SEBI requires companies to be serious in reporting Insider Trading lapses

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Pammy Jaiswal

Partner, Vinod Kothari and Company

corplaw@vinodkothari.com

The listed entities are burdened with the compliance requirements under numerous regulations issued by SEBI including the SEBI (Prohibition of Insider Trading) Regulations, 2015 (‘PIT Regulations’). The said regulations lay down various to dos for the listed companies as well as the designated persons (‘DP’) for the purpose of regulating and prohibiting the insider trading in the securities of the listed company.

SEBI has vide its circular[1] dated 19th July, 2019 laid a format for reporting insider trading lapses thereby forcing all companies to follow a standard reporting format. The existing practice of companies using rather informal and self- generated reporting formats will no longer be available to them.

It is not that insider trading lapses noted by companies are those of profiteering based on Unpublished Price Sensitive Information (UPSI). Most of the noted instances in practice are technical and unintentional breaches of either the trading window closure or contra trading restrictions. Most of these are reported to the audit committee or stakeholder’s relationship committee which typically takes action based on the gravity of the offence. However, reporting to SEBI was done on a rather diminutive manner.

Further, the circular also provides for recording the violations in the digital database maintained by the compliance officer under the PIT Regulations for the purpose of taking appropriate action against the offender. The said circular is effective with immediate effect.

Current Reporting Scenario

The current practice of the corporates for reporting the violation under the code (either for entering into contra-trade within a period of six months or trading during the closure of trading window, etc.) along with the action taken by the entity is diverse. While some companies used to mark a copy of the reprimand to SEBI while sending the same to the concerned DP or their immediate relatives, others used to send a brief of the violation along with the action taken to SEBI depending on the frequency and gravity of the violation so made in accordance with their respective codes.

Revised Reporting

The revised reporting format contains all the required fields for the entity (listed entity, intermediary or fiduciary) to report the violation to SEBI. Following is the summary of details that is mandatory required to be filled up about the entity, the DP or his immediate relative and the violation along with the action taken by the entity:

Information about the entity Information about the DP/ immediate relative Transaction details
·            Name and capacity of the entity.

·            Action taken by the entity.

·            Reasons for the action taken.

 ·     Name and PAN.

 

·     Designation and functional role of DP.

 

·     Whether a part of the promoter and promoter group or holding CXO position.

 

 

 ·      Name of the scrip

·      No. and value of shares traded (including pledge)

·      In case trading value exceeds Rs. 10 lakhs date of disclosure made under regulation 7 of the PIT Regulations by both the entity as well as the concerned person.

 

·      Details of violation observed under the PIT Regulations.

 

·      Instances of any violation in the previous financial year.
Concluding Remarks

Evidently, the format contains concrete information about the violation which will place SEBI in a better position to oversee and take on record the instances of violation taking place in the regulated entities. While the current practice had deficiencies in terms of the basic information supplied to SBI, the revised reporting format will take care of the same henceforth.

However, the prompt reporting will be a task for the entities. At the same time, SEBI will now be in receipt of the complete information on the offence and may take strict action against the offender or may even direct the entities to take stricter action in cases where it feels the action taken is not commensurate with the nature and gravity of the violation.

 

Our other resources on SEBI PIT Regulations can be viewed here

[1] https://www.sebi.gov.in/legal/circulars/jul-2019/standardizing-reporting-of-violations-related-to-code-of-conduct-under-sebi-prohibition-of-insider-trading-regulations-2015_43618.html

Abrupt auditor resignations: SEBI seeks transparency

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By Vinod Kothari & Vinita Nair,

Partner, Vinod Kothari & Co

corplaw@vinodkothari.com

Original: July 19, 2019

Version: October 19, 2019

 

A SEBI proposal by way of a Consultative Paper[1] dated July 18, 2019 to amend Reg. 33 of SEBI (LODR) Regulations, 2015 (Regulations) sought to lay down in the rule book of listed entities that when auditors want to resign in the middle of an auditing assignment, they cannot be allowed to leave citing reasons such as “pre-occupation”. They must be encouraged and asked to open their heart, and speak out the real reason, or confirm that there is no reason other than the one that they mention while resigning. Also, the auditor must not leave the auditee in the lurch, and complete the on-going audit engagement to the point of completing the audit of the year or limited review of the quarter. The resignation must be discussed with the Audit Committee chairman, and thence, to the Audit Committee, highlighting the concerns, if any. The views of the Audit Committee will be filed before the stock exchanges.

In essence, the proposal of SEBI tried to implement what seems to be the clear intent – that the veil of secrecy behind auditor resignation, where everyone can sense that everything is not alright but does not get to know what exactly it is – should be lifted.

The Consultative Paper was open for public comments till 8th August, 2019. Accordingly, on 18th October, 2019, SEBI came out with a Circular[2] implementing the aforesaid proposal. While the Circular does not amend Reg. 33 of Regulations, as proposed, it has laid down the doables for the auditors of the listed entities and material subsidiaries at the time of resignation.

Inspiration of the amendment

The inspiration of the amendment is the recent turmoil in the corporate sector, where, mostly in the midst of worsening financial position, auditors put in papers. There are rumours of auditors’ discomfort with the financial statements; mostly people smell transactions that may involve transfer of assets to connected entities, inflation of profits or hiding of losses. One wonders as to why most of these resignations come only when the financial position of the entity is suddenly worsening – is it that in good times, financial statements are immune from such vulnerable transactions or practices? However, it mostly seems that an impending default will bring the entity into regulatory glare, and the auditor may have to face persecution action.

What has made the auditor fraternity even more jittered is the action of the regulators against auditors of a failed financial entity, seeking to use the very heavy provisions of section 140 (5) of the Companies Act. It is just a matter of time when the country will witness class action suits against auditors, which abound in the Western world.

The instinctive auditor action in such cases is, to try to control the damage by quitting the scene, rather than qualifying the statements which, in the past, have been affirmed by the same auditor. Of course, the reasons cited can be as slippery as “pre-occupation” or lack of bandwidth.

It was reported in 2018 that the Minister of State for Corporate Affairs, P P Chaudhary’s written reply to the Rajya Sabha stated that as per the filings in MCA 21 registry, auditors of 204 listed entities had resigned since January 1, 2018 to July 17, 2018.

ICAI also constituted a Group and the task of developing guidance for the members was entrusted to the Auditing and Assurance Standards Board (AASB). In December 2018, ICAI released ‘Implementation Guide on Resignation/Withdrawal from an Engagement to Perform Audit of Financial Statements’ [3] which provides matters to be included in the resignation letter (Para 19) which is similar to the Annex-B of the SEBI Consultative Paper. It additionally required the response from the management or those charged with governance, on the written communication made by the auditor, to be included in the resignation letter.

Is it wrong to resign?

No, as ICAI’s auditing standards (SA-705) provides the situation under which an auditor may resign from the audit. If the auditor concludes that the possible effects on the financial statements of undetected misstatements, if any, could be both material and pervasive so that a qualification of the opinion would be inadequate to communicate the gravity of the situation, the auditor shall resign from the audit, where practicable and not prohibited by law or regulation.

Is it necessary to cite reason for resignation?

Section 140 (2) of Companies Act, 2013 mandates an auditor to indicate the reason and other facts as regard to its resignation while filing the statement of resignation with the Registrar and the Comptroller and Auditor-General of India, where applicable.

What is the meaning of resignation?

It is important to note that the appointment of an auditor is done for a term of 5 years. Therefore, even if an auditor resigns after completion of the audit for a financial year, within the term of 5 years, it is still a case of resignation.

Provisions of section 139 (9) may be interpreted to mean that the auditor may actually state before a general meeting, within the term of 5 years, that he is not willing to be reappointed. However, is that a case of resignation?

Read with section 140 (2), even an unwillingness to be reappointed becomes a case of resignation. This is so because the appointment is done for 5 years, and the ratification of the appointment at the annual general meeting, every year during the 5 year term, has been done way with by the Companies (Amendment) Act, 2017 w.e.f. May 7, 2018.

Therefore, the following are some examples of what may be construed as a case of resignation:

(a) The auditor was appointed in the AGM of Year 1, for completing the audit for FY 1 to FY 5, until the conclusion of the AGM for year 5. At the end of Year 2, after completing the audit of year 2, auditor gives a letter to the management that the auditor is not willing to audit for year 3.

(b) Same case as above, however, instead of the auditor indicating unwillingness to be reappointed, the audit committee while evaluating the performance of the auditor does not recommend continuation of appointment.

(c) Same case as (a), however, the auditor becomes ineligible to continue.

 

Case (a) is a case of resignation; (b) is a case of removal and (c) is a case of vacation of office resulting in casual vacancy.

SEBI’s prescription: Reveal the truth

The resigning auditor shall reveal all the reasons for resignation in the resignation letter along with the efforts made by the auditor prior to resignation. Whom the concern was raised? In relation to what the concern was raised? Why the concern was not addressed – due to a management-imposed limitation or circumstances beyond the control of the management. The auditor is expected to pour his heart out in the resignation letter, which is in line with the prescription made in ICAI’s implementation guide.

Role of Audit Committee

There are recourse available with the auditors of the listed entity/ material subsidiary as follows:

  1. In case, the listed entity/ material subsidiary does not co-operate or they do not provide information as required by the auditors, which may hamper the audit process, the Auditors may approach the Chairman of the Audit Committee and the Chairman shall receive such concern directly without waiting for the quarterly meetings.
  2. In case, the auditor proposes to resign, all concerns with respect to the resignation, along with the relevant documents shall be brought to the notice of the Audit Committee. In cases, where the proposed resignation is due to non-receipt of information / explanation from the company, the auditor shall inform the Audit Committee of the details of information / explanation sought and not provided by the management, as applicable.
  3. The auditor can provide an appropriate disclaimer in the audit report in accordance with the ICAI/ NFRA if the requisite information is not provided to the auditor as sought.

After the auditor approaches the Chairman/ Audit Committee, the Audit Committee has to communicate its views to the management and the auditor, which is also required to be disclosed to the stock exchange within 24 hours after the date of such Audit committee meeting.

As per the Regulations, the Audit Committee is responsible for the appointment, performance evaluation, ensuring independence of the auditors, finalising the audit plan and reviewing and monitoring effectiveness of the audit process. In view of the Circular, the companies shall now be required to modify the letter of appointment of the existing auditors. Further, the Audit Committee is also required to mandatorily review management letters / letters of internal control weaknesses issued by the statutory auditors.

Auditor’s duty to complete pending assignments

While the language of the Consultative Paper seemed unclear, the  Circular has clarified that the auditor shall be required to complete the audit in the following manner before resigning:

  1. If the resignation of the auditor is tendered within 45 days from the end of the quarter- the auditor shall, before such resignation, issue the limited review/ audit report for such quarter.
  2. If the resignation of the auditor is tendered after 45 days from the end of the quarter- the auditor shall, before such resignation, issue the limited review/ audit report for such quarter as well as the next quarter.
  3. If the auditor has signed the limited review/ audit report for the first 3 quarters- the auditor shall, before such resignation, issue the limited review/ audit report for the last quarter of such financial year as well as the audit report for such financial year.

A comparison between the Consultation Paper and the Circular

A quick snapshot of the major highlights of the Circular along with a comparison with what was proposed in the Consultation Paper is given below:

Sl. No. Requirement SEBI’s Consultation Paper SEBI’s Circular Impact of the change
1 Time of resignation i. If the auditor has signed the audit report for all the quarters (limited review/ audit) of a financial year, except the last quarter, then the auditor shall finalize the audit report for the said financial year before such resignation.

 

ii. In all other cases, the auditor shall issue limited review/audit report for that quarter before such resignation (i.e. previous quarter in reference to the date of resignation).

 

iii. In case of material unlisted subsidiary, the auditor shall issue the limited review/audit report for that financial year/ quarter, as applicable, before such resignation (i.e. previous financial year/ quarter in reference to the date of resignation)

 

 iv.                 i. Resignation of the auditor within 45 days from the end of the quarter- the auditor shall, before such resignation, issue the limited review/ audit report for such quarter.

v.

ii.                   Ii. Resignation of the auditor after 45 days from the end of the quarter- the auditor shall, before such resignation, issue the limited review/ audit report for such quarter as well as the next quarter.

iii.

iv.                 Iii. If the auditor has signed the limited review/ audit report for the first 3 quarters- the auditor shall, before such resignation, issue the limited review/ audit report for the last quarter of such financial year as well as the audit report for such financial year.

 With respect to the quarterly audits, the auditors shall be obligated to issue limited review report for the next quarter as well where the resignation is after 45 days from the end of the quarter. This shall provide the listed entity a reasonable time to search another auditor.

 

Further, with respect to the rest, the same was in line with the proposal provided in the Consultation Paper.
2. Reporting of concerns to Audit Committee i.                Approach the Chairman of the Audit Committee and the Chairman to receive the concern directly and immediately without waiting for the quarterly meetings.

 

ii.              All concerned reasons alongwith the relevant documents for shall be brought to the Audit Committee’s notice in case the resignation is due to non-receipt of information/ explanation from the company.

 

 i.                   Approach the Chairman of the Audit Committee and the Chairman to receive the concern directly and immediately without waiting for the quarterly meetings.

 

ii.                 All concerned reasons alongwith the relevant documents for shall be brought to the Audit Committee’s notice in case the resignation is due to non-receipt of information/ explanation from the company.

 The consultation Paper as well as the Circular are in sync.

 

The change shall enhance the role of the Chairman of the Audit Committee w.r.t. reporting the concerns to the management.
3. Deliberation by the Audit Committee Audit Committee shall deliberate on the matter and communicate its views to the management and the auditor. Audit Committee shall deliberate on the matter and communicate its views to the management and the auditor not later than the date of the next Audit Committee meeting. The Circular is in the line with the proposal made in the Consultation Paper.

 

The change shall keep the management in loop and it shall also know the detailed reasons of the resignation of the auditor within a specific time period.

 
4. Disclaimer in case of non-receipt of information from the entity If the reason for the auditor’s resignation is the entity not providing information, the auditor shall provide an appropriate disclaimer in the audit report to that extent. The auditor shall provide an appropriate disclaimer in the audit report, which may be in accordance with the Standards of Auditing as specified by ICAI / NFRA in case the entity does not provide information as sought. Again the Circular is in line with the Consultation Paper.

 

Such change shall now put the entity under an obligation to provide necessary support/ relevant information/ co-operation to the auditor in order to complete the audit.

 
5. Ensuring proper terms and conditions in the letter of appointment No such proposal The aforesaid shall be included in the letter of appointment of the auditor.

 

Where the auditor has already been appointed, the company shall issue modified letter of appointment.

 Considering the appointment of auditors must have been made in listed entities in the AGM held in the FY 19-20 and shall be valid till FY 2023-24, actionable on the part of the listed entities is to amend/ modify the terms of engagement and issue a fresh letter of appointment to the auditors.

 
6. Certification in Annual Secretarial Compliance Report (ASC) No such proposal A practicing company secretary shall be required to certify the aforesaid in the ASC Report. The same shall be an additional responsibility of the practicing company secretary while issuing ASC Report.

 
7. Disclosure of the views of the Audit Committee’s to the Stock Exchange The views of the Audit Committee and the Board of Directors of the entity be required to be submitted to the stock exchanges along with the disclosure of the resignation letter of the auditor in the format as prescribed.

 

 Post the deliberation of the views by the Audit Committee, the same shall be disclosed to the Stock Exchanges as soon as possible but not later than 24 hours after the date of such Audit Committee meeting. The Circular lays down a time which aligns with the requirement of Regulation 7(A) of Part A para A of Schedule III of the SEBI Listing Regulations.

 

The Circular does not prescribe any format for disclosing the views of the Audit Committee to the Stock Exchange.

 
8. Format of resignation letter Provided as Annexure- B Provided as Annexure- A Slight cosmetic changes have been made in the format.

Concluding remarks

Thankfully, for all Indians, one can relate most tricky situations in life to a Bollywood song, and that really helps to dismiss the gravity of the matter. When it comes to something like auditor’s resignations (judaai), or auditors’ silence (khamoshi), there will a large number of songs or flicks on such situations, evidently the popular themes for Bollywood. Therefore, without claiming to be the best for the situation, here is one that may possibly help to lighten the pain that SEBI and investors may be having:

कभी ऐसा लगता है

दिल में एक राज़ है

जिसे कहना चाहूँ, पर मैं कह पाऊँ ना

आँखों ही आँखों में कह जाती है जो ये

खामोशियों की ये कैसी ज़ुबां

मैंने सुना जो ना उसने कहा

 

[1] https://www.sebi.gov.in/web/?file=https://www.sebi.gov.in/sebi_data/attachdocs/jul-2019/1563449963980.pdf#page=1&zoom=auto,-15,842

[2] https://www.sebi.gov.in/legal/circulars/oct-2019/resignation-of-statutory-auditors-from-listed-entities-and-their-material-subsidiaries_44703.html

 

[3] https://resource.cdn.icai.org/52929aasbicai-igr.pdf

Applicability of NFRA Rules on overseas subsidiaries and associates: Conflict between the Rules and FAQs

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Pammy Jaiswal

Partner, Vinod Kothari and Company

 

Background

National Financial Reporting Authority (‘NFRA’) being a quasi-judicial authority has been empowered by the Central Government to independently regulate and monitor the accounting and auditing standards (‘A&AS’). The intent of NFRA is to oversee the quality of A&AS of large entities as mentioned under Rule 3 (1) of the NFRA Rules.

Evidently NFRA intends to oversee the A&AS of large entities in terms of being listed or the size of the company or being functionally different entities like electricity companies or insurance companies, etc. Such entities have the presence of its subsidiaries and associates all around the world which may be contributing materially in terms of Rule 3 (1) (e) of the NFRA Rules to the net worth and turnover of the Indian parent entity.

While the last date for filing one time return by bodies corporate is approaching fast i.e. 31st July, 2019, there seems to a lot of ambiguity in the applicability of the NFRA Rules.

This note has been prepared with the intent to showcase the conflict between the provisions of the Companies Act, 2013 (‘Act’) read with its allied Rules and the FAQs issued by NFRA.

Various Provisions of the Act applying to bodies corporate

  • Applicability section of the Act

The first section of the Act laying down the applicability of the Act clearly mentions the following under clause (f) of sub-section (4) – “such body corporate, incorporated by any Act for the time being in force, as the Central Government may, by notification, specify in this behalf, subject to such exceptions, modifications or adaptation, as may be specified in the notification.”

This provision makes it very clear that the Ministry of Corporate Affairs (‘MCA’) has been vested with the powers of applying the provisions of the Act to any bodies corporate. Further, the provision is also quite clear that such body corporate may be either incorporated under the Act or any other Act. This implies that even for foreign companies, the MCA has the power to apply the provisions of the Act subject to the changes as may be notified.

  • Definition of the term body corporate

Section 2 (11) defines the term ‘body corporate’ to include a company incorporated outside India. Here also, the intent of law is explicitly clear to cover the bodies corporate governed by foreign laws.

  • Chapter 22 of the Act

Section 379 (2) of the Act provides that a foreign company which is substantially owned and controlled by an Indian citizen or by an Indian company is required to comply with the provisions of the Act as mentioned thereunder.

Areas of conflict

While the consolidated financial statements of the Indian parent entities include the accounts of the subsidiaries and associates also, it cannot be argued that the quality of auditing and accounting is anywhere less relevant than the A&AS of the Indian parent. Therefore, it seems in fitness of things under clause (e) of Rule 3 (1) of the NFRA Rules to include foreign subsidiary and associates if they fulfil the condition of materiality under the said Rules (foreign subsidiaries and associates whose income or net worth exceeds 20% of the consolidated income and net worth of the Indian parent [‘material subsidiaries and associates]).

However, the FAQs[1] issued by NFRA have taken a different stand altogether with respect to the applicability of the NFRA Rules. It states that only those material subsidiaries and associates are covered under the scope which are having place of business in India.

While it sounds very surprising that if this wouldn’t have been the case, the condition of the foreign subsidiaries and associates which has an Indian parent, doing business back in India is very unlikely.

In any event, if merely by not having a business in India absolves the material subsidiaries and associates from the overview of the NFRA that would frustrate the whole intent and objective of the NFRA and allow such subsidiaries and associates to escape from the regulation of NFRA by virtue of the additional clause in the FAQs.

It seems that this condition of having business in India should have either be mixed with section 379 of the Act which talks about foreign companies having business in India or should may have actually been intended to be referred to the Indian parent’s business in India.

Further, if the question is one of jurisdiction as of how the Act extends its application to foreign bodies corporate not having business in India is concerned, it may be noted that section 1 (4) of the Act allows the Central Government to extend the provision of Act to bodies corporate, and it may therefore, it may be construed that in a manner of speaking is actually extended to foreign bodies corporate which have a business connection in India by virtue of having an Indian parentage.

Conclusion

One of the major questions in front of the stakeholders is the jurisdiction of NFRA which the FAQs have seemingly restricted to bodies corporate having place of business in India. However, considering the other provisions of the Act, it is quite clear that NFRA has been constituted not only to govern the auditors registered in India but also those in abroad as MCA has left number of provisions open under the Act which applies to bodies corporate.

If one interprets the applicability of NFRA on Indian bodies corporate, the whole intent and object of setting this regulatory body will get frustrated.

Related articles –

  1. http://vinodkothari.com/2019/07/faqs-on-national-financial-reporting-authority-nfra-rules-2018/
  2. http://vinodkothari.com/wp-content/uploads/2019/07/MCA-Notifies-NFRA-Rules.pdf

 

[1] https://nfra.gov.in/sites/default/files/FAQ.pdf

Distinguishing between Options and Forwards

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By Falak Dutta (rajeev@vinodkothari.com)

Ruling of Bombay High Court

The Bombay High Court on March 27, 2019, in the case of Edelweiss Financial Services v. Percept Finserve Pvt. Ltd.[1], ruled out an award passed by a sole arbitrator with respect to a share purchase agreement (SPA). The High Court allowed enforcing of a put option clause to be exercised by Edelweiss, the appellant, to sell back the shares it had acquired from Percept Group, the respondent.

Before delving into the proceedings of the aforesaid case, it is important to understand certain basic concepts, to appreciate the ‘option clause’ in the case. An option is a derivative contract which gives the holder the right but not the obligation to buy (call) or sell (put) the underlying within a stipulated time in exchange for a premium. Options are not just traded on exchanges but are also used in debt instruments (eg. callable and puttable bonds), private equity and venture capital investment covenants. Even insurance is a type of option contract where the insured pays monthly premium in exchange of a monetary claim upon the future occurrence of a contingent event (accident, disease, damage to property etc.).

 

Facts of the case

Edelweiss Financial Services Pvt. Ltd. entered into a share purchase agreement (SPA) dated 8, December, 2007 with the Percept Group where it invested in the shares of Percept Group subject to a condition that the latter shall restructure itself as agreed between the parties followed by an IPO. Under the terms of the SPA, the appellant (Edelweiss) purchased 228,374 shares for a consideration of Rs. 20 crores. One of the conditions in the agreement, required Percept to entirely restructure by 31st December, 2007 and to provide proof of such restructuring. Upon failure of compliance by the respondent, the date was further extended to 30 June, 2008 with obligation to provide documentary evidence of completion by 15th, July 2008. Upon non-fulfillment within the extended date, Edelweiss had the option to re-sell the shares to Percept, where Percept was obligated to purchase the shares at a price which gave the appellant an internal rate of return of 10% on the original purchase price.

As was the case, Percept failed to restructure itself within the stipulated time. Subsequently in view of this breach Edelweiss exercised the put option and Percept was required to buy back the shares for a total consideration of Rs. 22 crores. Since the respondent refused to comply the appellant invoked the arbitration clause in the SPA and a sole arbitrator was appointed to adjudicate the dispute. The arbitrator submitted that despite Percept being in breach of the conditions in the SPA, the petitioner’s claim to exercise the put option was illegal and unenforceable, being in conflict with the Securities Contracts regulation Act (SCRA), 1956. The unenforceability was proposed on two grounds. First, for the clause being a forward contract prohibited under Section 16 of SCRA read with SEBI March 2000 notification, which recognizes only spot delivery transactions to be valid. Secondly these clauses were illegal because they contained an option concerning a future purchase of shares and were thus a derivatives contract not traded on a recognized stock exchange and thus were illegal under Section 18 of SCRA, which deals with derivative trading.

Aggrieved by the arbitrator’s order, Edelweiss challenged it before the Bombay High Court under section 34 of the Arbitration & Conciliation Act, 1996.

 

The Judgement

The Bombay High Court observed the reasoning of the order by the arbitrator and the contentions made by Percept. The said order confirmed the breach caused by Percept, but found the particular clauses of put option in the SPA to be illegal under two grounds as mentioned earlier. The Court divided the judgement along the sections involved.

The first of the arbitrator’s conclusion was found untenable when referred to the judgement in the case of MCX Stock Exchange Ltd. vs. SEBI [2]which deals with such a purchase option as in the present case. The Court observed that the put option clause contained in the SPA cannot be a derivatives contract prohibited by SCRA, because there was no present obligation at all and the obligation arose by reason of a contingency occurring in the future. The contract only came into being upon the following two conditions being met: (i) failure of the condition attributable to Percept (ii) exercise of the option by Edelweiss upon such failure. Whereas a forward contract is an unconditional obligation, the option in the SPA only comes into being when the aforesaid conditions are met. Thus, the arbitrator’s claim of the clause being a forward contract disregards the law stated by the Court in MCX Stock (supra).

Subsequently, respondent (Percept Group) challenged the relevance of the MCX Stock case to the present one. In the MCX Stock Exchange case, upon the exercise of the option the contract would be fulfilled by means of a spot delivery, that is, by immediate settlement. Whereas Edelweiss’s letter by which it exercised the put option required the shares to be re-purchased with immediate effect or before 12 Jan, 2009. This deferral of repurchase upon exercise of the option was not part of the MCX Stock Exchange case’s option clause and hence is not comparable to the present case.

This too was disregarded by the Court on the ground:

“It is submitted that in as much as this exercise of options demands repurchase on or before a future date, it is not a contract excepted by the circular of the SEBI dated 1 March, 2000.

Just because the original vendor of securities is given an option to complete repurchase of securities by a particular date it cannot be said that the contract for repurchase is on any basis other than spot delivery.

There is nothing to suggest that there is any time lag between payment of price and delivery of shares.”

Now, this brings us to the second leg of the arbitrator’s award regarding the illegality and unenforceability of the SPA option on account of breach of Section 18A of SCRA, which deals in derivative trading. The following is an excerpt from Section 18A:

Contracts in derivative. — Notwithstanding anything contained in any other law for the time being in force, contracts in derivative shall be legal and valid if such contracts are—

(a)Traded on a recognized stock exchange;

(b) Settled on the clearing house of the recognized stock exchange. In accordance with the rules and bye-laws of such stock exchange.

The respondent appeals that as the put option was not of a recognized stock exchange, it stands unenforceable and illegal. In response, the court submitted that the contract does contain a put option in securities which the holder may or may not exercise. But the real question is whether such option or its exercise is illegal? The presence of the option does not make it bad or impermissible.

“What the law prohibits is not entering into a call or put option per se; what it prohibits is trading or dealing in such option treating it as a security. Only when it is traded or dealt with, it attracts the embargo of law as a derivative, that is to say, a security derived from an underlying debt or equity instrument.”

There was further cross objections filed by the respondent but it was ruled out under Section 34 of the Arbitration & Conciliation Act, which deals with the application for setting aside arbitral award. Since the provisions of Civil Procedure Code, 1908 are not applicable to the proceedings under Section 34 and the section itself does not make any provision for filing of cross objections, the appeal was ruled out.

Conclusion

This Bombay High Court ruling in favor of Edelweiss provides an important distinction of options, from forward contracts. It highlighted that although both options and forwards are commonly categorized as derivatives, they share an important difference. On one hand, a forward contract contains a contractual obligation to buy or sell, on the other hand, the option gives the holder the right or choice but not the obligation to do the same. Options have always been integral to finance, routinely appearing in corporate covenants and contracts. Options are widely observed in mezzanine financing, private equity, start-up and venture funding among others. Given the Court’s distinction of forwards from options in their very essence and nature, the author believes this ruling is likely to be useful and a point of reference in future derivative litigations.

 

[1]https://bombayhighcourt.nic.in/generatenewauth.php?auth=cGF0aD0uL2RhdGEvanVkZ2VtZW50cy8yMDE5LyZmbmFtZT1PU0FSQlAxNDgxMTMucGRmJnNtZmxhZz1OJnJqdWRkYXRlPSZ1cGxvYWRkdD0wMi8wNC8yMDE5JnNwYXNzcGhyYXNlPTA0MDYxOTEwMDAyOQ==

[2] https://indiankanoon.org/doc/101113552/

FAQs on National Financial Reporting Authority (NFRA) Rules, 2018

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MCA set to deploy the eForm for reporting details of SBOs

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Ambika Mehrotra

corplaw@vinodkothari.com

Background

Amendment to Section 89 and insertion of Section 90 are one of the key amendments brought in by the Companies (Amendment) Act, 2017 (‘Amendment Act’).  The said provisions were enforced w.e.f. June 14, 2018and Companies (Significant Beneficial Owners) Rules, 2018 were notified[1] (‘SBO Rules’). MCA, thereafter, issued General Circular No 7/ 2018[2]for extending the last date of filing eForm BEN-2 and 08/ 2018[3] to the effect that the format of declaration to be submitted by Significant Beneficial Owner (SBO) will undergo revision.

MCA on February 8, 2019[4] amended SBO Rules by amending the definition of significant beneficial owner. The due date for submission of declaration in Form BEN-1 was 90 days from the said amendment. However, eForm for filing the said declaration with MCA was not made available.

MCA, on July 1, 2019, issued Companies (Significant Beneficial Owners) Second Amendment Rules, 2019[5]thereby notifying eForm BEN-2 required to be submitted by companies.

Scope of Section 90

Section 90 focuses on the identification of a ‘significant beneficial owner’ through his ‘indirect holdings’ in an entity, which is to be considered only where the individual has majority interest in the vehicle holding stake in the “reporting company”, or in the ultimate holding entity of such holding vehicle. That is to say, simply direct holding or direct control, or direct significant influence (without any indirect holdings) were not required to be reported as significant beneficial interest under the Rules, irrespective of the magnitude of direct holding. Therefore, the direct holding of interest by an individual is relevant only if the direct holding may be clubbed with indirect holding.

Onus of making the declaration

The individual holding significant beneficial interest by virtue of holding shares or voting rights or right to distributable dividend or exercising significant influence was required to furnish the declaration in Form No. BEN-1 within 90 days of February 8, 2019 and thereafter in case of any change, to the reporting company. Herein, the onus lies on the individual to come forward and submit the declaration. The reporting companies on the other hand were required to give notice to members (other than individual) holding 10% or more of participating interest [either of shares, voting rights, or right to receive or participate in the dividend or any other distribution],  seeking information about the individual who is significant beneficial owner in the reporting company in Form BEN-4.

It is pertinent to note that the obligation of the individual to self-declare his significant beneficial holdings and the obligation of the company to send notice seeking information from members in terms of Rule 2Aare independent obligations.

Intimation to the ROC by the reporting entity

As per the SBO Rules as amended from time to time, the declaration of beneficial interest is required to be filed in e- Form BEN-2 with the Registrar in respect of such declaration, within a period of thirty days from the date of receipt of declaration by the company.

With the deployment of e-Form BEN -2 vide Companies (Significant Beneficial Owners) Second Amendment Rules, 2019, the Companies shall be required to intimate the same to the Registrar within 30 days of its deployment.

Companies are facing difficulty in identification of SBO in view of complex structures. Until receipt of declaration in Form BEN-1, companies will not be able to file eForm BEN-2.

Consequences of non-filing

Section 90(11) of the Act, 2013 provides for penal provisions for the failure of the part of the company and every officer in default in complying with the provisions of Section 90(4) i.e. filing of the above return  and changes therein with the Registrar with a fine:-

  • For company and every officer in default:- Rs. 10 Lakhs – Rs. 50 Lakhs
  • For Continuing default: – Upto Rs. 1000 for every day after first day of failure.

Analysis of e-Form BEN -2

  • Declaration of holding reporting company

 Pursuant to Rule 8 of the SBO Rules, which states that the rules are not applicable to the extent the shares of the reporting company is held by its holding reporting company. It is presumed that the SBO of the holding company is also the SBO of the subsidiary company for the shares held by the holding company.

First bullet of Field no. 3 requires the companies to report the details of such holding reporting company which shall be mapped through the CIN of such company.

  • Requirement to furnish copy of agreement

 In order to specify the manner in which significant beneficial interest is being held or exercised either indirectly or together with any direct holding or right, the form requires attachment of agreement in following cases:

  1. Exercise of control
  2. Exercise of significant influence

 This might be a serious constraint, as it may not be necessary that the companies might have in place a written and executed agreement specifying the control and/ or significant influence exercised by the members. However, at present the mode of mapping of control and/ or significant influence has only been done through the agreement to be attached in the form.

Conclusion

While, the eForm BEN-2 seems a derivative of the format of declaration Form BEN no. 1, companies will be able to report correctly subject to receipt of accurate declarations from the SBOs.

Other practical difficulties in reporting in the eForm can be ascertained once the eForm is deployed on MCA portal.

 

Other related articles on SBO can viewed here-

http://vinodkothari.com/2019/02/mca-revisits-sbo-rule/

http://vinodkothari.com/wp-content/uploads/2019/03/Final-FAQs-on-revised-SBO-Rules_17.03.2019-1.pdf

http://vinodkothari.com/wp-content/uploads/2019/03/Guide-to-identification-of-SBO-in-your-Company.pdf

http://vinodkothari.com/2019/02/new-sbo-rules-illustrations/

http://vinodkothari.com/wp-content/uploads/2019/02/Amended-SBO-Rules.pdf

 

[1]http://www.mca.gov.in/Ministry/pdf/CompaniesSignificantBeneficial1306_14062018.pdf

[2]http://www.mca.gov.in/Ministry/pdf/GeneralCircularNo.7_06082018.pdf

[3]http://www.mca.gov.in/Ministry/pdf/GCCircularBen_10092018.pdf

[4]http://www.mca.gov.in/Ministry/pdf/CompaniesOwnersAmendmentRules_08020219.pdf

[5]http://www.mca.gov.in/Ministry/pdf/CompaniesSignificantRules_01072019.pdf

 

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