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SELLING SHARES – WHETHER SELLING OF AN UNDERTAKING?
Corporate transactions often involve complex decisions and strategies that require strict compliance with legal provisions. One such crucial aspect is determining whether certain transactions necessitate special resolutions from shareholders. Among these transactions, the sale or disposal of a company’s assets or business operations is a significant area of focus.
In India, the Companies Act, 2013 provides a framework for governing corporate actions and safeguarding the interests of shareholders. Section 180(1)(a) of the Act is particularly noteworthy as it imposes restrictions on the board of directors regarding the sale, lease, or disposal of an undertaking. This provision mandates that such actions can only be undertaken with the approval of shareholders through a special resolution, which requires a three-fourths majority.
The term ‘undertaking’ is pivotal in understanding the scope of this provision. Section 180(1)(a) stipulates that the board’s powers to dispose of an undertaking are restricted, emphasizing the need for significant shareholder consent. However, the Act does not provide a direct definition of ‘undertaking’ in this context, leading to ambiguity and requiring judicial interpretation.
The significance of this provision becomes particularly pronounced in cases involving holding companies and their subsidiaries, especially in family-run or promoter-driven business structures. In such contexts, where a holding company might not have active business operations of its own but holds shares in subsidiaries that are operational, understanding whether the sale of these shares constitutes a ‘sale of an undertaking’ is crucial.
Definitions
Section 180 of the Companies Act, 2013 defines ‘undertaking’ to mean an undertaking in which the investment of the company exceeds twenty per cent of its net worth as per the audited balance sheet of the preceding financial year or an undertaking which generates twenty per cent of the total income of the company during the previous financial year; and the expression ‘substantially the whole of the undertaking’ in any financial year means twenty per cent or more of the value of the undertaking as per the audited balance sheet of the preceding financial year.
As per Section 2 (57) of the Act, the term ‘net worth’ is defined as the aggregate value of the paid-up share capital and all reserves created out of the profits, securities premium account and debit or credit balance of profit and loss account, after deducting the aggregate value of the accumulated losses, deferred expenditure and miscellaneous expenditure not written off, as per the audited balance sheet, but does not include reserves created out of revaluation of assets, write-back of depreciation and amalgamation.
The above provisions do not clarify whether sale of shares of a subsidiary or a downstream company would qualify as a ‘sale of an undertaking’.
Judicial Interpretation
In the case of P.S. Offshore Inter Land Services Pvt. Ltd. v. Bombay Offshore Suppliers and Services Ltd. [1992] 75 Comp Cas 583, the Bombay High Court offered a thorough interpretation of the term ‘undertaking’ as used in the Companies Act, 1956. The court clarified that ‘undertaking’ should be understood as the entire business unit or operation, encompassing all its components and assets, rather than just individual assets. The court indicated that the term ‘undertaking’ could include all or nearly all of the business’s assets. To determine if major capital assets constitute the undertaking, the key test is whether the business can continue to operate effectively after the assets are disposed of, or if only the residual shell of the business remains. The focus is on whether the disposed assets represent a significant portion of the company’s assets and are integral to the overall business.
According to Section 293(1)(a) of the Companies Act, 1956 corresponding to Section 180(1)(a) of the Companies Act, 2013, all capital assets of an undertaking collectively are considered the ‘undertaking,’ to prevent directors from evading the requirement for general body consent by disposing of the whole or substantially the whole of the business. If nearly all of the company’s capital assets are sold, leaving only a minimal remainder, it would be challenging to argue that only the assets and not the entire undertaking has been disposed of. Therefore, the court held that the board of directors cannot dispose of all the capital assets if it would deprive the company of its business or leave only a minimal part of it remaining. The court’s interpretation focused on whether the remaining parts of the business after the disposal would still allow the business to operate effectively. Thus, a sale of shares does not meet this criterion because it does not directly affect the operational unit or core business assets of the company.
In C.D.S. Financial Services (Mauritius) Ltd. v. BPL Communications Ltd. [2004] 56 SCL 665, the Bombay High Court noted that the law clearly requires a resolution to be passed in the general meeting of the company if the company plans to dispose of its undertaking. However, the court found that the business in question remained with the subsidiaries, meaning that even if shares were sold, the core business continued to be owned by the same group of companies.
The court also acknowledged that, although in some cases, especially within corporate groups, there might be a tendency to treat related companies as a single economic entity, the language of Section 293(1)(a) does not require such an approach. It does not compel lifting the corporate veil to treat the companies as a single entity. The court concluded that selling shares does not equate to selling an undertaking or a significant part of the business, and thus, the specific Section of the Companies Act did not apply to the sale of shares in this case.
In Brooke Bond India Ltd. v. U. B. Ltd. [1994] 79 Comp Case 346, the Bombay High Court held that the sale of shares, whatever be their number, even if it amounts to a transfer of the controlling interest of a company, cannot be equated with the sale of any part of the ‘undertaking’ so as to come within the purview of Section 293(1)(a) of the Companies Act, 1956 corresponding to Section 180(1)(a) of Companies Act, 2013.
In Tracstar Investments Limited v. Gordon Woodroffe Limited and Others [1996] 87 Comp Cas 941 (CLB), the Company Law Board (CLB) examined whether the sale of shares could be classified as a sale of the company’s entire business or “undertaking.” The petitioners contended that since the shares were the only assets of the company, their sale should be regarded as the sale of the company’s undertaking. They argued that this would necessitate compliance with Section 293(1)(a) of the Companies Act, which requires special resolution for the sale of an undertaking, and any non-compliance would render the sale illegal.
However, the CLB rejected these contentions. The Bench applied the PS Test, which assesses whether the company can continue to operate effectively after the sale of its major assets. In this case, the CLB found that although the sale of shares might temporarily halt the company’s main business activities, it would not preclude the company from resuming business operations in the future. The Bench also noted that according to the company’s memorandum of association, its primary business did not involve merely investing in shares of other companies.
Thus, the CLB concluded that the sale of shares does not constitute a sale of the company’s undertaking. The company could still function and pursue its business objectives, and hence, the sale of shares does not meet the criteria of selling the company’s undertaking as outlined under Section 293(1)(a) of the Companies Act.
In the case of Principal Commissioner of Income Tax – 16 v. UTV Software Communication Limited, the Bombay High Court differentiated between the terms “transfer of shares” and “transfer of an undertaking” under the Income Tax Act, 1961. The court ruled that a transfer of shares cannot be equated with a slump sale of an undertaking as defined under Section 2(42C) of the Act. The court referred to the Income Tax Appellate Tribunal’s (ITAT) decision, which it ultimately upheld. In reaching its conclusion, the ITAT had relied on the Supreme Court’s judgment in Bacha F. Guzdar v. CIT, where it was noted that a shareholder’s interest, whether individually or collectively, amounts only to the right to share in the company’s profits. The company itself, as a separate legal entity, owns the property, not the shareholders.
Conclusion
The analysis of judicial precedents and legislative definitions reveals a consistent interpretation that the sale of shares does not qualify as a ‘sale of an undertaking’ under Section 180(1)(a) of the Companies Act, 2013. Judicial precedents have clarified that there is a significant distinction between selling operational business assets and transferring share ownership. The legislative intent behind Section 180(1)(a) is to ensure that major disposals of business assets are not executed without proper authorization from shareholders, thereby safeguarding the company’s operational integrity and ensuring that such decisions receive adequate approval.
The case law and legislative context discussed strongly suggest that shares do not fall within the definition of an ‘undertaking’ as contemplated by Section 180(1)(a). Consequently, the law does not mandate shareholder approval by special resolution for the sale or disposal of shares, even if it exceeds the numerical thresholds prescribed under the Explanation to Section 180(1)(a).
However, it is important to note that Section 180(1)(a) lacks a specific definition of what constitutes an ‘undertaking’. The introduction of numerical criteria under the Explanation to Section 180(1)(a) has not resolved the ambiguity surrounding the term ‘undertaking’. This absence of clarity has perpetuated the debate over the precise scope and definition of the term within the context of the section.
Abhinaba Datta, Associate under assistance of Rohit Kaushik, Senior Associate