Role of Due Diligence in Mergers and Acquisition

logoRole of Due Diligence in Mergers and Acquisition

Introduction

Ever since the Indian Economy opened itself to the foreign market after the economic liberalization reforms of 1991, Mergers and Acquisitions have become a common phenomenon throughout India. In a highly competitive global environment, mergers and acquisitions have turned out to be one of the fastest strategic options for companies to gain competitive advantage. While a merger is a combination of two companies, with one company merging itself into the other and losing its identity, while the other prominent company gains more importance and either absorbs the other company or consolidates itself with the other company, an acquisition is the action whereby the acquiring company purchases the interests of the acquired company’s shareholders and ceases to have any interest or right after the acquisition.

 

Merger is an arrangement that assimilates the assets of two or more companies and vests their control under one company. Acquisition simply means buying the ownership in a tangible or intangible asset such as purchase by one company of controlling interest in the share capital of another company or in the voting rights of an existing company. In the merger context, both companies pool their interests, which mean that the shareholders of both companies still hold on to their portfolio interests from their company and also gets interests in the other enterprise.

 

The term ‘amalgamation’ is used synonymously with the term merger and both these terms are used interchangeably but both these terms are not precisely defined in The Companies Act, 1956. Section 390 to 395 of Companies Act, 1956 deal with arrangements, amalgamations, mergers and the procedure to be followed for getting the arrangement, compromise or the scheme of amalgamation approved in India but the term merger or acquisition is not defined within the Act. However, the Income Tax Act, 1961 defines the term ‘amalgamation’ under section 2(1B) of the Act as the merger of one or more companies to form one company in such a manner that all the properties and liabilities of the amalgamating company(s) become the properties and liabilities of the amalgamated company, and not less than three-fourth shareholders of the amalgamating company become the shareholders of the amalgamated company.

 

Under Section 5 of the Competition Act, 2002, “combinations” are defined with reference to assets and turnover of merging companies located exclusively in India or located in India and outside India. Section 6 of the Competition Act, 2002 states that, no person or enterprise shall enter into a combination which causes or is likely to cause an appreciable adverse effect on competition within the relevant market in India and such a combination shall be void. All types of intra-group combinations, mergers, demergers, reorganizations and other similar transactions are thus within the purview of the Competition Act, 2002 unless specifically exempted.

 

Further, mergers and acquisitions are also governed by the SEBI Take Over Code, 1994 and requires mandatory permission from High Courts of the respective jurisdiction of such companies to enable any scheme of amalgamation or merger or arrangement to come through.

 

Why Mergers and Acquisitions?

Mergers and Acquisitions is an important way for companies to grow and become stronger and better organizations. The main reasons underlying such operations are:

– Enhanced reputation in marketplace or with stakeholders

– Reduction of operating expenses or costs

– Access to management or technical talent

– Access to new product lines

– Growth in market share (complement/extend current business)

– Quick access to new markets or entry into new industry (diversification)

– Reduction in number of competitors

– Access to new technology, manufacturing capacity or suppliers

 

Now, even though Mergers and Acquisitions have several advantages, but the risks involved are equivalent too. The real motive behind mergers or acquisitions should be on the table for all the parties concerned to ensure real success of such merger or acquisition. The post implementation phase is a very critical part where several mergers or acquisitions fail and before onset of any deal, most companies should conduct due diligence to ascertain the real risks and profitability of such deals. Due Diligence Due Diligence in Mergers and Acquisitions is the process of evaluating and investigating a prospective business decision by getting information about the financial, legal, intellectual and other material information from the other party.

 

The ultimate goal of such activities is to make sure that there are no hidden drawbacks or traps associated with the business transaction under consideration. By performing due diligence, a perfect strategy can be evolved to carry out the merger or acquisition. Failure to exercise due diligence prior to entering into a transaction of enormous proportions such as a merger or acquisition may lead to a precarious situation where the asset acquired, may be marred by encumbrances, charges and other liabilities which get automatically transferred to the acquirer as a result of such acquisition. While the cost involved in performing a due diligence is on the higher side, as it usually involves the services of a CA and an attorney, the importance of conducting a thorough due diligence before undertaking a transaction cannot be undermined under any circumstances. To any company involved in merger or acquisition, the due diligence investigation will attempt to reveal all material facts and potential liabilities relating to the target company/unit/business.

 

The purpose of due diligence is to confirm that the business actually is what it appears to be. While gaining information about the business, the company conducting the due diligence can definitely identify deal killers and eradicate them. Further, information for valuing assets, defining representations and warranties, and/or negotiating price concessions can also be obtained vide due diligence. The information learned while conducting due diligence will further help in drafting and negotiating the transaction agreement and related ancillary agreements.

 

This information will also be helpful in allocating risks in regards to representations and warranties, pre-closing assurances and post-closing indemnification rights of the acquirer, organizational documents to determine the stockholder and other approvals required to complete the transaction, contracts, including assignment clauses, and permits and licenses, to determine whether the transaction is contractually prohibited or whether specific consents are required, regulatory requirements, to determine if any governmental approvals are required, and debt instruments and capital infusions, to determine repayment requirements. Why Due Diligence? Mergers and Acquisitions revolve around certain specific steps and due diligence is the first step to make the end business successful. Due diligence helps in understanding the following about the company:

 

 Capital structure including shareholding pattern.

 Composition of board of directors.

 Shareholders’ agreement or restrictions on the shares, for example, on voting rights or the right to transfer the shares.

 Level of indebtedness.

 Whether any of its assets have been offered as security for raising any debt.

 Any significant contracts executed by it.

 The status of any statutory approvals, consents or filings with statutory authorities.

 Employee details.

 Significant litigation, show cause notices and so on relating to the target and/or its areas of business.

 Intellectual Property of the Company

 Any other liability, existing or potential.

 

Conducting Due Diligence: By conducting due diligence before finalizing any merger or acquisition helps in evaluating and structuring the transaction and identify legal or contractual impediments that might impact the end result. It also helps to validate the business plan and mitigate any risks that seem imminent and formulate solutions to deal with various issues. The first step in conducting due diligence is to plan the due diligence so that the business transaction can undergo smoothly. Liaisons with Regional Legal Advisor/General Counsel, Contracting Officer/OAA, Program Office, or other office to plan an efficient approach toward conducting the due diligence should be conducted to determine and plan the due diligence memo. Secondly, information should be gathered about the company from public domains such as news articles, company reports and subscription-only resources, such as Dun & Bradstreet, Lexus-Nexus, Factiva, etc. Constitutional documents of the Company, annual reports and annual returns filed with statutory authorities, giving information on shareholdings, directors should also be analyzed including quarterly and half-yearly reports, in the case of listed companies (in accordance with the standard listing agreement prescribed by the SEBI). Government resources should be checked to see if there are particular issues concerning the business, relationship with a particular country, government, or client, or other policy concern.

 

The top managers or board members of the company can also be scrutinized by conducting a search involving sensitive information to determine if the company individual is eligible for a visa to the US, which is one way to identify risks to the agency. By conducting web searches about the company untapped information about the company may also become evident which would be helpful in furthering the business transaction. Local searches should also be conducted to gather information about the company’s current customers, suppliers, and/or private sector or government partners, relevant local associations and to assess the overall reputation of the company. Thirdly, after all the information about the company has been obtained, the same must be analyzed to understand the business operation and the key strengths and weakness of entering into any scheme of merger or acquisition with such company.

 

Fourthly, the stock exchanges where merging and merged companies are listed should be informed about the merger proposal. From time to time, copies of all notices, resolutions, and orders should be mailed to the concerned stock exchanges. Fifthly, the due diligence memo must be prepared and discussions held with the company to bring out the true nature of the transaction process and finalize the transaction. The Memorandum of Understanding (MOU) must be drafted thereafter and reviewed by the Agency deciding official well before serious alliance discussions begin with the potential partner. The Board of Directors of each company must approve the draft merger proposal and pass a resolution authorizing its directors/executives to pursue the matter further.

 

Although it might seem that due diligence has come to an end after the draft merger proposal has been approved by both the companies, however, due diligence is an ongoing process and may continue right throughout the existence of the amalgamated or merged company to evaluate any risk that may crop up at any point of time during the alliance. Conclusion Once the Memorandum of Understanding and merger proposal has been approved by both the companies, each company should make an application under the Companies Act, 1956 to the High Court of the State where its registered office is situated so that it can convene the meetings of share holders and creditors for passing the merger proposal.

 

Thereafter notices must be dispatched to the shareholders and creditors of the company to convene a meeting and such meeting must be subsequently held where at least 75% of shareholders of the company who vote either in person or by proxy must approve the scheme of merge. Once the scheme of merger has been approved by the creditors and shareholders, another petition to High Court to confirm the scheme of merger must be presented and notices regarding the same published in two newspapers. After the High Court passes an order approving the scheme or merger or amalgamation, the certified true copies of the orders must be sent to the registrar of the companies and assets and liabilities of the companies stands transferred to the amalgamated company. It has been reported that mergers and acquisitions take about a three to four months for completion

 

although the SEBI Takeover Regulations require the acquirer to complete all procedures relating to the public offer including payment of consideration to the shareholders who have accepted the offer, within 90 days from the date of public announcement. However, ultimately, whatever the time limit might be, mergers and acquisitions definitely help the companies to strengthen and expand their business operations to increase profitability and consolidate the business structure. With strict due diligence in place, companies can definitely hope to tackle the risks involved and make the end result successful for effective mergers and acquisitions. Today, India presents the right opportunities for companies to engage in cross-cultural transactions and amalgamations and Indian markets are registering massive growth in mergers and acquisitions with consolidation of international businesses in India and fierce competition amongst business houses who are seeking to expand their market.

Director Identification Number

DIRECTOR IDENTIFICATION NUMBER

All existing and any person intending to be appointed as a director are required to obtain the Director Identification Number(“DIN”). DIN is also mandatory for directors of Indian Companies who are not citizens of India. DIN is a unique identification number for an existing director or a person intending to become the director of a company.

The Ministry of Company Affairs (“MCA”) has launched a major e-Governance initiative “MCA 21”. It envisages e-filing of all documents related to company matters on the MCA portal. For obtaining DIN, directors are required to submit an application in e-form DIN-1 online through MCA portal.

Who should apply for DIN?

– Any person who is a director of a company or anyonewho intends/proposes to be a director of company in future needs to apply for DIN;

– As per the recent amendment in the Companies Act ,1956 DIN has become mandatory for all the directors;

– DIN is individual specific and not company specific, so only one DIN is required per director/person.

Fees for applying DIN :

There is no fees for the purpose of applying DIN.

Documents required for applying DIN:

1. Identity Proof (Any one of the following)

PAN Card / Driving License / Passport / Voter Id Card

2. Residence Proof (Any one of the following)

Driving License / Passport / Voter Id Card / Telephone Bill / Ration Card / Electricity Bill

3. Coloured Photo Graph

Following persons can attest the annexure required with the DIN application:

a) Gazzetted officer

b) Notary

c) Practicing CS/CS/ICWA

d) Company Secretary in employment

 PROCEDURE FOR OBTAINING DIRECTORS IDENTIFICATION NUMBER:

1. Log on to www.mca.gov.in.

Click on ‘Obtain Director Identification’.

3. After you click, a new page will open having the DIN application form, fill the details in the form

4. After you filled the application form, click the “submit” button.

5. The DIN application with the provisional DIN number will come as a result

The provisional DIN shall be valid for a period of 60 days from the date on which it was generated.

Now, you have to take a print of the final form. It is recommended that you also save a copy of the form by clicking the circle shown in above picture.

You need to affix your photograph on the space provided on the form. And attach a proof of identity and a proof of residence with the form. Please note that the photo affixed on the form and the proofs attached must be certified by a Public Notary or Gazetted Officer or any certified professionals (viz. Company Secretary/ Chartered Accountant/ Cost and Works Accountant). In case of certified professional, they have to affix their stamp and registration number along with signature.

The form along with the above documents has to be sent to following address by ordinary post:

 MCA DIN Cell

Post Box No. 03

NOIDA, Uttar Pradesh � 201 301, India

Or

The above form can also be sent by courier or registered post to the following address

MCA DIN CELL

PDIL bhawan

A-14, sector-1 Noida

Uttar Pradesh

The Central Government shall communicate within one month of receipt of application, its approval or disapproval of the application, in writing by a letter or by electric mode.

After verification by MCA authorities your DIN will be confirmed.

If DIN is allotted, it is valid for the life time of the recipient.

The applicant within one month of receipt of DIN, shall intimate to the company or companies concerned in which he is a director, the DIN in Form DIN-2.

The Company, in turn, shall intimate the DIN communicated to it within one week of receiving the DIN to the concerned ROC in DIN-3.

Every director in the event of any change in his particularsas stated in Form No. DIN-1, who has been allotted a Diretor Identification Numberunder the Rules, shall intimate such change(s) to the Central Government within a period of 30 days of such change(s) in particulars by using Form No. DIN-4 made available by the ministry on the website.

 

 

 

 

 

 

Demerger – An Analysis

DemergerDefinition and Meaning of Demerger:

Demerger is a form of corporate restructuring. One of the prime reasons why large corporate houses go in for demerger is to increase the role of specialisation in the particular segment. In case of large conglomerates, demerging entities often are the departments which are growing at an impressive rate and have substantial potential.

Demerger is the converse of a merger or acquisition. It describes a form of restructure in which shareholders or unit holders in the parent company gain direct ownership of the demerged entity or the subsidiary entity. Underlying ownership of the shares of the company/ trusts that formed part of the group does not change. The company or entity that ceases to own the entity is called the demerging entity. If the parent entity holds a majority stake in the demerged entity, the resulting company is referred to as the subsidiary.

Sections 391 to 394 of the Companies Act, 1956 deal, inter-alia with the reconstruction and amalgamation of companies or what is commonly referred to as “mergers”. The procedures contemplate an application by the company to the concerned High Court by way of a scheme of compromise or arrangement with its creditors or members or any class of its members. Such a Scheme is a viable option for the amalgamation of two or more Indian companies. Moreover, sections 391 to 394 of the Act envisage a “single window clearance” by providing a composite code for facilitating mergers and amalgamations which obviates the need for making multiple applications under the Act and ensures that the interested entities are not put through unnecessary and cumbersome procedures involving protracted consequences for implementing such schemes

Sec 390 – Interpretation of sections 391 and 393 (Companies Act, 1956).

[In sections 391 and 393,

(b) the expression “arrangement” includes a reorganisation of the share capital of the company by the consolidation of shares of different classes, or by the division of shares into shares of different classes or, by both those methods] ; and

Sub Section 19AA of Section 2 of Income Tax Act, 1961:

[(19AA) “demerger”, in relation to companies, means the transfer, pursuant to a scheme of arrangement under sections 391 to 394 of the Companies Act, 1956 (1 of 1956), by a demerged company of its one or more undertakings to any resulting company in such a manner that—

(i) all the property of the undertaking, being transferred by the demerged company, immediately before the demerger, becomes the property of the resulting company by virtue of the demerger;

(ii) all the liabilities relatable to the undertaking, being transferred by the demerged company, immediately before the demerger, become the liabilities of the resulting company by virtue of the demerger;

(iii) the property and the liabilities of the undertaking or undertakings being transferred by the demerged company are transferred at values appearing in its books of account immediately before the demerger;

(iv) the resulting company issues, in consideration of the demerger, its shares to the shareholders of the demerged company on a proportionate basis;

(v) the shareholders holding not less than three-fourths in value of the shares in the demerged company (other than shares already held therein immediately before the demerger, or by a nominee for, the resulting company or, its subsidiary) become share-holders of the resulting company or companies by virtue of the demerger,

otherwise than as a result of the acquisition of the property or assets of the demerged company or any undertaking thereof by the resulting company;

(vi) the transfer of the undertaking is on a going concern basis;

(vii) the demerger is in accordance with the conditions, if any, notified under sub-section (5) of section 72A by the Central Government in this behalf.

Explanation 1.—For the purposes of this clause, “undertaking” shall include any part of an undertaking, or a unit or division of an undertaking or a business activity taken as a whole, but does not include individual assets or liabilities or any combination thereof not constituting a business activity.

Explanation 2.—For the purposes of this clause, the liabilities referred to in sub-clause (ii), shall include—

(a) the liabilities which arise out of the activities or operations of the undertaking;

(b) the specific loans or borrowings (including debentures) raised, incurred and utilised solely for the activities or operations of the undertaking; and

(c) in cases, other than those referred to in clause (a) or clause (b), so much of the amounts of general or multipurpose borrowings, if any, of the demerged company as stand in the same proportion which the value of the assets transferred in a demerger bears to the total value of the assets of such demerged company immediately before the demerger.

Explanation 3.—For determining the value of the property referred to in sub-clause (iii), any change in the value of assets consequent to their revaluation shall be ignored.

Explanation 4.—For the purposes of this clause, the splitting up or the reconstruction of any authority or a body constituted or established under a Central, State or Provincial Act, or a local authority or a public sector company, into separate authorities or bodies or local authorities or companies, as the case may be, shall be deemed to be a demerger if such split up or reconstruction fulfils 81[such conditions as may be notified in the Official Gazette82, by the Central Government];

(19AAA) “demerged company” means the company whose undertaking is transferred, pursuant to a demerger, to a resulting company;]

Demerger of a company takes place when:

1. De-merger is essentially a scheme of arrangement under Section 391 to 394 of the Companies

Act, 1956 requiring approval by;

i. majority of shareholders holding shares representing three-fourths value in meeting convened for the purpose, and;

ii. sanction of High Court.

2. De-merger involves ‘transfer’ of one or more ‘undertakings’.

3. The transfer of ‘undertakings’ is by the demerged company, which is otherwise known as transferor company. The company to which the undertaking is transferred is known as resulting company which is otherwise known as ‘transferee company’.

Existing provisions relating to amalgamations of companies were rationalised and new ones relating to demerger of companies, or sale/transfer of business as a going concern through slump sales were introduced.

In demergers, tax benefits and concessions available to any undertaking are made available to the undertaking on its transfer to the resulting company. The condition regarding continuity of the same business for the allowability of loss to an assessee under Section 72 of the Income-Tax Act, 1961 was dispensed with. The accumulated losses and unabsorbed depreciation in a demerger is allowed to be carried forward by the resulting company if these are directly relatable to the undertaking proposed to be transferred. Where it is not possible to relate these to the undertaking, such losses and depreciation will be apportioned between the demerged company and the resulting company in proportion of the assets coming to the share of each as a result of demerger. Tax benefit to such business reorganisation is limited to transfer of specific assets, which would amount to sale of assets and not business reorganisation.

Demerger And Spin Off/Out:

Another term commonly associated with demerger is that of a ‘spin out’ or ‘spin off’.

Spin out refers to the process when a division of a company or organization becomes an independent business. The “spin-out” company takes assets, intellectual property, technology, and/or existing products from the parent organization. Shareholders of the parent company receive equivalent shares in the new company in order to compensate for the loss of equity in the original stocks; thus, as the moment of spin-off, the ownership of the original and spun-off companies are identical.

A demerger can take place through a spin out by distributed or transferring the shares in a subsidiary holding the business to company shareholders carrying out the demerger.The demerger can also occur by transferring the relevant business to a new company or business to which then that company’s shareholders are issued shares of.

Demerger also take place through the process of ‘decartelisation’, i.e the transition of a national economy from monopoly control by groups of large businesses, known as cartels, to a free market economy.

Demerged Company and Resulting Company – Meaning of

According to Sub-section (19AAA) of Section 2 of the Income-tax Act, 1961, “de-merged company” means the company whose undertaking is transferred, pursuant to a de-merger, to a resulting company.

According to Sub-section (41A) of Section 2 of the Income-tax Act, 1961 “resulting company” means one or more companies (including a wholly owned subsidiary thereof) to which the undertaking of the de-merged company is transferred in a demerger and, the resulting company in consideration of such transfer of undertaking, issues shares to the shareholders of the de-merged company and includes any authority or body or local authority or public sector company or a company established, constituted or formed as a result of demerger.

The definition of ‘resulting company’ has clearly brought out three important requirements while establishing its relationship with de-merging company. They are:

1. Consideration for transfer of undertaking would be by issue of shares only by resulting company. [Price Consideration]

2. Such consideration would be paid only to the shareholders of de-merged company.

3. Resulting company can also be a subsidiary company of a de-merged company.

Conclusion

It is now a just and proper statement to state that, demergers are a fairly common term involved with corporate restructuring nowadays. They provide an opportunity to create individual profit centres and investors in the company also benefit from the process as there is fresh valuation of the demerged entity which in turn often results in an increase in the share price. Demerger is often done with an eye to segregate, categorise and more importantly specialise a particular segment of a corporate entity.

However due to the creation of an altogether new business entity, the same requires prudence and astute decision making on the part of the investor.

The following are some of the important points and key notes that the investors must make and

take heed of in case of Demerger of a corporate restructuring:

Extent of separation

First, the activities separated at the time of demerger is a critical factor. It is important to remember that the overall size of the business entity and the extent of the profits that it makes is one important factor that determines the pricing of the newly-listed shares. Also, the future potential will determine the price impact after the demerger.

Identifying benefits

The key role for the investor is to identify an entity where the strong or profitable business remains. And then, look for the company which has a future potential.

Trading price

Demerger can lead to some immediate gains for the investors where the price of the separate entities shoots up. Too high a rise and one should immediately opt for the sell option. It is not uncommon to find valuations touch dizzying heights after a demerger and the benefits have to be booked.

Investor interest

There is often a high interest on a particular scrip, immediately after the demerger leading to a shooting up of the scrip. Following a thumb rule where the price of the scrip vis-a-vis actual valuation gives a fair idea about the extent of overvaluation or undervaluation taking place.

Limitations/Hindrances in the Current Legal Provisions Relating to Demerger:

Questionable re-structuring exercises are undertaken with a view to strip parent companies of

vital assets and defeat revenue. In the process, the parent company’s business is reduced to the minimum and no significant assets are left from which the I-T Department can recover its dues.

The parent company becomes a shell company though styling itself as a holding company.

When the amendments were made, the Central Government was able to prescribe guidelines or

conditions so as to ensure that the demergers were made for genuine business purposes. Section

281 of the I-T Act declares certain transfers to be void. But this applies where such transfers are

made during the pendency of any proceeding under the Act. It also does not apply to assets not

forming part of the stock-in trade of the business. It was not anticipated that the provisions would be abused not merely to take advantage of tax concessions but also to defeat legitimate tax revenues.

Asset-stripping is a favourite mechanism always used by errant taxpayers to defeat the Revenue. Such abuses have, however, not become widespread. Proper amendments should be made to the law to safeguard revenue.

The definition of demerger in Section 2 (19AA) requires fresh look. The property and liabilities of the undertaking being transferred by the demerged company, as per the definition, will be transferred at book value. Even a unit or a division or a business activity of an undertaking can be transferred. No doubt, all the property of the undertaking, including liabilities relatable to the undertaking being transferred by the demerged company, shall become the property and liabilities of the resulting company. But it is necessary to specifically lay down that demergers should not result in defeating the Revenue by way of transfer of assets.

 

 

Pre-emptive rights of shareholders of Private Company

Pre-emptive rights of shareholders of Private Company: Enforceable to what extent

Transferability of shares is the primary feature of the incorporation of a company. Section 3 (iii) and (iv) of Companies Act 1956 deals with the definition of private and public company which determines the freedom and restriction to transfer shares as exercised by the shareholders of private and public companies respectively.

If we go through some of the cases filed at the Supreme Court of India in relation to restriction on transferability of shares, then we may conclude that in some of the cases, appellants have objection on their brethren shareholder’s act of transferring shares not in according with the shareholders agreement. Although Section 82 of the Companies Act states that the shares or debentures or other interest of any member in a company shall be movable property, transferable in the manner provided by the articles of the company.

Lets have a view on some of the landmark Supreme Court decisions relevant to transferability of shares:

The questions raised in the case of V.B Rangaraj v. V.B Gopalkrishnan and ors [1992] 73 is whether the shareholders can among themselves enter into agreement which is contrary to or inconsistent with the Articles of Association of the Company.

In this case the shares of a company are held by two brothers. There was an agreement between brothers that each branch of the company would hold equal number of shares. Hence if any member of the branch wished to sell its share, first option was to be given to member of that branch. The agreement was not incorporated in AOA and one of the member sold the shares in contravention of agreement.

The defendant contended the following contentions in defense:

• The restriction was not envisaged by AOA, thus it is not binding on shareholders or a vendee of the shares.

• It was unenforceable in law and thus not binding on the company.

The Supreme Court held that the Companies Act 1956 makes it clear that AOA is binding on company and shareholders and transfer of shares is regulated by AOA. The only restriction on transfer of shares binding on the company is one contained in AOA. Restrictions not specified in AOA is neither binding on company nor on the shareholders. Vendee cannot be denied registration except for grounds in AOA.

 

In the case of Madhusoodhanan v. Kerala Kaumudi the issue raised was whether a suit for specific performance would lie upon contravention of pre-emptive right in family settlement (Karar). In this case there were 9 shareholders (family members) in a private company. 5 shareholders enetered into a Karar (family settlement) that on the death of the Chairman (also a shareholder) her shareholders would divide in ratio of the 50:25:25 between the three shareholders. 50% was to be held by Madhu. The Karar was embodied in AOA.

 

On the death of Chairman, the 50% shares were not transferred to Madhu in terms of Karar. Hence Madhu filed a suit for specific performance.

The defendant contended that this restriction on transfer of share is in contravention of AOA, therefore unenforceable both against company and shareholders and no suit for specific performance would lie.

The Supreme Court held that holders of shares in a private company may agree to sell his shares to a person of his choice. Such agreements are specifically enforceable under Specific Relief Act.

Generally, Specific Relief does not lie for contract to transfer movable property unless covered by exception to Section 10. One such exception is if the property is not easily obtainable in the market. Shares of private limited company are not easily obtainable in the market. Thus Suit for specific performance would lie.

In this case the decision given in Rangaraj case was overruled making it clear that the Court never held that an agreement for transfer of shares among particular shareholders cannot be enforced like any other agreement.

In the case of Rolta India Ltd and Another v. Venre Industries Ltd and Others the appellants asked for the following relieves

• Restraining the defendants from taking any steps pursuant to or in implementation or in furtherance of the resolution passed in respect of the allotment of rights shares.

• Restraining the appointment of any additional directors on the board of directors of defendant Company.

This case was filed on the basis of a pooling agreement on curtailing the statutory rights given to the Board of directors to manage the company.

The defendant contended that a pooling agreement may be utilized in connection with the election of directors and shareholders’ resolutions where shareholders have a right to vote. However, a pooling agreement cannot be used to supersede the statutory rights given to the Board of directors to manage the company, the underlying reason being that the shareholders cannot achieve by pooling agreement that which is prohibited to them, if they are voting individually. Therefore, the power of shareholders to unite is not extended to contracts, whereby restrictions are placed on the powers of directors to manage the business of the Corporation. It is for this reason that a pooling agreement cannot be between directors regarding their powers as directors.

The Supreme Court held that since the company was in need to increase the capital, there was need for professionalization, but it would be deprived of it despite the fact that there is no such restriction in the articles of association. The objection was raised on the basis of Clause 8 of MoU. In our view, the curtailment of the powers of director by enforcement of such a clause would not be permissible. Clause 8 would result in curtailment of the fiduciary rights and duties of the directors. The shareholders cannot infringe upon the directors fiduciary rights and duties. Even directors cannot enter into an agreement, thereby agreeing not to increase the number of directors when there is no such restriction in the articles of association. The shareholders cannot dictate the terms to the directors, except by amendment of articles of association or by removal of directors. The agreement infringes upon the right of the first defendant to have more number of directors, in the interest of the company. The grant of interim injunction would amount to stultifying management of the company.

In Satyanarayana Rathi v. Anna Maliar Textiles Pvt. Ltd., (1999) 32 CLA 56, the articles of as-sociation of a private company contained that no share of the company shall be transferred to any person who is not a member of the company so long as any member of the company is willing to purchase the same at a fair price which shall be determined by directors from time to time. The appellant, in whose favour certain shares were pledged for dues for supply of cotton, asked the company to register the transfer of shares in his favour as the dues were remaining. The company refused to register the transfer as it would have been against the Article of Association. The Company Law Board (CLB) upheld the decision of the Board. It observed that a close scrutiny of the above articles will show that no share shall be transferred to an outsider if any member of the company is willing to purchase the same at a fair price which shall be determined by the directors. Further, transfer to an outsider is permissible only when the Board is unable to find a willing member to purchase the shares within a stipulated period.

In Tarlok Chand Khanna v. Raj Kumar Kapoor, (1983) 54 Com. Cas. 12 (Delhi), one of the regulations in the articles of the company was that all transfers of shares shall be sanctioned only with the unanimous decision of the directors. The Delhi High Court held that such provision which is preserved by S. 111(1) [now S. 111(13)] of the Act and being not inconsistent with any provision of the Act would be outside the reach of S. 9 of the Act. In the absence of any words of limitation such as the expression ‘Present and voting’ in the phraseology of the article, the same should be construed to mean that the sanction should be with the unanimous decision of all the directors of the company and a transfer which is otherwise valid, cannot be given effect to when it is based on the decision of the board in a meeting at which one of the directors was absent.

If we consider what Section 111 says then we will construe that the company has the power to refuse to register the transfer of shares if it is in contravention of AOA or otherwise. Also there is a remedy lying with the transferor or transferee to appeal against the refusal to register in CLB.

Likewise Section 111A says that the shares or debentures and interest therein of a company shall be freely transferable. In case the company without sufficient cause refuses to register the transfer, the transferee may appeal to CLB against refusal to register the transfer.

Thus it may be concluded that the power to refuse the transfer of shares cannot be exercised arbitrarily or for any other collateral purpose and can only be exercised for a bonafide reason in the interest of the company and general interest of the shareholders. However in cases where by its articles of association a company reserves the right to refuse the transfer of shares, the burden of proving that such refusal was not bonafide is on the person who so alleges.

This may also be noted that there may be restriction on transferability of the shares, there cannot be an absolute prohibition on the right to transfer shares. A pre-emption right has been held to not amount to a prohibition upon transfer.

SECTION 25 COMPANIES UNDER COMPANIES ACT 1956

 Under Indian law, 3 legal forms exist for Non-Profit organizations:

  1. Trusts
  2. Societies
  3. Section 25 companies

 Due to better laws, Section 25 companies have the most reliable strongest organizational structure. Section 25 companies are those companies which are formed for the sole purpose of promoting commerce, art, science, religion, charity or any other useful object and have been granted a licence by the central government recognizing them as such. Thus, there are three criteria for determining whether a particular company is section 25 company or not:

1) Its objects should be only to promote commerce, art, science, religion, charity or any other useful object.

2) It should intend to apply its profits or other incomes only in promoting its objects; and

3) Central government should have granted a licence to such a company recognizing them as such, these types of companies can be either public company or private company having a limited liability.

FORMATION PROCEDURE OF SECTION 25 COMPANIES:

Step – 1 Form 1A: Name approval: An application in E-Form 1A has to be made for availability of name to the registrar of companies, with a fee of Rs. 500/-. It can be filed electronically. Six name in preferential order need to be proposed

Step-2 Application to Regional Director: After the availability of name is confirmed, an application should be made in writing to the regional director of the company law board for granting license under this section. The application must include copies of the memorandum and articles of association of the proposed company, as well as a number of other documents, including a statement of assets and a brief description of the work proposed to be done upon registration. 

Step – 3 Filing of Application copy to the RoC: The applicants must also furnish to the registrar of companies (of the state in which the registered office of the proposed company is to be, or is situate) a copy of the application and each of the other documents that had been filed before the regional director of the company law board.

 Step – 4 Publication of Notice: Within a week from the date of making the application to the regional director of the company law board, the applicants are required to publish a notice in the prescribed manner at least once in at least two news papers. One notice should be in an English newspaper circulating in that district and in a  language of the district in which the registered office of the proposed company is to be situated or is situated and circulating in that district.

 Step – 5 Grant of Approval: If the registrar satisfies that the application is complete in all respects and in the best interest of the country, regional director can grant the licence under this section with or without conditions and may also direct the company to insert in its memorandum, or in its articles, or in both, such conditions of the licence as may be specified by him in this behalf

Step – 6 Other Incorporation formalities: After obtaining licence under section 25 the company shall be formed as a normal company and the other formalities of incorporation shall be complied with.

Step – 7 Registration under Section 80G: If a section 25 company gets itself registered under section 80G then the person or the organization making a donation to the NGO will get a deduction of 50% from his/its taxable income. The company has to apply in Form No. 10G to the Commissioner of Income Tax for such registration. Normally this approval is granted for 2-3 years but can be granted earlier depending upon the situations.

Grant of licence to an existing company:

An existing company should pass special resolution to restrict its object for non-profit making purposes and also obtain approval of the Company Law Board for the same. Name of the company should be changed (including deletion of the word ‘limited’ or ‘private limited’ ) with the permission of the Central Government . 

The ADVANTAGES of section 25 companies over other companies registered under companies act are discussed below:

 1)      All companies having limited liability are required to use the term ‘limited’ or ‘private limited’ as the case may be in their names as required by section 13. But section 25 companies are allowed to dispense with the use of term ‘limited’ or ‘private limited’ from their names [sub-sec. (6)]. This helps the company to enjoy limited liability without disclosing to the public the nature of liability of its members.

2)      A partnership firm is allowed to be a member of the section 25 company [sub-sec (4)] inspite of the fact that the law does not recognizes them as a legal person. The only limitation in this regard is that on dissolution of such a firm its membership of the company ceases.

3)      Minimum Share Capital: As per the provision of section 3 of the companies act a private company is required to have a minimum share capital of rupees one lakh and public company is required to have minimum share capital of five lakh rupees. However Section 25 Companies have been exempted from this requirement regarding minimum share capital by insertion of sub-section (6) through Amendment Act of 2000. As such they can be registered even if they have share capital less than the statutory minimum.

4)      Publication of Name: A section 25 company has been exempted from the provisions of section 147 and as such is not required to mention its name and address as required in case of all other companies.

5)      Annual Returns of a Company not having Share Capital: Section 25 Company without a share capital is also required to file returns with the Registrar as required by section 160 but it has been exempted from mentioning the particulars of the members who are presently with the company or have ceased to be members since holding of its last AGM.

6)      Time and Place of AGM: Section 25 Company has been exempted from provisions provided under section 166(2), As such they are free to determine the date, place and time of its AGM according to their convenience and feasibility the only condition being that time, place and date of such meeting should have been pre determined by the Board of Directors in accordance with directions of the company if any.

7)      Notice of AGM: By virtue of section 171(1) a company is required to call AGM by giving not less than 21 days notice in writing to its members. But Section 25 Company has been given some relief in this regard by allowing them to hold an AGM after giving a notice of 14 days length instead of 21 days as required by section 171(1).

8)      Maintaining of Books of Accounts: Every company is required by section 209(4-A) to maintain books of accounts relating to a period of eight years immediately preceding current year along with its vouchers. However a Section 25 Company is required to maintain books of account relating to a period of only four years instead of eight years immediately preceding the current year.

9)      Increase in Number of Directors: Under section 259 a public company is not allowed to increase the number of it directors beyond the permissible limits under its articles without the approval of Central Government provided such increase results in total number of directors to go beyond twelve. But Section 25 Companies are exempted from this section and are thus free to increase the number of its directors without seeking approval of central government[vide Notification No. 2767, dated 5-8-1964].

10)  Board Meetings: Under section 285 the meeting of Board of Directors should be held at least once in every three months and four meetings should be held in a year. However section 25 companies are required to hold meetings of Board of Directors/Executive Committee/Governing Committee only once in every six months [vide Notification No. SO 1578 dated 1-7-1968]. The rest of the section 285 will apply to section 25 companies as it is, therefore section 25 companies are allowed to hold Board meetings only once in six months but should have held four meetings in a year.

11)  Quorum for Meetings: The required quorum for a board meeting of any company under section 287 is one/third of its total strength which is arrived at after deducting the number of interested directors from the total number of directors on the Board or at least two whichever is higher. But the section 25 company is exempt from this section to the extent that the required quorum for any board meeting is eight members or one/fourth of its total strength whichever is less provided it should not be less than two members in any case.

12)  Exercise of certain Powers: Section 25 companies are allowed to decide following three matters by passing a resolution by circulation instead of at meetings: · the power to borrow moneys other than on debentures, · the power to invest funds of the company, and · the power to make loans. The remaining powers specified in section 292 viz., power to make calls on shareholders in respect of money unpaid on their shares; power to authorise by back of shares in accordance with section 77A; and power to issue debentures, can be exercised only by passing of resolutions at duly conducted meeting of Board of Directors of section 25 company [vide Notification No. 2767, dated 5-8-1964].

13)  Maintenance of Registers of Contracts: Under section 301 a company is required to maintain register of all the contracts to which section 297 or 299 applies. But a section 25 company is exempt to the extent that it allowed to maintain register of only those contracts to which sub-sections (1) and (3) of section 297 apply. Thus they are exempted from maintaining registers of those contracts which are made in pursuance of sub-section (2) of section 297 or are covered by section 299.

14)  Maintenance of Register of Directors: Section 25 company has been exempted from operation of sub-section (2) of section 303 and as such they are not required to notify changes among its directors, etc to the Registrar. They are only required to maintain Registers of their Directors, Managing Directors, Managers and Secretary in prescribed format containing specified particulars and updating the register by making changes in it as when there is some change among the Directors, Managing Directors, Managers and Secretary of the company.

15)  Qualification for Secretaryship: A Section 25 Company is exempt from the provision of section2(45) to the extent that the rules regarding the qualification of a Secretary do not apply to them [vide Notification NO. F.2/3/76-CLV dated 09-01-1976]. As section 2(45) do not apply to them they are free to appoint any person as its Secretary whom it feels fit and proper for the same.

16)  Applicability of CARO: Section 25 Companies are exempted from applicability of Companies Auditor’s Report Order 2003(CARO). CARO has been made applicable to all companies from 1st January 2004. But CARO expressly exempts section 25 companies from its applicability vide Clause 2(iii) of Para I of the Order.

17)  Payment of Registration Fees: The fees payable by a Section 25 Company at the time of registration and further increase of its share capital has been kept very low in comparison to other companies and is at present fixed at mere Rs. 50/- irrespective of the authorized amount of share capital (Circular No. 6 dated 24-06-1996 and Notification No. SO 3879 dated 22-12-1962)

18)  Stamping of Memorandum and Articles: The Articles and Memorandum of a Section 25 Company are not required to be stamped in accordance with the Indian Stamp Act, 1899.

19)  Raising Money: A Company can sell shares of the Company to the public or can accept deposits from public and can therefore raise money easier than other business structure types. The modes of financing business carried on by company are numerous

20)  Easy Transferable Ownership: The shares and other interest of any member in the Company shall be a movable property and can be transferable in the manner provided by the Articles, which is otherwise not easily possible in other business forms. Therefore , it is easier to become or leave the membership of the Company or otherwise it is easier to transfer the ownership.

Drawbacks or Obligations of section 25 companies:

 

Though a Section 25 Company has many advantages and enjoys many privileges yet there are some statutory obligations which are required to be complied with and taken care of by such companies.

1) A Section 25 Company has to ensure that its profits and all other incomes are utilised only for the purpose of promoting its objects and not for any other purpose.

2) It should also ensure that its profits are not distributed as dividend among its members.

3) Section 25 Company cannot alter its objects clause in its Memorandum without seeking the written approval of central government [sub section (8)].

4) If the Central Government has imposed some conditions and regulations upon the company for granting a licence under section 25 then such a company is bound by such conditions and has to ensure adequate compliance with them. Where such conditions and regulations have been imposed then such conditions and regulations are required to be included in the Articles or/and memorandum of the company as may be directed by the government.

5) Section 25 Company is regarded as a ‘company’ within the meaning of the Income Tax Act, 1961 and as such its income is taxable according to the applicable rates similar to those applying to other companies.

 6) If an existing company obtains a licence under section 25 it has to ensure that its objects are confined to those mentioned in section 25 itself and if not make proper alteration to its memorandum and articles.

7) Long Closing Proceedings: It is generally not easy to close the company as compared to other forms of business, the procedure to close is long and involves compliance of various formalities, at times it takes 1-2 years to completely wind-up the company. Moreover in certain cases, it is necessary to take the permission of the High Court to close the Company.

Revocation of Licence: The Central Government after giving reasonable opportunity of hearing can revoke the licence by passing a speaking order.

 Winding up of the company It can also be wound up if the objects for which it had been established have been fully achieved. The surplus assets if any may be given to a similar charitable cause.

 Hence, having noticed various benefits and drawbacks of section 25 companies, its clear that such companies are a well regulated form of non-profit organizations and the prescribed incorporation and dissolution procedures and other provisions helps the government in keeping a check on the working of such companies.