Companies Act 2013 and Draft Rules there under – Commentary on Drafting anomalies, aberrations, contradictions et al – Urgent Need for Review

Introduction

The much awaited Companies Act 2013 (hereinafter referred to as The Act) is now a valid piece of legislation having received presidential assent in August last year. The Act is now operational, albeit, partially with 98 provisions having been notified for application effective September 12,2013.The other provisions have been kept in suspended animation awaiting as they are for the complementary  sub-legislation in the form of  Rules to be finalized, feedback from all Quarters having been received to the drafts circulated by the Government.

The Companies Act is overwhelmingly dependent on sub-ordinate legislation which is somewhat intriguing, given the fact that in a procedural legislation such as the Act there is no place for so much delegated provisions as opposed to fiscal Statutes which are generally Rule bound having regard to the need for them   to be far more dynamic, requiring fine tuning often in line with the dynamics of business and the economic environment.

Readers are also aware that the Companies Act 2013 has come about after a prolonged period of incubation with a chequered history dating back to the year 1998 when a serious attempt was made to overhaul the 1956 Act. Considering the above, it was only fair that there was widespread expectation particularly from the professional fraternity that the new law would be easier on the eye,   lucid and simpler as well. The powers that be have made a liposuction of the mother Act, trimming the number of Sections to 470 from the previous Act but have very deftly and unobtrusively transferred the extra fat elsewhere by making the provisions so much dependent on Rules which can be prescribed from time to time without going through the rigours of parliamentary sanctions.

Viewed against this backdrop of expectancy, the Companies Act 2013, to be honest, is a huge disappointment in terms of its   quality of drafting. The Act is also replete with grammatical errors and   inherent contradictions. In many places the draft Rules run   contrary to the Act which is totally unacceptable, given the fact that sub-ordinate legislation has to be necessarily subservient to the mother Act.  In this write up, we shall list out some obvious aberrations which, it is desirable, are rectified before the Act becomes fully operational, the general expectation for the same being the starting date of the fiscal year 2014-15.

Section 2(47)-Definition of Independent Director

Section 2(47) states that an Independent director means an independent Director referred to in sub-section (5) of Section 149.If one looks at Section 149(5), the definition is missing !.The same is contained in Section 149(6).As neither Section has yet been notified this obvious error should be deleted.

Section 135- Non-existent   definition of Corporate Social Responsibility (CSR)

This   Section, inter alia, speaks about the applicability of CSR to companies belonging to a particular genre. The draft CSR Rules 2013 which have been provided under Chapter IX, state that CSR means CSR as defined in Section 135 of the Act. No definition of CSR is provided by Section 135. The CSR activities to be undertaken by the Company have been, however, spelt out under Schedule VII of the Act. The definition to the term can be appropriately inserted in the Rules.

Section 165-Number of Directorships

Sub-section (2) of Section 165 reads as follows:

Subject to the provisions of sub-section (1), the members of a company may, by special resolution, specify any lesser number of companies in which a director of the company may act as directors (Emphasis supplied).

The s after director in the sub-section needs to be obliterated.

Section 181-Contribution to bona fide and charitable funds

Proviso under the above section states that prior permission of the company in general meeting shall be required for such contribution in case any amount, the aggregate of which, in any financial year, exceeds five percent of its average net profits for the three immediately preceding financial years.

The proviso is silent as to whether the prior approval in general meeting shall be by means of a special resolution or ordinary resolution. The type of resolution to be passed needs to be specified. In the absence of an express provision, companies will be justified in obtaining shareholder approval by ordinary resolution.

Section 194-Prohibition on forward dealings in securities of company by director or key managerial personnel-Divergence between Sub-section(1) and the Explanation under the Section

Sub-section (1) reads as follows:

No director of a company or any of its key managerial personnel shall buy in

The company, or in its holding, subsidiary or associate company”

(a) A right to call for delivery or a right to make delivery at a specified price and Within a specified time, of a specified number of relevant shares or a specified amount Of relevant debentures; or

(b) A right, as he may elect, to call for delivery or to make delivery at a specified Price and within a specified time, of a specified number of relevant shares or a specified Amount of relevant debentures.

A plain reading of the above sub-section indicates that a Director or key managerial personnel is prohibited from entering into forward dealing contracts involving either the company™s securities or those of its   holding or subsidiary or its associate companies.

However the Explanation under the Section which is reproduced below tells a different story:

Explanation.”for the purposes of this section, ˜˜relevant shares™™ and ˜˜relevant Debentures™™ mean shares and debentures of the company in which the concerned person is A whole-time director or other key managerial personnel or shares and debentures of its Holding and subsidiary companies.

From the above Explanation,   it follows that the Section applies only to whole time directors or other key managerial personnel. In addition the restriction on acquisition of   relevant shares and debentures applies only to such securities issued by the company, its holding companies and subsidiary companies. Associate Companies are conspicuous by their absence in the Explanation which implies that there is no bar to forward dealing in the securities of such companies.

The Explanation therefore runs contrary to what is contemplated by the provision and needs to be realigned appropriately.

Section 177 and 188-Authorization to Related party transactions-Redundancy in procedure and apparent disconnect between the provisions

Section  188 of the Companies Act 2013 lays down the code for obtaining authorization of the Board and in applicable cases   , the approval of the members for entering into related party transactions. The Section contemplates that for entering into transactions of the genre prescribed in sub-section (1), approval of the Board shall become necessary.

 Authorization by the Board would become a requisite only if the transaction with the related party is not:

a)    In the ordinary course of the company™s business and

b)    The transaction is not on an arm™s length basis.

As per the draft rules issued under Chapter XII, prior approval of the members by special resolution will be required for related party transactions in cases where:

a)  The company has a paid up share capital of Rupees one Crore or more or

b) where the value of the transaction individually or taken together with previous transactions during the financial year  exceeds five percent of the annual turnover or twenty percent of the net worth of the company as per its last audited financial statements whichever is higher  in respect of transactions specified in sub-section(1) of section 188.

The   above   provisions by itself generate enough food for thought;   hence, we do not intend to go into the fine print of the provisions as they would be a separate subject for a discussion paper. Suffice to say for the purposes of this exposition that approval of the Board or shareholders as the case may be, shall be called for only subject to exceptions provided in the draft Rules, if the transaction is not in the ordinary course of business and it is not on arm™s length basis.

It is pertinent to point out that clause(iv) under sub-section (4) of section 177 provides that the Audit Committee of the Board should grant approval to any related party transaction  as also subsequent amendments in the terms  thereto. The thresholds laid down in the draft Rules as stated above shall not prima facie, apply so far as section 177 is concerned. Further,  the test as to whether the transaction is in the ordinary course of business and it is not on arm™s length terms which are pre-requisites for the application of Section 188 would also not come in the way of seeking approval of the Audit Committee   u/s 177.The above dichotomy in the Companies Act 2013 needs to be addressed urgently  as otherwise companies will have to comply  with both Sections 177 and 188 simultaneously which will lead not only to redundancy in procedure but also queer the pitch so far as ensuring compliances are concerned.

Disqualification of Directors u/s 164 and vacation of office  by Directors u/s167-Divergence

Section 164 lays down the circumstances under which a Director is disqualified from appointment. Sub-section (1), inter alia, provides that disqualification will follow in the following cases:

a) Where there is a conviction by a court of any offence involving moral turpitude or otherwise involving imprisonment for a period of not less than six months and a period of five years has not elapsed from the date of expiry of the sentence.

b) An order disqualifying the director has been passed by a court or Tribunal and the order is in force.

c) Where there is a conviction for any offence relating to related party transactions during the last five preceding years.

Reference in this connection may be made to Clauses (d), (e) and (g) in Section 164(1).

The proviso to section 164(3) lays down that the disqualifications referred to under the above circumstances shall not take effect for a period of 30 days from the date of the conviction as also in cases where the order has been appealed against, during the pendency of the appeal and for a further period of seven days from the date on which the appeal or petition has been disposed off.

Section 167 lists out the circumstances in which the office of a director shall fall vacant. Vacation   of office would also arise in case where there is a conviction for an offence involving moral turpitude or otherwise involving punishment by way of imprisonment for six months.

The proviso to Section 167 states that the office of the director shall stand vacated even if the director has preferred an appeal against the order of conviction.

It is hard to believe that under the tapestry of the same Act, vacation of office would arise even where an appeal is preferred whereas disqualification arising out of a similar offence would be held in abeyance pending disposal of an appeal against the order of conviction!

There is therefore an urgent need for a convergence of Section 164 and 167 on the above issue.

Section 195-Prohibition of Insider trading of Securities

The Section states that no person including any director or key managerial personnel (KMP) of a company shall enter into insider trading.

As the Section applies to any company it is fair to assume that it will apply to both listed as also unlisted companies. It may be noted that as per the draft rules every company which has a paid up capital of Rs 5 Crore or above has to appoint KMPs. It is impossible to comprehend how directors or KMPs of unlisted companies can indulge in insider trading! It should have been stated clearly that the provisions would apply only to a listed company.

In addition, from a plain reading of the Section it can be inferred   that any person including   directors or KMPs would also be prohibited from insider trading. Such an inference would be justified given the language used in the section which runs as follows:

No person including any director or KMP of a company¦..

Persons other than directors or KMPs have not been separately identified for coverage under the above provision.

Suitable amendments are called for to overcome the anomalies pointed out above.

Section 195-Definition of price-sensitive information

The definition to the term price-sensitive information has been provided under clause (b) to the Explanation to Section 195.The definition has been copied in part from   the definition to the term given in the SEBI (Prohibition of Insider Trading) Regulations, 1992.What is however inexplicable is that the Explanation contained in the definition to the term in the SEBI code by which the contours of price sensitive information were widened have been deleted in the Companies Act 2013.

Therefore the definition in the Act is not in sync with the SEBI  code .What constitutes price sensitive information as per the Act will not be in tandem with the SEBI code thus giving rise to avoidable confusion in the matter of ensuring compliances.

Section 184-Disclosure of Interest by Director

The Section enjoins upon the director of a company to disclose to the Board his interest or concern ,whether direct or indirect ,in any   contract or arrangement proposed to be entered into with an Entity in which the Director is interested in the manner stated in sub-section(2) which is reproduced below to facilitate a discussion.

(2) Every director of a company who is in any way, whether directly or indirectly, Concerned or interested in a contract or arrangement or proposed contract or arrangement Entered into or to be entered into”

(a) With   a body corporate in which such director or such director in association with   any other director, holds more than two per cent. shareholding  of that body corporate, or is a promoter, manager, Chief Executive Officer of that body corporate; or

 (b) with  a firm or other entity in which, such director is a partner, owner or  member, as the case may be, shall  disclose the nature of his concern or interest at the meeting of the Board in which the contract  or arrangement is discussed and shall not participate in such meeting:

Provided that where any director who is not so concerned or interested at the time of

entering into such contract or arrangement, he shall, if he becomes concerned or interested after the contract or arrangement is entered into, disclose his concern or interest forthwith when he becomes concerned or interested or at the first meeting of the Board held after he becomes so concerned or interested.

A plain reading of the above indicates that the duty to disclose the director™s interest arises where the contract or arrangement   is   with a Company in which the director either by himself or in association with other directors holds more than 2% of the share   capital of the other company or where he is a promoter, Manager, chief Executive officer of the other company. In addition, disclosure would be necessary where the contract is with a firm or entity of which such director is a partner, owner or member as the case may be.

It is pertinent to point out that where the interest is in the capacity of a promoter, manager, chief Executive officer of the other company   , the duty to disclose is cast irrespective of whether the director holds shares in the company. In respect of contracts with non-corporate entities, disclosure would be needed where the involvement of the director is in the capacity of a partner, owner or member of the firm.

Having said this, let us look at the contents of   sub-section (5) which are reproduced below.

(5) Nothing in this section”

(a) Shall be taken to prejudice the operation of any rule of law restricting a director of a company from having any concern or interest in any contract or arrangement with the company;

(b) shall apply to any contract or arrangement entered into or to be entered into between two companies where any of the directors of the one company or two or more of them together holds or hold not more than two per cent. Of the paid-up share capital in the other company.

From a plain reading of Clause (b) it is apparent that the provisions of section 184   in its entirety would apply only in respect of contracts in which directors of a company or two or more than together hold 2% or more of the paid up share capital in the other company. In fact it would appear as if sub-section(2) as quoted above has been rendered in fructuous  due to the language used in sub-section(5).Drawing such a conclusion would  not be  logical when one considers that the duty of the director to disclose his interest in a contract arises as per sub-section(2) above not only in respect of contracts with a company in which there is holding of 2% or more but also in cases where he is interested in the capacity of a promoter ,manager, CEO of the other  company without being a member but also with those non-corporate entities with which the director is associated as a partner, owner or member of the entity. The contents of Sub-section (5) above would appear to defeat the very   purpose of Section 184 and an appropriate modification to sub-section (5) is called for.

Requirement of Independent Directors-Does it applies to private companies as well?

From a reading of the  draft rules issued under Chapter XI corresponding to Section 149 to 172 of the Companies Act 2013 ,it can be inferred that the requirement of appointing Independent directors shall apply only to listed companies and to those unlisted public companies which have:

a)    paid-up capital of Rs 100 Crore or  more or

b)    turn-over of Rupees three hundred Crore or more or

c)    Outstanding loans or borrowings or debenture or deposits exceeding two hundred crores.

As the term public company as defined by Section2(71)shall also include a private company which is a subsidiary of a public company such companies satisfying any of the bench marks laid down above shall also have to appoint independent directors.

Drawing the above conclusion would be premature when one considers the provisions contained in Section 135 as regards Corporate Social Responsibility(CSR). Section 135 applies to every company   which would obviously include a private company which satisfies any of the thresholds prescribed for the applicability of CSR. Section 135(1) provides, inter alia, that a CSR Committee of the Board should be constituted and that the Committee should consist of at least one independent director.   Therefore a private company would also be, willy-nilly, drawn into the vortex of having an independent director despite the fact that the intention of the Act would appear to be different.

It is therefore imperative to clarify that the provisions relating to CSR shall not apply to private companies or alternatively it should be stated that such companies need not appoint independent directors.

Section 149-Timelines for appointing Women Directors-Divergence between draft Rules and the Act

Rule 11.1 of the draft rules prescribed under chapter XI   which corresponds to the second proviso to section 149(1) provides that every listed and unlisted public company satisfying the criteria stated in the preceding paragraph should have at least one woman director. Listed companies are expected to comply with this requirement within one year from the commencement of the second proviso to section 149(1).Unlisted public companies are required to comply with the above norm within three years from the date of applicability of the second proviso to section149(1).

The above timelines are in variance with the requirements of section 149(2) which provides that   every company which   was existing on or before the commencement of the Act   should satisfy the requirements of Section 149(1) within one year from the date of applicability of Section 149(1).

It is also essential to clarify whether the woman director would be an independent director or not. The draft rules are silent on this point.

Conclusion

In the above discussion, we have only cherry picked some of the provisions in the Companies Act 2013 and in the draft rules to drive home the areas of divergence that need immediate attention. We are sure that there would be several other provisions   in the Act which would require modifications due to improper construction.

We would submit that what has emerged as a final product in the form   of the new Act could have been drafted   a lot better, so that it could have stood out as a qualitative piece of legislation. We are conscious of the fact that no piece of legislation can be perfect and flawless. Surely with some greater care, the flaws of the genre described above in the Act could have been avoided.

For the discerning user of the Companies Act 2013, the wish list would be endless in so far as the removal of the cobwebs of doubt over some of the newly inserted provisions   is concerned. There is a famous English proverb which goes like this, ˜If wishes were horses, beggars would ride,   if turnips were swords, I would have one by my side.

All our desires cannot come through. We have to therefore live with the new enactment hoping fervently that at least some of the discordant notes as pointed out above are eased out before the Act becomes enforceable in full measure.

Ramaswami Kalidas

January 7, 2014

Tags: Board of directorsCompanies ActCompanies Act 1956Companies Act 2013CompanyDebentureGovernmentSections

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Kalidas Ramaswami

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