By 19 April, 2010

Any entrepreneur would prefer the benefit of a ‘corporate entity’ and consequent ‘limited liability’ over any other business vehicle. A private company has a very unique position under law, where a person doing business can enjoy the advantages of a corporate personality and, at the same time, maintain the privacy of its business and restrict the ingress of outsiders. The question often comes to the fore in the structuring of PE deals where the target (which is private company) is held by an Indian company which is a public company or when post investment the target (a private company) becomes a subsidiary of a company which is a public company under the Companies Act.  

Under law, a company would be treated as a ‘private company’, if its articles of association (i) restricts transferability of shares, (ii) restricts the number of its members to fifty, (iii) prohibits public invitation for its shares or debentures, and (iv) prohibits invitation or acceptance of deposits from persons other than its members, directors or their relatives. A private company is also entitled to a number of privileges and exemptions under law as against a public company.  

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Section 3(1)(iv)(c) of the Companies Act, 1956 which came into effect from December 13, 2000 provides that a ‘public company means a company which is a private company which is a subsidiary of a company which is not a private company’. A plain reading of this provision suggests that a private company which is a subsidiary of a public company would be deemed to be a public company under the Companies Act. Interestingly, the explanation to Section 90 of the Companies Act reads, ‘For the purposes of this section, references to a public company shall be construed as including references to a private company which is a subsidiary of a public company’. Does this imply that a company which is a subsidiary of a public company would not be deemed to be a public company unless specifically stipulated by the provisions of the Companies Act? Otherwise, Section 90 is superfluous.

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The inclusion of Section 3(1)(iv)(c) in the Companies Act without consequent changes in provisions like Section 90 (of the Companies Act) created uncertainty on the applicability of provisions governing a public company to a private company which is a subsidiary of a public company. Further, where does the law as it stands today leave private companies floated by public companies?

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In light of above, does it mean that the draftsman intended that a private company on becoming a subsidiary of a public company is required to (i) amend its articles of association to delete the provisions which constitute such company as a private company (including provisions relating to restriction on free transferability of its shares as Section 111A of the Companies Act provides that all the shares and debentures of a pubic company shall be freely transferable); (ii) apply to the registrar of companies to issue a fresh incorporation certificate with the word ‘private’ deleted from its name; (iii) increase the number of its member to seven as required by Section 12 of the Companies Act; (iv) comply with the provisions of sub-sections (1), (1A), and (2) of Section 81 of the Companies Act, which prescribes the manner of further issue of share capital; (v) increase the quorum requirement for general meetings from two members to five members as per Section 174 of the Companies Act (this should also be viewed in light of such private companies which are incorporated by only two persons); (vi) increase the minimum number of directors from two to three as per Section 252 of the Companies Act; (vii) have an audit committee in terms of Section 292A of the Companies Act; and (viii) in general comply with each of the provisions of the Companies Act which are applicable to public companies.

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It is also unclear, (i) whether a public company will be allowed to incorporate its subsidiary as a private company; and (ii) whether different rules framed under the Companies Act which are applicable to public companies (like Unlisted Public Companies (Preferential Allotment) Rules, 2003) will also apply to a private company which is a subsidiary of a public company.       

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There is an argument based on a plain reading of Section 3(1)(iv)(c) that a pre-requisite for the applicability of this sub-clause is that such a company must be a ‘private company’. In other words, such a company must satisfy the basic characteristics of a private company in terms of Section 3(1)(iii) of the Companies Act. If this argument is acknowledged then it appears that the legislature intended to create a ‘third category of companies’, which remains a private company for the purposes of Section 3(1)(iii) of the Companies Act but shall be treated as a public company for the other provisions of the Companies Act, if such a private company is a subsidiary of a public company.

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Further, there are several provisions under the Companies Act which are not applicable to private companies, but have been specifically made applicable to a private company which is a subsidiary of a public company, like Section 77 of the Companies Act which deals with prohibition against giving financial assistance by the company for purchasing its own shares or the shares of its holding company and Section 295 of the Companies Act dealing with loans to directors. Similarly Section 372A which deals with restrictions on making loans, giving guarantees or providing securities and inter-corporate investments in securities, is not applicable to a private company but is applicable to private company which is a subsidiary of a public company.

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Therefore, these provisions which are specifically applicable to private company which is a subsidiary of public company gives some strength to the argument that wherever the Companies Act seeks to treat a private company as a public company by operation of law it has done so by incorporating a specific provision. In all other cases it continues to be a private company. But, doesn’t such an interpretation render Section 3(1)(iv)(c) redundant?     

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It should also be noted that under law a private company which a subsidiary of a public company does not cease to be a ‘private company’ by virtue of any specific provision of the Companies Act, unlike a private company which has been converted into a public company under Section 44 of the Companies Act. Section 44(1) of the Companies Act provide that if a private company alters its articles of association in such a manner that they no longer include such provisions which constituted it to be a private company then it shall as on date of such alteration to the articles of association, cease to be a private company. However, no such provision has been made for a company falling under Section 3(1)(iv)(c) of the Companies Act. 

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It has also been observed by the Company Law Board (‘CLB’) in the case of Hillcrest Realty Sdn. Bhd. v. Hotel Queen Road Pvt. Ltd. and Others [(2006)71 SCL 41(CLB)], that the basic characteristics of a private company in terms of Section 3(1)(iii) of the Companies Act do not get altered just because it is a subsidiary of a public company in view of the fiction of Section 3(1)(iv)(c) of the Companies Act that it is a public company.

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The CLB further observed that it may be a public company in relation to other provisions of the Companies Act but not with reference to its basic characteristics. Therefore, all the provisions in the articles of association to maintain the basic characteristics of a private company in terms of Section 3(1)(iii) of the Companies Act will continue to govern the affairs of the company even though it is a subsidiary of a public company. Furthermore, CLB has observed that one of the basic characteristics of a private company in terms of Section 3(1)(iii) of the Companies Act is restriction on the right to transfer and the same will apply even if a private company is a subsidiary of a public company.

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It is pertinent to note that this judgment of CLB has been challenged in the Supreme Court of India and we should expect some clarity on this issue from the Apex Court.   

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In light of the above discussion, a better view would be that a private company which is a subsidiary of a public company will not lose the basic characteristics of a private company under Section 3(1)(iii). In other words a private company which is a subsidiary of a public company is a hybrid company which is "private company" for certain purposes (i.e. the basic characteristics of a private company) and "public company" for certain purposes.

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The legislature will do well to review the need for Section 3(1)(iv)(c) since the practical difficulties of incorporating a subsidiary private company (by a public company) and the unnecessary complexity and ambiguity in interpreting the basic provisions of the Companies Act must be resolved to facilitate business development without regulatory free will.    

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(Abhishek Sinha is part of the M&A, PE team at Khaitan & Co.) 

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