Summary: The Companies Act, 2013, imposes absolute structural restrictions on most classes of companies (barring a few) from having more than two layers of subsidiaries. This blog analyses whether such absolute restrictions will meet the test of proportionality laid down by the SC, considering that prima facie such restrictions violate the fundamental right to carry on any occupation, trade or business.
Background
The 2001 Stock Market Scam (Ketan Parekh Scam) led to the appointment of a Joint Parliamentary Committee (“JPC”), which recommended steps to prevent companies from using the subsidiary route to siphon off funds by providing intercorporate loans. Further, to ensure that complex corporate structures are not used to bypass regulatory restrictions, the Ministry of Corporate Affairs (“MCA”) in the Companies Bill, 2009, proposed a statutory cap on the number of layers of subsidiaries permitted for a holding company. Additionally, it was also proposed under Section 186(1) of the Companies Act, 2013 (“Act”), that a company cannot have more than two layers of investment companies. The Parliamentary Standing Committee (“PSC”) on Finance, in its 57th Report, submitted to the Government in 2012, supported MCA’s proposal to impose a two-layer limit for investment subsidiaries. Basis the recommendations of the PSC, the Act also introduced a proviso in the definition clause of ‘subsidiary’ under Section 2(87) as under:
“Provided that such class or classes of holding companies as may be prescribed shall not have layers of subsidiaries beyond such numbers as may be prescribed.”
Expert Committee’s Recommendations
Interestingly, two expert committees: (i) J. J. Irani Committee, 2005, and (ii) Company Law Committee, 2016 (“CLC”), recommended against imposing such layering restrictions, and instead favoured disclosure-based approach over structural restrictions.
The J. J. Irani Committee in its report concluded that: “The Committee noted that these recommendations were in context of the stock market/ banking scams witnessed in India over the past decade. At the same time, it was argued that the creation of subsidiaries for separate manufacturing entities, joint ventures was a reality and there were no restrictions on foreign companies operating internationally… For these reasons, the Committee took the view that limiting the layers of subsidiary investment companies was not feasible. Instead, a regime for preventing misuse of this mechanism should be devised based on transparent Board processes and disclosures under close supervision of the regulator for listed companies.”
The CLC, in its 2016 report, made a similar recommendation, which stated that: “The Committee noted that this provision was included to address practices of creating subsidiaries aimed at making it difficult to trace the source of funds and their ultimate use, and reduce the usage of multiple layers of structuring for siphoning off of funds, and that the same was incorporated in the Act in the wake of various scams in the country. However, this could hit legitimate business structuring…. The Committee, therefore, felt that while the proviso to Section 2(87) has not yet been notified, it was likely to have a substantial bearing on the functioning, structuring and the ability of companies to raise funds when so notified and hence recommended that the proviso be omitted.”
It is also interesting to note that basis the 2016 CLC Report, Companies (Amendment) Bill, 2016 was introduced in the Parliament on March 16, 2016, to remove the layering restrictions under Sections 2(87) and 186(1) of the Act. However, when the Bill was referred to the PSC, the restrictions were reintroduced without any explanation for rejecting the CLC’s recommendations. Subsequently, on September 20, 2017, the Companies (Restriction on Number of Layers) Rules, 2017, were notified. Accordingly, all classes of company had to adhere to the absolute structural restrictions of not more than two layers of subsidiaries from the notification date with exemption being given only to banking companies, systemically important NBFCs, insurance companies and government companies. Additionally, structures existing on the date of notification were grandfathered. The authors could not find any rationale for restricting the number of layers to ‘two’ and it appears to have been fixed arbitrarily.
International Position
Our research suggests that apart from India, only Israel has imposed such restrictions on the number of layers. Even Israel has imposed such restrictions only on publicly traded companies. However, India imposes such restrictions on any class of companies — listed and unlisted, as well as public and private.
Is the restriction constitutionally valid?
Article 19(1)(g) of the Indian Constitution guarantees the right to practice any profession, occupation, trade or business, including the right to incorporate a company and conduct its affairs, subject to the reasonable restrictions prescribed under Article 19(2) and 19(6) of the Indian Constitution. Article 19(6) prescribes that the state can enact laws restraining the right under Article 19(1)(g) if it is in the public interest. Although the Constitution does not mandate the restrictions to be proportionate, the judicially created test laid down in K.S. Puttaswamy v. Union of India[1] has been applied in interpretation of multiple fundamental rights, including rights enumerated under Article 19 of the Indian Constitution (for instance, the Electoral Bonds case[2]).
The four limbs of the Proportionality test state that the measure taken by the State (a) shall have a legitimate aim; (b) shall have a rational connection with such aim; (c) is the least restrictive measure among alternatives; and (d) strikes a balance between fundamental right and pursued public purpose.[3]
The cap on the number of layers of subsidiaries was intended to simplify tracking the origin and final use of funds, and limit the use of multiple layers for siphoning off funds, which was certainly a legitimate aim. It may be argued that there is some rational connection between limiting the number of layers and preventing diversion of funds even though there are valid counterarguments for the same. In arguendo, even if the first two prongs of the proportionality test are satisfied, adequate disclosure and reporting standards may serve as a less restrictive alternative to layering restrictions and prove equally effective. An increased compliance is in any case less restrictive than an explicit restriction on corporate structuring. The fact that there was no rationale provided for limiting the number of layers to two (2), buttresses the argument that other options might not have been considered, which prompts questions about whether the current framework truly represents the least restrictive alternative.
Further, globalisation of businesses has led to complex corporate structures being used to meet the requirements of different jurisdictions and hence flexibility in structuring is an important aspect of the right to carry on trade and business. It can be argued that if a balance has to be struck between restrictions and fundamental rights, such a balance should tilt heavily in favour of a more flexible regime, as the layering restrictions have had limited efficacy in curbing diversion of funds and has in fact had a countervailing economic impact.
Lastly, it may be argued that as most other countries do not impose such restrictions, these restrictions put India Inc. at a competitive disadvantage.
Concluding Thoughts
The empirical evidence suggests that layering restrictions introduced since 2017 have not really achieved their objective and have in fact created serious obstacles in structuring of M&A transactions and fund raising. Inadequate drafting of rules has resulted in many interpretative challenges and has created serious impediment in carrying out legitimate business activities. While no one, so far, has challenged the constitutional validity of layering restrictions, the authors are of the view that if these rules were to be challenged, there is a high probability that constitutional courts of this country will strike down these rules as they are disproportionate and violative of the fundamental right to carry on trade and business. It is, therefore, advisable that the MCA should seriously re-examine the necessity of such restrictions and achieve the same objective by providing adequate disclosure requirements. Mandatory consolidation of financial statements of the holding and subsidiary companies under Section 129 of the Act has largely resolved the problem.
[1] K. S. Puttaswamy v. Union of India, (2017) 10 SCC 1.
[2] Association for Democratic Reforms (Electoral Bond Scheme) v. Union of India, (2024) 5 SCC 1.
[3] Para 252, Association for Democratic Reforms
