RBI makes 1000s of companies anxious by “Are you an unregistered NBFC?” notices

Over last week, Reserve Bank of India has sent notices to thousands – tens of thousands perhaps – of companies asking them whether they are NBFCs. And, if yes, why they have not registered.

This is worrying because if a Company is an NBFC and has not registered, it entails serious consequences for the Company and its concerned directors/officers. For example, the law provides for minimum and mandatory punishment of one year for non-registration as NBFC.

The other thing is that the definition of NBFC itself is confusing and contradictory. On one hand there is a qualitative definition that treats the principal business as the determining factor whether the Company is an NBFC. On other hand, in certain circulars/press note, Reserve Bank of India has provided for quantitative method/formula for determining what is an NBFC. The nature of activities included as finance activities is also broad but subject to different interpretation. Even relatively minor terms like “financial assets” are subject to varying interpretations. For example, is fixed deposit in bank a “financial asset”?

It does not help that Reserve Bank of India has expressly declared that it is the sole and final judge (subject to “consultation with the Central Government”) to decide whether a Company is an NBFC or not. It also does that help that there is no appellate tribunal to appeal against decisions of Reserve Bank of India.

Further, even the Reserve Bank of India and law makers are sending mixed signals. In perhaps unduly haste, the law makers made a drastic and unduly broad law in 1997. It required any and every company engaged in specified finance activities to register as NBFC first even if it intended to use own funds for its business and not accept any public deposits. There is no minimum size of companies that are exempt from registration. In fact, there is a minimum entry barrier of Rs. 2 crores net owned funds for registration. Hence, even the smallest and largest of companies are subject to registration. The registration process is not a simple process of filing some documents. It is a prolonged affair involving detailed scrutiny of antecedents even for small companies operating with own funds. Several times initiatives were taken to make these absurdly broad provisions narrow. About two years back, a fairly large category of companies – Core Investment Companies – were exempted from registration but subject to certain restrictions and requirements. Further, just last year, an expert Committee recommended that companies below certain size (Rs. 1000 crores of assets in some cases) should not be required to be registered. That would have excluded most medium sized and small companies. Indeed a few months back, Reserve Bank of India even issued draft guidelines proposing to give effect to this, though final guidelines have not been issued.

And now these notices. The process of responding and disposal will be prolonged and time consuming for the companies, their auditors and of course the Reserve Bank of India itself. As stated above, determining whether a Company is an NBFC or not is subject to qualitative and/or quantitative criteria.

There are other concerns too. The consequences of non-registration are not just the stringent punishment of imprisonment for non-registration and fine. The question is what would happen of consequential non-compliances. A registered NBFC is required to follow several directions, particularly relating to Prudential Norms. It is possible that these would not have been followed.

The onus of reporting whether a Company is NBFC or not is on their auditors too by specific Directions addressed to them. Non-compliance by them would be subject to fine, in some cases prosecution and also reference to the Institute of Chartered Accountants of India.

It is possible that one reason for this step is the recent uncovering of numerous companies in West Bengal and elsewhere having raised thousands of crores from the public, a large part of which may be lost.

The coming days would thus be anxious days for these companies – and others who have not yet received such notices.

One Person Company – a still-born, half-baked concept?

The Companies Bill 2012 proposes a new concept of One-person Company (OPC). The obvious objective is to overcome the hurdle of needing a second person to form a company, despite the saying that “two’s company”. This brief post is to highlight its nature, some issues and also questioning the real benefit of an OPC.

OPC, as the term implies, is a company with one and only one shareholder. The need to have two directors also is avoided and only one director is needed. However, unlike a shareholder, the number of directors can be more than one. And the single shareholder need not be the director or any of the directors. A succeeding shareholder will have to be named in case of death of the initial shareholder.

Thus, it is expected to help an individual incorporate himself/herself. The need to find a second shareholder/director for a proprietary business in corporate form is avoided.

Succession/transfer of a business in corporate form is clearly easier than if it owned in a sole proprietary form. And one can delink different businesses in separate OPCs since there is no limit on how many OPCs one single individual can form.

The OPC will have to add the tag One-person Company under its name.

Some other procedural concessions in terms of meetings, etc. are given for obvious reason that there cannot be a “meeting” of a single shareholder/director.

However, beyond a few procedural concessions, and avoidance of the need of second shareholder/director, it is not clear what substantial benefits are available. The relatively long/complicated procedure for formation, maintenance and dissolution of a Company remain without any major relief. The requirement of finding a second shareholder/director is generally not found cumbersome in India where a friend, relative or staff member can easily act as such.

Further, except a few minor procedural concessions, the provisions of accounts, audit, etc. would also apply to an OPC.

Certain businesses like that of finance may face problems if sought to be carried in a Company form. Thus, an individual engaged in business of lending or investments may need prior registration from the Reserve Bank of India, minimum net owned funds of Rs. 2 crores, etc.

Conversion of existing proprietary businesses can create complexities of tax. There is an existing provision in the Income-tax Act, 1961 (section 47(xiv)) which should help in availing relief from capital gains, even if originally it was not framed with an OPC in mind. However, other tax issues may remain. The concern of deemed dividends under Section 2(22)(e), the question of allowability of remuneration to proprietor, etc. are some other challenges an OPC may face. The other challenge will be of stamp duty on transfer of the business to the OPC.

Strangely, it is not clear how an OPC may go to the next logical step of becoming a non-OPC when it wants to introduce more shareholders. Ideally, a simple amendment of its memorandum and articles should have sufficed. However, there are no specific provisions enabling this. The question therefore is whether an OPC is doomed to remain a one shareholder company during its existence?

Conversion from a non-OPC to an OPC has also not been provided for. Thus, an existing private limited company may not be able to convert itself into an OPC.

OPCs should have been useful particularly in case of wholly owned subsidiaries of companies where the parent company would be the sole shareholder. However, there is a requirement that makes one wonder whether a company can be the sole shareholder. The definition of OPC does talk of a “person” being a shareholder. However, it is required that a succeeding shareholder be named in case of death of the initial shareholder. The concept of death is generally understood in sense of natural persons and not companies. Thus, unless one takes a view that this requirement is not a mandatory one or stretch it to include dissolution of a company, the concept of OPC may not be available for forming a WOS.

All in all, it seems that despite the initial enthusiasm that this concept received, it seems that in practice, this by itself is not likely to encourage sole proprietors to convert into a company in large numbers. 

Mandatory imprisonment under Companies Bill 2012

The Companies Bill 2012 has an innocuously titled chapter titled “Miscellaneous” which provides stringent and perhaps unprecedented punishment.

The Chapter provides for imprisonment and fine for several types of situations. A minimum imprisonment (six months/three years) is also provided.

Clause 447, for example, says that any person found guilty of fraud shall be punishable with imprisonment of at least six months but which may extend to 10 years and fine. The fine shall be at least the amount involved but may extend to 3 times such amount. If the fraud involves the public interest, the minimum imprisonment would be 3 years.

The term fraud is widely and inclusively defined. It has to be in relation to a company/body corporate, public or private, listed or unlisted. There should be an intent to deceive, to gain undue advantage from or to injure the interests of specified persons. There are no requirements of minimum amount, materiality, etc. for such act/omission, etc. to be treated as fraud. The affected person may be the Company, the shareholders, the creditors or any other person. The fraud may be committed by any person. The person need not have gained any amount and the affected person need not have lost any amount.

There are other provisions in the Bill that refer to this clause and deem certain actions to be “fraud” punishable under clause 447. For example, furnishing of false information or suppression of material information in documents filed with the Registrar in relation to registration of a Company amounts to fraud and punishable under clause 447. So is the making certain untrue/misleading information in any prospectus.

Clause 448 refers to intentional making of materially false statement or omitting material facts. These may be in documents such as report, certificate, financial statement, prospectus, or other document required by or for the purposes of the Act or rules. These too will be punishable as fraud under Clause 447.

Clause 449 states that intentional giving of false evidence while being examined on oath or in a solemn affirmation attracts minimum imprisonment of 3 years and which may extend to 7 years.

In view of specific provisions in clause 441, the offences listed above are not compoundable.

While frauds, misstatements, etc. have been of serious concern recently, one wonders whether such stringent, minimum and mandatory punishment for such a broad group of cases is justified and whether it has been adequately debated. 

Yet another CIS scam? Further loss of 100s of crores of rupees by investors?

Yet another CIS scheme is unearthed, by income-tax authorities who intimates the details to SEBI. SEBI investigates and passes an Order asking the Company to repay investors or face prosecution. However, it is almost certain that investors will lose significant part of their monies, considering the huge amounts collected and the low assets the company has. The liabilities in this case are at least Rs. 800 crores, while the stated market price of the assets are barely half of this amount. And this value too would not be wholly realised in case of a distress sale. On other hand, it is not wholly clear whether the amount of liability is all inclusive.

The modus operandi of the company, if one accepts the allegations of SEBI as fully true, is depressingly familiar and just one of the many variants seen in such cases. Highly paid agents are employed. In this case, the commission paid to agents are as high as 30% of the amounts collected in several years. The amounts are collected on the basis of an assured return which, in this case, is12% p.a. However, the company claims that this is really a booking amount for land but has option for refund with assured returns. SEBI rejects this submission as unacceptable considering various factors such as no land deeds being registered, the plot of land not even been identified, the almost nil record of any investor opting to buy land and so on.

Since this Scheme has been operating over several years, the amounts collected accumulate, far exceeding the assets. If the findings of SEBI are correct, then this seems to be yet another Ponzi scheme.

SEBI has ordered the company to refund the amounts raised with promised returns within three months. SEBI has stated that in case of non-compliance, it will initiate prosecution and refer matter to the State as well as Ministry of Corporate Afairs.

It is almost certain that the Company will not be able to make such payments. The book value of the assets, consisting of at least 50% immovable property, is about 50% of its dues. It is not wholly clear whether even such dues include the returns promised and if they do not, the shortfall will be even higher. The shortfall will also almost certainly increase since the land will realize much lesser value on distress sale. Considering the huge cumulative shortfall, it that the investors will lose substantial money and will be a long time before they see any of it.

Another interesting aspect is that the Company seems to have been operating at least from 1999, the year in which SEBI notified the CIS Regulations and continued upto 2009 till the income-tax department informed SEBI of the acts of the Company. Thus, in this case, there was neither prevention nor detection by SEBI. Remedy, as discussed above, also seems to be unlikely. At best, the Company and its Promoters will join the long list of parties against whom SEBI has instituted prosecution.

It is also curious that despite several states, including Maharashtra where this Company is located, have broadly framed and fairly stringent State laws for taking action against persons who raise monies in this manner, such Schemes continue to operate and collect huge amounts of monies. The Supreme Court has recently upheld these Acts reversing certain earlier decisions that had held them to be unconstitutional. SEBI too has stated in its Order that it will refer this matter to the concerned State authorities for taking action. It will have to be seen whether and how action would be taken under such acts will be.

The Mint also reported recently the fact that such schemes are rampant in West Bengal. As per this report, SEBI has asked the finance ministry that the task of overseeing such companies should be to a regulatory watchdog. One wonders how SEBI could say this, considering the provisions relating to CIS under the Act and specific Regulations therefor. Reserve Bank of India too, as per this article, is claiming that the manner in which the monies are raised do not fall under its jurisdiction.

A thorough review of the law and its implementation seems due not to ensure that a duly empowered body in a speedy and effective manner prevents, detects, investigates and remedies such cases and in appropriate cases levies stringent punishment. 

Amendments to Takeover Regulations

SEBI has recently made certain amendments to the Takeover Regulations 2011 which are as follows:-

Public announcement in case of preferential allotment

In case an open offer is triggered by a preferential announcement, it is now provided that the public announcement shall be made on the date when the Board of Directors authorizes such resolution. The erstwhile requirement was that public announcement shall be made on date of passing of special resolution approving the preferential allotment. A related amendment further provides that in case the acquisition through preferential allotment is not successful, the open offer shall still not be withdrawn.

There can be a valid concern that the acquirer would have to make an open offer and acquire shares even if he is unable to acquire shares pursuant to the preferential allotment. However, it is generally unlikely that the Board would initiate a proposal for preferential allotment and then the resolution is not approved.

This preponement may affect the pricing of the open offer since the minimum offer price is calculated with reference to the date of public announcement. The schedule of open offer would also change.

Revised trigger date for public announcement for multiple methods of acquisition

A new non-obstante clause 12(2A) provides for a revised trigger date for public announcement when the acquisition is proposed through (i) agreement and one or more specified modes, or (ii) otherwise through one or more of such specified modes. In such cases, the public announcement shall be made on the date of the first of such of such acquisitions and the acquirer cannot wait till the open offer trigger is actually crossed. Thus, if, say, an acquirer proposes to acquire 31% through 3 modes, 10%, 12% and 9% in that sequence, the public announcement needs to be made on making of the first acquisition of 10%. The acquirer shall disclose the proposal to make further acquisitions in such public announcement.

This would apply if all the acquisitions are together “proposed” at the first instance. If, however, shares are acquired below the trigger point and later further shares are acquired without the later acquisition being part of the original proposal, then I think the public announcement would be triggered only when the open offer trigger is crossed.

Completion of acquisitions during the offer period

Where the acquisition is proposed through preferential allotment or through stock market settlement process (other than bulk/block deals), the acquirer can now complete the acquisition while the open offer is in process. However, the shares shall be kept in an escrow account and the acquirer shall not exercise voting rights on such shares. The shares in escrow account may be released after 21 working days of the public announcement if the acquirer deposits 100% of the open offer amount assuming full acceptance.

Disclosures when acquirer’s holding goes below 5%

Disclosures of holdings are intended to begin when an acquirer acquires 5% or more shares and thereafter when he further acquires/sells 2% or more shares. A question that arose recently whether disclosure is required if there is a sale of 2% or more shares and the post-sale holding thereby goes below 5%. The amended clause now provides that disclosure is required also for the sale which results in the holding going below 5%. This was even otherwise an accepted interpretation as, for example, in Bhavesh Pabari v. SEBI (2012) 24 Taxman 64 (SAT).

Reference date in case of buyback of shares

Increase in percentage holding of a non-participating shareholder in buyback of shares may result in implications under the Regulations. A certain period is given to the shareholder to restore his shareholding so that there are no implications. It is now specified that this period shall be calculated from the date of the closure of the buyback offer.

Zenith SEBI Order - disturbing findings and curious SEBI Order

SEBI’s recent interim Order and findings in Zenith’s case again present many disturbing things, as appears from SEBI's allegations in the orders. How Promoters can easily divert to related parties monies belonging to creditors and shareholders. How existing laws cannot prevent them and even their enforcement and recovery of lost monies could be a prolonged process. Thus creditors have to wait a long time and spend a lot of efforts and monies before they can get some of their dues. How shareholders would lose their monies – like Satyam – and may finally have only some satisfaction that the Promoters are punished. And how SEBI resorts to drastic and desperate orders which though may appear to be justified and directly resolving the issue, may be tough to implement and have shaky foundation.

The Zenith Infotech Limited's (Zenith/Company) case has been in the news for more than a year now. Here is a brief summary of SEBI's allegations that led to this order. Zenith defaulted (despite supposedly having large liquid assets in its balance sheet) to repay the first tranche of its FCCBs (which incidentally caused default of 2^nd tranche too on account of acceleration clause). It obtained approval of shareholders in general meeting by borrowing money and sale of its divisions. This approval was taken specifically for repayment of FCCBs. It sold a division in a fairly convoluted way and through a series of related party transactions. The sale proceeds were only partly received by the Company and partly by a subsidiary. Even after receipt of monies, they were used for payment mainly to related parties for purposes not wholly clear, for payment to creditors (not FCCBs holders) and purchase of capital assets. Worse, the Company made several misleading/false statements and omissions though eventually it admitted the facts. The share price halved twice, once till the date of company making disclosure and again after such date. In barely a few months, the price of the shares reduced from 190 to 45.

There were other allegations of false disclosures/non-disclosures under the listing agreement, the SEBI Insider Trading Regulations, etc.

Legal proceedings by the FCCBs holders for winding up, etc. are on before the court.

SEBI passed an interim order directing two things. Firstly, it banned the specified Promoters from accessing the capital markets and dealing in securities. Secondly, it directed the Board of Directors of the Company to give a bank guarantee in favor of SEBI within 30 days for the amount of $ 33.93 million allegedly diverted for uses other than repayment of FCCBs. The Board, however, use the funds of the Company or secure its assets for this purpose. The guarantee shall be valid for at least one year during which SEBI may invoke it in case of adverse findings to compensate the Company.

The manner in which the transactions are carried out raises questions once again as to the effectiveness of laws relating to companies. The Company allegedly used funds for purposes other than for what the shareholder approved. However, the legal consequences of such act are curious. Firstly, this does not necessarily mean that the transactions carried out are null and void. Secondly, it is arguable that such transactions can be ratified in a subsequent general s meeting and since the Promoters held 64% shares, this should have been easy. Thirdly, the punitive consequences under the Act on the Company, its Board and the Promoters are not stringent. This is of course assuming that the payments were genuine and not diversion/siphoning off of funds as SEBI alleges.

But even if there was diversion/siphoning off, there are no quick remedies for recovery of the monies, repayment to creditors and punishing the directors/Promoters concerned.

The provisions concerning related party transactions again get highlighted. The restrictions on them seem flimsy in law and even flimsier in enforcement. Often, companies may get away by mere disclosure.  

Coming to the SEBI direction for bank guarantee, again many things are curious. Does SEBI have power in the circumstances to direct the Board to give such a bank guarantee without using company funds? On first impression, this appears not only justified but is also the only just way. The shareholders had authorized the Board to use the sale proceeds for repayment of FCCBs. However, they were used for other purposes. Thus, the Board ought to compensate the Company and for this purpose, giving a bank guarantee that SEBI may invoke to compensate the Company or perhaps directly the FCCBs may make sense. However, several questions arise.

Firstly, does SEBI have such powers at all?

Secondly, can it direct the Board of Directors as a whole without making a specific finding that it was they who approved such uses of funds? Or that they were negligent in monitoring the use of such funds?

Thirdly, why not allow the Company, at least as an alternative, to get the funds back? Why insist only on a guarantee?

Fourthly, even if assuming that they were used for other purposes, what if such uses were genuine? For example, funds were used for payment to creditors, acquisition of capital assets, etc. There are no findings on record that these were bogus, just that these purposes were not for which the Company took approval.

Fifthly, what if the Company had (and still can, though this is highly unlikely now) obtained ratification of shareholders which, considering the 64% holding of Promoters, would have been a breeze? SEBI's whole basis of passing this order, despite making a multitude of other allegations, is this approval of shareholders.

Sixthly, is an Order on the Board as a whole without making a finding of role of the Promoters on one hand and the non-promoter directors on the other, fair and valid? How would it be enforced and punitive action taken, if they are unable to provide such a guarantee? Will the liability of the Directors be joint and several?

Nevertheless, as the investigation progresses, the role of the Auditors in this case may also come under review, in view of reports that huge amounts of cash was supposedly shown in the balance sheet though the FCCBs remained unpaid even after raising further monies on account of sale of assets.

All in all, this case, assuming many of the allegations are found true, presents a murky and sordid state of affairs in listed companies and the ineffectiveness of laws, even though they are many and complex.

The case is likely to show several developments soon, since SEBI has provided post-decision hearing and SEBI may pass a revised order. 30 days are given to the Board to furnish this guarantee and it is possible that they are unable to so provide. It appears quite likely that the Promoters/Board may appeal to SAT. It will be worth seeing whether this case creates good precedents in law for keeping malpractices in check or it again shows that the action and remedies will be prolonged and perhaps finally ineffective for some or all of the parties who have lost money.

Introduction

I aim to share certain selected thoughts and developments in Indian securities, corporate, tax and other/related laws of India. Developments in corporate restructuring such as mergers, takeovers, buybacks, etc. will also be covered. Aim of blog is to give implications, in as lay terms as possible, the nature and implications of such developments.

A special focus is on the inter-relationship of various laws affecting corporates and their transactions. Often, one law is modified or made without considering implications of other laws. Further, a transaction cannot be planned and structured without considering implications of the multitude of laws that apply to them.

Objective also is to consider wider social and moral implications of such developments. From time to time, laws and happenings beyond the core subjects of this blog will also be covered.

These laws and transactions continuously see changes and I hope to learn through this process of writing. Feedback is certainly welcome through comments on posts and email.

- CA Jayant Thakur