India: Holding And Subsidiary Company Regulations - A Complicated Matrix

1. Introduction

Section 4 of the Companies Act, 1956 (the Act) prescribes dual test and conceptually defines the Holding-Subsidiary company relationship. This is a special provision extending the provisions of the Act to intra-company relationships. Two significant factors which determine the relationships are control and ownership. The business conduct of such companies are regulated in certain respects and the effect of such regulations will result in treating another company as a Subsidiary of the Holding company. With the result, the provisions of the Act applicable to a public company will also apply to the subsidiary private company. However, the character of private remains unchanged.

2. Board Control

The most common form of control in the case of bodies corporate is controlling the composition of the Board without being a member of the company. This may happen by direct control of the Board or through one or more Subsidiaries. Be that as it may, the Board occupies a pre-eminent position in the corporate hierarchy from the point of the view of enormous power it exercises and control it secures over the management of another company. It is not merely an economic unit but a power house. Considering these and other factors, the Act rightly recognizes the structure of the Board as a manifestation of its inherent strength and standing in the corporate structure.

3. Section 4 of the Act

The composition of Board of a company is deemed to have been controlled, by another company if, but only if, that other company, without the consent or concurrence of any other person, can appoint or remove the holders of all or majority of the directors by virtue of exercise of some power exercisable by it, at its discretion. Further, the other company shall be deemed to have such a power of appointment

  1. if the person thereto cannot be appointed without the exercise of the said power in his favor by the other company
  2. that a person's appointment thereto follow necessarily from his appointment as director or manager or to any other office or employment in that other company or
  3. that the director-ship is held by an individual nominated by that other company or a Subsidiary thereof.

This is the sum and substance of sub-section (2) of section 4 of the Act. If the conditions specified in the said sub-section are satisfied, then the first mentioned company is deemed to be Subsidiary of the other company by virtue of Board control.

4. Holding & Subsidiary Company Relationship

The manner of securing Board control is not envisaged as it is a matter relating to business practice. However, this is possible if the Articles of Subsidiary company specifically provide for a power to the other company to nominate all or majority of directors on the board of first mentioned company. The moot question is, can the Articles provide for such a provision if the other company does not hold all or majority of shares.

However, there can be an arrangement between the lender and borrower companies as part of financing under which the lender may nominate all or majority of directors with or without a specific provision in the Articles for the purpose of ensuring proper utilization of funds. This is possibly one of the reasons why section 4 provides for Board control as a means of creating Holding & Subsidiary company relationship. The immediate effect of such an arrangement is that lending company becomes a Holding company by virtue of section 4 of the Act.

5. Examination of Section 4 in relation to Section 255

Another dimension relates to the validity of section 4 vis-a-vis section 255 of the Act which deals with appointment and retirement of directors by rotation. At least two-thirds of the total number of directors of a Public Company or a Subsidiary Private Company should be persons whose period of office is liable to retire by rotation. However, Section 255(1)(b) saves the arrangement in section 4 of the Act. With the result, prima facie, there is no conflict between section 4 and section 255 of the Act.

Does this mean that the directors appointed by virtue of section 4 are not liable to retire by rotation, more so in the case a public company or Private Subsidiary Company?

While sub-section 255(1) (b) saves the arrangement envisaged in section 4 by using the words "save as otherwise expressly provided in this Act", section 255(1)(a) provides that not less that two-thirds of total number of directors shall be persons whose period of office are liable to retire by rotation. This is a mandatory provision.

6. Case law on the subject;

There is an interesting case on the above subject. In the case of Oriental Industrial Investment Corporation of India vs Union of India (1981)51 Com Cases 487(Del), the effect of section 4 in relation to sections 255,256 and 257 came up for consideration. The facts of the case is that by an agreement dated August 19, 1975 between Oriental Limited and Poonam Hotels, Oriental was given full and absolute power to appoint five directors on the board of directors of Poonam Hotels. This gave power to Oriental to appoint majority of directors on the board of Poonam Hotels with power to remove such directors and to appoint another in his place. Poonam also amended its Articles suitably and Oriental appointed five of its directors on the board of Poonam Hotels. This brought about holding and subsidiary relationship in terms of section 4 of the Act. Thereafter Oriental acquired 88% percent shares of Poonam Hotels in two tranches. Oriental made an application to the DCA for extending the financial year of its Subsidiary to bring it in line with its accounting year for complying with section 212 of the Act. The Department rejected the application on the ground that Article included by Poonam conferring authority on Oriental to appoint majority of directors is violative of sections 255,256 and 257of the Act and treated it as void as per section 9 of the Act and consequently Poonam cannot be treated as Subsidiary company. Request of Oriental for reconsideration did not evoke positive response and the Department reiterated its stand whereupon Oriental filed a writ in the High Court of Delhi.

7. Decision of Delhi High Court

The High Court observed, inter alia, that the contention of the counsel for the Union of India that "the control of Oriental over the composition of the Board of Poonam Hotels which they exercise by virtue of their agreement dated August, 1975 is in contravention of the provisions of Sections 255,256 and 257 of the Act overlooks the important fact that section 255 excludes from its purview cases which have been otherwise expressly provided in the Act. The words "save as otherwise expressly provided in this Act" used in section 255(1)(b) are of commanding significance. Section 4(2) is an express provision for the appointment of the directors on the Board of Subsidiary. This provision is not hit by Section 255 because it is expressly excluded."

The High Court also observed that "there is no denying the fact that the right of the members of a public company to appoint directors of their choice at a general meeting is greatly abridged when there comes into being a relationship of a Holding and Subsidiary Company. But this restriction inheres in the definition of the Holding Company. It is firmly embedded in section 4 of the Act. The ability to control the conduct of the Subsidiary is the hall-mark of the Holding Company. The Holding Company is the controlling company. The controlled company is called a Subsidiary."

8. Revised clarification by DCA

Following the Judgment of the Delhi High Court, the Department of Company Affairs (DCA) issued a clarification modifying their earlier views on the above matter which is reproduced below;-

"Department views";- The Department has issued a circular 14\74 dated 28-8-1974 to the effect that the Articles of a company which confer upon another company the right to make provisions for appointment of director upon another company with a view to make the company a subsidiary is invalid under section 9 of the Companies Act. On a combined reading of the provisions of sections 255, 256 and 257 and because section 257 is a mandatory provision, this view does not seem to be well founded. The appointments made pursuant to an arrangement whether by the Articles or by an agreement is not invalid merely because any shareholder may seek election at an annual general meeting. Section 257 only deals with the right of a person other than a retiring director to stand for election at the annual general meeting. The agreement or Article of a company, in so far as it or they invest a company with the status of holding company in relation to the company of which the board is controlled cannot be said to be inconsistent with section 257 which comes into operation only when elections are to be held at the annual general meeting.

It follows from the above that a public company is not required to comply with the requirements of sections 255 to 257, if it is a Holding Company having the right to appoint majority of directors on the Board of the Subsidiary company pursuant to section 4 of the Act.

9. Shareholding Control- Direct ;

This is the second method by which Holding & Subsidiary company relationship can be established. This is possible if one company holds more than half in nominal value of equity capital of another company as per section 4(1)(b)(ii) of the Act. This is a case of direct investment and indicates the financial interest and stake of the Holding Company in its Subsidiary. This is however subject to sub-section 4 (3) of the Act which seeks to exclude certain shareholdings for the purpose of reckoning half the nominal value of equity shares aforesaid.

They are;-

  1. any shares held or power exercisable by that other company in fiduciary capacity is considered as having not been held or exercisable by it. What is referred to is the equity shares carrying voting rights. Fiduciary capacity creates a relationship under which one owes to another the duties of good faith, trust and confidence. It is a company to company relationship;
  2. any shares held by a nominee of that company, except as a fiduciary is considered as having been held by that company;
  3. any shares held by a nominee for a Subsidiary of that company, not being a Subsidiary connected as a fiduciary is considered as having been held by that company;
  4. any shares held or power exercisable by any person as security for the debentures of the first mentioned company or of a trust deed for securing any issue of debentures is to be disregarded;
  5. any shares held or power exercisable by or by a nominee for that other or its Subsidiary shall be treated as not being held or exercisable by that other ,if such holding or power is by way of security only for the transaction of lending in the ordinary course of business.

10. Indirect Control

This is envisaged in section 4(1)(c) of the Act as third type of relationship applicable mainly in the case of group companies. A Subsidiary of a Subsidiary becomes a Subsidiary o f the ultimate Holding Company. This may be second or third generation Subsidiary by virtue of management or shareholding control and the linkage is endless.

Another distinctive feature can be seen in sub-section (5) of the Act. For the purpose of section 4, the expression "company" is defined to include any body corporate, whereas for other provisions of the Act, "body corporate or corporation" includes a company incorporated outside India as defined in section 2(7) of the Act.

11. Extension of the Principle of Control.

Sub-section (6) seeks to extend the principle of control in the case of a body corporate incorporated in a country outside India, a Subsidiary or Holding Company of such a company shall be deemed as Subsidiary or Holding Company of the body corporate within the meaning and for the purposes of Indian law, whether the requirements of section 4 are fulfilled or not. In this case, the same status is accorded under the Indian law to a body corporate as in the country of its incorporation in relation to its Holding or Subsidiary relationship. Here the shareholding control or management control discussed above are not relevant.

12. An Indian Private Company as Subsidiary of foreign body corporate

Sub-section (7) of section 4 provides for a deeming provision. The intention is to place a Private Company registered in India which is a Subsidiary of a foreign company on par with a Private Company which is a Subsidiary of Public Company registered in India. To achieve this purpose, sub-section (7) provides that a Private Company which is a Subsidiary of the company incorporated outside India, which if incorporated in India would be a Public Company within the meaning of the Act shall be deemed as Subsidiary of a Public company, provided that the entire share capital in that Private Company is not held by the body corporate, whether alone or together with one or more bodies corporate incorporated outside India. This provision is based on the recommendation o f the Joint Company Law Committee as it considered unnecessary to treat an Indian Private Company, the entire share capital of which is held by one or more bodies corporate incorporated outside India as a Private Company which is a Subsidiary of a Public Company for the purposes of the Act.

A close look at the provision indicates that the exemption is based on a similar position as in the case of private company whose entire share capital is held by one or more companies and none of them hold 51% or more of share capital o f the private company. Even if all these companies are public companies, the private company continues to be a private company, particularly in the context of deletion section 43A of the Act from the statute book.

Needless to say that a private company whose entire capital is held by one or more bodies corporate, whether incorporated in India or outside stands on a different footing, as such holding amounts to indirect public holding. Such companies have to have greater degree of accountability and transparency in their operations for the benefit of their shareholders. It is therefore necessary that legal framework to address this requirement should be in place.

13. Conclusion

A look at the path we have traversed indicates that what started as direct or indirect control, be it shareholding or otherwise has inevitably resulted in having to rope in Subsidiary Companies being increasingly set up by foreign companies. That these companies should, no doubt, be brought within the regulatory provisions as applicable to Indian companies but the matrix of Holding-Subsidiary Company relationship has become more complex and complicated. This appears to be inevitable in the context of globalisation of Indian economy and increasing flow of foreign exchange into our country through Foreign Direct Investment (FDI) in joint ventures or Subsidiary companies.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Authors
D. K. Prahlada Rao
 
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