Auditors more accountable, need to be more independent under new company law

DeepaMookerjee_CompaniesBillSeeking greater transparency and corporate responsibility, the Companies Act, 2013 (“New Companies Act”) has changed the role of auditors in companies.

Discussions about the role of auditors took center stage in the United States after a number of corporate scandals — the best documented of them being the Enron scandal, which sounded the death knell for its auditor, Arthur Andersen. Reacting to this scandal, the United States passed the Sarbanes Oxley Act, 2002 (“Sarbanes Act”).

Arthur Andersen (1885-1947) was one of the founders of the firm that came to be known as Arthur Andersen & Co. in 1918.
Arthur Andersen (1885-1947) was one of the founders of the firm that came to be known as Arthur Andersen & Co. in 1918.

This law established a separate body for the independent oversight of public company audits. This ended more than hundred years of self-regulation of the public company audit profession. The Sarbanes Act also prescribed that all audit committees (in listed companies) be independent of the management. This independent audit committee, rather than the management, would be directly responsible for the oversight of the external auditor. Additionally, audit firms were prohibited from providing certain non-audit services to the companies they audit.

All these provisions — ensuring that auditors are independent, free from all external influences, and solely responsible for doing their job efficiently — stem from the basic motive of increasing their accountability. Since its notification, the Sarbanes Act has been both critiqued and applauded.

In India, the Satyam scandal brought to the fore the inadequacies in the regulatory scrutiny of accounting. It is shocking that B. Ramalinga Raju could stand before the company’s board and admit that he had falsified accounts for “several years” to stave off a takeover, when a reputed accounting firm such as Price Waterhouse India (“PWC”) had been auditing their accounts for several years. While PWC claimed that they had received adequate evidence from Satyam and had carried out audits in accordance with applicable Indian auditing standards, the scandal begged the question whether it could have been averted if there had been stricter regulatory scrutiny of auditors. The following questions were also asked: Should a company be forced to rotate its auditors? Should there be a greater liability on auditors to deter such scandals? Let us now see whether the New Companies Act provides any answers.

Auditor’s term                                                          

Advanced Commercial ContractsUnder the Companies Act, 1956 (“1956 Act”), an auditor was appointed at the annual general meeting, for a term of one year. Under Section 139 of the New Companies Act, an auditor will be appointed at the first annual general meeting and will hold office till the end of the sixth annual general meeting, though its appointment will be ratified at every AGM.

Mandatory rotation

The New Companies Act (Section 139(2)) read with the draft rules provide for the mandatory rotation of auditors. Individual auditors will be compulsorily rotated every five years and the audit firm will be rotated every ten years in all companies except one-person companies and small companies. This step was inserted to ensure that auditors do not increase their familiarity and reduce their independence by continuing to audit a company for an unlimited period of time. One questions however, whether such stringent requirements are needed in private companies.

A more basic question is whether the rotation of auditors really results in independence? The Standing Committee on Finance reviewing the Companies Bill was sure that rotation does in fact lead to independence. On the other hand, some feel that companies do not have much choice in relation to auditors, and that such rotation may lead to cartelisation among large audit firms. Another argument is that the rotation policy discourages small and medium-size audit firms from investing in technology and training because of the uncertainty of securing another client of the same size operating in the same industry, given that there are only a few large players operating in a particular industry. Arguments from both the sides appear to have some strength.

Cooling period

A cooling period of five years is also prescribed (Proviso to Section 139(2)) before the reappointment of auditors who complete one term. The same company cannot reappoint such auditors or audit firms for the next five years after completion of one term.

Non-audit services

Similar to the Sarbanes Act, the New Companies Act in Section 144 lists a few services that a company’s auditor cannot provide, directly or indirectly, to the company and its holding and subsidiary companies. The intent is to ensure that the auditor avoids any conflict of interest arising from the provision of other services such as accounting and book keeping, internal audit, management, and actuarial and, investment advisory services.

Tribunal’s power to remove auditors

While no separate regulatory body has been set up to regulate auditors, the National Company Law Tribunal (“Tribunal”) has (in addition to the company itself) the power to order the removal of auditors. The Tribunal under Section 140(5) can order a company to remove its auditor, if it believes the auditor has acted in a fraudulent manner, or abetted or colluded in any fraud.

Reporting fraud

The New Companies Act also enhances the accountability of auditors. It does so by placing on auditors, the onus of reporting fraud noticed by them, during the performance of their duties (Please see the draft rules).

(Deepa Mookerjee is part of the faculty on


Put and call options: New legitimacy but doubts remain

DeepaMookerjee.jpgIn what is being termed as an “investor friendly” move, the Securities and Exchange Board of India (“SEBI”), permitted put and call options in shareholders agreements through a notification dated October 3, 2013. It appears that it will help clear up some of the ambiguity regarding the validity of these options under Indian law.

Simply, a “call option” is a right but not an obligation to purchase shares at a specified price, on the happening of a specified event. Assume that there are two investors — A and B — in a joint venture company. A has a call option over twenty-six per cent shares held by B, which he can exercise once the foreign direct investment (“FDI”) cap is raised. This means that once the FDI cap is raised, A has a right to purchase twenty-six per cent shares from B. If A exercises this right, B cannot decline to sell the shares to A.

A “put option” on the other hand, is a right but not an obligation to sell shares upon the occurrence of a specified event at a specified price. Here, assume that A has a put option over twenty-six per cent of his own shares in the company. A can exercise this option once the company is insolvent. If the company declares insolvency, A can sell his shares to B. Once A exercises his put option, B cannot decline to purchase A’s shares.

Historically, put and call options, along with other rights such as pre-emption rights and right of first refusal have been the subject of much controversy in India.

Prohibition under company law

Section 111A of the Companies Act, 1956 stated that shares of all public companies were freely transferable. Hence, any restriction on the transfer of shares (including options in shares) would be illegal. Since, put options and call options restricted a person’s right to transfer shares, such options were illegal. Based on this, some market players took the view that even though these options were prohibited in a public company, private companies were free to incorporate such conditions.

This issue has been put to rest in the Companies Act, 2013, which states in the proviso to Section 58(2) that any contract or arrangement between two or more persons in respect of the transfer of shares will be enforceable. Though there has been no formal explanation for its insertion, one could argue that the proviso recognises shareholders’ competence to contract. It appears therefore, that this proviso lends legal sanctity to put and call options, which are essentially agreements for the transfer of shares between shareholders.

Prohibition under securities law

The Securities Contracts (Regulation) Act, 1956 (“SCRA”) and the Securities and Exchange Board of India (“SEBI”) are the next set of roadblocks to these options. This is because, the SEBI had issued a notification in 2000, which provided that no person can enter into any contract for the sale or purchase of securities other than spot delivery contracts (Section 18, SCRA) or permissible contracts in derivatives. A “spot delivery” contract is one where the delivery and payment of shares takes place on the same or following day. (For a more detailed understanding of the development of the law, please look at Investment Agreements in India: Is there an “Option?”)

Through a number of decisions (the Cairn Vedanta case and the Vulcan case), the SEBI reiterated its view that call and put options were prohibited because:

  • they were not valid derivative contracts that can only be traded on a stock exchange (Section 18A, SCRA); and
  • put or call options give parties the right to trade on shares at a future date which makes it an invalid “spot-delivery” contract under Section 2 (i) of the SCRA.

Contingent contracts and the Bombay High Court

Securities-LawMoreover, the Bombay High Court in Niskalp Investments held that a clause permitting the buy back of shares if certain conditions were not met would be hit by the restriction in relation to spot delivery contracts. Contingent contracts were also therefore, hit by prohibitions on spot delivery contracts. One can argue that call and put options are contingent contracts that come into effect once they are exercised. Once exercised, the delivery of shares and payment can take place simultaneously. These clauses therefore, are not invalid spot-delivery contracts. This position gained legal backing in MCX Exchange, where it was held that options come into existence only once the option is exercised. Till such exercise, the option is not fructified and therefore not hit by the prohibition. From all this, it was clear that there was much judicial debate on this issue. No clear answer was emerging.

In its recent notification, the SEBI has permitted options in shares and rescinded its 2000 notification. Put and call options are now permitted provided the seller owned the “underlying securities” for at least one year from the date of the contract, the transfer is priced according to existing laws, and the underlying securities are delivered. This puts the controversy to rest as far as SEBI is concerned, to a certain extent.

The RBI’s view

The Reserve Bank of India (“RBI”) had also expressed doubts on put and call options. It felt that granting put options to non-resident investors was akin to a debt investment made by such an investor. This is because an investment backed by a put option meant that the non-resident was guaranteed a specific rate of return. Such a transaction would therefore need to comply with the External Commercial Borrowing (“ECB”) Regulations. In fact, the Consolidated FDI Policy of October 1, 2011 contained a provision that stated that equity instruments issued or transferred to non-residents having in-built options or supported by options sold by third parties would lose their equity character and such instruments would have to comply with the extant ECB guidelines.

Interestingly however, this statement was later deleted from the policy by a notification issued by the Foreign Investment Promotion Board. This led to further confusion. Did the withdrawal mean that the RBI had implicitly permitted these transactions or that it was simply a withdrawal due to public pressure? The RBI has not clarified matters and this confusion still exists. Therefore, even though listed companies may get the go ahead from the SEBI, the RBI may still be a roadblock.

The Bombay High Court, the RBI, the SEBI, and the Ministry of Corporate Affairs have all made their views on put and call options heard.
The Bombay High Court, the RBI, the SEBI, and the Ministry of Corporate Affairs have all made their views on put and call options heard.

To conclude therefore, the SEBI Notification has not put the controversy to rest. Since the SEBI Circular is only prospective, it only protects investments from October 3, 2013. Clarity is still required on the treatment of those arrangements entered into prior to October 3, 2013. Will those clauses be void?

Till these final issues are put to rest, the question mark still remains over the validity of put and call options.

(Deepa Mookerjee is part of the faculty on



Hold your horses, we don’t have a new company law just yet

DeepaMookerjee_CompaniesBillThe Companies Bill, 2013 finally received Presidential assent on August 29, 2013. It has also been published in the Official Gazette, as the Companies Act, 2013 (the “Act”). Even so, this law has not yet come into force totally. All the substantive provisions have not yet been notified. This is clear from Section 1(3).

“This section shall come into force at once and the remaining provisions of this Act shall come into force on such date as the Central Government may, by notification in the Official Gazette, appoint and different dates may be appointed for different provisions of this Act and any reference in any provision to the commencement of the Act shall be construed as a reference to the coming into force of that provision.”

The substantive provisions of the Act therefore, will be effective only once notified by the Central Government in the Official Gazette. No such notification has been made. Until then, we can assume that the Companies Act, 1956 continues in operation.

Given that the Act proposes sweeping changes in the way business is carried out, it is expected that the Act will be implemented in phases, giving companies enough room to comply with the new provisions.

The Corporate Affairs Ministry is also drafting new rules for implementing the Act. The draft rules will soon be published on the website of the Ministry of Company Affairs and all interested parties, including the general public would have the opportunity to provide comments and suggestions within a prescribed period.

Mergers-and-Acquisitions-LawWhile there is no schedule or timeline for the Act to come into force, companies should consider setting their house in order, to ensure they are in a position to be compliant with the new provisions.

(Deepa Mookerjee is part of the faculty on



Companies Bill – Of public offers and private companies

The inclusion of two definitions — “private company” and “listed company” — in the Companies Bill, 2012 (“Bill”) raises some questions. Our current understanding of company law suggests that the two terms cannot apply to the same company at the same time. Let us see how the Bill has changed that.

Private company

Under Section 3(1)(iii) of the Companies Act, 1956 (“Act”), a “private company” cannot have more than fifty members. The definition in Clause 2(68) of the Bill says a “private company”:

… means a company having a minimum paid-up share capital of one lakh rupees or such higher paid-up share capital as may be prescribed, and which by its articles,—

(i) restricts the right to transfer its shares;

(ii) except in case of One Person Company, limits the number of its members to two hundred…

So the Bill has proposed that the limit on the maximum number of members that can constitute a private company be increased from fifty to 200.

When is a public offer necessary?

There is a problem when this proposal is read with Clause 42 of the Bill. Clause 42 is part of Chapter III, which deals with the allotment of securities by companies and features in Part II of Chapter III, where private placement is discussed. It states that:

42. (1) Without prejudice to the provisions of section 26, a company may, subject to the provisions of this section, make private placement through issued of a private placement offer letter.

(2) Subject to sub-section (1), the offer of securities or invitation to subscribe securities, shall be made to such number of persons not exceeding fifty or such higher number as may be prescribed, [excluding qualified institutional buyers and employees of the company being offered securities under a scheme of employees stock option as per provisions of clause (b) of sub-section (1) of section 62], in a financial year and on such conditions (including the form and manner of private placement) as may be prescribed.

Explanation I. – If a company, listed or unlisted, makes an offer to allot or invites subscription, or allots, or enters into an agreement to allot, securities to more than the prescribed number of persons, whether the payment for the securities has been received or not or whether the company intends to list its securities or not on any recognised stock exchange in or outside India, the same shall be deemed to be an offer to the public and shall accordingly be governed by the provisions of Part I of this Chapter.

Publicoffer_PrivateCompanyClause 42(2) will therefore create a contradiction when it becomes law. Private companies are permitted to have more than fifty members but any offer to more than fifty people will amount to a public offer and trigger all the requirements to be fulfilled under Part I of Chapter III of the Bill, which deals with public offers.

Listed company

Another question arises when we consider the definition of “listed companies” in the Bill. Currently, Section 2(23A) of the Act defines the term “listed public companies”. The Bill, however, defines the term “listed company” in Clause 2(52), thus proposing an increase in the scope of the current definition. The new definition is not limited to public companies and includes any company that has any securities listed on a recognised stock exchange.

Securities-LawThe proposed change will impact companies that have so far listed securities like debentures without technically falling within the ambit of the definition of “listed public companies”. Additionally, where such companies are private companies and have offered these securities to more than fifty people, it will be difficult to determine how they are to be treated under the proposals of the Bill.

The proposed definitions therefore, can create a dichotomy in the law — a company can be a private company and still be forced to make a public offer, while remaining a private company under the provisions of the same law. Until this position is clarified, it remains to be seen how securities lawyers and companies issuing securities will tackle it once the bill is notified.

(Deeksha Singh is part of the faculty on


Companies Bill brings in changes to mergers and amalgamations regime

DeepaMookerjee_CompaniesBillThe Companies Bill, 2012 (“Companies Bill”) proposes a number of key changes to the manner of implementing mergers and amalgamations in India. Let us have a look at Clauses 230 to 240, the provisions that impact the mergers and amalgamations regime as a whole.

Recognition of the forms of business restructuring

In the explanation to Clause 232(8), the Companies Bill has recognised, for the first time, the various forms of business restructuring used in the market.

A merger by absorption: The undertaking, property, and liabilities of one or more companies, including the company in respect of which the compromise or arrangement is proposed, are to be transferred to another existing company.

A merger by formation of new company: The undertaking, property, and liabilities of two or more companies, including the company in respect of which the compromise or arrangement is proposed, are to be transferred to a new company.

A scheme: The undertaking, property, and liabilities of the company in respect of which the compromise or arrangement is proposed, are to be divided among and transferred to two or more — existing or new — companies.

Regulatory approval for mergers and de-merger schemes

The Companies Bill has also proposed replacing the High Court with the National Company Law Tribunal (“NCLT”). All merger and de-merger schemes would now have to be filed before the NCLT for approval. While the creation of a single forum for approving mergers and amalgamations is welcome, it is still to be seen when the NCLT will be established. After all, even the Companies Act, 1956 (“Companies Act”) had provided for its establishment. Till the NCLT is formed, the power to approve schemes will continue to lie with the High Courts.

Currently mergers between listed companies need prior approval from the securities regulator, the Securities and Exchange Board of India (“SEBI”) (Feb 4, 2013 SEBI circular), and certain combinations need approval from the competition regulator, the Competition Commission of India (“CCI”). Clause 230 (5) of the Companies Bill, makes it mandatory that a notice for a merger or de-merger to be sent to the:

  • Central Government,
  • Income tax authorities,
  • Reserve Bank of India (“RBI”),
  • SEBI,
  • Registrar,
  • Stock exchanges,
  • CCI,
  • official liquidator, and
  • any other sectoral regulator.

These notices need be sent only if the particular regulator has jurisdiction over the deal. For instance, a merger between two unlisted companies need not be notified to the stock exchanges or the SEBI. However, depending on the market share in question, it may need to be notified to the CCI. Each regulator has also been given a time period of thirty days to file any representations or objections it may have. Once the thirty-day period expires, it is deemed that the regulator has no objections.

It will be interesting to see how these provisions tie in with the current notification requirements under the Competition Act, 2002 and the SEBI regulations. The Companies Bill does not remove the requirement for notification under the other laws. Notification requirements under the Companies Bill therefore, may amount to an additional procedural step. It is however a step in the right direction because an attempt has been made to consolidate different requirements under one main law.

NCLT can dispose of a creditors meeting

Another interesting proposal is to empower the NCLT to dispense with creditors meetings. Under the Companies Act, all schemes must be approved at a shareholders and creditors meeting, by a majority in number, representing three-fourths of the value, of those present and voting. While this requirement has been retained, given the serious nature of a merger or de-merger, the NCLT can now dispense with calling of a meeting of creditors or a class of creditors where those creditors or class of creditors, having at least ninety per cent value, agree and confirm, by way of affidavit, to the scheme of compromise or arrangement (Clause 230(9), Companies Bill).

This should go a long way in simplifying the process for a merger or de-merger, while at the same time ensuring that a majority of the creditors agree to such a fundamental change in the company.

Fast-track amalgamations

The new Companies Bill seeks to simplify the merger process for a certain types of companies. In a “fast-track approval”, companies need not file schemes with the NCLT. The Central Government has the power to approve the scheme. Once approved, the scheme may be filed with the Registrar of Companies within thirty days. On registration, the scheme will be effective.

Clause 233 of the Companies Bill permits fast-track mergers or de-mergers, between:

  • Two or more small companies;
  • A holding company and a wholly-owned subsidiary company; and
  • Such other classes of companies as may be prescribed.

A small company has been defined to mean a ‘private company’ that has paid-up capital that does not exceed Rupees Fifty lakh (or higher amount as may be prescribed but not be more than Rupees Five crore), or turnover (as per its last profit and loss account) that does not exceed Rupees Two crore (or higher amount as may be prescribed but not more than Rupees Twenty crore) (Clause 2(85), Companies Bill).

This definition is important because the Companies Bill does not provide this exemption to small companies that are public companies. Only small private companies that are merging with each other are entitled to this relaxation.

Cross-border mergers

Clause 234 of the Companies Bill permits mergers and amalgamations between Indian and foreign companies subject to rules prescribed by the Central Government in consultation with the RBI. A foreign company can, subject to the prior approval of the RBI, merge, or amalgamate into an Indian company or vice-versa. The Companies Act on the other hand, only permitted a merger of a foreign company with an Indian company.

Mergers-and-Acquisitions-LawThese are just a few of the broad changes proposed in relation to mergers and amalgamations. In the next post, we will explore the law in relation to the acquisition of minority interests in mergers and amalgamation schemes, and how these changes affect other aspects of M&A law.

(Deepa Mookerjee is a member of the faculty at