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CO-FOUNDER LEAVING THE COMPANY? FEW THINGS TO CONSIDER[1]

Co-founders, separating, is a harsh reality in early-stage companies, due to a plethora of reasons ranging from differences in opinion with regards the conduct of affairs, daily administration and management of the Company, to the relationship not working out organically, or in some instances simply due to personal reasons. The trouble in paradise gets worse when such separation is due to bad reasons such as non-compatibility between the founders and their inability to work with each other.

Structuring exit terms of a co-founder could be quite challenging, given the same is greatly dependant on ownership stakes, involvement in finances/intellectual property and/or other functional/operational/strategic matters in the company. As such, separation terms need to be carefully negotiated and structured to protect the rights of all parties involved and especially that of the company. We typically suggest entering into and executing a written agreement clearly laying down the terms of the separation and settlement thereof. Getting to the signature stage of this document becomes relatively easier if there is any signed founders’ agreement/shareholders’ agreement in place. To refer to our earlier post on founders’ agreement please see here.

There are various points of consideration that should be kept in mind for structuring separation terms, which, many a time, go a long way in either making or breaking a company.

If you are a continuing founder, you may begin by asking yourself the following questions:-

  1. How much equity is the exiting co-founder holding?

Typically, if there is a founders’ agreement/shareholders’ agreement in place, vesting related clauses get triggered and that serve as a good starting point for negotiations/discussions on the rest of the points. In the absence of such agreement, equity distribution discussions may prove to become major roadblocks as emotions run high during such events. While it is true that equity is the most preferred compensation mechanism in early-stage companies and therefore, it is inevitably required for attracting talent and getting future co-founders, it is also only fair to ask for what one deserves. Continuing founders may push for a complete exit, but exiting co-founder would want value for sweat, time, reduced remuneration, etc. Also, any retained equity by the exiting co-founders may be considered as “dead equity” in an early stage company, wherein investors invest in the caliber and business idea of the founders, more than anything else.

There are various means through which equity of an exiting co-founder is given back to the company/remaining founders/incoming co-founders depending on various parameters, and especially the value that the company has generated till the time of such exit.

  1. What is the exiting co-founders’ contribution to the development of the business? Is there any IP involved?

In early-stage companies, intellectual property (IP) could be the main stock in trade and therefore it is essential to establish that the company is the owner of the IP. The presence of an employment agreement or founders’ agreement makes this process simpler, as they typically contain clauses on ownership and assignment of the IP in the favor of the company, by the founders. However, in the absence of a clear contractual assignment, it becomes essential during a separation event, to get all IP assigned in favor of the company.

  1. Is the exiting co-founder also a director in the Company?

If the exiting co-founder is a member of the board of directors of a company also, the separation terms should address the issue of his/her resignation and filing of such resignation within 30 days with the registrar of companies having jurisdiction. The continuing founder shall ensure that there continues to be at least 2 (two) shareholders and 2 (two) directors in the company, even after the separation, in compliance with the provisions of the Companies Act, 2013.

  1. Taking stock of liabilities and indemnities:

During separation, it is important to take note of the stock in trade, books of accounts, statutory and contractual dues, pending litigations, indemnification obligations under any existing agreements and other financials of the Company. The exiting co-founder may be held liable for any and all statutory and contractual dues, especially for any defaults of the company during his/her tenure of association with the company. In instances such as fraud, wilful misrepresentation etc. the exiting co-founder may also be held personally liable for any damage, loss caused to the company (any existing shareholders’ agreement must also be evaluated in this regard).

  1. Other Considerations:-

In addition to above, the other material issues for consideration could be:-

  • Non-disparagement: This obligation is generally mutual in nature. Instances of disparagement may lead to bad name and reputation of all parties involved in the separation.
  • Non-compete, non-solicit: Typically, these flow from employment agreements/founders’ agreement, if executed.
  • Confidentiality: The exiting co-founder should be contractually restricted from disclosing any confidential information obtained by such co-founder during the course of his/her association with the Company. Any such disclosure of confidential information may lead to irreparable harm to the business of the Company.
  • Branding: The exiting co-founder post such exit, should not brand himself/herself as being associated with the company. The company should always intimate other parties working with the company and revise (to the extent practicable) all agreement, commercials, vender contracts and any other such document where the exiting co-founder has been a party in his capacity as a founder.
  • If an exiting co-founder retains equity in the company, post-exit;
  • the duration of non-compete, non-solicit in some instances should be linked to shareholding in the Company.
  • there should be a power of attorney in favor of one or more of the continuing founders, for ease of operational matters.
  • there should be transfer restrictions and provisions for treatment of equity (especially in case of an exit event for the company or a drag situation).

Each separation is unique in its own way and the dynamics vary depending on the relationship between the parties, many times they are just friends, family or ex-colleagues. Arriving and implementing the separation terms is a tricky affair that most importantly requires a neutral perspective and there have been various situations where mediation have come handy to resolve complex situations. To know more about mediation, you may see our posts available here.

[1] Please note that this post is a marker of reference points, only. Each separation requires customized advice and readers are requested to kindly seek professional advice in this regard.

Authors: Ms. Ayushi Singh, associate at NovoJuris Legal and Ms. Sohini Mandal, Junior Partner at NovoJuris Legal.

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APPLICABILITY OF LIMITATION ACT UNDER IBC (BK EDUCATIONAL SERVICES PVT. LTD Vs. PARAG GUPTA ASSOCIATES)

Background

Under the Insolvency and Bankruptcy Code 2016 (the Code), there has been an ambiguity with respect to applicability of the Limitation Act, 1963 (the Limitation Act). This has been deliberated upon in several judgments of the National Company Law Tribunal (the NCLT) and the National Company Law Appellate Tribunal (the NCLAT). In the case of Mis Deem Roll Tech Limited, the NCLT held that the Limitation Act is applicable to proceedings under the Code and dismissed the debt of the petitioner as being time barred and in the case of Neelkanth Township and Construction Private Limited Vs. Urban Infrastructure Trustees Limited, the NCLAT held that the provisions of the Limitation Act, 1963 would not apply to the Code. As observed above, it may be noted that applicability is being interpreted on the merit of each case and this has led to the confusion. The Supreme Court in case of Parag Gupta Vs. B. K. Educational Services held that the provisions of the Limitation Act is applicable for initiation of Corporate Insolvency Resolution Process.

Facts of the Case

  • There was a dispute on liability between Parag Gupta & Associates, Chartered Accountants (Financial Creditors) and B. K. Educational Services Private Limited, (Corporate Debtor).
  • The Corporate Debtor denied the financial liability and contended that the all the financial claims were false except one genuine debt, being immovable property allotted by Greater Noida Industrial Development Authority (GNIDA).
  • The Corporate Debtor further alleged that the records were tampered and manipulated by the relatives of the Financial Creditors.
  • The amounts claimed were time-barred.
  • It was showed that there was nothing on record that would extend the limitation to recover the same since the period was between 01 October 2012 to 05 February 2013.

The NCLT held that documents produced by the applicants were not justifiable for the purpose of extending limitation. Therefore, the amounts stated by the petitioner are not legally recoverable. But with respect to liability of sum which was given by petitioner on 25 February 2015, it was entitled to be recovered.  However, that amount the debtor had liquidated the recoverable after admission of the application. Subsequently, the NCLT held that there were no further actions acquired and disposed of the application.

Challenging the order of NCLT, the Financial Creditor had appealed the said order of the NCLT and filed an appeal before the NCLAT. Contrary to the NCLT order, the NCLAT held that the provisions of the Limitation Act were not applicable for initiation of Corporate Insolvency Resolution Process (CIRP) under the Code and passed an order to accept the application for initiation of CIRP. Consequent upon this, the Supreme Court stayed the order of the NCLAT dated 7 November 2017. The Supreme Court[1] pointed out that ‘NCLAT Order has erred in holding that the right to apply under Section 7 of the Code for initiating Corporate Insolvency Resolution Process, accrues from 1 December 2016 i.e. from the date the Code came into force. It is submitted that in the event the rational given by the NCLAT is given effect to, it will lead to an anomalous situation where even in case of defaults in respect of debts more than fifty years ago a party will be able to initiate Corporate Insolvency Proceedings under the IBC.

The Indian jurisprudence opines that if a law is a complete code, then an express or necessary exclusion of the Limitation Act should be respected. In light of the confusion in this regard, the Insolvency Law Committee, set up on 16 November 2017 deliberated on the issue and unanimously agreed that the intent of the Code could not have been to give a new lease of life to debts which are time-barred. It is settled law that when a debt is barred by time, the right to a remedy is time-barred. This requires being read with the definition of ‘debt’ and ‘claim’ in the Code. Further, debts in winding up proceedings cannot be time-barred, and there appears to be no rationale to exclude the extension of the principle of law to the Code.

Conclusion

In view of the above the Committee recommended that it would be fit to insert a specific section applying the Limitation Act to the Code. The relevant entry under the Limitation Act may be on a case to case basis. However, in the absence such explicit provisions in the Code, the creditors would get a right to make an application for time-barred debts too. Given this, a need is felt for more clarity pertaining to entry under the Limitation Act as it is vague and criteria is not recommended, which once again leaves the question unanswered.

It is pertinent to note that the non-application of the law of limitation creates the following glitches: (i) It re-opens the right of financial and operational creditors holding time-barred debts under the Limitation Act to file for CIRP, the trigger for which is default on a debt above INR One Lakh. The purpose of the law of limitation is “to prevent disturbance or deprivation of what may have been acquired in equity and justice by long enjoyment or what may have been lost by a party’s own inaction, negligence or latches”. Though the Code is not a debt recovery law, the trigger being ‘default in payment of debt’ renders the exclusion of the law of limitation counter-intuitive.  (ii) It re-opens the right of claimants (pursuant to issuance of a public notice) to file time-barred claims with the Insolvency Resolution Professional/Resolution Professional, which may potentially be a part of the resolution plan. Such a resolution plan restructuring time-barred debts and claims may not be in compliance with the existing laws for the time being in force pursuant to Section 30(4) of the Code.

[1] http://supremecourtofindia.nic.in/supremecourt/2017/41322/41322_2017_Order_10-Jan-2018.pdf

Withdrawal Application after Initiation of Corporate Insolvency Proceedings under the IBC

Introduction

In case of any disputes between the parties, there are probabilities that parties might compromise and settle the matter during the pendency of the case before the Court.  In this blog, we analyse the situation where the application has been made before the National Company Law Tribunal (the NCLT) or National Company Law Appellate Tribunal (the NCLAT) under the Insolvency and Bankruptcy Code 2016 (the Code) and in case if such application has been admitted and the Corporate Insolvency Resolution Process (the CIRP) is initiated by the NCLT and the parties with consensus ad idem wish to withdraw the said application.

On July 24, 2017, the Hon’ble Supreme Court in case of Nisus Finance and Investment Managers LLP (“Facility Agent” or “Financial Creditor”) and Lokhandwala Kataria Construction Pvt. Ltd. (“Debtor”) ordered that the application for CIRP could be withdrawn or the subject matter could be settled by the parties even after the CIRP have been initiated.

Facts of the Case:

Nisus Finance and Investment Managers LLP (“Facility Agent” or “Financial Creditor”) filed an application before the National Company Tribunal (“NCLT”), Mumbai against the Lokhandwala Kataria Construction Pvt. Ltd. (“Debtor”) for initiation of insolvency proceedings. The Debtor was acting as a guarantor of Vista Homes Pvt Ltd. (“Principal Debtor”) with respect to amount owed by the Principal Debtor. The Financial Agent, the Debtor and the Principal Debtor are one among the parties to the Debenture Trust Deed executed between the Principal Debtor, Facility Agent and other Debenture holders. The Debtor was acting as a guarantor to redeem the debentures in the event if Principal Debtor, fails to pay to the debenture holders. The Facility Agent had the authority to invoke its rights to ensure that the returns are reached to the debentures holders. The Principal Debtor failed to redeem the debentures which were due for its redemption and the Facility Agent filed application under the Code for CIRP with the NCLT, Mumbai. The NCLT admitted the application of Facility Agent on being satisfied that the Debtor defaulted in redeeming the debentures.

Upon Moratorium being declared by the NCLT, Mumbai, the parties approached the NCLAT with a plea requesting to set aside the order of the NCLT and allow them to withdraw the case as the parties had settled the dispute and the dues are paid by the Debtor.

The NCLAT rejected the plea that the Adjudicating Authority may permit withdrawal of the application on a request made by the applicant before its admission and same cannot be withdrawn once the order for admission is issued and Moratorium is declared. Contesting the order of the NCLAT, the parties appealed the said order with the Hon’ble Supreme Court highlighting that NCLAT could utilize the inherent power recognized by Rule 11 of the National Company Law Appellate Tribunal Rules, 2016 to allow a compromise between the parties after admission of the matter.

Judgement:

The Hon’ble Supreme Court highlighted that the Rule 11 of the National Company Law Appellate Tribunal Rules, 2016 was not notified as on the date of order passed by the NCLAT. However, the Hon’ble Supreme Court utilised its powers under Article 142 of the Constitution of India, which states that Supreme court in the exercise of its jurisdiction may pass such order or decree as is necessary in doing complete justice. The Hon’ble Supreme Court while exercising its powers allowed the parties to withdraw the application. The Hon’ble Supreme Court disposed the appeal after accepting and recording the consent of the parties, where parties undertook to abide by the consent terms and the debtor agreed to pay the sums due. It is important to note that the intention of law is to provide the justice, therefore depending on the facts and circumstances, an application may be withdrawn even after the admission of the application.

Some thought provoking facts from the case:

  1. One of the objections raised by the Debtor before the NCLT, Mumbai was that the Facility Agent has no locus standi to file the case as no liability has been shown as owed and Facility Agent is not an authorised agent and not permitted under the law to file an application, hence application is not maintainable. The NCLT, Mumbai highlighted that since all the parties being privy to the Debenture Trust Deed, the Debtor cannot backout saying that the Facility Agent cannot act as Financial creditor on behalf of or as Debenture holders to initiate the CIRP against the Debtor.

 

  1. The NCLAT dismissed the appeal of the Debtor for withdrawal of application on the ground that before admission of an application under Section 7, it is open to the Financial Creditor to withdraw the application but once it is admitted, it cannot be withdrawn and is required to follow the procedures laid down under Sections 13, 14, 15, 16 and 17 of the Code. Therefore, parties cannot be allowed to withdraw the application once admitted, and matter cannot be closed till claim of all the creditors are satisfied by the corporate debtor. However, as explained in this blog, the Supreme Court may on a case to case basis, allow to withdraw the application which is already admitted by applicable authority.

 

  1. It is pertinent to note that the Supreme Court while passing order highlighted and agreed to the view of the NCLAT on Rule 11 has not been adopted at that point of time and in the absence of no inherent power, the question of exercising inherent power does not arise. Therefore, the Supreme Court took the cognizance of Article 142 of the Constitution of India where the Apex Court has authority to pass such order or decree as is necessary in doing complete justice.

Authors: Ms Shivani Handa and Mr Ashwin Bhat.

Cross Border Mergers – Key Regulatory Aspects to Consider

Introduction

Cross-border mergers and acquisitions have rapidly increased reshaping the industrial structure at the international level. A cross-border merger means any merger, amalgamation or arrangement between an Indian company and a Foreign Company[1] in accordance with the Companies Act, 2013 and the Companies (Compromises, Arrangements, and Amalgamations) Rules 2016.

The Ministry of Corporate Affairs notified Section 234 of the Companies Act, 2013 thereby enabling cross-border mergers with effect from 13 April 2017. Thus, it was a matter of time that the Reserve Bank of India notified the regulations in order to operationalize the cross-border merger.

Regulatory Framework

In India, Cross border is majorly regulated under (i) the Companies Act 2013; (ii) SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 2011; (iii) Competition Act 2002; (iv) Insolvency and Bankruptcy Code 2016; (v) Income Tax Act 1961; (vi) The Department of Industrial Policy and Promotion (DIPP); (vii) Transfer of Property Act 1882; (viii) Indian Stamp Act 1899 (ix) Foreign Exchange Management Act 1999 (FEMA) and other allied laws as may applicable based on the merger structure.

The two most relevant regulations under FEMA from a merger & amalgamation perspective are Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000 (the FDI Regulations) and Foreign Exchange Management (Transfer or Issue of any Foreign Security) Regulations, 2004 (the ODI Regulations). In addition to this, the Reserve Bank of India (the RBI) has notified Foreign Exchange Management (Cross-Border Merger) Regulations, 2018 (the Cross-Border Regulation) under the Foreign Exchange Management Act, 1999 to include enabling provisions for mergers, demergers, amalgamations and arrangements between Indian companies and foreign companies covering Inbound and Outbound Investments. This is a significant move as there will be a massive surge in the flow of Foreign Direct Investment with the enactment of new laws and tweaking of existing policies.

Inbound & Outbound Merger

Cross-Border Merger could be either Inbound merger or Out-bound Merger. Inbound Merger means a cross-border merger, where the resultant company is an Indian company. An outbound merger means a cross-border merger where the resultant company is a foreign company. A resultant company means an Indian company or a foreign company which takes over the assets and liabilities of the companies involved in the cross-border merger.

Key provisions of the Cross-Border Regulation in case of Inbound Mergers

Issuance of Securities

As a consideration, the Indian company would issue or transfer of securities to the shareholders of transferor entity which may include both persons resident in India and person resident outside India. In case of a person resident outside India, the issuance of securities shall be in accordance with the pricing guidelines, sectoral caps and other applicable guidelines as prescribed under the Cross-Border Regulation. However, if the foreign company is a JV/WOS then it shall comply with the conditions prescribed as specified in Foreign Exchange Management (Transfer or Issue of any Foreign Security) Regulations, 2004. Further, if the inbound merger of the JV/WOS results into an acquisition of the one or more step-down subsidiary of JV/ WOS of the Indian party by the Resultant Indian company, then such acquisition should be in compliance with Regulation 6 and 7 of the ODI Regulations.

Vesting of Assets & Liabilities

  • Any borrowings or guarantees of the transferor company shall become the borrowings or guarantees of the resultant company. A timeline of two years has been provided to conform with the external commercial borrowings compliance. The end use restrictions would not apply in such cases.
  • Any asset acquired by the resultant company can be transferred in any manner as permissible under the Act or regulations. Where such asset is not permitted to be acquired, the resultant company shall sell the same within two years from the date of sanction of order by the National Company Law Tribunal (the NCLT) and the sale proceeds shall be repatriated to India immediately through banking channels. Where any liability outside India is not permitted to be held by the resultant company, the same may be extinguished from the sale proceeds of such overseas assets within the period of two years.
  • The resultant company is permitted to open a bank account in the foreign country’s jurisdiction for overseeing transactions related to the merger for a maximum period of two years from the date of sanction of scheme by the NCLT.

Valuation

The valuation shall be done as per Rule 25A of the Companies (Compromises, Arrangements, and Amalgamations) Rules 2016 i.e., by Registered Valuers who are members of recognized professional bodies in the prescribed jurisdictions of the transferee company and such valuation is in accordance with internationally accepted principles on accounting and valuation.

Key provisions of the Cross-Border Regulation in case of Outbound Mergers

Issuance of Securities

(a) As a consideration, the Foreign Company would issue securities to the shareholders of Indian entity which may include both persons resident in India and person resident outside India. In case if shares are being acquired by a person resident in India, then such acquisition shall be subject to the ODI Regulations as prescribed by the RBI.

Vesting of Assets & Liabilities

  • The guarantees or borrowings of the resultant company shall be repaid as per the scheme sanctioned by the NCLT. Further, they should not acquire any liability not in conformity with the Act or regulations as prescribed. A no objection certificate to this effect should be obtained from the lenders in India of the Indian company.
  • Any asset acquired can be transferred in any manner as permissible under the Act or the regulations thereunder. In cases where it cannot be held or acquired by the resultant company, it shall be sold within two years from the date of sanction of the scheme by the NCLT and the sale proceeds shall be repatriated outside India immediately through banking channels. Repayment of Indian liabilities from sale proceeds of such assets or securities within the period of two years shall be permissible.

Opening a Bank Account

The resultant company is permitted to open a Special Non-Resident Rupee Account (SNRR Account) for the purpose of for overseeing transactions related to the merger for a maximum period of two years from the date of sanction of a scheme by the NCLT.

Valuation

The valuation shall be done as per Rule 25A of the Companies (Compromises, Arrangements, and Amalgamations) Rules 2016 i.e., by registered valuers who are members of recognized professional bodies in the prescribed jurisdictions of the transferee company and such valuation is in accordance with internationally accepted principles on accounting and valuation.

Other Compliances

  • The resultant company and/or the companies involved in the cross-border merger shall be required to furnish reports as may be prescribed by the RBI, in consultation with the Government of India, from time to time.It is pertinent to note that at the time of sanctioning the merger of a foreign transferor body corporate with an Indian transferee company, the NCLT shall consider the validity of the merger as per the laws of the country in which the foreign body corporate has been incorporated, and any transaction on account of a cross-border merger undertaken in accordance with Cross-Border Merger regulations will be deemed to have prior approval of the RBI.

Conclusion

A range of complex issues must be navigated in an effort to successfully complete cross-border mergers. Each cross-border merger is different and implementation of these issues will greatly depend on the facts, dynamics, scale and geographic scope of both companies. The Cross-Border Regulations being fairly new, a lot of practical issues are yet to be identified and shall be addressed as and when encountered in the due course of time.

Authors: Ms. Ifla. A and Ms. Shruthi Shenoy, associates at NovoJuris Legal.

[1]Section 2(42) of the Companies Act 2013 defines Foreign Company as any company or body corporate incorporated outside India which: (a) has a place of business in India whether by itself or through an agent, physically or through electronic mode; and (b) conducts any business activity in India in any other manner.

Codification of Duties of Directors under the Companies Act 2013

Introduction

While the rights, powers, and duties of Directors defined in the Articles of Association of the Company, a need was felt for legal clarity. Under the Companies Act 1956 (the Erstwhile Act), there were no explicit provisions regulating the duties of the directors of the Company.  The J.J. Irani Committee report suggested that the duties of a Director should be “inclusive, and not exhaustive in view of the fact that no rule of universal application can be formulated as to the duties of the directors.”

On the basis of the JJ Irani committee report, a specific provision governing the duties of directors was included in the Companies Act, 2013 (the Act), which applies to directors both individually as well as collectively to the Board.  The section 166 of the Act has consolidated the law governing directors’ duties making it more certain. Although this consolidation is not exhaustive, as certain duties of directors are still enumerated under other sections of the Act, for instance, Section 184 of the Act obliges a director to disclose his interest in a contract with the company, nonetheless, director’s actions are benchmarked against responsibilities explicitly identified under section 166 which directors are expected to abide by, both individually and collectively as a Board.

General principles regarding duties of Directors:

A director of a company:

  1. shall, subject to the provisions of the Act, act in accordance with the articles of association of the company.
  2. should act in good faith in order to promote the objects of the company, for the benefit of its members as a whole, and in the best interest of the company, its employees, the shareholders, the community and for the protection of the environment;
  3. shall exercise his duties with due and reasonable care, skill and diligence; shall exercise independent judgment.
  4. shall not involve in a situation in which he may have a direct or indirect interest that conflicts, or possibly may conflict, with the interest of the company.
  5. shall not achieve or attempt to achieve any undue gain or advantage either to himself or to his relatives, partners or associates and if such director is found guilty of making any undue gain, he shall be liable to pay an amount equal to that gain to the company.
  6. shall not assign his office and any assignment so made shall be void.

Classification of duties of directors

These duties can broadly be classified into two categories:

  1. Duty of care, skill and diligence & independent judgement:

The duty of care, skill and diligence require directors to devote the requisite time and attention to affairs of the company, pursue issues that may arise through “red flags” and make decisions that do not expose the company to unnecessary risks.

  1. Fiduciary duties:

Fiduciary duties, on the other hand, require the directors to put the interests of the company ahead of their own personal interests. The rules that prevent conflict of interest and self-dealing on the part of directors are integral to this set of duties.

Section 166 of the Act applies to directors of all types of companies. The aforementioned directors’ duties extend to all categories of directors, including independent directors. However, in addition to Section 166, independent directors have to comply with the Code of Conduct under Schedule IV of the Act.

The Act necessitates a holistic approach to decision-making at the Board level. Codification of directors’ duties forces directors into being more accountable and responsible towards the management of a company, thereby improving transparency and corporate governance standards.

Implications of the codification of directors’ duties:

  1. Use of discretion: Exercise of discretion by a director ought to be well-founded and based on a thorough examination of all relevant facts.
  2. Full disclosure: Directors are likely to expect full disclosure of relevant information for basing their decision.
  3. Impact on nominee directors: A significant impact of section 166 (2) will be on the relationship between a nominee director and his nominating shareholder. Considering the statutory requirement for a director to act in the best interests of the members as a whole and to exercise independent judgment while deciding on a matter, a nominee director may find it difficult to harmonise his statutory, duties under section 166 with such instructions of his nominating shareholder, which most of the times are inconsistent with the interests of the company or a class of shareholders.

Non-adherence to section 166 of the Act

Breach of section 166 is an offense punishable by a fine for an amount not less than rupees one lakh but which may extend to rupees five lakh. However, where a director is guilty of making an undue gain, he will also be liable to pay to the company an amount equal to the gain.

Clarity of directors’ duties may make it easier for shareholders to initiate a class action suit for a claim of damages against the company and/or its directors, if breach of directors’ duties results in the management or conduct of the affairs of the company being run prejudicial to the interests of the company or its shareholders.

Conclusion

Given the liability of directors for non-compliance with their statutory duties, the following measures may be considered by a company and its Board:

  1. The directors should be given a thorough briefing on the statutory duties. The level of the briefing will vary depending on a director’s familiarity with his duties but should be gradually subsumed into a company’s induction process for all directors.
  2. Directors should adopt a balanced approach to decision making, and not act as a ‘Dummy’ director.
  3. If required, the board of directors should seek professional advice to understand the implications of a particular decision for making an informed decision’ after considering all relevant factors.
  4. If the Board is of the view that there is a potential conflict between two provisions of Section 166. In such conflicting situations, perhaps it will also be appropriate for the Board to hear the views of each stakeholder and seek expert advice prior to deciding on a matter.
  5. Directors should attend as many Board meetings as possible so to ensure that they are fully briefed on developments affecting the company’s business.
  6. A Nominations Committee may be constituted which should evaluate applications for directorships on an objective basis while ensuring that any new Board member, particularly an independent director, has the requisite skills and experience required for that particular position.
  7. Directors should consider on a regular basis whether a particular contractual arrangement or role performed by them can reasonably be regarded as likely to give rise to a conflict of interest. If it can be so regarded, the director concerned ought to make appropriate disclosures to the Board, in accordance with the articles of association of the company or provisions of the Act.
  8. The Company Secretary responsible for preparing Board related documents should be made aware of the requirements of Section 166 so that the Board is given adequate information, including of opinion of experts that may be relevant for an informed decision-making process.

Author: Ms. Ifla.A is an associate at NovoJuris Legal.

Breach Notification – A right to be informed

In November 2017, reports confirming a massive data hack at Uber compromising data of almost 57 million users surfaced online. It is pertinent to note that these reports surfaced almost one year after the actual breach occurred. Uber had not intimated when the incident occurred. This incident is an example to understand, why under GDPR providing a breach notification within 72 hours of any such breach has been mandatory if such a breach is directly going result in a risk to the rights and freedoms of natural persons.

The General Data Protection Regulation (“GDPR”) which will be effective from May 2018, will transform the way personal data of users/ individuals/ data subjects will be treated. Given the wide territorial scope of GDPR the Regulation applies to the processing of personal data of a person (data subject) who are in the EU, regardless of where the data is processed, ie. in EU or outside of EU. We believe that GDPR is setting a gold-standard for data security, across the world.

The concept of breach notification was seen under the security breach notification law enacted by the State of California in the year 2002. The security breach notification law was enacted to increase public awareness with regards security issues and risks that the internet and data industry faces.

  • Article 33(1) of GDPR mandates data controllers to “in the case of a personal data breach, the controller shall without undue delay and, where feasible, not later than 72 hours after having become aware of it, notify the personal data breach to the supervisory authority competent in accordance with Article 55, unless the personal data breach is unlikely to result in a risk to the rights and freedoms of natural persons. Where the notification to the supervisory authority is not made within 72 hours, it shall be accompanied by reasons for the delay.
  • Article 33(2) mandates data processors to “notify the data controller without undue delay after becoming aware of a personal data breach.”

In light of the requirements prescribed under GDPR, it is a pre-requisite to have in place an effective data security incident reporting mechanism including data breach response procedures to enable notifications to be made to data subjects “without undue delay” in the plain language in such circumstances.

GDPR prescribes that every breach notice should describe the exact nature of the personal data breach including the nature, extent and likely factors that may have resulted in breach based on preliminary assessment, where possible, the categories and approximate number of data subjects concerned and nature of data under threat or compromised, including and the categories and approximate number of personal data records concerned with an aim of charting out an effective mechanism to address the breach and resolve the issue without delay.

All entities dealing with personal data should comply with the requirements of reporting breaches in a timely manner. Every “notice of breach” should clearly indicate the cause of breach (Accident / negligent/malicious attack) due to (a) internal factors or (b) external factors and the estimated intensity and consequences of such attack. Such notices should promptly be followed by a detailed report indicating causes, consequences, action taken, including actions taken as preventive mechanism adopted to avert such instances in future.

To be compliant with GDPR, it is recommended for all data controllers and processors to have extensive internal policies within the company, including a breach notification policy addressing the procedures to be followed should there be a security breach. For ease of understanding, think of this security breach policy as a fire safety plan that has to be followed in case a fire breaks out. A fire safety plan will clearly indicate the do’s and don’ts, evacuation plan to follow, reporting mechanism, who should what, emergency numbers, internal training and all other necessary steps to be followed so as to contain and reduce the harm caused due to such an accident to the extent possible.

Similarly, a security breach policy will aid an organization to respond to such a data breach within a matter of minutes and enable them to take necessary actions so as to contain and reduce the harm. Additionally, such a policy will enable an organization to comply with the provisions of Article 33 (1) of GDPR, i.e. to report a data breach within a time frame of 72 hours.

In reference to Article 33 of GDPR data controllers may consider following points while considering the implementation of policy in their organization:

  1. Scope and intent of the policy will define how it will be implemented. There are two ways to define a scope, either you can have policy document regulating each and every aspect of GDPR to be followed all across the organization or there can be a series of policies implemented, for example, a policy specifically for security breach and notification thereunder. The second option will allow you to focus and concentrate on minute details of processes, controls, and compliances to be made at each level.
  2. Setting goals for the policy will provide you with accountability and definitive purpose for the whole organization. While setting goals for the policy do think about:
    • Practicality: Ensure that goals that you make are approachable and are ordinary in nature. At the same time keep in mind that these goals are solving the purpose of their implementation, including a way to maintain an internal log, audit trail of how data is used.
    • Risk Management: Focus on what kind of data is at risk? this may be dependent on the industry you might be doing business in. Focus on how a data breach can occur? What are the weaknesses of your system?
    • Flexibility: Try to keep your policy adaptive in nature i.e. it should be able to safeguard you in all sort of data breach situations.
    • Compliance: It should be compliant with law and aid in efficient compliance.

Data controllers, in particular, shall implement processes to identify and respond to data breaches as soon as the event occurs, to have evidence in place to show that where, when and how did data breach occur. Demonstrating that adequate security procedures were in place is essential in order to claim reduced penalties as well.

Status of data protection in India:

Information Technology Act, 2000 and Rules thereunder, ie. Rule 8 of Reasonable Security Practices and Procedures and Sensitive Personal Data or Information, Rules 2011, provides that in case of information security breach, the body corporate shall be able to demonstrate that it has implemented security control measures as per their documented information security programme and information security policies. It would be beneficial if the Rules also provided for notification of breach as well. If personal data is a Fundamental Right of the Indian citizen, then, citizens should have a right to know if such personal data has been subject to a data breach.

If an Indian company is processing data of an EU resident, then GDPR compliances become mandatory. In other cases, Indian companies can adopt best practices such as having detailed policies covering above aspects, periodical audit and availability of audit report to be shared to an external party, maintaining a log of what, how, who, why, where, data is processed. Currently, Government is not included under the ambit.

ISO 27001 certification for data security is also useful.

India would do well in having these gold-standards for data protection and it would augur well if even Government is included to follow the compliance requirements.

Author: Technology Practice Group @ NovoJuris Legal

REMUNERATION TO INDEPENDENT DIRECTOR

The role of Independent Director features prominently in Corporate Governance Codes. In India, the Companies Act 2013 (the Act) and SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 have completely revamped the country’s corporate governance code.

Corporate governance generally places a fair amount of emphasis on the independence of a Board and the corporate governance models in India have drawn large references from the recommendations of the Cadbury Committee (1992) of the UK and the Sarbanes-Oxley Act of 2002 of the USA.

A director is independent only if the Board affirmatively determines that he or she has no material relationship with the company that adversely affects his or her ability to be independent from management in connection with the performance of duties as a Board member and committee member.  This assessment is fact specific and when assessing the materiality of such relationship, the Board should consider the source of the director’s compensation including any consulting, advisory or other compensatory fees.  This includes consideration of whether the director receives compensation from any person or entity that would impair his ability to make independent judgments about the company’s management decisions.

Please see our recent post on the independence of Independent Directors here.

It is pertinent to note that only listed companies and public companies having a paid-up share capital of ten crore rupees or more or having turnover of one hundred crore rupees or more, or having in aggregate, outstanding loans, debentures, and deposits, exceeding fifty crore rupees have to mandatorily appoint at least two Independent Directors (or such higher number as mentioned specifically under Rule 4 of the Companies (Appointment and Qualification of Directors) Rules 2014]. Private companies are exempted from appointing Independent Directors. However, private companies may appoint them if the Board is of the opinion that there is a requirement of an Independent Director or if any investment agreement mandates such appointment.

Independent Directors devote their valuable time to addressing the strategic issues in the course of the Board and Committee meetings and use their expertise while guiding the management of the Company from time to time. Independent directors, who are truly independent, can be an effective barricade against corporate frauds. However, active oversight and prudent judgment may suffer when remuneration comes into the picture, as it is an important factor which needs consideration. The extent of remunerating Independent Directors determines their retention and motivation to discharge their duties without cloudy judgments.

As per the Companies Act 2013, “remuneration” means any money or its equivalent is given or passed to any person for services rendered by him and includes perquisites as defined under the Income-Tax Act, 1961. Now, let us examine the various remuneration models of Independent Directors in India.

The remuneration of an Independent Director is restricted to the following emoluments:

  1. Sitting Fee: Sitting fee to an Independent Director may be paid for attending meetings of the Board or committees thereof, such sum as may be decided by the Board of directors of and shall not exceed INR 1,00,000 per meeting of the Board or committee thereof.The sitting fee to be paid to Independent Directors shall not be less than the sitting fee payable to other directors.
  2. Commission: The Act allows a company to pay remuneration to its Independent Directors either by way of a monthly payment or a specified percentage of the net profits of the company or a combination of both. Further, it states that where the company has either a managing director or whole-time director or manager, then a maximum of 1% of its net profits can be paid as remuneration to its Independent Directors. In case there is no managing director or whole-time director or manager, then a maximum of 3% of net profit can be paid. Thus, the basis of payment to the Independent Directors is the net profit of the Company. The Company is however not obligated to remunerate its Independent Directors. Hence the Company may pay profit related commission to the Independent Directors with prior approval of the members. Given this, the commission should be profit-linked only and not revenue based. The Act does not eliminate profit-related commission which could create a conflict of interest since the commission is linked to the company’s performance.
  3. Consulting Fee: The remuneration of Independent Directors has been restricted to sitting fees, reimbursement of expenses for participation in the board and other meetings, and profit-related commission. Therefore, it can be noted that Consulting Fee is not allowed to be paid to Independent Directors.
  4. ESOP: The Act and SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 prohibit the issuance of stock options to Independent Directors, in a bid to address the concern that it might be causing a conflict of interest and will affect their independence. An alternative option could have been to place restrictions either on the total amount of issue of stock options or put a time limit on exercising stock options, rather than having a complete prohibition.
  5. Sweat Equity: The Company may opt to remunerate its Independent Director by way of issuing sweat equity shares. However, such issuance shall be in accordance with the procedure prescribed under the Act. The total percentage of voting power of such independent director together with his relatives shall not exceed more than two percent.
  6. Refund of excess remuneration paid: If the Independent Director draws or receives, directly or indirectly, by way of fee/remuneration any such sums in excess of the limit as prescribed or without the prior sanction, where it is required, such remuneration shall be refunded to the Company within two years or such lesser period as may be allowed by the company and until such sum is refunded, hold it in a trust for the Company. The Company shall not waive the recovery of any sum refundable to it unless approved by the Company by special resolution within two years from the date the sum becomes refundable.

Thus, to sum up, apart from the restriction on stock options, the remuneration of independent directors has been limited to sitting fees, reimbursement of expenses for participation in the board and other committee meetings, profit-related commission, and issuance of sweat equity shares as may be approved by the shareholders.

Additionally, the SEBI (Listing Obligation Disclosure Requirement) Regulation 2015 requires every listed public company to publish its criteria for payment of remuneration to Independent Directors in its Annual Report. Alternatively, this may be published on the company’s website and reference may be drawn thereto in its annual report. Section 197 of the Companies Act, 2013 and Regulation 17(6)(a) of SEBI (Listing Obligation Disclosure Requirement) Regulation 2015 states that the prior approval of the shareholders of the company is required for making payment to its Independent Directors, as recommended by the Board of the Company.

Authors: Ms. Ifla.A (Associate at NovoJuris Legal)