Intercorporate Investments: Changes Galore

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Synopsis
The 2nd phase of the provisions of the Companies Act, 2013 has been made operative w.e.f. 1st April, 2014. This includes provisions dealing with intercorporate investments. Substantial changes have been made in the law in this respect. It is time for Corporate India to unlearn and relearn all they know in this respect. This article examines the salient features of the new provisions on intercorporate investments.

Introduction
Part-II of the Companies Act, 2013 (“the Act”) has made about 183 further sections (after the initial 98) effective from 1st April, 2014 and a Part-III is pending. The Rules in respect of Part-II sections have also been notified. One of the sections notified in Part-II is section 186 which deals with “Loans and investments by a company”. Section 186 coupled with section 185 has caused maximum heartburn amongst corporate India. This section 186 is a modern day avatar of section 372A of the Companies Act, 1956 (which in itself was a modern day avatar of the erstwhile section 372 of the same Act), but it has undergone a transmutation as compared to the original section. As the heading of the section suggests, it deals with two legs ~ loans by a company and investments by a company. In addition, there are certain other sections of the Companies Act, 2013 which deal with intercorporate investments. Through this article, let us examine the provisions relating to investments by a company in another body corporate, i.e., intercorporate investments.

Applicability
One of the most distressing features of section 186 is that it even applies to private limited companies which are not subsidiaries of public limited companies. Section 372/372A had a blanket exemption for private limited companies. A similar exemption is not found u/s. 186. Thus, all private companies would now have to comply with the provisions of this section.

Limit on Investments
The overall limit for a company to invest in the securities of another body corporate u/s. 186(2) is the higher of the following two limits:
(a) 60% of paid-up share capital + free reserves + securities premium; or
(b) 100% of free reserves + securities premium

This limit applies to investment by way of fresh acquisition or purchase or otherwise of securities of another body corporate.

The term ‘Securities’ has been defined u/s. 2(81) of the Act to mean securities as defined u/s. 2(h) of the Securities Contract (Regulation) Act, 1956. Thus, they would include shares (equity, preference, convertible preference, non-voting rights shares), debentures, bonds, derivatives in securities, warrants, other marketable securities of a body corporate. The limit would apply to investment by a company in the securities of both listed as well as unlisted companies.

Next let us examine the definition of the term ‘body corporate’. Section 2(11) of the Act defines it as including a company incorporated outside India. However, it does not include a corporate sole, a co-operative society and any other body corporate so notified by the Government. The most important aspect of a body corporate is that it is an independent legal entity with a distinct identity which is separate from its partners/shareholders/members and has a perpetual succession. It can own property on its own accord and in its own name. Hence, investing in the securities of a foreign subsidiary/joint venture would also fall within the purview of these limits. However, a mutual fund structured as a trust is not a body corporate and hence, investment in the units issued by a mutual fund (structured as a trust) would not be within the purview of section 186.

Let us next look at the composition of the limits for considering the 100% or 60%:

(a) Section 2(64) of the Act defines the phrase ‘paid-up share capital’ to mean such aggregate amount of money credited as paid-up as is equivalent to the amount received as paid-up in respect of shares issued and also includes any amount credited as paidup in respect of shares of the company but does not include any other amount received in respect of such shares, by whatever name called.

(b) The phrase ‘free reserves’ is defined by section 2(43) to mean such reserves which are available for distribution as dividend. These reserves are to be reckoned as per the last audited balance sheet of a company. The following are however, not treated as free reserves:

(i) any amount representing unrealised gains, notional gains or revaluation reserve, or
(ii) any change in carrying amount of an asset or of a liability recognised in equity, including surplus in profit and loss account on measurement of the asset or the liability at fair value.

(c) T he last component of the limits is ‘securities premium’ which is governed by section 52 of the Act and it states that where shares are issued at a premium, the amount of the premium received on those shares shall be transferred to a “securities premium account”.

What if Limits are to be exceeded?

In case the investment in another body corporate is to be in excess of the limits specified above, then the investor company must obtain a prior special resolution of its shareholders passed at a general meeting. The Rules notified u/s. 186 provide that this would not be required where a holding company proposes to invest (by way of subscription or acquisition) in shares of its wholly owned subsidiary. However, the resolution would be required if the subsidiary is not a 100% subsidiary. Thus, if any, only if, the entire share capital is held by the investor and/or its nominees, would a special resolution not be required. The resolution must specify the total amount up to which the Board is authorised to make such acquisition. Section 110(1) of the Act and the Rules notified therein specify the items which must be transacted through postal ballot. While giving of loans/guarantees/security in excess of limits u/s. 186 have been specified, investment in excess of the limits u/s. 186 has not been specified. Hence, such a resolution is not mandatorily to be passed via a postal ballot.

In addition, the requirements of the Companies (Management and Administration) Rules, 2014 as well as the revised Clause 35B of the Listing Agreement should be complied with by all listed companies. This requires that for all resolutions to be passed at General Meetings, evoting facility must be provided by the listed company.

Layers of Investment Companies

S/s. (1) of section 186 introduces a novel concept, i.e., any company can make an investment through not more than two layers of investment companies. Companies in India are accustomed to having a web of investment companies. This has often been criticised on the grounds that it gives rise to opacity and proves difficult for regulators to ascertain the ultimate owner of an investee company. Thus, any company desiring to make an investment, after the coming into force of section 186, can do so either directly or through an investment company or through one investment company followed by a 2nd layer of investment company. However, it cannot have a 3rd layer of investment company under the 2nd layer of investment company. This s/s. prohibits making any investment, unlike the limits u/s. 186(2)(c) (which apply only for investment in a body corporate) and this does not restrict the scope to investment in a body corporate. Hence, any investment by a company through more than 2 layers of investment companies is not allowed. Thus, investment in a company, LLP, body corporate, partnership firm, etc., would all be covered. Considering the way the s/s. is worded, one wonders whether this prohibition would also apply to investment by a company in other asset classes, such as, land. However, a harmonious reading with the other sub-sections does not seem to indicate so.

The restriction is on routing any investment through more than 2 vertical layers of investment companies as illustrated by the following diagram (illustration-1) which violates section 186:

Thus,  since aBC  has  routed  its  investment  in  XYZ  via 3 layers of investment companies, the prohibition u/s.
186(1) would apply.

It may be noted that the prohibition is on having more than 2 layers of investment companies and hence, we need to ascertain what constitutes an investment company? the section defines an ‘investment company’ to mean a com- pany whose principal business is acquisition of shares, debentures or securities. at the outset, it is very clear that the definition only applies to a company and not to any other body corporate or entity. A company is defined to mean a company incorporated under the act or under any previous company law. Hence, if an LLP is used as an investment vehicle then this prohibition u/s. 186 would not apply. Whether you can incorporate an investment LLP is another story altogether.

Secondly, it must be a company whose principal business is acquisition of securities. What is principal business has not been defined. In this context, the principal business tests  laid  down  by  the  reserve  Bank  of  india  to  determine what constitutes an nBfC (non-banking financial Company) may be helpful. according to these tests, a company will be treated as an NBFC if it satisfies both the following conditions as per its audited accounts:

(i)    Its financial assets as per the last audited Balance Sheet should be more than 50% of its total assets (netted off by intangible assets) and

(ii)    Its income from financial assets as per the last audited Profit & Loss Account should be more than 50% of its gross income.

It should be noted that both these tests should be sat- isfied in order to treat a company as an NBFC. A company whose principal business is acquisition of securities may generally also qualify as an NBFC unless it can be treated as a Core investment Company or a CiC or if it is a company exempted from nBfC provisions, e.g., stock brokers. in this respect, the decision of the madras high Court u/s. 372 of the Companies Act,1956 in HC Kothari, 75 Comp. Cases 688 (mad) may be referred to. this decision held that it is clear that the income derived from the business is not the criteria. the test would rather be, as to what is the principal business of the company? a balance- sheet should show as to what is the principal business of the company.

The  department  of  Company  affairs’  views  (dated  1st July, 1963) under the erstwhile section 372 may also be considered:

“In the Department’s opinion whether a company is or is not an investment company and the business which it should or should not transact to fall within the provision of the definition of an “Investment company” within the meaning of section 372(10) is actually a question of fact. The words used in the section are “whose principal business is the acquisition of shares.  ” These words imply that the company concerned is expected to hold the shares, etc., acquired by it for a reasonable time.”

The Department’s views (dated 23rd February, 1961 and 4th October, 1961) under the erstwhile section 372, in relation to a share trading company, were as follows:

“The question as to whether a particular share trading company which deploys its funds for short-term transaction in buying and selling shares is an investment company or not, is one of fact which has to be determined in relation to the actual business transacted by it. The Department is inclined to the opinion that a company should be treated as an investment company if the whole or substantially the whole of its business relates to shares, securities, stock and debentures, etc. A share trading company may take advantage of these provisions of section 372 if it can be classed as an investment company.”

The act expressly provides that the restriction on two layers of investment companies even applies to an NBFC whose principal business is acquisition of securities. CiCs are a class of NBFCs which invest 90% of their net assets in group companies’ securities and at least 60% of 90% of their net assets in group companies’ equity shares. thus, even NBFCs and CiCs are restricted from having only two layers of investment companies.

The investor company could be an investment or an operating company but it cannot route its investment via more than 2 layers of investment companies. if the investment is routed through an operating company or one whose principal business is not acquisition of securities, then the restriction u/s. 186 on 2 layers would not apply. The following diagram (illustration-2) would amplify this statement:

Thus, since PQR has routed its investment in XYZ via a mix of 2 layers of operating companies and 2 layers of investment companies, the prohibition u/s. 186(1) does not apply. as explained the prohibition is only on more than 2 layers of ‘investment’ companies. one additional factor to be borne in mind in structuring an investment through an investment company is the NBFC directions. it is quite possible that the investment company, i.e., one whose principal business is acquisition of securities may constitute either an NBFC or a CIC. if it is an NBFC-ND-SI/Systemically Important Non-deposit taking NBFC, i.e., one which has total assets of rs. 100 cr. and above, then the NBFC directions impose a restriction that it cannot lend and invest more than 40% of its owned funds to a single group of parties and more than 25% of its owned funds to a single party. thus, in such a case, the twin restrictions of the act as well as of the directions would have to be borne in mind.

Exemption:
The  prohibition  on  making  investments  only  through   a maximum of two layers of investment companies will not affect the following two cases:
(i)    a company from acquiring any other company incorporated in a country outside india if such other company has investment subsidiaries beyond two layers as per the laws of such country; or
(ii)    a subsidiary company from having any investment subsidiary for the purposes of meeting the requirements under any law or under any rule or regulation framed under any law for the time being in force.

Further, section 186(1) gives power to the Government to prescribe such companies which can invest via more than 2 layers of investment companies.

Thus, exceptions presently available are if the indian in- vestor company has acquired a foreign company which, in turn, has more than two layers as per the laws of its country or if the subsidiary of an investor company, in turn, has any investment subsidiary for meeting the requirements of any law.

When indian companies make overseas investments, several times they consider routing such overseas investments through an intermediate holding Company (IHC), regional holding Company (RHC), etc. it is a moot point whether the prohibition u/s. 186 can apply to an investment made in a foreign company via more than 2 layers of IHCs/RHCs? This is because a company is defined under the act to mean a company incorporated under the act or under any previous company law and an ihC or a RHC incorporated abroad is a body corporate but not a company within the meaning of the act. interestingly, under the fema regulations, the RBI is also known to frown upon the use of multi-layered SPVs for making an overseas direct investment.

   Other compliances
in addition to the above substantive provisions, section 186 also lays down several compliances for the investor company, such as, holding investments in its own name, board resolution to be passed by unanimous consent of all directors present at the meeting, maintaining a register of investments, obtaining prior approval of financial institutions in certain cases, etc.

except the provisions relating to two layers of investment companies, none of the other provisions of section 186 are applicable to the following cases of investments:

(a)    to any acquisition made by a registered NBFC whose principal business is acquisition of securities in respect of its investment activities. it may be noted that the exemption is only available to an nBfC which is registered with the rBi. under the CIC directions, a CiC is also a class of nBfCs. hence, this exemption should be available even to registered CICs. however, only CIC-nd-Si, i.e., those which have an aggregate asset size in excess of rs.100 crore need to be registered with the rBi. other CiCs are exempted from  registration  both  as  a  CiC  and  as  an  nBfC. hence, will such exempted CiCs be eligible for the exemption u/s. 186 is a moot point?
(b)    to  any  acquisition  made  by  a  company  whose  principal business is the acquisition of securities. Such companies could be NBFCs, CICs, stock/subbroking companies, Venture Capital Companies, alternative investment funds structured as companies, etc.
(c)    to any acquisition of shares allotted in pursuance of clause (a) of s/s. (1) of section 62, i.e., allotment under a rights issue.

A related compliance is laid down u/s. 187 of the Act which requires all investments made or held by a company to be held in its own name. however, it may hold shares in its subsidiary company in the name of its nominees if it’s required to ensure minimum number of members. unlike the earlier section 49 of the 1956 act, section 187 even applies to a company whose principal business consists of buying and selling of securities.

An  additional  compliance  is  incorporated  in  the  report of the Board of directors. it requires to give particulars   of investments u/s. 186. Further, the Audit Committee’s terms of reference includes scrutiny of intercorporate investments.

Further, section 179(3) states that the power to invest the funds of the company can be exercised by the Board of directors only at a meeting of the Board. hence, a Circu- lar resolution is not possible.

    Exemptions u/s. 372a Dropped

Section 372A of the Companies Act, 1956 contained several exemptions which have been done away with by section 186 of the act. the differences in the exemptions are as follows:

details	Section 372a of the 1956 act	Section 186 of the 2013 act
Applicability to Private Companies	Entire Section did not apply to Private Limited Companies	Entire Section applies to Private Limited Companies. This is a major change
Companies whose	Entire Section did not	Restriction on invest-
principal business	apply to a company	ment through 2 layers
is acquiring securi-	whose principal busi-	of investment com-
ties	ness was acquisition	panies even applies
	of securities	to a company whose
		principal business is
		acquisition of securi-
		ties. The remaining
		s/s.s of section 186
		do not apply to such a
		company.
NBFCs	No exemptions for	Restriction on invest-
	NBFCs	ment through 2 layers
		of investment com-
		panies even applies
		to an NBFC but the
		remaining sub-sections
		of section 186 do not
		apply to an NBFC.
Acquisition by	Entire Section did	Now the exemption is
Holding Company	not apply to subscrip-	only available qua the
	tion or purchase of	passing of a special
	securities by a Holding	resolution by the Hold-
	Company in its wholly	ing Company if the
	owned subsidiary	limits u/s. 186 would
		be exceeded by virtue
		of such acquisition.
		However, the other
		s/s.s of section 186
		continue to apply.

    Penalty
Section 186 imposes a heavy penalty for the violation of the provisions of this section. if a company contravenes the provisions of this section, the company shall be pun- ishable with fine which ranging from Rs. 25,000 to Rs. 5 lakh. Every officer who is in default shall be punishable with a term which may extend to 2 years and with fine ranging from rs. 25,000 to rs. 1 lakh.

  Layers of Subsidiaries
in addition to the restriction on layers of investment companies u/s. 186, there is also a restriction u/s. 2(87) of the act on the number of layers of subsidiaries which certain prescribed class of holding companies can have. a subsidiary includes a company as well as a body corporate, such as an LLP. Thus, in respect of prescribed holding companies they cannot have more than certain number of layers of subsidiaries. it may be noted that unlike the restriction on layers of investment companies, this restriction applies both to operating as well as investment subsidiaries and to subsidiaries which are companies or body corporates. Currently, no class of holding companies or number of layers have been prescribed.

one may compare the restrictions contained in section 186 vs. section 2(87) as follows:

 Compilance for The Investee company
The  investee  company  needs  to  pay  special  attention as to whether the issue of fresh securities to the investor company would constitute a private placement u/s. 42 read with the Rules notified thereunder and/or a preferential issue u/s. 62(1)(c) read with the Rules notified thereunder? Several substantive and procedural conditions have been laid down in this respect for the investee company.

Conclusion
The  law  relating  to  intercorporate  investments  is  one area which has witnessed a sea change under the Companies Act, 2013 as compared to the Companies Act, 1956! Corporate india is going to have to grapple with several intended and unintended consequences of these new  provisions  but  then,  who  said  law  and  logic  go together?