ISSUANCE OF CONVERTIBLE NOTES IN STARTUPS PERMITTED

Vide a notification dated 10 January 2017, the Reserve Bank of India (RBI), has amended the Foreign Exchange Management (Transfer or issue of Security by a Person Resident outside India) Regulations, 2000 (FEMA 20/2000), implementing a key change in the foreign exchange policy by allowing startup companies to issue convertible notes to foreign investors.

A convertible note is an instrument given as a debt and convertible to equity at the option of the holder, upon a future contingency taking place, usually when start-ups get an additional round of investments. Therefore convertible notes allow investors to invest in start-ups without worrying about their valuations which are difficult to determine at inception, as convertible notes are merely an instrument advanced as a loan, and converted to equity at a later stage, when the startup is better established.

Following are the salient features of the Notification:

Definition of convertible note: The notification defines a convertible note as an instrument issued by a startup company evidencing receipt of money initially as debt, which is repayable at the option of the holder, or which is convertible into such number of equity shares of such startup company, within a period not exceeding 5 years from the date of issue of the convertible note, upon occurrence of specified events as per the other terms and conditions agreed to and indicated in the instrument.

The notification however, is applicable only to companies defined as start-ups, in the applicable government circular, which defines an entity as a startup, if 5 years have not elapsed from the date of its incorporation, its turnover for any of those years does not exceed Rs 25 crores and it is working towards innovation, development, deployment or commercialization of new products, processes or services driven by technology or intellectual property. Therefore entities which fall outside this definition shall be unable to avail of the benefits of this notification.

Persons eligible to purchase convertible notes: A person resident outside India (other than an individual who is citizen of Pakistan or Bangladesh or an entity which is registered / incorporated in Pakistan or Bangladesh), may purchase convertible notes issued by an Indian startup company for an amount of Rs 25 lacs or more in a single tranche. A person resident outside India may acquire or transfer, by way of sale, convertible notes, from or to, a person resident in or outside India, provided the transfer takes place in accordance with the pricing guidelines as prescribed by RBI. However, a startup company engaged in a sector where foreign investment requires Government approval may issue convertible notes to a non-resident only with approval of the Government. NRIs may acquire convertible notes on non-repatriation basis in accordance with the applicable FEMA Regulations.

Other formalities: A startup company issuing convertible notes to a person resident outside India shall receive the amount of consideration by inward remittance through banking channels or by debit to NRE / FCNR (B) / Escrow account maintained by the person concerned in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016, as amended from time to time.

The startup company issuing convertible notes shall be required to furnish reports as prescribed by Reserve Bank.

MHCO COMMENT:

The notification is an encouraging step towards promoting a conducive environment for start-ups in the country and shall be instrumental in boosting both investor sentiment and promoting entrepreneurship in the country.

The views expressed in this update are personal and should not be construed as any legal advice. Please contact us directly on +91 22 40565252 or legalupdates@mhcolaw.com for any assistance.

TESTAMENTARY DISPOSITIONS OVERRULE NOMINATIONS UNDER THE COMPANIES ACT

The Bombay High Court has in the recent judgement of Shakti Yezdani And Anr vs Jayanand Jayant Salgonkar ("Yezdani" ) clarified the contentious question regarding legal rights of nominees with respect to shares by holding that nominations with respect to shares of a company, do not overrule testamentary dispositions with respect thereof and a mere nomination does not confer beneficial ownership to the nominee.

The question of a nominee's ownership rights, first arose before the Court, in 2010 in the case of Harsha Nitin Kokate v. Saraswat Co-operative Bank Limited (2010 ( 112 ) BOMLR 2014) ("Kokate") wherein after a judicial analysis of Sections 109A and 109B of the Companies Act, 1956 (which deal with nomination), it was held that a nominee is entitled to the beneficial ownership of the shares or securities which are the subject matter of nomination to the exclusion of all other persons who are entitled to inherit the estate of the holder, according to applicable succession laws.

However, this view was overruled in the case of Jayanand Jayant Salgaonkar vs. Jayshree Jayant Salgaonkar ("Salgaonkar" ) in 2015, where it was held that legal heirs and not nominees are entitled to beneficial ownership of the shares and securities of a company. In that case, late Jayant Shivram Salgaonkar expired, leaving behind shares in several companies. However, there were discrepancies between the bequests of the said shares in his will and persons appointed as nominees of the same, thereby leading to a dispute with regards to their ownership.

One of the Defendants in Salgaonkar preferred an appeal to the division bench against the said decision, thereby leading to the present case. The division bench considered a slew of judgements in Yezdani, put forth by both parties, including the recent judgement of Indrani Wahi vs. Registrar of Co-operative Societies, pronounced by the apex court, wherein it was held that a nominee of shares in a co-operative society is a mere trustee for the legal heirs of the member and nomination by itself does not have any relevance to the issue of title between the inheritors or successors to the property of the Deceased. The Court also considered a number of judgements dealing with statutes that contain similar provisions for nomination. While upholding the view pronounced in Salgaonkar and denouncing the stance taken by the Kotate judgement, the Court held that

"Considering the consistent view taken by the Apex Court while interpreting the provisions relating to nominations under various Statutes, there is no reason to make a departure from the consistent view. The provisions of the Companies Act including Sections 109A and 109B, in the light of the object of the said Enactment, do not warrant any such departure. The so called vesting under Section 109A does not create a third mode of succession. It is not intended to create a third mode of succession. The Companies Act has nothing to do with the law of succession...Hence, the view taken in Kokate's case is not correct."

MHCO COMMENTS:

Even though this decision appears inconsistent with the wordings of Section 109A and 109B of the Companies Act, 1956 (which is identical to the corresponding Section 72 of the Companies Act, 2013), it goes a long way in clearing up the confusion on the legal rights of nominees. Accordingly, this decision constitutes a binding precedent for future cases as well, unless set aside by the apex court.

The views expressed in this update are personal and should not be construed as any legal advice.
Please contact us directly on +91 22 40565252 or legalupdates@mhcolaw.com for any assistance.

DISPUTES ARISING OUT OF TRUSTS | NON ARBITRAL IN INDIA

The Indian Trusts Act, 1882 Act ("Trust Act"), which is a comprehensive code broadly, lays down inter alia the manner of creation of trust, the rights, powers and duties of the Trustees, provisions relating to breach of trusts, remedies for seeking redressal of grievances arising out of the Trust Deed etc.

In a recent case of Vimal Shah & Ors V/s Jayesh Shah and Ors ("Vimal Case"), the Supreme Court of India ("Supreme Court") has held that the disputes relating to Trusts, Trustees, and beneficiaries arising out of the Trust Deed and/ or Trust Act are not capable of being adjudicated by an arbitrator despite existence of an arbitration agreement between the parties.

Brief Facts of Vimal Case:

• A private trust deed was executed in favor of six minor beneficiaries in 1983 ("Trust Deed"). Under the Trust Deed, two trustees were appointed to manage the affairs of the Trust. The Trust Deed also provided for an arbitration clause.
• Since 1990, certain differences arose amongst the beneficiaries. The arbitration clause in the Trust Deed was invoked by them and subsequently, an application for appointment of Arbitrator under Section 11 of the Arbitration and Conciliation Act, 1996 ("Arbitration Act") was preferred by some of the beneficiaries ("Section 11- Application").
• The said Section 11- Application was contested inter alia on the ground that the said Application is not maintainable as the beneficiaries having not signed the Trust Deed, they cannot be termed as 'parties' to such Trust Deed and nor can such Trust Deed be termed as an arbitration agreement within the meaning of Section 2(b), 2(h) and Section 7 of the Arbitration Act.
• The Bombay High Court allowed the Section 11- Application and appointed a sole arbitrator for adjudication of disputes. Aggrieved by the order one of the parties preferred an appeal before Supreme Court.
  

Issues for Determination: The following issues cropped up before the Supreme Court for its determination:

• Whether an arbitration clause in a Trust Deed constitutes a valid arbitration agreement under provisions of the Arbitration Act?

• Whether disputes relating to the management of Trust are capable of being settled through arbitration?

Judgement and Analysis:

Trust Deed and Arbitration

With regards to the validity of arbitration clause in a Trust Deed, the Supreme Court held that an arbitration clause in a Trust Deed does not constitute a valid arbitration agreement as required under Section 2(b) read with Section 7 of the Arbitration Act. The SC placed reliance on its own judgment in Vijay Kumar Sharma case (2010 (2) SCC 486, 2010 (1) SCR 582) ("Vijay's Case"). In this case, a similar question arose as to whether a clause in a Will which provided for settling disputes by an arbitrator in respect of bequeathed property would constitute a valid arbitration agreement or valid arbitration Clause. It was held that in no case an arbitration clause in a Will constitutes a valid arbitration agreement. It was further held that such a clause is a unilateral declaration by the testator.

While comparing the Trust Deeds with Will of the Testator, the Supreme Court opined that principles laid down in Vijay's case must be made applicable to an arbitration clause in a Trust Deed, in the light, that, in both the cases it is the Settlor / Testator who signs the document alone in favour of Beneficiaries / Legatees, the Beneficiaries / Legatees are not required to sign the document and hence they are not regarded as party to such deed or an agreement between such parties.

The Supreme Court while deciding the issue also placed reliance on a judgment of Honorable Calcutta High Court in Bijoy Ballav Kundu’s case (AIR 1965 Calcutta 628) ("Bijoy Case"). In this case, an Arbitration clause in a Trust Deed was invoked and an award was passed. The legality of Award was challenged in the Civil Court. The same was set aside by the Civil Court. An appeal was preferred to the Calcutta High Court. The Calcutta High Court analysed that for a valid agreement there must be a proposal and an acceptance. It further held that by accepting a trust, a trustee merely undertakes to carry out obligations of managing a trust. In accepting the Trust, the trustees are bound to follow the provisions of the Trust Deed whether or not they accept the clauses of the Trust Deed.

The Supreme Court, applying the principles in Bijoy’s Case, opined that, the concept of proposal and acceptance which are integral conditions of a valid agreement are not required in the case of a Trust. Although the Trustees accept the creation of the trust, they merely undertake to carry out the terms of Trust Deed. Such terms are mere directions in respect of how the affairs of the Trust are supposed to be managed. It cannot be said that the Trustees or beneficiaries have agreed amongst themselves as to how they should spend the money or manage the Trust. The Supreme Court held that the Trusts Act provides a forum for redressal of grievances and the same should be strictly interpreted.

Management of Trust | Settled through Arbitration

Supreme court held that the disputes relating to trust, trustees and beneficiaries arising out of the Trust Deed and the Trust Act are not capable of being decided by an arbitrator despites existence of arbitration agreement to that effect between the parties. The Supreme Court placed reliance on another of its own judgement in the Booz Allen case (2011) 5 SCC 532 ("Booz Case") wherein, the following six categories of disputes were held to be non-arbitral disputes which include (i) rights and liabilities arising out of or giving rise to criminal offences; (ii) matrimonial disputes; (iii) guardianship matters; (iv) insolvency and winding up; (v) testamentary matters; (vi) eviction or tenancy matters where tenants enjoy statutory protection.

The Supreme Court opined that the Trusts Act specifically confers jurisdiction on civil courts to redress grievances in the respect of Trusts and hence the same cannot be decided by an arbitrator under the Arbitration Act. Finally, the Supreme Court laid down an additional seventh category of disputes that are non-arbitral namely, cases arising out of Trust Deed and Trusts Act.

MHCO COMMENT

Many countries across the globe are considering the introduction of arbitration provisions in trust laws. Although strictly speaking, the Trust Deed cannot be considered as an agreement as rightly laid down by the High Court, however, a liberal approach and modification must be followed in the sense that benefiting from the trust may be deemed an agreement to submit to arbitration. However, until then, in the light of the above judgment, disputes relating to trusts are non-arbitral in India.