This article is a continuance effort from our previous article on restructuring, and an endeavor to touch upon some of the pertinent regulatory issues. While COVID-19 poses a series of challenges to public health followed by a likely setback to the economy, this article keeps a focus on issues that the board and the management of corporates are likely to come across against the backdrop of COVID-19. We hope this article based on pertinent regulatory issues can guide corporates on facing this situation appropriately.
It is settled law that directors owe fiduciary duties towards company and members. They act as a trustee or custodian of stakeholders. Directors' duties all along have been evolved under common law, but for the first time, the Companies Act, 2013, laid down codified duties of directors (see: s.166). The directors' duties inter alia lay down that "a director of a company shall act in good faith in order to promote the objects of the company for the benefit of its members as a whole, and in the best interests of the company, its employees, the shareholders, the community and for the protection of environment." The provision seeks to cast a moral duty on directors in the widest sense and assumes utmost importance in the present scenario given directors will be subjected to make realistic business decisions.
Health & Safety
The pandemic could be disruptive to certain business practices and could particularly impact the health and safety of employees. The need is not only from the present situation point of view but also there is a regulatory mandate under the Factories Act, 1948, to look after the health and safety of employees while they are working in factories. There will be a definite requirement to take extra efforts in the form of educating employees on preventive measures, including social distancing even after business achieves normalcy post lockdown. Safety measures can also be sensitized through continuous communication and laying policies in respect thereof.
Unlike other jurisdictions, India doesn't have a provision of force majeure recognized in statute but is evolved through judicial precedents on the backdrop of provisions of Contract Act, 1872 (see: s.32 and s.56). When a party to a contract is unable to perform its contractual obligation due to a supervening impossibility which the party could not prevent, then the defaulting party may be excused from the performance of the contract in accordance with section 56 of the Indian Contract Act, 1872. The impossibility of the performance of terms of contract or frustration of contract would excuse the performance of the said contract. However, it should be carefully examined to see which contracts could possibly invoke such clauses. Also, one needs to critically evaluate the impact of force majeure, whether it would discharge from the performance of a contract or postpone the obligation to perform the contract. More critical would be supply chain and service contracts, which could interrupt the business continuity, and hence in such cases, constructive dialogue and negotiation with contracting parties would be inevitable to find a realistic solution.
Liquidity crunch may pose insolvency risk for the business, and the board needs to be vigilant on insolvency actions brought against a company due to default in payment. Unfortunately, statistics show operational creditors initiate a majority of the insolvency actions as a recovery tool under the insolvency code. Recognizing the need of hour (and rightly anticipating that), the Government has raised the threshold of default in payment of a debt from present INR 0.1 million to INR 10 million to be eligible to bring insolvency action under Insolvency and Bankruptcy Code, 2016. However, this provision may be relevant only in the case of small and medium corporates because the default threshold still remains to be very low. However, the Finance Minister, while issuing a press statement, has indicated that, after evaluating the situation arising from COVID-19 in due course, the Government may think of suspending the relevant provisions of the Insolvency Code for some time to save corporate from a likely rigor of insolvency actions. Anticipating liquidity challenges, wherever possible, the board should direct senior management to initiate a discussion with contracting parties apprising them on the present situation and draw a plan to find a resolution to such issues. This will enable management to arrive at an acceptable resolution to non-payment without approaching regulators. A constructive dialogue will be an important tactic when a company is on the creditor side and given that it will have limited regulatory recourse due to increased threshold or suspension of charging provisions of insolvency code (if the Government chooses to do so). Fortunately, the Reserve Bank of India has advised certain measures like a temporary moratorium, rescheduling of payments, and relaxation in asset classification on account of the aforementioned measures. Further, the lender is required to frame a policy for granting relaxations to borrowers, and in case of borrowers above prescribed loan exposure, the lender needs to develop an MIS on relaxation granted.
It is expected that lenders being institutions may refrain themselves from taking insolvency action as they are better positioned to assess the situation to make an informed decision. However, corporates may have raised money from public investors through debt securities, and given that the company law provides various tools for enforcing recovery of such investments, corporates will be facing a double-edged sword of tackling regulatory and investor issues. Not only that, but the company law also mandates provisioning norms in their balance sheet in respect of money raised through debt securities, which will pose another challenge.
While that will be position on one hand, on other hand fundraising through investment may take a hit as foreign investments may slow down for some time, which will leave corporates with the only option of tapping the domestic debt market. It is expected that in the overall economic interest, the Government may pitch for lowering interest rates and pouring liquidity in the system in some or the other way.
The outbreak of pandemic followed by lockdown has forced the closure of business operations across the country. This has caused an economic burden on corporates. Further, post lifting of lockdown also, it is anticipated that operational normalcy will take some time, and it is unclear at this time as to what rippling effect the business will have due to the adverse economic conditions. Such a situation will, however hard a choice may be, force the management to re-evaluate their wage costs and undertake certain rationalization measures. The Government circulars on non-termination of employment and wage cuts are advisory in nature and make a moral appeal only. The management will have to carefully deliberate people issues from an overall perspective having regard to the nature of their industry and impact analysis. This follows a regulatory requirement for downsizing of the workforce if the Industrial Dispute Act,1947, is applicable to a company. Besides that, union issues and other welfare legislation are very strict in India. That involves cost and regulatory processes apart from people management (which is a very critical part). The board of a company needs to be mindful of these aspects while taking any decision as it may invite operational disturbance.
This unprecedented situation may subject corporates to certain disclosures. Typically, publically listed entities will be required to give various disclosure of material events or impact of the pandemic on business operation and the financial position in pursuance of provisions of SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, in order to keep the investor informed of the actual position. This will cast an extra obligation on the board to ensure that accurate information is present in the letter and that the spirit is disseminated to the investors in a timely manner. This will also force corporates to correct their guidance and forward-looking statements suitably.
Importantly, poor earnings would put pressure on the value of scrips. Hence, the board will have an additional task of keeping a close watch on business hostilities. Also, insider trading and shareholder activism could be other issues that the board may have to deal with.
Besides above, the company law also expects the board to present a true and fair view of the company's financial position, which includes compliance with accounting standards mandating disclosure on a fair value basis. This requires an exercise in itself to make relevant assumptions and take a decision in respect thereof. First and foremost, the board is required to comment on the going concern assumption and risk that may threaten the existence of the company. It involves comprehensive working in support thereof. The fair value statements resulting in deterioration of financial condition due to the outbreak of pandemic will need consideration from an existing borrowing position point of view and particularly with regards to security cover, covenant tests and solvency ratios.
Under company law, the board is under an obligation to report on the state of the company's affairs in detail. Admittedly, the outbreak of pandemic in India has taken a serious turn at the end of the financial year, and the companies will be required to report their financials by September 2020 (unless this timeline is extended). Hence, the board must be cautious while reporting material changes and commitments that affect the financial position of the company, which have occurred between the financial year and date of the board's report. Since quite a few series of issues would have occurred in that timeframe, which would result in a rippling effect on the company's financial position, it must be reported carefully by the directors as it will be direct communication to the stakeholder through board's report.
Further, a certain class of companies is required to have a risk management system in place, elaborating risk factors of the business and how to mitigate such risks. The outbreak of pandemic will force management for an in-depth evaluation of risks and mitigation strategies in relation thereto. This aspect also needs to be discussed in detail with the management, and a discussion analysis report, which a listed company needs to provide in its annual report to shareholders must be included.
Given the timeline to report the financial statements, a tight-roped schedule will have to be drawn by companies to complete the statutory audit and reporting of financials, especially by publically listed companies.
The previous economic crisis caused by the global economic slowdown has forced corporates to undergo financial restructuring. Likewise, a pandemic situation would also inevitably require corporates to undergo a restructuring in response to the strained economic situation. This restructuring becomes a much needed exercise due to issues such as liquidity crisis, cash flow management, debt situation, balance sheet mismatch, inter-group transactions, business discontinuance or downsizing and accumulated losses, etc. The following could be few of restructuring measures:
- Consolidation of synergetic business or spin-off of noncore Business;
- Business discontinuation or permanent closure;
- Utilization of capital reserve or securities premium;
- Writing-off of losses or capital reduction to resize the balance sheet;
- Account for diminution in value of investments, impairment of assets, loss on the sale of an investment, etc.;
- Workforce rationalization or factory relocation;
- Write-off of payables due to haircuts taken by creditors;
- Debt restructuring involving conversion into shares, rescheduling of payments, reduction and waivers of loans, etc.
However, the aforesaid examples of restructuring come under the regulatory framework. Typically, the company law procedures and considerations on account of tax and exchange control regulation would require a thorough evaluation. Further, compliance with accounting standards and mindfulness of regulatory approval is another part while evaluating restructuring exercise.
Fortunately, rising to the crisis, the regulatory authorities have swiftly responded with the various relaxations in compliances to which the companies must adhere. The board and management constantly need to remain updated with those relaxations to use them for their advantage.
The principles embodied in the legal maxims 'lex non cogit ad impossibilia' and 'impotentia excusat legem' could come to the rescue in such situations. This means, the law does not compel a man to do that which cannot possibly be performed (lex non cogit ad impossibilia), and the law will generally excuse a default if a party is unable to perform a duty created by the law without any default in him and where he has no remedy (impotentia excusat legem). However, this is not a straight jacket position, and the impossibility of compliance will have to be examined according to the facts of each case.
The SEBI has extended timelines for making various compliances, whereas the Ministry of Corporate Affairs has also extended certain timelines and granted flexibility in day-to-day affairs. The notable reprieve is Companies Fresh Start Scheme 2020, which enables corporates to cause overdue filings without additional fees and seek immunity from prosecution to make a fresh start. The Reserve Bank of India has also granted relaxation by enhancing the timeline for realization and repatriation of export proceeds within fifteen months from the existing nine months.
A similar compliance extension has also been granted by the tax department as well. However, the Government may have to think out of the box to utilize tax incentives to boost economic activity. In that regard, corporates can make meaningful representation to the Government and work closely to find a solution to the systemic issues.
Regulatory Administrative System
Lastly, we are governed by regulatory eco-system, like courts, tribunals, and adjudicating authorities, etc., whose functions are discharged by various dignitaries, who are at present also subject to lockdown. On resumption of duty and normalcy in their functioning, we will definitely see an increased burden on the regulatory system in addition to existing pendency. This will be a setback to a developing nation. Therefore, the board will have to be mindful of its impact on issues such as contractual disputes, tax disputes, and other litigation of corporate importance. Any protraction or escalation of the issue should also be evaluated from the practical reality of the present situation.