RISKS OF FIRM OWNERSHIP AND MANAGEMENT STRUCTURE

Prof. Anil B. Suraj, IIMB

The basic principle that guides regulation of business entities in India can be summed up

as – wider the investor base, the greater the regulation. This form of proportional regulation is

evident in terms of the disclosure requirements, and the compliance frequency and monitoring

of ongoing activities. While it is not mandatory to pursue business interests only through a

registered entity, it is most certainly advisable and preferred, more so for business reasons, than

legal. A number of business factors are relevant to determine the ideal/optimal form of entity to

do business. The functional or operational flexibilities required; the ‘entry’ and ‘exit’ norms and

regulations; the need to attract and sustain investor interest; to leverage credibility-based

finance options; to attract and retain the best human talent; among other such various factors

may need to be evaluated.

The following are the different forms of business entities that are possible options to

consider in the Indian context:

1. General Partnership – perhaps the oldest form of doing business, a general partnership

is the most facilitative of all forms of business entities. Governed by the Indian Partnership

Act, 1932, it provides an enabling regulatory framework by recognizing the

contractual/partnership deed between the partners as the primary basis of governance

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 and accountability. In fact, a general partnership could even exist “at-will”, which means

there need not even be a contract/deed of terms and conditions between the partners,

in which case it would be considered as an unregistered “association of persons”. The

maximum number of partners for a general partnership has recently been raised from 20

to 100 (as notified by the new Companies Act, 2013). However, the major limitation of

this form of partnership is that every partner is ‘jointly and severally’ (individually) liable

for “all acts of the firm done while he is a partner” (Section 25 of the Indian Partnership

Act, 1932). The basic tenet of general partnerships is that each partner is an agent of the

other partner, therefore, even if there is a wrongful loss caused to the firm by one partner,

all the other partners would also be subject to satisfy the firm’s liabilities, either

collectively or individually, whichever is found to be most feasible/convenient to the

creditor in the circumstances. This is the most intrusive form of personal and unlimited

liability, and indeed a major risk, thereby casting a shadow over this format, which

otherwise enjoys a fair degree of functional, operational and regulatory flexibilities.

2. Limited Liability Partnership (LLP) – It was only in 2009 that LLPs were given legal

recognition in India, but they seem to have become quite a rage in the past few years.

The rate of registration of new LLPs under the Limited Liability Partnership Act, 2008 has

been on an average over 1000/month in the last one year. A LLP retains all the operational

flexibilities of a general partnership, but excludes its all-pervasive form of liability. It

introduces the concept of a registered ‘body corporate’ and makes the firm to bear the

burden of liabilities and allows the partners to contractually agree on their share of profits

and respective contribution, if there are liabilities. This is turning out to be an excellent

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 mode of doing business where highly skilled professionals and consultants wish to come

together, especially to build and enable multi-disciplinary synergies. It is also observed

that most registrations of LLPs are taking place in Mumbai and Bangalore, which are

considered as epicentres of new-age economic activity in India. An additional advantage

is that there is no maximum limit on the number of partners, thereby not restricting the

aspirations of growth for the people involved in the firm’s business and making it more

participatory. The only drawback appears to be that LLPs are not seen to be the ideal

forms of businesses to attract investor/venture-capitalist attention. There could be a

couple of reasons for this. Firstly, most LLPs are people dependent and operate on a risky

basis of partners enjoying easy “entry” and “exit” norms (sometimes even pre-

determined); and secondly, an investor would also necessarily have to become a ‘partner’

as there is no concept of a ‘shareholder’, which means an investor who wishes to stay

away from day-to-day activities may not be able to keep an arm’s length from the

management, since the law, as well as the popular and external perception, treats all

partners similarly, irrespective of their role/status in the executive functions. The level of

regulatory filings and disclosure requirements may be classified as LOW.

3. Corporate formats – It was a decision of the UK Court of Appeal in 1897, in the matter of

Saloman v. Saloman, that the legal distinction of a shareholder from the incorporated

business entity was firmly established. Even to this day this concept has in many ways

been pushed to its limits of credibility in the face of many regulatory and governance

challenges.

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The new Companies Act, 2013 has established the National Companies Law Tribunal for

redressing issues of law and governance relating to the companies in a dedicated manner.

Indian laws, as evident in the new Companies Act, 2013, has adopted a whole lot of

principles of company law and governance. From the UK, the concept of “key managerial

personnel” has been now introduced into the Indian law, for identifying the category of

persons in the management who shall be primarily responsible for compliance and

governance of a company.

The age-old concept of “corporate criminal liability” is now adequately revisited in the

light of global trends. The Indian Supreme Court, while holding a Company liable for

committing the crime of cheating, quoted that – “There is no dispute that a company is

liable to be prosecuted and punished for criminal offences. Although there are earlier

authorities to the effect that corporations cannot commit a crime, the generally accepted

modern rule is that except for such crimes as a corporation is held incapable of committing

by reason of the fact that they involve personal malicious intent, a corporation may be

subject to indictment or other criminal process, although the criminal act is committed

through its agents.” [Iridium India Telecom Ltd. v. Motorola Inc., (2011)1 SCC 74]

The Indian Supreme Court has also been quite active in enlarging the scope for ‘piercing

the corporate veil’ and has held that – “Generally and broadly speaking, we may say that

the corporate veil may be lifted where a statute itself contemplates lifting the veil or fraud

or improper conduct is intended to be prevented or a taxing statute or a beneficent state

is sought to be evaded or where associated companies are inextricably connected as to

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be, in reality, part of one concern.” [Union of India v. ABN Amro Bank & Others, 2013(9)

SCALE 407]

While there are obvious legal and regulatory challenges, the different formats of

companies available to pursue the legitimate business and strategic interests are as

follows:

a. One-Person Company – the Companies Act, 2013 has now introduced the

possibility of a ‘One-Person’ Company in India. It provides for a single shareholder

and mandates only one Director for such Companies. While there certainly could

be many issues of credibility and challenges of effective governance, one-person

company format has certainly come as a boon to many indigenous and cottage-

industry businesses in India. Inclusivity and regularization of business activity has

taken a huge leap with the introduction of this format, and it is reported that more

than two thousand one-person companies have been registered in just over a

year. The level of regulatory filings and disclosure requirements may be classified

as LOW to MODERATE.

b. Private Limited – universally the most preferred mode of doing business is that of

a private limited company. It assures limited liability to its shareholders; provides

space for establishing a model balance of investor-ownership and professional-

management; and through a calibrated form of transparency also inspires

credibility in the eyes of external stakeholders, such as bankers, investors,

creditors, vendors, employees, among others. The new Companies Act has now

raised the maximum limit of shareholders from 50 to 200 as well, thereby

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 facilitating this format of doing business even further. The level of regulatory

filings and disclosure requirements may be classified as MODERATE.

c. Public Limited – the major advantage of this format over the private limited is that

there is no maximum limit on the number of shareholders and the shares are

freely transferable, though they cannot be offered to the public in general. This

form of doing business is usually subjected to HIGH levels of regulatory filings and

disclosure requirements and is therefore typically used as an intermediate step

towards the listing of the company.

d. Public (Listed) – The most regulated corporate entity in any legal system is a

company that is listed on a stock exchange, after having successfully made an

Initial Public Offer (IPO). The reason for the HEAVY level of quarterly regulatory

filings and wide ranging disclosure requirements is the need to maintain probity

for the benefit and protection of the vast community of retail investors and

members of the general public. The Securities and Exchange Board of India (SEBI)

is a dedicated regulator for all the Listed companies in India.

4. Special Purpose Vehicle (SPV) – SPV is a term that acquires the form and meaning

according to the context. It may refer to any of the above forms of entities of doing

business. It can also be a reference to ad-hoc formations like a joint-venture (JV) or a

public-private partnership (PPP).

In fact, in contrast to all the forms mentioned till now, a SPV can be a term to refer to

even a ‘not-for-profit’ form of entity too. In India, ‘not-for-profit’ entities may exist either

in the corporate form (under Section 8 of the Companies Act, 2013); as a Society or a

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 Cooperative Society (under the Societies Registration laws made by the respective

States/Provinces in this regard); or as a Trust with a dedicated endowment (under the

Indian Trusts Act, 1882). However, as is evident, a ‘not-for-profit’ cannot declare any form

of share in its profits or a dividend thereof, thereby restricting its ability to attract

monetary contributions.

Factors that may determine the choice of the business format:

1. Public participation – the ideal mode to enable wide participation by public/community

is through a ‘not-for-profit’ entity. It inspires collective leadership and ideological

ownership.

2. Establishing core talent pool – LLPs appear to be the preferred mode for bringing people

together to form core teams of expertise, especially across multiple domains.

3. Ownership-driven control – for greater level of stability, continuity and mission-mode

rigour, a private limited company format is best advised.

4. Credibility for large scale investments – to be transparent is the need of the day to attract

the various forms of investments – loans, credits, early-stage funding rounds, and venture

capital/angel investments. To aid in this process, while not compromising on the

operational flexibility and close control, a private limited company is best suited to

balance all these concerns adequately.

5. Regulatory and compliance costs – the one major drawback of a private limited company

is that a fairly significant level of financial and strategic information is to be mandatorily

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made public on an annual basis. In fact, thanks to big-data technologies, there are many

service providers who offer analytics based on such declarations made every year and

across regions and sectors. This level of regulatory and compliance requirements could

have inherent strategic costs.