Indian industry is thrilled about some provisions in the new Companies Act; so why are they complaining?

Some fear that the new Companies Act will make it harder to find independent directors.
Some fear that the new Companies Act will make it harder to find independent directors.
Image: AP Photo/Jacquelyn Martin
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It was crafted painstakingly as the replacement for a six-decade old legislation, but still the Companies Act 2013 remains contentious. Parts of it, in fact, are making industry so uncomfortable that the new Narendra Modi government has said that it may even consider amending the act.

Over all, though, it is a mixed bag. Here is a closer look at provisions that India Inc. likes—and those it disapproves of.

The good

1) The one-person company: The act introduces the concept of a one-person company, which, as it suggests, means only one member is required for the formation of the company. Already popular in the United Kingdom and elsewhere in the European Union, this could potentially make life easier for start-ups.

“It helps small entrepreneurs to establish a company with relaxed compliance requirement,” says J.N. Gupta, managing director of SES Governance, a corporate governance research firm. He warns, however, that the government should ensure that this provision is not misused by large corporations.

2) More members: The number of members allowed in a private company has been increased from 50 to 200, as per the new act. This, according to Gupta, will help companies raise funds from a larger pool of members without necessarily going public.

3) Independent directors: The 1956 Companies Act was vague when it came to defining the duties, roles and liabilities of an independent director. The new legislation not only prescribes detailed qualifications for the appointment of an independent director but also provides more clarity on their role and responsibilities.

There are now also clear guidelines to curb conflicts of interest. For instance, the promoter of a company, or any of its subsidiaries, can no longer be appointed as an independent director. Independent directors also cannot be related to any of the promoters or directors in the company or its subsidiaries. Their relatives, too, are not permitted to have any transactions with the company.

4) Mergers and acquisitions: The 2013 act has streamlined the mergers and acquisitions processes, including cross-border deals by allowing Indian companies to merge with foreign entities, with was hitherto impossible. It also empowers private equity investors to enforce various restrictions in the merger agreements, and check promoter malpractice by increasing transparency in their operations.

Private equity investors can now use clauses such as ‘tag along’ and ‘drag along’ in the shareholder agreement with the promoter. The former allows them to sell their stake along with the majority shareholder, while a ‘drag along’ gives a majority shareholder or promoter the right to force a minority shareholder, such as private equity investors, to sell its stake.

“The new companies act makes it possible for Indian companies to buy foreign companies by paying through stock, which was not possible so far,” added Shriram Subramanian, managing director of Ingovern, a proxy advisory firm.

5) Minority shareholders empowered: Class action suits can now be initiated by minority shareholders against a company and auditors. “Though this is a step in right direction,” explained SES Governance’s Gupta, “Investors need to be educated about their rights and processes.” But there are also some fears about these minority shareholder misusing their position to arm-twist the management for their personal gain.

And the not-so-good

1) Mandatory corporate social responsibility: The new act requires every company with net worth over Rs500 crore, or net profit of Rs5 crore, to spend at least 2% of its average net profit on corporate social responsibility activities. Experts, however, fear that this may be misused by politicians, possibly through requests to build hospitals or colleges in their constituencies in return for favours.

“Compulsory spending on CSR should not be mandated by law,” argued Ingovern’s Subramanian. “It is government’s responsibility to spend on social programs and not that of firms.”

2) Multi-layered investment companies: Indian firms sometimes set up investment companies, which are essentially subsidiaries, to help with acquisition of shares and securities. The new Companies Act restricts corporates from making investments through more than two tiers of such subsidiaries (investment companies). But this may deter private equity players from investing in sectors such as infrastructure, where such structures are commonplace.

“Imposing restrictions on investments in multi layered companies does not make sense,” said Subramanian, as long as they are abiding by the law and paying taxes.

The provision was of course brought in to prevent beneficial owners from hiding behind a maze of companies that own each other.

3) Independent directors: The tenure of independent directors is now limited to two consecutive terms, with restrictions on issuance of stock options and sitting fees. All this may make it difficult to find qualified professionals to fill boards.

“We don’t just need directors to ensure that financial statements go on time,” said N. Venkatram, managing partner of the audit firm Deloitte, “but we need someone who can understand business and who can challenge the management to grow the business.”

4) Auditor rotation: With the new act, auditors can now handle a company’s accounts for a maximum of five consecutive years in the case the auditor is an individual, and 10 years if the auditor is a company. And these auditors can only be reappointed after a break of five years.

“In other countries, companies are only required to rotate the people who conduct the audit, and not the audit firm. It is the partners who build relationship with the clients and not the firm,” said Venkatram.

“The required rotation of auditors will lead to chaos as there are only limited number of firms who are in position to service larger clients, with the possible unintended consequence of allowing big audit firms to get bigger,” he added.