STAY-IN-INDIA CHECKLIST MCA 1. Grant of ESOPs to Promoters and Independen t Directors The provisions of the Companies Act do not permit to grant ESOPs to promoters or members of the promoter group or independent directors. There is no rationale for this restriction as the promoters, essentially function as employees of the Company. Further, through multiple rounds of fund raise, the stake held by the Promoters would have significantly diluted. Also, to get good professionals to join as independent directors, it is important to issue them ESOPs as payment in cash for compensating them is a burden on the Company s resources. Provisions of the Companies Act to be amended to permit issue of ESOPs to promoters and members of the promoter group and independent directors. Management ESOP should be permitted for unlisted to keep the Promoters incentivized and motivated. Likewise, role of advisors is critical for the success of the ventures. Equity seems to be the only logical form of incentive, given the lack of liquidity. 1 MCA s comments is that the relevant Rules on ESOPS have been formed keeping in SEBI (share based Benefits) Rules, 2014, and in case SEBI is willing to change their regulations, amendment of corresponding Rules would be taken up by MCA. However, it must be noted that the same level of requirements may not be required for public listed as well as private and unlisted public. 1 Jurisdictions such as Singapore link the grant of ESOPs with shareholding (i.e., ESOPs not to be issued to a person holding more than 25% of share capital). However, the test to qualify as a promoter under the Companies Act is quite broad and links to various forms of control. Thus, a simpler way of defining persons ineligible for ESOPs (such as a person who, directly or indirectly or through his relatives, holds more than 25% of share capital) may be adopted.
2. Outbound merger 3. Private placement At present, an Indian company cannot merge with a non-resident entity. If allowed, this would permit foreign investors to structure FDI transactions in efficient and flexible manner. The Companies Act contains provisions for such mergers. However, these provisions have not yet been notified. Startups see a lot of primary investment rounds in their initial stage, wherein, a new investor comes in at investment round. Under Indian law, such issuance to new investors is made by way of a private placement. The process of private placement is lengthy and cumbersome, including the following aspects: Provisions of Companies Act for outbound merger to be notified. 2 MCA has stated that it is has sought comments from RBI on these. Section 234 of the CA, 2013 deals with the subject. This would be commenced with the establishment of NCLT in near future. The process for raising capital by private placement to be relaxed for private. MCA has stated that this under process. Public disclosure of significant non-public information such as: o valuation of the company o risk factors o details of directors and their remuneration Requirement to issue offer letters and obtaining acceptance letters (while there is no issue in getting this done, from a process standpoint, it is unnecessary paperwork for investors, who anyway have detailed investment agreements with representations and warranties) Requirement of receiving the subscription money in a separate bank account and keeping a record of the bank account from where subscription money has been received is also unnecessary, as a prohibition on use of subscription amount can be imposed and enforced regardless of the subscription money being received in a separate bank account 2 We note that this will be done post establishment of NCLT in a couple of months.
4. Convertible notes 5. Converting LLP into company Convertible note is a type of security frequently issued by startups when raising seed capital. With convertible note, the startup issues the seed investor a promissory note for an investment amount, which contains a conversion feature. The conversion feature is the mechanism by which the convertible note will convert to equity (new shares for the investor) upon a future event (typically the next round of financing). If such an event does not take place, the note is not converted into equity shares and the principal amount (together with agreed interest) is repaid by the startup to the seed investor. Since a convertible note only converts into equity on the happening of a contingent event, it may be treated as an optionally convertible debenture under Section 2(30) of the Companies Act. Also, debentures that are optionally convertible into equity, issued to investors which are not, may be considered as deposits under the Companies Act (Rule 2(1)(c) of the Companies (Acceptance of Deposits) Rules, 2014). In terms of the provisions of Section 73 of the Companies Act, private can accept deposits only from its members. A lot of startups commence as a partnership between the founders, and when the business is slightly stable, they wish to convert to a limited likably company. Thus, ideally, it would be convenient for the startups to commence as an LLP and then convert such LLP into a company when the time is right. While the process of converting a company into an LLP is clearly provided under the LLP Act, the process of converting an LLP into a company is not very clear under Section 366 of the Companies Act, and it appears that in its current form, the process entails the same of work as would be required to dissolve the LLP and incorporating a new company. Convertible notes should be recognised as a specific instrument for investment. Conversion may be linked to valuation at a later funding round and if there is no next round within a specified time, then it can be linked to the valuation of the previous round. Special provisions relating to the same could also be carved out in the Companies Act. MCA has stated that it is considering it. Process of converting a LLP into a company (without dissolution and reconstitution) to be clearly set out in the Companies Act on similar lines as the LLP Act. MCA has stated that this is under process.
Also, requirement such as having seven or more members for converting into a company are unnecessary, and may be removed. 6. Applicability of provisions relating to insider trading on private As per Section 195 of the Companies Act, no director or key managerial personnel of a company should engage in insider trading which would include subscribing or selling the securities or providing any price sensitive information to any person. The Section which deals with prohibition of insider trading essentially captures the essence of Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 1992 but extends its applicability to unlisted. The broadly worded restriction is creating practical difficulties in deal structuring since almost every deal in the unlisted company space involves sharing of information by directors or key managerial personnel or subscription or sale of shares by promoters who are normally in an executive capacity within the company. As a result of the prohibition under Section 195, directors/key managerial personnel in private will be unable to transfer their shares till the company goes public, since they are reasonably expected to have access to nonpublic price sensitive information in respect of securities of the company. Similarly, a transfer of shares within the promoter group or from a promoter to a strategic investor will also come within the purview of Section 195. Further, in case of closely held where there is a dispute between two It is suggested that the MCA by way of a notification provide an exemption to private from the provisions of Section 195 of the Companies Act. MCA has stated that this is under process.
shareholders, this provision effectively prohibits one shareholder from buying the shares held by the other. 7. Inclusion of certain private under the purview of the term listed company' 8. Removal of limit on acceptance of deposits from shareholder s The definition of listed company under Section 2(52) of the Companies Act provides that listed company means a company which has any of its securities listed on any recognised stock exchange. Since it is permissible for even private to issue and list debentures in accordance with the SEBI (Issues and Listing of Debt Securities), 2008 and the listing agreement it appears that even those private and public that do not have their shares listed on a recognized stock exchange but have only listed debentures, are within the ambit of listed. Such are required to comply with requirements of, inter alia, filing a return with respect to change of in shareholding of promoters and top ten shareholders, appointing an internal auditor, audit committee, nomination and remuneration committee and having a vigil mechanism. Further, such are to be regulated by SEBI in respect of provisions relating to issue and transfer of securities. Under Section 73 of the Companies Act, private are allowed to accept deposits from their shareholders up to 100% of their share capital and free reserves. However, since most startups require constant funding during initial years, and do not have free reserves, such limit may be removed for them. It is suggested that the definition be amended to exempt private which have their debt securities listed from the purview of this definition. MCA has stated that this is under consideration. The aforesaid limit of 100% of share capital and free reserves to be removed. MCA has stated that there is no restriction on directors or their relatives. However, the restriction on shareholders remains, which should also be removed.
9. Incorporatio n process to be simplified 10. Applicability of provisions relating to forward contracts on private Presently, the process of incorporating a company is extremely cumbersome (with DSC requiring PAN Card and address proof of director to be attested by Gazetted Officer or Post Master or Bank Manager, or notarised and apostilled if abroad, and name approval taking close to two weeks). Section 194 of the Companies Act puts a prohibition on directors and key managerial personnel ( KMP ) of the company from dealing in securities of the company on a forward basis. Pursuant to Section 194, directors and KMP are prohibited from buying, in a company, its holding company, subsidiary or associate company, a right to call for delivery, or a right to make delivery at a specified price and within a specified time, of a specified number of relevant shares or a specified amount of relevant debentures. A contravention of these prohibitions would render the concerned director or KMP punishable with imprisonment which may extend to 2 years or with fine which shall not be less than 1 lakh rupees but which may extend to 5 lakhs rupees, or with both. Furthermore, such defaulting director or KMP would be required to surrender any securities so acquired and the company would not be permitted to register such securities in favour of such director or KMP, and if they are in dematerialized form, the company shall inform the depository not to record such acquisition and such securities. In both the cases, it shall continue to remain in the names of the transferors. Process of incorporating a company (specifically obtaining DSC and name approval to be simplified). 3 With respect to DSC, acceptance of e-sign to be allowed. MCA has stated that this under process and will be notified soon. One notification in this regard has already been released It is suggested that the MCA by way of a notification provide an exemption to private which do not intend to get their securities listed from the provisions of Section 194 of the Companies Act. Alternately, suitable amendments may be made in the Companies Act to permit the directors and KMP of such to enter into call and put options with respect to shares/debentures of the company after making a disclosure of the same to all the shareholders (in case of with more than 100 shareholders), or after taking consent of the shareholders by way of special resolution in a meeting (in case of with less than 100 shareholders). 3 We understand that this process is already underway, and will be notified in the next couple of months.
A blanket prohibition on directors and KMP of a company on buying options pertaining to securities of private is posing practical difficulties for structuring transactions involving closely held private where the promoters are directors and/or KMP. Also, an outright prohibition on subscription/buying/selling of securities by directors and KMP (being reasonably expected to have access to non-public price sensitive information in respect of securities of the company) renders any transfer of securities by directors and KMP of closely held impossible. Given that the object of these provisions is to prevent illegal enrichment of directors of KMP to the detriment of other shareholders by using special knowledge (i.e. non- public price sensitive information), an applicability of these sections to all private deals involving transfer/acquisition of securities in private is leading to absurd situations. The rules against forward dealing are intended to prevent speculation which may occur only in widely traded where there is a possibility of markets being efficient, i.e. that the availability of information can impact the market price. There is no relevance of application of this prohibition to private. 11. Increased liability directors of The Companies Act has potentially created an increase in personal liabilities for directors. The language in the Companies Act should be amended to remove ambiguities in relation to increased personal liability of directors. The amendment should also provide more effective provisions for director indemnification by the company and third parties. There should be a limitation on the liability of directors (particularly nominee directors).
12. Appointmen t of nominee directors It is not clear as to whether a nominee director may be appointed without approval of shareholders in a general meeting. A clarification needs to be issued to provide whether nominee directors may be directly appointed to the board, pursuant to Section 161(3) of the Companies Act. 13. Buyback The process for buyback is complicated and very restricted. Exemption from the complicated buy-back process under the Companies Act. Permit buy-back freely as long as the Board of Directors approves the transaction. 14. Compliance rules and processes for mergers 15. Investment in social venture funds Statutory mergers/demergers involve court process. There is a need to encourage investments in SVFs. Establish statutes for automatic (by operation of law) mergers and demergers on a tax free basis upon meeting prescribed criteria. Mergers/Demergers between startups are tax free as long as consideration is at least 90% stock for stock. Mergers between startups and non-startups can be tax free if at least 50% of the consideration is stock for stock. Investments by corporates in SEBI-registered Social Venture Funds should be considered as a part of their mandatory CSR spend. The SVFs are currently permitted by SEBI to accept grants. 16. Use of LLP as investment vehicle There is a need to align norms pertaining to LLPs to global best practices - An LLP is the ideal investment vehicle as (i) it is a body corporate from a legal and tax perspective, and (ii) it offers one layer of taxation for all partners.
- Allow proprietary domestic capital to set up an LLP as an investment vehicle for the object of investment - The LLP can self-certify that all their capital is contributed by partners and that they do not accept public deposits or use borrowed funds to registrar of 17. Public company level compliance 18. Related party transactions There are too many compliance and ongoing filing requirements which result in unintended non-compliance by startups and the consequent imposition of penalties. In terms of Section 188 of the Companies Act, when related party decisions are being taken the related directors cannot be part of the board decision. It therefore makes it impossible for with 2-3 directors to implement such a decision, when such directors are interested in the transaction. - Eliminate some or all trivial compliance and notice requirements. - There should also be exemption from compliance and notice requirements under most of the statutes (list to be developed). - A Single Window government body for remediating compliance faults should be set up. There should be a single flat fee payment for penalties for compliance faults and the response times by the Single Window should be less than two weeks. An exception to this rule can be made for private
19. Loans to directors including with common directors 20. Audit requirement for small Section 185 restricts loans to directors or any other person in whom director is interested (including any private company of which such director is a director or member). This restricts ability of a startup to give a loan even to a subsidiary company (unless it is a wholly owned subsidiary company). The exemption provided to private is also qualified as it does not apply to a private company which has a corporate shareholder (startups which invite funding from PE/VC investors may end up having one or more corporate shareholders) The requirement of auditing accounts of a company is extended to all. This provision increases cost for small. The exemption provided under Section 185 should be made available to all startups irrespective of their shareholding pattern or conditions relating to maintenance of 2:1 debt equity ratio Can follow the system followed in other countries such as the United States, i.e. no audit requirement for small, and specify audit requirement to be triggered only after a certain revenue limit.