmentation of liquidity and an increased likelihood of failed trades. To prevent this, SEBI should take certain measure like trade limit for a specific settlement cycle to ensure that the liquidity is sufficient, if not equal in both the trade settlement cycles.

    To bypass this hurdle, SEBI will have to formulate a mechanism similar to the one implemented in China. China, at the time of introduction of the T+0 settlement cycle for Stock Connect, was facing several challenges as it increased the operational burden for foreign investors and market participants to complete the settlement obligations. Also, when China A-shares got listed on global indexes such as Morgan Stanley Capital International and Financial Times Stock Exchange, foreign interest in the Chinese onshore equity market skyrocketed. It became very crucial to make an A-share investment channel to entice foreign investment. Thus, in partnership with Depository Trust and Clearing Corporation, Hong Kong Exchanges and Clearing Limited (“HKEX”) launched HKEX Synapse, a revolutionary settlement platform specialized to Northbound Stock Connect. 

    Synapse works as a standardized and centralized platform that efficiently transmits settlement instructions to all relevant parties concurrently. This simultaneous processing ensures full transparency in the trade processing status. After obtaining consensus and approvals, Synapse transmits settlement instructions to the Central Clearing and Settlement System (“CCASS”) for final settlement. Real-time integration with CCASS allows Synapse to provide prompt status updates to all involved parties after a matching or settlement batch run. This results in comprehensive transparency, improved control, and increased efficiency for investors and their counterparts throughout the settlement process.

    In India, if instant trade settlement has to be introduced despite having several loopholes, a platform similar to HKEX Synapse is necessary to ensure that international investors gain immediate access to the real-time status of their trade settlements. This would provide a measure of relief from the constraints imposed by the narrow settlement window. Also, this will standardize and simplify post-trade procedures and empower investors to optimize connectivity and operational efficiencies within a framework that is both transparent and secure. Custodians will be equipped with comprehensive insights regarding the parties that have endorsed and sanctioned specific trades, thereby furnishing them with the essential data needed to promptly address and rectify any trade anomalies prior to the designated cut-off time. 

    Apart from this, SEBI can also give brokers the responsibility of guaranteeing payments on behalf of foreign investors, effectively extending them credit for the interim two-day period until the transactions are duly finalized. For instance, Indian stockbrokers can vouch for foreign investors and settle their trades in instant trade settlement, and later, these investors can repay money to the brokers within two days. While the brokers would take some risks, in the long term they would benefit from the new inflows. 

    Concluding Remarks

    India has at various instances, taken the lead in terms of technological innovation by changing the digital infrastructure with platforms like CoWIN and Unified Payments Interface. Instant trade settlement might put India at the forefront of the globe in terms of trade settlement if it is proven to be the fastest and most efficient in the world. 

    However, it is crucial to recognize the complexities and potential disruptions it may introduce to the existing financial framework. Foreign investors, in particular, will face significant hurdles with the proposed instantaneous settlement. This may necessitate prefunding transactions, introducing added complexity and risk to the process. Additionally, the implementation of this measure may lead to increased operational costs for foreign investors, potentially making the Indian financial markets less attractive on a global scale. SEBI’s assurance that traditional settlement processes will still be accommodated is a positive step, but it may not entirely alleviate concerns, especially if a significant portion of retail volume opts for instantaneous trade settlement.

    Therefore, careful consideration and strategic measures are essential to mitigate potential risks and ensure a seamless transition. By adopting proven mechanisms and addressing the concerns of foreign investors, India can pave the way for a more dynamic and resilient financial ecosystem in the years ahead.

  • Navigating Uncharted Territories: ICSID Tribunal’s Power to Remove Counsel

    Navigating Uncharted Territories: ICSID Tribunal’s Power to Remove Counsel

    BY AARyA PARIHAR, THIRD-YEAR STUDENT AT RMLNLU, LUCKNOW

    Introduction

    The role of a lawyer is extremely crucial in an arbitration proceeding. The right to effective legal representation of one’s choice is recognized explicitly in various international instruments, like Article 14 of the International Covenant on Civil and Political Rights and Article 6 of the European Convention on Human Rights. Such a right is equally essential in investor-state arbitration proceedings, where it may form part of the due process expectations of the parties to the proceedings with serious transgressions from the principle, even potentially constitute a ground to challenge the award itself. The ICSID Convention, Rules, and Regulations do not expressly address the authority of ICSID Tribunals to permit the withdrawal of legal counsel or to compel their continued participation in the proceedings (against their wishes). This post discusses the authority of ICSID Tribunals to exclude or require the presence of particular counsel in a dispute. The post then discusses the existing arbitral decisions on this issue to examine the contours of ICSID Tribunals’ powers concerning these matters.

    Do ICSID Tribunals Have the Power to Remove/Exclude Counsel?

    ICSID Tribunals are formed to resolve treaty disputes between contracting parties. Every dispute has its own Tribunal with separate procedural rules that disputing parties agree on. Arbitration’s inherent nature of being party-centric, where parties’ autonomy is given primacy, leads to divergent procedural practices. Additionally, the non-binding nature or lack of precedential character of ICSID awards over other ICSID Tribunals leads to differing awards. Thus, it is essential that before moving to ICSID Tribunals, assistance shall be taken from the federal courts of the United States, who have often used their power to decide upon the issue of counsel resignation.

    The U.S. Court in May v. Seibert enquired about the existence of good cause, which depends upon the facts and circumstances of every case. Simply put, there is no straitjacket formula to when a counsel can legally stop their representation. It largely depends upon the peculiar factual matrix of every case and the application of mind by the judge presiding over it.

    In the realm of ICSID, only a few Tribunals were called upon to decide upon the issue of counsel resignation or removal of counsel. Five publicly available awards are from the Hrvatska Tribunal, Rompetrol Tribunal, Edmond Khudyan Tribunal, Fraport Tribunal, and Theodore David Einarsson Tribunal. These five orders from five different Tribunals delve into the removal of counsel. In all these five decisions, the Tribunal found its power to remove counsel under Article 44 of the ICSID Convention, providing residuary power to the Tribunals. It empowers the Tribunals to decide upon any question of procedure which is not explicitly covered under the ICSID Convention, Rules, and Regulations.

    Due to the heavy amount of cross-referencing/quoting done in these decisions, discussing them separately and conjointly is essential. The post attempts to cull out only the important dictum from these decisions, which is required to facilitate analysis in the present article.

    Hrvatska Tribunal

    In the Hrvatska award, the removal of counsel was warranted because of his apparent connection with one of the arbitrators, which might have caused bias. The Tribunal found that the right to effective representation is pitted against the right to effective and unbiased proceedings. After due deliberation, the Tribunal found itself empowered to rule on this issue by virtue of Article 44 of the ICSID Convention.

    Rompetrol Tribunal

    The Respondent in the Rompetrol decision cited the Hrvatska decision as the sole authority to bolster their argument regarding ICSID Tribunals’ authority to exclude counsel from the proceedings. The Tribunal found it has inherent power to exclude counsels under Article 44 of the ICSID Convention but refused to exercise the same in the present dispute. According to this Tribunal, this power should only be used in exceptionally uncommon circumstances where the integrity of the whole proceeding is in question/dispute.

    Edmond and Fraport Tribunals

    In the decision rendered in the Edmond dispute, the Tribunal reiterated that it has the power to exclude the participation of counsel under Article 44 of the ICSID Convention. In this case, both parties agreed to this power of the Tribunal without any disagreements. The Tribunal again emphasized using this power sparingly and only in certain circumstances. It should be used only to protect the proceedings’ integrity and fairness and to ensure the parties’ equality. The Tribunal heavily quoted from the Fraport decision, reaching a similar conclusion. The Fraport Tribunal also imposed the necessary contours of “ensuring fair conduct of the proceedings” while exercising its power under Article 44 of the ICSID Convention.

    Theodore Einarsson Tribunal

    Another crucial decision in this aspect is of the Theodore Einarsson Tribunal, where the Tribunal while deliberating on the removal of a counsel, outlined that the ICSID Tribunals do not have the power to police the compliance of counsels with their deontological or ethical mandates imposed by any local code/rule. These ethical constraints are generally introduced by a local code governing the professional conduct of the lawyer practicing thereof. They include the duty to not discontinue representation without a good cause or the commitment to confidentiality. It reasoned that since the removal of counsel attacks the core of the fairness of proceedings, it is a mandate of the ICSID Tribunal.

    The Contours of the Power of ICSID Tribunals to Control Representation of Counsels

    The Tribunals in all the above-quoted disputes have reasoned that the power to remove counsel is exercised to ensure the fairness and integrity of the proceedings. In both the decisions in Fraport and Theodore, the Tribunals refused to look into the counsel’s deontological or ethical mandate. They found it outside the purview of their authority and a question that is to be decided by local or regional courts.

    It can be understood that the ICSID Tribunals have been reluctant to rule on anything else apart from simply the participation of a counsel. The Author believes that the power to exclude includes the power to retain counsel by overriding the parties’ choice. In simpler words, there are instances where the Client/Party does not want their counsel to continue. The Tribunals have the power to order the continuation of their representation against the party’s wishes. One crucial aspect is the conditions or situations where a counsel can be removed from the ongoing proceedings.

    Ruling on Counsel’s request for removal

    The five above-referenced awards do not concern any situation where the Tribunal was required to address a counsel’s request to resign. Almost all of them had some bias or conflict between the challenged counsel and an arbitrator. There may arise a situation where the counsel wishes to resign, whether voluntarily or per the desire of either party that wants their counsel to discontinue representation. In these scenarios, as already stated, the courts generally use their wisdom to decide based on every case’s peculiar facts and circumstances.

    Generally, counsels decide to withdraw their representation when there is a breakdown of any attorney-client relationship. Simply put, it is when the attorney has lost faith in his client and their case or vice versa. It is broken down to such an extent that the representation would only harm the client’s case. Also, it is essential to note that the withdrawal should not cause undue or unreasonable delay to the proceeding. This also means that there should be no prejudice caused to parties involved by the ‘withdrawal of a counsel’.

    In the Jean-Boscotrial, the International Criminal Tribunal (hereinafter “ICT”) for Rwanda denied withdrawal/replacement of counsel because of the possibility of undue delay in the proceedings that would cause prejudice to the parties. It was highlighted in the Jean-Bosco decision that new counsel needs to acquaint themselves with the facts, documents, and figures of the existing case. Sometimes, this process of getting acquainted with everything also causes an undue delay in the proceedings, and the Courts have rejected the withdrawal for this reason of delay. This similar reasoning was also employed by the ICT for Rwanda in the Jean-Bosco Trial to decide on dismissing the withdrawal/replacement of counsel.

    Suggestions and Conclusion

    There is an apparent dearth of awards and decisions by ICSID Tribunals on the issue of counsel withdrawal/exclusion. The available awards reiterate the similar reasoning applied by the Tribunals in every dispute. There seems to be a well-founded reluctance by ICSID Tribunals to adjudicate over counsel’s withdrawal or exclusion with full vigor. ICSID Tribunals are constituted mainly to resolve the dispute between investors and States. The contours of a Tribunal’s powers are well-defined in the ICSID Convention, Rules, and Regulation. Thus, the Tribunal finds itself in a quagmire or conundrum where the chances of overreach exist. In light of various awards highlighted in this article, it is abundantly clear that the ICSID Tribunals have discovered their inherent power to decide on any question of “procedure” of the dispute flowing from Article 44 of the ICSID Convention. Issues of counsel’s conduct and obligations are not the mandate of ICSID Tribunals. If the Tribunals are given unfettered power to decide upon the issue of counsel’s ethical obligations, it will open a floodgate of fresh proceedings and further cause delay. This would defeat the purpose of arbitration proceedings, where the primary aim is to promote expediency and efficiency.

    If a further step could be taken, the ICSID Convention should insert an explicit provision defining the power of its Tribunals to decide upon the issue of counsel resignation/removal in cases of apparent bias/conflict with the arbitrator or irrevocable breakdown of attorney-client relationship. To develop their contours or limits, the Tribunals may take assistance from decisions of local courts and international tribunals where the issue of counsel resignation has been discussed in length.

  • Arbitral Tribunal’s Powers To Grant Interim Measures Affecting Third Parties: Still At Crossroads?

    Arbitral Tribunal’s Powers To Grant Interim Measures Affecting Third Parties: Still At Crossroads?

    BY PRIYANSHI BHAGERIA, FOURTH-YEAR STUDENT AT RMLNLU, LUCKNOW

    Introduction

    Section 17 of the Arbitration & Conciliation Act 1996 (‘Act’) empowers the Arbitral Tribunal to grant interim measures during the arbitral proceedings. The phraseology of Section 17 is similar to Section 9 of the Act, which grants similar powers to the courts. Both the sections are similar in the sense that they not only deal with the grant of interim measures, although at different stages, but also the orders passed under the respective sections are deemed to be court orders and shall be enforceable in the same manner. 

    One major question that is a subject of repeated discourse is whether the tribunal has the power to grant measures affecting the rights of the third parties since a similar power is often exercised by the courts under Section 9. In this context, it is important to examine if there is a difference in the scope of the powers under both these sections. 

    This article analyses the bare provision and tries to establish that the Tribunal has powers that are at parity with a civil court and are to be governed by the Civil Procedure Code, 1908 (‘CPC’). Further, the effect of the conversion of Section 9 applications to Section 17 applications is dealt with by the author to make a case for the power of the Tribunal to grant interim measures affecting the third parties. Lastly, the article highlights the applicability of the group of companies doctrine and the necessity to grant such a power to the Tribunal. 

    Nature & Scope of Section 17

    A reading of Section 17 suggests that the Tribunal has powers to grant interim measures like interim injunctions, appointment of receivers, appointment of guardians, etc. The powers of the Tribunal are wide and the same can be gauged from Section 17(1)(ii)(e) which empowers the Tribunal to grant any other measures, apart from the ones enumerated in the provision, that it deems just and convenient. Despite the wide ambit of powers, the primary argument against the applicability of Section 17 with respect to third parties is that it is a creation of an express contract between two parties and the tribunal hence cannot pass orders affecting the rights of the third parties. However, this argument cannot be seen in isolation. 

    It is important to note that there is a reference under this section about the powers of the tribunal being akin to that of a court while granting interim measures. It is significant to highlight that such a mention was specifically made by the Arbitration and Conciliation (Amendment) Act, 2015, highlighting the unambiguous intention of the legislature. Moreover, Section 17(2) states that an order under this section is deemed to be a court order and would be enforceable under CPC. In Pearl Hospitality & Events Pvt. Ltd. v. OYO Hotels and Homes Pvt. Ltd., the Delhi High Court held that the principles governing Order XXXVIII Rule 5 would be applicable, while considering a prayer for furnishing security, under Section 9 or Section 17.  In another case, Navtrip Implementation Society v. IVRCL Ltd., the Delhi High Court observed that the object of Section 17 of the Act is similar to that of Order XXXVIII, Rule 5 of the CPC, and therefore its conditions have to be kept in mind while passing orders under Section 17. This shows that the principles of CPC govern the powers of the Tribunal despite there being resistance regarding the same. Hence, it is absurd to assume that some principles of CPC which grants inherent powers to the courts to grant interim measures affecting the rights of third parties will not be applicable while some mentioned above would still continue to guide the proceedings under Section 17. It is important to clarify that a blind application of all the existing principles of CPC is not desirable. However, unsubstantiated exclusion of these specific principles raises concerns and leads to adverse repercussions for the parties as explained further in the article. 

    Furthermore, Section 28(1)(a) of the Act states that the tribunal shall be bound by the substantive law of India in case of domestic arbitrations. In a number of cases, the Indian courts have enumerated general principles of granting interim measures and the same would apply to the Tribunal by virtue of it being a part of the substantive law of India.

    Therefore, the nature of the power under Section 17 is guided by the principles of CPC and is placed at a similar stature to that of a court. 

    Practice of Converting Section 9 Applications into Section 17 Applications

    Secondly, it is important to highlight a practice of the courts while dealing with an application under Section 9. In a catena of cases, the courts have converted an application under Section 9 to an application under Section 17 once the tribunal has been constituted. If we have a look at the data of the years 2022 and 2023, a significant number of applications filed under Section 9 before were converted into an application under Section 17 by various High Courts. 

    Court YearTotal Number of Applications Filed u/s 9 of the ActNumber of Section 9 Applications converted to Section 17 Applications
    Delhi High Court202240076
    Delhi High Court2023 (till May)18923
    Mumbai High Court202221824
    Mumbai High Court2023 (till May)532

    A bare look at the data might suggest that the number of Section 9 applications converted to Section 17 applications is only a small proportion. However, one must consider that even if the number is not compelling enough, the data indicates a practice which is prevalent. And the repercussions of such a practice are borne by one of the parties who is ultimately rendered remedy less. This also points to the fact that this practice which is supposedly ‘pro-arbitration’ can infact disincentivise arbitration if the Tribunals are not given powers at parity with the courts.

    The prayer under that Section 9 application which is now being converted to a Section 17 application before the Tribunal remains the same. It is impractical to assume that the Tribunal would not have the authority to grant measures at parity with the Court in the same prayer which is now to be dealt with by the Tribunal on the direction of the Court itself. For example, a prayer may pertain to custody or sale of the goods which are subject matter of the arbitration agreement and could include situations where the goods are in the possession of a third party. In such a scenario, the conversion of the Section 9 application to a Section 17 application would cause prejudice to the parties. 

    Moreover, if we were to assume that the powers of the court and the Tribunal are uneven, this conversion would disincentivize the constitution of the Tribunal. The parties would prefer applications under Section 9 or under the allied provision of CPC to an application under Section 17, where the Tribunal’s power is limited. This would create a lacuna and would defeat the purpose of the Act, i.e., to facilitate arbitration.

    Group of Companies Doctrine: Its Effect on Section 17

    Although the final verdict on the applicability of the group of companies doctrine by the Apex Court in Cox and Kings Ltd. v SAP India Pvt. Ltd. is awaited which would give more clarity, it is nonetheless important to analyze the position with regard to the Tribunal’s power under Section 17 affecting the rights of non-signatories. 

    The Supreme Court in cases, such as Chloro Controls (I) Private Limited v. Severn Trent Water Purification Incorporated, Ameet Lalchand Shah v. Rishabh Enterprises, and Mahanagar Telephone Nigam Limited v. Canara Bank, has acknowledged the multi-layered and complex nature of transactions in today’s times and has allowed that in certain exceptional situations, even non-signatories to an arbitration agreement could be referred to a composite arbitration proceeding and could be bound by the award. 

    There is still an absence of consensus with regard Tribunal’s powers under Section 17. This absence of consensus has resulted in courts giving conflicting judgments on the same issue. For example, in Prabhat Steel Traders Pvt. Ltd. v. Excel Metal Processors Pvt. Ltd., the Bombay High Court recognized that the interim orders passed by the Tribunal under Section 17 may affect non-signatory third parties in a direct or indirect manner. However, the same court in Bombay Slum Redevelopment Corporation Limited v. Samir Narain Bhojwani held that a Tribunal passing interim orders against a third party would be overstepping its jurisdiction under Section 17. 

    While ascertaining the Tribunal’s power in this context, the legislative intent must also be considered. Before the 2015 Amendment, Section 8 used the word ‘party’ which was replaced by ‘a party to the arbitration agreement or any person claiming through or under him’. This broadens the definition of party to make space for non-signatories. Hence, the complex nature of today’s transactions must be seen a reason enough for the Tribunal to exercise powers under Section 17 to grant measures that might affect the rights of the third parties.

    Conclusion

    Therefore, it is evident that there is a need to expand the powers of the Tribunal under Section 17 so as to grant interim measures that may affect the rights of the third parties. In order to incentivize arbitration, the Tribunal must be given such power to ensure that the measures granted can be practically executed which is only possible when the Tribunal has the liberty to include third parties. Even if there is no concrete provision establishing this power of the tribunal, the same should be seen in the context of the above arguments and the need of the hour. The courts must formulate guiding principles in this regard and the same must be allowed, even if it is only limited to exceptional circumstances. 

  • Shareholder Intervention in Resolution Proceedings: A Potential Misinterpretation of IBC 2016

    Shareholder Intervention in Resolution Proceedings: A Potential Misinterpretation of IBC 2016

    BY YADU KRISHNA PALLIKKARA, FOURTH-YEAR STUDENT AT SYMBIOSIS LAW SCHOOL, PUNE

    Introduction

    Recently, in Dr. Ravi Shankar Vedan vs. Tiffins Barytes Asbestos (Tiffins), the shareholder of a corporate debtor sought an appeal for two interlocutory orders of the adjudicating authority. First of which was an application seeking a forensic audit of the books of accounts of the corporate debtor and the second regarding approval of resolution application under Section 30 (6) of the Insolvency and Bankruptcy Code (Code). The court dismissed the shareholders’ objections and clarified that shareholders have no locus standi to challenge the resolution plan initiated against the corporate debtor. 

    The post aims to analyse the rationale employed by the court in denying locus standi to the shareholders. It offers a critique of the tribunal’s decision by first, expounding on the concept of shareholders as “persons aggrieved” under Section 61 of the Code . Second, it analyses the interpretation of Section 30(2) of the Code  related to deemed approval and the existing legal position surrounding it. It concludes by advocating for a nuanced approach that protects shareholders’ legitimate concerns while maintaining the effectiveness of the insolvency resolution framework.

    Shareholder as a person aggrieved 

    Herein, the Hon’ble National Company Law Appellate Tribunal (NCLAT) held that the shareholders have no locus standito challenge the resolution plan at any stage, by reasoning that Section 30(2) of the Code provides for deemed approval by shareholders of the corporate debtors, which cannot be taken away by objecting to a resolution plan. 

    Similarly, in Nirej Vadakkedathu Paul & Ors v. Sunstar Hotels and Estates Pvt. Ltd. & Ors  (McDowell Holdings), the NCLAT Chennai denied locus to shareholders who challenged the Corporate Insolvency Resolution Process (CIRP) initiated against the corporate debtor in which they held majority shares.  It forms a part of a catena of judgements, including ICP Investments v. Uppal Housing, Punit Garg vs. Ericsson India Pvt. Ltd., and Anant Kajare vs. Eknath Aher, denying locus standi to shareholders in CIRP proceedings by reasoning that shareholders cannot be aggrieved by initiating CIRP against the corporate debtor, as such interventions in the name of derivative action can render the entire process futile. Accordingly, the contesting parties can only be the financial creditor or the corporate debtor as represented by the Interim Resolution Professional.

    These judgements seemed to altogether overlook the true intention of Section 61 (1) and Section 61 (3) of the Code . While Section 61 (1) provides for “any person aggrieved” by an order of the Adjudicating Authority to prefer an appeal to the NCLAT, Section 61 (3) provides the grounds under which such appeals can be set out, allowing for resolution plan to be challenged for the first time in the appellate stage. While it does specifically identify those who may file an appeal, it sets out that any person aggrieved under Section 61(1) can initiate a proceeding challenging a plan approval order, and shareholders shall come well under this meaning. On a combined reading of both provisions, it is in no way anticipated to exclude shareholders from the meaning of “aggrieved persons,” as that would be a clear injustice and in effect a narrowing of the scope of Section 60 (1).    

    While in McDowell Holdings, the shareholders were denied locus by citing a lack of statutory backing for shareholders ability to challenge a CIRP process and such frequent derivative actions being against the efficiency and purpose of the Code, the court in order to reach its decision had expounded Section 61 (1) of the code. It stated that under Section 61 (1) of the Code, any ‘person aggrieved’ by the order of the Adjudicating Authority may prefer an appeal to the “NCLAT”. The definition of ‘person’ as provided under Section 3(23) of the Code includes ‘individual’, which is a term wide enough to encapsulate ‘shareholders’ within it. This clarifies that while interference from shareholders are generally not preferred, the Code in no manner intends the deprivation of their representative capacity in insolvency proceedings as held in the case of Tiffin’s. 

    In Ashish Gupta v. Delagua Health India Private Limited, the court held that the majority shareholders of a company have the right to challenge the admission of CIRP against the corporate debtor when the admission arose out of collusion among the creditors. It is an example of when courts have considered the specific circumstances demanding intervention by the shareholders and dealt with the same on merits. It proves that shareholder intervention may not always be against the efficiency and purpose of a resolution process under the code and can help in identifying irregularities’ and illegalities in the resolution plan,  aiding in the successful revival of the corporate debtor.

    Also in Tiffins, by interpreting Regulation 2(k) of the Liquidation Regulations 2016, the court held that shareholders who come under the category of ‘stakeholders’ are only recognised in the liquidation process and lack representative capacity in the CIRP. But, according to the same logic, other stakeholders of the corporate debtor such as directors or creditors, can be denied representative capacity by categorizing them as “shareholders” and their consent deemed to be approved, which is totally unwarranted under the code.

    Blurred lines of Deemed Approval and Locus Standi

    Deemed approval of a resolution plan finds no backing in the Code. Under Section 30(2) of the Code, the Resolution Professional (RP) has to ensure that the resolution plan to be submitted meets certain requirements. Under clause (e) of the provision, the RP shall ensure that the plan submitted does not contravene any law in force. The explanation to it provides that the shareholder approval required under the Companies Act, 2013, or other relevant laws for the implementation of the resolution plan is deemed to have been given, provided it is valid and not in contravention of that Act or law. 

    Through Tiffin’s judgement, court has interpreted this explanation of clause (e) as a mechanism of ‘deemed approval’, allowing actions under the resolution plan requiring shareholder approval to have been automatically approved, and more importantly, holding that shareholders have no locus to challenge or object to it. Similar subscription to the deemed approval doctrine can be seen in cases including Jaypee Kensington Boulevard Apartments Welfare Association. vs. NBCC (India) Ltd., DMI Finance Pvt. Ltd. v. Abloom Infotech Pvt. Ltd., Airro Holdings v. Abhilash Lal,  Mr. Keshav Agrawal  Vs. Abhijit Guhathakurta where the courts have rooted their reasoning to the explanation of Section 30 (2) (e) of the Code.

    The courts have overlooked the fact that the explanation was intended solely to facilitate actions that typically need shareholder approval under laws like the Companies Act, such as capital reductions or director appointments, without requiring specific approval for each. It wasn’t meant to cover the entire resolution plan but only those actions needing shareholder consent, and it cannot be used to oust the shareholder’s locus on all matters concerning the CIRP. The MCA notification of 2017 also clarified that the approval mechanism applies only to specific actions required for the implementation of a resolution plan as required under the Companies Act 2013 or any other law in force.

    Shareholders should be allowed to voice concerns about other aspects of the plan, such as illegality, procedural irregularity, or actions harming the company or the public interest, which do not require shareholder approval. [AM7] The same has been clearly set out under Section 60 (5) (c) and Section 61 (3) of the Code, the former of which provides that the Adjudicating authority is empowered to hear any question of law or facts arising in relation to the insolvency resolution of the corporate debtor. The latter provides that any person aggrieved may appeal against an order of the Adjudicating Authority approving a resolution plan, in the circumstance it contravenes the provision of law or if there is material irregularity in the powers exercised by the resolution professional. The provisions can be seen to have been deployed by shareholders to resolve their concerns in various cases including Synergy Technologies vs Parthiv Parikh and Dr. Periasamy Palani Gounder vs Mr. Radhakrishnan Dharmarajan. 

    Conclusion

    In the landmark case of Swiss Ribbons v UOI, the Supreme Court had held that the Code is a beneficial legislation that is aimed at putting the company back on its feet rather than being mere recovery legislation for the creditors. Such an effort to recoup the company requires adequately tending to all the stakeholders involved, including the shareholders of the corporate debtor. While sources such as the Bankruptcy Law Reform Committee Report of 2015 hints that the Code aims at a complete reduction of share capital and the shifting of control to creditors, the mechanism of ‘deemed approval’ of the shareholders and depriving them of representative capacity is not envisaged under the code.

    There is no contention as to the fact that the resolution plan is generally binding on the shareholders post-approval under Section 30(6) and that those shareholders challenging the plan for malicious and vindictive reasons shall not stand strict judicial scrutiny under Section 61(3) of the Code. However, there is no reasonable explanation to prohibit them from challenging the plan for bona fide reasons. 

    Such a blanket decision denying locus to shareholders on all and any matters of Code is unwarranted and can bring in uncertainty considering the concerns that the shareholders can face during a CIRP, including procedural irregularity or illegality in the resolution plan as seen in DHFL’s case  or unfair treatment of shares of the company in the resolution plan as seen in Sintex Industries Case . SEBI had issued a consultation paper in November 2022 proposing protection to minority shareholders of companies undergoing resolution. If the position as laid out in the case of Tiffin’s is maintained, such protections shall be rendered redundant, putting shareholders in a vulnerable position. Given these circumstances, it is imperative that the code does not restrain shareholders from raising their grievances, and the courts may hear the instances and decide on the merits of the case and the degree and reason for such intervention. This will aid in balancing the interests of relevant stakeholders and help in an effective and successful revival of the company. 

  • Unlocking Competition Law For Public Sector: Challenges & Prospects

    Unlocking Competition Law For Public Sector: Challenges & Prospects

    BY ANOUSHKA ANAND AND MD. HASHIR KHAN, FOURTH-YEAR STUDENTS AT NLU, JODHPUR

    Introduction

    India’s journey towards industrialization began in the mid-20th century, shortly after gaining independence from British colonial rule. The country sought to reduce poverty, promote self-sufficiency, and enhance economic growth. The establishment of Public Sector Undertakings (PSUs), thus, became a cornerstone of India’s planned development strategy, which aimed to harness and channel resources effectively for national development. Since then, PSUs have been instrumental in the development of strategic sectors such as defense, energy, telecommunications, and transportation. These sectors are crucial for national security, self-sufficiency, and infrastructure development. Examples include Bharat Heavy Electricals Limited in the power sector and Bharat Electronics Limited (BEL) in defense electronics. PSUs have also aided in regional development – Oil and Natural Gas Corporation is a prime example of a PSU that has contributed to the development of several regions in India through its oil exploration and production activities.

    After the enactment of the Competition Act 2002, which aimed to prevent anti-competitive practices and maintain a level playing field in the market, anti-trust scrutiny was made applicable to PSUs and private entities alike. However, under Section 54, the act provided for an exemption for activities related to sovereign function and allowed the central government to exempt the act, by notification, for enterprises performing a sovereign function or if such exemption is necessary for the public interest. Despite this, the application of the act to PSUs has not been smooth, with various concerns regarding the definition and demarcation of ‘sovereign function’ and ‘non-sovereign function’. The recent Supreme Court ruling in Coal India, however, settles the dust to an extent, when it comes to implementation of the act to PSUs.

    The Supreme Court Ruling

    The case arose when the Competition Commission of India (CCI) fined Coal India Limited (CIL) ₹591.01 crore for imposing unjust and discriminatory terms in fuel supply agreements (FSAs) with power producers for non-coking coal. In essence, CIL was found to provide lower-quality essential resources at inflated prices, along with unclear conditions in the contract regarding supply standards and quality. The regulator argued that Coal India and its subsidiaries operated without market competition and held a dominant position in the Indian non-coking coal production and supply sector. CIL contended that it bases its operations on the ideas of advancing the common good and making sure that coal, a crucial natural resource, is distributed fairly. Further, it argued that it uses differential pricing to encourage the production of captive coal with the aim of preserving the greater functioning ecosystem and pursuing welfare goals. The court, however, took a two-tier approach to reject the contentions of the appellants in this case. Firstly, it delved into Section 2(h) of the Competition Act to investigate if CIL fell within the definition of “enterprise” which is defined as a “person or a Department of the Government who or which is, or has been, engaged in any activity, relating to the production, storage, supply, distribution, acquisition or control of articles or goods, or the provision of services, of any kind”. The court held that CIL would fall into the category of a person since the term includes a company or a corporation under Section 2(i). Further, under Section 2(i) the term goods includes products manufactured, processed, or mined, thus the court concluded that there is no doubt that the appellant is a person, who is engaged in activity relating to production, storage, supply, distribution, and control of goods. Secondly, the court analyzed Section 2(h) to see if CIL fit within the exception carved out under the provision– the same being an activity of the government related to sovereign function. It went on so far as to say that what is excluded from the act is a government department performing sovereign functions and not a government company. Following this, the court concluded that carrying on business in mining, cannot, by any stretch of imagination, be described as a sovereign function.

    Implications

    The judgment’s pivotal advantage lies in its recognition of the paramount importance of competition in driving efficiency and fostering performance improvements within state monopolies and Public Sector Undertakings. By subjecting these entities to the purview of competition law, the market environment is revitalized, thereby cultivating a culture of innovation, cost optimization, and enhanced service delivery for consumers. This measure not only instills healthy competition but also stimulates these entities to evolve and adapt to changing market demands, ultimately benefitting the broader economy. Further, the endorsement of divestment and privatization by the court is a welcome move since if PSUs are subjected to market-driven pressures, they are compelled to streamline their operations, reduce inefficiencies, and elevate the quality of goods and services provided to consumers.

    However, at the same time, the judgment’s accentuation of competition and efficiency may have inadvertent ramifications on general welfare schemes provided by PSUs. As these entities grapple with the imperatives of competition and profit optimization, there is a prospect of diverting focus from welfare objectives to revenue maximization. For example, a government-owned telecom service provider offering reduced tariffs for rural areas to ensure connectivity for all citizens might start to focus on more lucrative urban markets, potentially neglecting the expansion and maintenance of services in remote or less profitable regions, impacting connectivity and communication access for marginalized communities. The complexity further deepens when considering turnover calculation, a fundamental aspect in assessing the applicability of enforcement mechanisms. Unlike private enterprises, PSUs often operate in sectors with complex interdependencies and cross-subsidization, making the calculation of turnover more intricate. When it comes to sanctions, traditional mechanisms might not be as effective for PSUs. Turnover-based fines, a common approach in competition enforcement, might prove cumbersome to compute given the intertwined roles of PSUs in both economic and social spheres. Additionally, monetary penalties might not effectively deter anti-competitive behavior if the financial burden is borne by taxpayers, diverting from the intended purpose of competition enforcement.

    Unsettled Concerns

    While the debate has been settled to an extent, it is still unclear as to what other activities would be qualified as “sovereign functions” other than those dealing with atomic energy, currency, defense and space. Additionally, Section 54 gives the Central Government powers to exempt an enterprise in the name of public interest – however, there is a lack of specific guidelines as to what comprises “public interest” and to what extent can these enterprises be exempted. In the absence of specific guidelines, the act bestows a wide discretion to the government which could be easily misused and exposed to subjective interpretations. Furthermore, exceptions must be defined to encompass a wide range of essential services, such as government-delegated water supply to economically disadvantaged or remote regions.

    A Way Forward

    There needs to be legislative changes to address the aforementioned concerns and to clear ambiguity regarding the extent and scope of competition law on PSUs. A solution could be the introduction of a public interest assessment mechanism that allows competition authorities to consider the broader public welfare implications when evaluating the competitive conduct of PSUs. This assessment should involve weighing the benefits of competition against the potential adverse effects on public services, national objectives, or other social and economic factors. An example of balancing the applicability of competition law on PSUs or State Owned Enterprise (SOEs) and public interest can be taken from the Italian Competition Authority’s (ICA) decision on breaches of competition rules by Ferrovie dello Stato (FS), the Italian incumbent railway undertaking. While the authority qualified the conduct of FS as a serious competition breach, it levied on it a competition fine of a negligible amount, relying on a special provision that allows the authority to impose the fine of a symbolic amount in certain circumstances. In this case, the authority considered the economic efficiencies and public welfare due to the long-awaited electrification of the Bulleno link as a strong factor for the minimal fine imposed.

    Further, it is time to consider a strict demarcation between the social and commercial functions of Public Sector Undertakings. In essence, this proposition advocates for a deliberate separation of roles that PSUs undertake in the realms of social welfare and commercial enterprise. While PSUs historically embraced multifaceted responsibilities, the interplay of competition law and changing economic landscapes necessitates a refined approach. By delineating their functions, much like the distinct poles of a compass, PSUs can navigate the course more effectively, shedding the inefficiencies that stem from blurred roles and curbing the rampant issue of free-riding. A cardinal benefit of demarcation is the enhanced accountability it ushers in. With delineation, PSUs are better equipped to define their objectives and allocate resources accordingly. This crystallization of purpose not only simplifies governance but also paves the way for enhanced transparency, making it easier to track performance against set goals. Additionally, the separation of roles allows for a more precise evaluation of how PSUs interact with markets and whether their actions may have adverse consequences on competition. For instance, when the social and commercial functions are distinct, it becomes easier to scrutinize whether a particular PSU is using its dominant position in one sector to gain an unfair advantage in another, potentially anti-competitive manner.

    While the concept of clear delineation holds promise, its execution is not without challenges. Identifying the line that separates social and commercial functions demands meticulous analysis, considering factors such as public interest, economic impact, and market dynamics. Striking the right balance between social welfare and business viability requires deliberate calibration. Nonetheless, navigating the delicate balance between PSUs and the Competition Act underscores the need for a nuanced approach that fosters both public welfare and fair market dynamics.

  • Obsolescing Bargain: Do Ex-Ante Provisions Curb Opportunism In Public-Private Partnerships?

    Obsolescing Bargain: Do Ex-Ante Provisions Curb Opportunism In Public-Private Partnerships?

    BY SATCHITH SUBRAMANYAM, A FOURTH-YEAR STUDENT AT GNLU, GANDHINAGAR

    Introduction

    The primary objective of procurement is to source goods or services, at the right quality and price, at the right time. While ‘public procurement’ refers to broader exercise, public-private partnerships (‘PPP’) projects are a means to public procurement. The Government of India views this exercise as entering into a procurement function, as opposed to perceiving it as a mere partnership. This is apparent from the definition of PPP under the Public Procurement Bill, 2012. India is one of the leading markets for PPP projects. Nevertheless, data suggests that out of 1500 projects, that commenced two decades ago, only 48% of them are operational. Even those projects which are operational have left private developers in disdain, due to the lack of adequate financial returns resulting in reduced participation.

    The legal framework for such projects has been streamlined by the Department of Economic Affairs in the form of appraisal and approval mechanisms, which consist of separate guidelines to be followed. The responsibility to oversee such compliance is with the Public-Private Partnership Appraisal Committee (‘PPPAC’). Further, Concession Agreements (‘CA’) are sector-specific and define all the aspects related to the partnership, such as ownership, responsibilities, risk allocation, and contract management. It is essentially a standardized form of the concession agreement between a Government Contracting Authority (‘GCA’) and a private entity (‘Concessionaire’), wherein the GCA awards certain rights to the concessionaire for the implementation and execution of public services. For instance, an agreement is entered into between the National Highway Authority of India and a private operator. In the said agreement certain rights are granted and vested in the private entity for undertaking the operation, maintenance & management of a project highway.

    PPP contracts are intrinsically subject to reassessment, which may be attributed to the long duration of such contracts, spanning years. Decision-makers cannot foresee all the risks. Hence, a critical feature of a PPP transaction is the transfer of specified risks from the GCA to the concessionaire. From the standpoint of the government, this is one of the key methods for obtaining value for money in a PPP transaction by having the private sector take on some risks that would often be borne by the government in a conventional public works project. On the other hand, from the perspective of the private sector, the concessionaire is willing to accept various risks and earn profits by managing them efficiently.

    The downside of incompleteness in concession contracts is that it promotes opportunistic behavior on the part of the contracting parties who seek to interpret this vagueness to their advantage. It ensues in conflicting interpretations, with each party promoting its own agenda. The typical solution to this issue is renegotiation of the contract. It refers to the process of making modifications to the original contract, in order to address unforeseen events, which often entails significant changes to the core concession clauses. Almost 40% of the PPP projects in India are renegotiated. Nevertheless, there is no established legal or institutional framework which governs such renegotiation.

    One central issue associated with the renegotiation of concession contracts is that it can lead to retrospective distortion of the competitive tender procedure. The key attribute of awarding contracts through competitive tenders is that it provides the potential concessionaires with a fair chance to compete for the contract. Moreover, it also ensures that the GCA selects the most qualified concessionaire based on a competitive price while maintaining high standards of performance.

    Post renegotiation, it is doubtful whether the concessionaire chosen for the project delivers the best cost-effective option. This is due to the fact that the projects that were originally tendered and those that were renegotiated are literally two separate projects. Further, the GCA has to be cautious of opportunistic renegotiation initiated by the concessionaire. In the same vein, opportunistic renegotiation on the part of the GCA will not just jeopardize its relationship with the concessionaire but will also serve to be detrimental to the long-term interest of the private sector.

    Obsolescing Bargaining Theory-

    Obsolescing Bargain refers to a private player’s gradual loss in power of negotiation in PPP contracts. This phenomenon results in government opportunism, giving the government an upper hand over the concessionaire. The theory posits that the negotiating leverage shifts during the course of the project. At first, the government offers enticing terms because it needs private investors. Once the project is up and running, the investors need a long amortization period to realize their promised return while the government has already acquired the necessary resources, making the initial agreement no longer relevant. 

    Private entities see a lot of commercial & regulatory risks in infrastructure investment. As compensation for bearing these risks, they expect high returns, which the government is willing to concede ex-ante. Nevertheless, once investors sunk their capital, created jobs, utilized technology, and produced output, their bargaining power was reduced, and the private returns that the government thought were reasonable ex-ante, seemed excessive and superfluous ex-post. Projects like the GMR Ambala Chandigarh Expressway and L&T Halol Shamlaji Tollway, are quintessential to this aspect. In these projects, the issue was attributed to the unrealistic traffic projections before the agreement was entered into. During the operation stage there was lower-than-expected traffic growth which resulted in reduced toll fee collection and, hence lower returns.  

    Indian Contract Law-

    The contractual concept of undue influence, economic duress and the judicial dicta on renegotiation of contracts in general, are against the government engaging in such behavior. In, Atlas Express Ltd. v. Kafco ltd, the Queen’s bench held that, where a party to a contract was under economic pressure to the extent that he was compelled by the other party to renegotiate the terms of the contract to his detriment, his apparent acquiescence to the new terms was vitiated by economic duress. Further, in Mahavir Singh v. State of Haryana, there was a disparity in the bargaining power of the petitioner and the GCA. The court underscored that in such circumstances the private entities are expected to sign on dotted lines, which amounted to renegotiation vitiated by economic duress.

    In tune to these judicial pronouncements, a committee was constituted to formulate a policy on efficiently regulating renegotiation. 

    The Kelkar Committee-

    To curb phenomena such as obsolescing bargaining among others, the government formed the Kelkar committee. The committee report gave many recommendations to revitalize the PPP model in India. Among these, the committee recommendations on obsolescing bargaining was one based on incorporating safeguards in favor of the concessionaire in the CA. The key recommendation was the inclusion of ex-ante provisions in the renegotiation framework. The committee made a case for the ab initio inclusion of such contractual safeguards to ensure a certain level of bargaining power during the renegotiation of issues and prevent jeopardizing the sanctity of the bid award long after the project is finished. Further, the report posits the ex-ante establishment of critical assumptions, and only if the actuals deviate significantly from these assumptions can the renegotiation of the terms of the original contract be allowed.

    One critical prerequisite for the implementation of these recommendations is identifying the possible contingencies while drafting the CA. This usually involves front-end transaction costs which are the costs incurred on identifying possible future events and the efficient allocation of obligations, which are usually high. Concessionaires may protect themselves from these risks through such ex-ante contractual designs. Nevertheless, a major fallout of such measures is that they fail to redress the fundamental incentive for the government to renege. Additionally, a government that is motivated to renege may concoct justifications or look for legal loopholes to do so. Moreover, the government may renege even in cases where a scenario transpires that was anticipated in the original CA. For instance, the government reneges when the country witnesses a macroeconomic shock. Indeed, in such situations, the government indulges in “wholesale reneging” (across several agreements).

    It is understandable that ex-ante provisions in the context of renegotiation attempt to incorporate the flexibility required to promote efficiency. Nevertheless, the likelihood of renegotiation may jeopardize ex-ante efficiency. Consider a scenario where the parties to a CA renegotiate it to ensure effective performance. To do this, they must come to a new understanding of how to divide the surplus brought about by their trade. This surplus is inclusive of the gains from any particular investments, and the concessionaire who makes the investment will already have incurred the associated costs. Therefore non-investors (GCA) will benefit from a larger amount of the gains of investment, but will not incur a larger portion of the investment’s sunk costs (incurred on the investment which cannot be recovered) by participating in the redistribution of the surplus. Hence ex-ante efficiency is compromised since the initial investment is discouraged by the possibility of being “held-up” during renegotiation.

    Therefore, contract design can go some distance in safeguarding the concessionaire from the phenomenon of obsolescing bargaining, but only to a certain extent. At best they serve as an inception for renegotiation in cases where the GCA reneges. Therefore a more effective protection is to be found.

    Conclusion

    The issue of obsolescing bargaining yields a very peculiar state of affairs. While precluding government reneging by means of contract design has failed to hold up well in practice, it suggests that concessionaires can be safeguarded by building a business strategy that ensures equity in bargaining relations. The concessionaire must deliver the project benefits gradually over time. For instance, the concessionaires may intend to develop a project in stages, despite compromising on the economies of scale. The phased transfer of investment and technology will maintain the bargaining power with the GCA. Such a measure will not just protect the concessionaire from unforeseen changes beyond his control, but will also make sure that the recourse to renegotiation is not misused.

  • Financial Creditors As The Super Actors Of CIRP: A Psycho-Analytical Account Of Low Recovery Rates 

    Financial Creditors As The Super Actors Of CIRP: A Psycho-Analytical Account Of Low Recovery Rates 

    BY ROHIT DALAI, A FORTH-YEAR STUDENT AT NLSIU, BANGALORE

    Introduction

    This article argues that the low recovery rates from the Corporate Insolvency Resolution Process (‘CIRP’) under the Insolvency and Bankruptcy Code, 2016 (‘Code’) is a consequence of the vesting of extensive powers with the financial creditors (‘FCs’). This vesting of near plenary control of the CIRPs under the Code provides the FCs with the incentive to make self-interested decisions. The making of the self-interested decision by the FCs is evident in two contexts. First, the interaction of FCs with other actors upon the commencement of CIRP. Second, the decision-making by the FCs as the drivers of CIRP. To this end, the article is divided into three parts. The first part analyses the reasons behind low recovery rates under the Code. In doing so the article uses the social-psychological concept of the ‘discontinuity effect’ to scrutinise the interaction of distinct actors upon the commencement of CIRP. The second part builds on the ‘discontinuity effect’ to study the incentive of the actors and the effect of information asymmetry in a CIRP. In the third part, the article concludes by arguing that the combined effect of the ‘discontinuity effect’, distinct incentives and information asymmetry in the CIRP is the reason for low recovery rates.

     Low Recovery Rates: Discerning the Reasons

    To better appreciate the reasons behind the low recovery rates, it is imperative to delve into the objective of the Code. According to the Preamble, the Code provides for “reorganisation and insolvency resolution of corporate persons, partnership firms and individuals in a time bound manner”. Notably, the Report of the Working Group on Tracking Outcomes under the Insolvency and Bankruptcy Code, 2016 identifies reorganization as the “sole object of the Code” . In the context of the Code’s objective, reorganization rather than liquidation ought to be the mode of closure of the CIRPs. The reorganisation would necessarily entail the  restructuring of the assets and debts thereby ensuring that the business continues with its operations. It is through this objective of keeping the enterprise continuing its operation for the foreseeable future does the Code purport to ensure better returns for ‘creditors of all classes’. In the recent Supreme Court decision in K.N Rajakumar v. Nagaraj and Ors., Justice Gavai through a common judgement and order propounded that under the scheme of the Code, every attempt was to be “first made to revive the concern and make it a going concern, liquidation being the last resort”.[1] Interestingly, empirical evidence points to the fact that creditors of all classes generally get better returns in instances of reorganization vis-à-vis liquidation.[2] However, a scrutiny of the Code in effect evinces the fact that the predominant mode for closure of the CIRPs has been the commencement of liquidation. A perusal of the Quarterly Newsletters released by the Insolvency and Bankruptcy Board of India (‘IBBI’) from 2018-2022 reveals that on average 48% of the CIRPs that were closed, ended up in liquidation. This underlying cause of the mismatch between the purpose and the outcome of the Code can be attributed to the ‘discontinuity effect’. The term ‘discontinuity effect’ is used to refer to the typical phenomenon wherein “groups act more competitively and more selfishly when interacting with other groups than when individuals interact with individuals”. As a corollary to acting selfishly, groups end up engaging in a mode of thinking known as ‘groupthink’.[3] Groupthink is essentially the dominance of intragroup concurrence-seeking and the overriding of “realistic appraisal of alternative course of action”.[4] In the context of CIRP, discontinuity effect and groupthink are evident in the context of the decision making and control over the CIRP by the FCs. It has been observed that the vesting of “near-plenary control of CIRP” in the form of restriction of the voting membership in the Committee of Creditors (‘CoC’) to the FCs, in turn, leads to the FCs to seek a speedy return for themselves. This seeking of speedy returns by the FCs is at the same time a manifestation of the discontinuity effect and groupthink. This manifestation is evident from the frequent prioritisation by the FCs of their monetary payoff over alternative concerns,  “such as fairness or reciprocity” towards other players such as the Operational Creditors (‘OCs’) and the corporate debtor. Moreover, the manifestation is also apparent in opting for liquidation over reorganization even when the recovery rates tend to be low.

    A. Does the Judiciary Mitigate the Discontinuity Effect?

    Pertinently, the Supreme Court (‘SC’) in Swiss Ribbons Pvt. Ltd. and Anr. v. Union of India and Ors.  did charge the FCs who “drive the entire decision making on the CoC” to not ignore the claims of OCs.6 This essentially meant that all creditors were to be equitably treated, even if they have little say in the CIRP. However, a scrutiny of the subsequent judicial pronouncements points towards the adoption of an ‘extreme deferential standard’. Notably, the ruling in Karad Urban Cooperative Bank Ltd. v. Swwapnil Bhingardevay and Ors. and Kalpraj Dharamshi and Anr. v. Kotak Investment Advisors Ltd. and Anr. evinces this extreme deferential standard taken by the SC. The aforementioned cases pertained to allegations of breach of confidentiality while CIRP was underway. The SC in both cases exhibit deference to the commercial wisdom of the CoC. Interestingly, in both aforementioned cases, the SC did not necessarily refer back to the Code while exhibiting deference. This non-reference to the Code points to the fact that the SC failed to take a nuanced view of when the commercial wisdom of the CoC can be deferred to. A nuanced understanding suggests that the CoC’s decision in assessing the feasibility and viability of the Resolution Plan ought to be deferred. In instances where the commercial wisdom of the CoC is deemed to be paramount without the Code being necessarily referred to, the ‘discontinuity effect’ becomes pronounced. This is because in absence of substantial oversight, the FCs as the members of the CoC have ‘unconstrained interaction’ with other actors in the CIRP such as the OCs.7 This unconstrained interactiondoes lead to intergroup competitiveness as groups seek to maximise their benefits.8 In short-run, intergroup competitiveness to maximise outcomes results in a deadlock.9 However, when one of the groups such as the FCs has wider powers and informational asymmetry in its favour, a resultant deadlock is not the consequence. It is this informational asymmetry that further explains the greater liquidation and lower recovery rates.

    Distinct Incentives and Information Asymmetry

    A. Understanding Information Asymmetry Pre-2019

    As has been depicted through the discontinuity effect and groupthink above, distinct actors in CIRP have distinct incentives. It needs to be emphasised that the FCs are driven by the incentive of seeking debt recovery through liquidation. One of the aspects that significantly strengthens the incentive to go for liquidation is the asymmetry of information in CIRP. Pre-2019 the information asymmetry subsisted in the context of taking over of the control and management by the Resolution Professional (‘RP’) and the suspension of the board of directors (‘BoD’) of the company on the commencement of CIRP. Notably, upon suspension, the corporate debtors’ BoD were not allowed access to the resolution plan even though they are given participatory rights -“to be present when required or called for”– in the CoC meeting. This secrecy in the form of non-accessibility of resolution plans produced informational asymmetry. This secrecy with regards to the resolution plan was uncalled for as it was “contrary to the scope, intent and purpose of the Code”. The fact that the erstwhile BoD would know the intangible and tangible value of the assets in addition to them being interested in the value maximisation of the assets of the corporate debtor warranted the supplying of a copy of the resolution plan. Notably, the 2019 decision of the SC in Vijay Kumar Jain v. Standard Chartered Bank held that the erstwhile BoD was to be furnished with the copy of the resolution plan as part of the documents that have to be given in addition to the notices of CoC meetings. While the judgement addresses the problem of information asymmetry to some extent, the problem subsists nonetheless. 

    B. Information Asymmetry and Structural Issues

    The subsisting problem of information asymmetry is also structural when seen in the context of CIRP. While the CoC is entrusted with the task of evaluating the feasibility and viability of the resolution plan in addition to balancing the interest of all stakeholders, it does not necessarily have to deliberate with other stakeholders. For instance, the CoC can benefit from deliberations with OCs to whom the corporate debtor owes more than 10% of the value of its debt. However, the scope for deliberations is foreclosed by the fact that instances, where a single OC is owed such a sum, is likely to be relatively rare. In such circumstances, the CoC does not have to provide the OCs with a forum to put forth their concerns. This non-involvement of the stakeholders such as OCs by the design of the CIRP pronounces the information asymmetry. However, this information asymmetry is distinct in the sense that it works to the detriment of the FCs. Notwithstanding the discontinuity effect and the concomitant self-serving decision-making by the FCs, the free flow of information would allow the FCs to choose reorganisation over liquidation. The fact that FCs go for liquidation even when the probable consequence is low recovery points towards irrationality in decision-making. Put simply, when incomplete information is admitted while making decisions, the decision maker takes decisions that may turn out to be irrational post hoc. Since the CIRP is a “collective process” that intends to bind the corporate debtor’s stakeholders, it is imperative to make provision for effective participation of non-FCs, “whether by giving them an opportunity to vote on the resolution plan, or otherwise”.

    Conclusion

    The low recovery rates under the Code are a combination of two factors. First, the greater control of the FCs over the CIRP. Second, information asymmetry in the process of CIRP. An interplay of the two factors results in liquidation and the concomitant low recovery rates. While the Code seeks to emphasize restructuring, it is the actions of the FCs as the members of CoC that results in the purpose of the Code being defeated. It is only when the loopholes are plugged would the objectives of the Code be realized.

     

     

     

     

  • Extension Of ‘Angel Tax’ Provisions To Non-Residents: Is the Proposed Change Angelic Enough?

    Extension Of ‘Angel Tax’ Provisions To Non-Residents: Is the Proposed Change Angelic Enough?

    BY PURAVA RATHI, A SECOND-YEAR STUDENT AT NLIU, BHOPAL

    Introduction

    The Union Budget 2023, presented by Finance Minister Nirmala Sitharaman, proposed an amendment via the Finance Bill 2023 to Section 56(2)(vii-b) of the Income Tax, 1961. The amendment extends the applicability of the ‘Angel Tax’ to the funding received by privately held, unlisted companies from ‘non-residents’. This tax was previously levied only on the funding received from affluent ‘residents’ or high-net-worth individuals of the country. The provision was introduced in 2012 to mainly combat money laundering, corruption, and tax evasion. The imposition of such a tax is intended to increase transparency.

    However, due to its extension to non-residents, the proposed amendment is set to adversely impact the financing of start-ups, which has been showing a trend since 2022. Funding received by Indian startups has been showing a downward trend since 2022 and has plunged nearly 33% when compared to the previous year.

    This article intends to study the details of the proposed amendment and its impact on the start-up culture of the country. The apparent conflict pertaining to the calculation of the Fair Market Value (‘FMV’), between the Foreign Exchange Management Act, (1999) (‘FEMA’) and the Income Tax Act 1961 (‘IT Act’) has been highlighted. Moreover, the status of such a tax under different jurisdictions and initiatives taken by foreign governments to promote the start-up industry has also been put forth.  

    Details of the Provision and the Proposed Amendment

    Angel investors generally invest in firms where they see growth prospects. A corollary of the same is that they usually opt for convertible debt or ownership equity due to the unpredictability and volatility of the markets. This tax is imposed on the amount that startups receive while selling shares at a premium. When the shares of a company are sold at a higher share price than their FMV, the government taxes the excess income accordingly under the head of ‘Income from other sources’. This provision was introduced in 2012 because, then, the common practice was that of converting black money to white money by investing in shell companies. Therefore, its purpose was to mainly combat money laundering, corruption, and tax evasion.

    The introduction of such a provision was certainly a welcome move. However, there exists no mechanism to assess the genuineness of a transaction. As a result, due to the indistinguishability between bonafide and mala-fide transactions, these ventures suffer.  Therefore, the imposition of the same on finances raised from ‘non-residents’ might be detrimental to the growth of startups in India given that the government is majorly focussing on foreign direct investment, investment facilitation, and the ease of doing business in the Indian economy. 

    In this context, it is also pertinent to discuss certain exemptions from the applicability of the angel tax provided via the exemption notification of 2019. It stated that only ‘start-ups’ recognized by the Department for Promotion of Industry and Internal Trade (DPIIT) and whose total paid-up share capital and share premium after the issuance or intended issuance of shares, if any, do not exceed Rupees 25 Crores are eligible for the exemption. This is limited by the requirement that start-ups must not have invested in or would not invest in the class of assets that includes immovable properties, loans and advances, capital contributions to other entities, shares and securities, motor vehicles, or any other mode of transportation, jewelry, or any other asset class. Funds from non-resident investors shall not be included in computing the aforesaid threshold. However, it is expected that the exempted categories would also be amended soon to align them with the proposed amendment. 

    Implications of the Proposed Amendment

    Interestingly, the proposed amendment presents a dilemma for startup companies. This is because of the induced compulsion to raise shares at FMV. FEMA disallows the issuance of shares below the FMV and the IT Act taxes the amount raised in excess of the FMV. Therefore, startups are constrained to issue shares at the FMV.

    At a time when the startup industry is growing rapidly, with the most significant number of unicorns in India after the USA and China, this government initiative seeks to dampen the enthusiasm and growth prospects. The reason is that foreign investors are the major source of funding for start-ups in the country. India also provides for various schemes to promote and enhance the growth of startups. These initiatives include the Startup India Seed Fund Scheme, the Startup India initiative, and Startup Accelerators of MeitY Product Innovation and Growth (SAMRIDH). However, a provision like an angel tax may have an adverse effect on the advantages of these schemes. The growth of startups, as a result, may be impeded. An obvious outcome could also be apprehension amongst foreign investors due to the increased risk of litigation about the subjective valuation of the company, which is often challenged by tax officials. Due to the application of angel tax, these startups come under the close scrutiny of tax officials, since the excess amount is to be accounted for. The income tax provisions provide for a valuation mechanism for unquoted equity shares which permits the usage of net asset value (formula-based) or discounted cash flow approach as determined by a merchant banker. This creates subjectivity. A higher valuation is likely to be questioned by tax officials, and angel tax would be levied on the excess amount raised.

    Further, with the ambit of the ‘angel tax’ extended, startups would want to shift or establish their base in foreign countries where such tax restrictions are not applied. Such a move may also lead to ‘externalization’ which is the transfer of ownership to a holding company that is based in a conducive business environment in a foreign jurisdiction. This would further impact employment generation and the ease of doing business in the country. Therefore, it is hoped that the government will reconsider this proposed amendment given the complex consequences that are to ensue. 

    Position of ‘Angel Tax’ In Foreign Jurisdictions

    It is pertinent to note that angel tax is not a widely recognized concept in foreign jurisdictions. It is not surprising that such a tax, which disincentivizes funding for startups and the overall growth of the startup culture in the country, has not been adopted by other countries. 

    Canada

    In Canada, there is no specific angel tax provision, but there exist tax credits and incentives for investors who invest in certain types of companies, including startups. For example, the Canadian government offers the Scientific Research and Experimental Development (‘SR&ED’) tax credit to encourage investment in research and development. 

    Canada offers low business taxes for companies and a very good business climate. Total business tax costs here are by far the weakest among the G7 countries.
    Companies investing in Canada can benefit from a range of incentives and tax credit programs including the Global Skill Strategy, Accelerated Investment Incentive, and Innovation Superclusters initiative.

    Australia

    The Australian government, under its National Innovation and Science Agenda (NISA), provides for a ten-year exemption on capital gains tax for investments held as shares for more than 12 months. The scheme also provides for a 20 percent non‑refundable carry-forward tax offset on amounts invested in qualifying early-stage innovation companies (ESICs). Moreover, the country also provides capital gains tax exemptions to eligible foreign investors on their share of capital or revenue gains made under Venture Capital Limited Partnerships (VCLPs).  Such measures as providing tax offsets at the funding stage contribute to developing a healthy startup culture in the country.

    United Kingdom

    In the United Kingdom, the Enterprise Investment Scheme (EIS) and the Seed Enterprise Investment Scheme (SEIS) provide tax relief for investors. The UK has tried to maintain a congenial environment for attracting foreign direct investment. The country also imposes foreign equity ownership restrictions in a limited number of sectors. However, the UK’s decision to implement the improved National Security and Investment Act unfavorably affects the startup ecosystem in the country. The Act aims to investigate hostile foreign direct investment that threatens UK’s national security.  

    USA

    The USA does not have a central law for angel investments. However, it passed the Protecting Americans from Tax Hikes (PATH) Act of 2015 by amending Section 1202 of the Internal Revenue Code. This has made permanent a 100 percent exclusion from capital gains tax for any gains on long-term investments in qualified small businesses, up to 10 million dollars or ten times the original investment, whichever is greater.

    China

    China provides tax incentives to venture capitalists that invest at the seed capital stage. 70 percent of the investment amount can be offset against the taxable income of the venture capital enterprise for Corporate Income Tax (‘CIT’) purposes. Small businesses (whose annual income does not exceed RMB three million) have enjoyed a low CIT rate (2.5%) since 2020, up to a revenue of RMB one million. Small and Low-Profit Enterprises (‘SLPE’) are subject to a 20 percent CIT rate on 25 percent of their taxable income amount after the adjustment.  Therefore, the effective CIT rate for SLPEs is currently 5 percent. Because the SLPE evaluation is carried out at the entity level (instead of at the group level), small subsidiaries of foreign multinational enterprises (MNEs) in China can also benefit from these CIT cuts.

    Therefore, there do not exist any specific angel tax provisions in prominent foreign jurisdictions. These countries may serve as the perfect opportunity to escape the application of the angel tax provision, thereby leading to externalization, as discussed above. They function as tax havens, incentivizing the funding process for non-residents and subsequently benefiting the company.

    Conclusion

    In light of the above discussion, certain further amendments or notifications on the part of the government are expected to clarify the apparent conflict between the two laws. It is also imperative to consider that there already are various acts that govern and control these transactions in India, including the IT Act and FEMA. This raises pertinent questions as to the need for such a provision in the Indian context. Moreover, startups find it burdensome to bear the levy of this tax, as most of the funding received from non-residents goes into paying it. Since there are more unfavorable effects of the proposed amendment than favorable ones, it is imperative that the government reconsider the amendment before its implementation.