Legal Pre-Incorporation Compliances

Legal Pre-Incorporation Compliances

Author: Dhruv Suri, Partner PSA

The process of economic reforms in India was initiated in 1991. Since then there has been a constant endeavor to create a foreign investor friendly climate by simplifying procedures for entry and operations. This chapter provides a brief overview of Indian laws that should aid German start-ups to evaluate their India strategy from a legal and compliance perspective viz.

– choice of entity
– certain company law provisions
– Incentives to start-ups in India

 

1.0 Entry Options

A foreign investor may establish an entity in India depending on the nature of activities envisaged and the prevailing government policy in the proposed sector of investment. Broadly there are two types of vehicles that can be used for carrying on business (a) incorporated entities, namely, wholly-owned subsidiaries and joint venture companies which may be either public or private companies; and (b) unincorporated entities, namely, liaison and branch offices. These options are discussed below briefly:

1.1 Incorporated entities

These include corporations duly incorporated under the Companies Act, 2013.
The government permits setting up of a Wholly-owned subsidiary (WOS) in certain sectors like mining and exploration, petroleum and natural gas, greenfield civil aviation projects, non-scheduled air transport services, information technology, development of integrated township, establishment and operation of satellites, cash & carry wholesale trading, e-commerce activities, greenfield pharmaceutical activity, mass rapid transport services under the automatic route. In certain other sectors such as private sector banking, multi-brand retailing, foreign direct investments (FDI) up to 100 percent foreign equity may be inducted with prior approval of the concerned Administrative Ministry/Department. The obvious advantages of a WOS are, total control over funding, management and profit share of the business. However, the flip side is that in a WOS, where the total management is foreign, advantage of local knowledge is absent.
A joint venture is a popular route for FDI into India either because of the existing sectoral caps in certain areas of investment or it may be the preferred strategy for the foreign investor on account of local knowledge and expertise available through a domestic partner. The joint venture company into which investment is proposed may be an existing Indian company already in business or a new company in which both the foreign investor and the Indian partner acquire an equity stake. Joint venture agreements typically include provisions for resolving deadlocks between venture partners, exit options, equity participation by local and foreign investors, composition of the board and management

1.2 Unincorporated entities

These include the entities duly formulated for specific purposes and are regulated by the Indian federal bank i.e. the Reserve Bank of India (“RBI”).
In certain situations, where the foreign entity would like to assess the market in India, it may consider establishing a liaison/Representative office. A liaison office requires light structural setup and represents a place of business in India for the parent company. The liaison office can facilitate technical/financial collaboration between the foreign parent and Indian companies as well as promote exports to and imports from India. Such an office is not permitted to engage in any trading or commercial activity and the overseas head office, through remittances, meets all its expenses. German entities having a profit making track record for preceding 3 years are eligible for establishing a liaison office.
If the foreign entity envisages a greater presence in India and is keen to undertake activities (manufacturing/trading) of the head office in India, then it may consider setting up a branch office. A branch office is not a separate legal entity unlike a company and any liability of the branch would be the liability of the foreign entity. The purpose for which a branch office can be established includes export-import of goods, rendering professional/consultancy services, carrying out research work for the parent company, promoting technical/financial collaboration, representing and acting as the buying and selling agent for the parent company, rendering information technology, software development and other technical services. Although a branch office is not allowed to carry out manufacturing activities on its own, it is permitted to subcontract.

 

2.0 Company law

All companies in India are incorporated under and governed by the Companies Act 2013 (“the Act” in this section).

2.1 Types of companies

The Act provides for incorporation of different types of companies, the most popular ones engaged in commercial activities being the private limited and public limited companies (liability of members being limited to the extent of their shareholding). Since private companies have lesser day-to-day to compliances, it is usually the most preferred mode of doing business in India. India also has entity forms like limited liability partnerships, one-person company, etc., but these are not preferred in the start-up ecosystem, especially where the founders are looking to raise external capital. Therefore, a private company is the ideal entity structure for most foreign start-ups looking to do business in India.These are described below:

2.1.1 Private company

To incorporate a private limited, a minimum of 2 shareholders and 2 directors are required. However, it cannot have more than 200 shareholders and 15 directors. In case these thresholds are crossed, a private company would be deemed as a public company. Further, at least 1 director has to be an Indian resident. This is an important aspect for German start-ups to keep in mind.

Broadly, a private company:
– restricts the right to transfer its shares;
– prohibits any invitation to the public to subscribe for any of its shares or debentures.
The balance sheet and profit and loss account of the company has to be filed with the Registrar of Companies (“ROC”). Any person can inspect the profit and loss accounts of the company filed with the ROC upon payment of prescribed inspection fees.

2.1.2 Public company

A public company has a minimum of 7 shareholders and 3 directors. Like a private company, there cannot be more than 15 directors and at least 1 of them must be an Indian resident. A private company, which is a subsidiary of another company, not being a private company, shall be a public company and accordingly, must comply with the requirements of the Act as are applicable to a public company.
The profit and loss accounts, balance sheet, along with the reports of the directors and auditors, of a public company, are required to be filed with the ROC and are available for inspection to the public by paying prescribed inspection fees. Listed public companies are additionally regulated by the SEBI and have listing agreements with the respective stock exchange(s) on which they are listed.

2.2 Incorporation documents

The Memorandum of Association (“MoA”) and the Articles of Association (“AoA”) regulate the conduct of a company as its charter documents and are publicly available for inspection on the payment of a nominal fee. Shareholder agreements (“SHA”) regulate the relationship between shareholders and the company and are private documents. While it is not mandatory to execute SHAs, we highly recommend this, should German companies look to partner with their Indian counterparts.
MoA is one of the charter documents of the company. It predominately details the authorized capital and the main business objects that the company can carry out. The business objects must be broadly worded so that the activities carried out by the company are never outside its scope. If there is any lapse, the directors of the company can be made personally liable for losses incurred by the company while running any “unauthorized” business.
AoA is the other charter document which captures all governance related provisions. It regulates the internal management of the company. For instance, it details how meetings ought to be held, how decisions ought to be approved, what happens in instances of a deadlock, whether certain actions taken by the board would be permissible or not, etc. In essence, it is important for the directors to ensure that any decision or the manner of taking any decision by taken is consistent with the AoA of the company. Key terms of any SHA also have to be incorporated in the company’s AoA to make them legally enforceable.

2.3 Shareholders meetings

There are two types of shareholders meetings; Annual General Meeting (“AGM”) and Extraordinary General Meeting (“EGM”).
Companies are under a statutory obligation to hold an AGM every year. The first AGM has to be convened within nine months from the date of closing of first financial year of the company i.e. March 31. Subsequently, AGM must be conducted in such manner that a period of not more than fifteen months lapses between two AGMs and within six months from the closing of every financial year. A notice informing the date, place and agenda of the meeting has to be given to the members, directors and the auditors of the company.
The board of directors are authorized to call an EGM on their own or on a requisition made by the members, provided the members demanding the requisition hold not less than one-tenth of the paid-up capital of the company. The board has to call the meeting within twenty one days of deposition of valid requisition. If the board fails to do so, then the requisitionists may call the meeting themselves.

2.4 Management

The Act lays down specific provisions with respect to managing the affairs of a company so as to protect the interest of its shareholders and investing public.

2.4.1 Directors

Directors are trustees and agents of a company and are obliged to act in the company’s interests. Board of directors has the power to take decisions on behalf of the company provided these decisions are compliant with the AoA. Consequently, all directors are collectively responsible for a company’s non-compliance. However, a director is absolved of liability if the non-compliance has occurred without his or her consent or knowledge. In fact, as per the Act, a director may be imprisoned for certain non-compliances such as failures in (i) filing annual returns, (ii) maintaining true and fair financial accounts, (iii) obtaining approval from board of directors prior to entering in transactions with related parties and (iv) disclosing interest in another entity.
Unlike a lot of other jurisdictions, there is no mandatory requirement for Indian companies to appoint a Managing Director, Chief Executive Officer, etc. However, if and when such persons are appointed, it is important that the provisions of the Act are followed.

2.4.2 Board meetings

Upon incorporation, a company must hold its first board meeting within thirty days from the incorporation date. Thereafter, board meetings are required to be held at least once in every one hundred and twenty days and at least four such meetings must be held in every year. Directors can convene board meetings by giving a 7 day notice to all directors detailing the time, place, venue and the business to be transacted at the meeting. Directors can participate and vote in Board Meetings through video-conferencing or other audio-visual means. Decisions at board meetings are through a simple majority, unless the AoA provides otherwise.
The board can exercise a number of powers at a meeting, by way of a resolution, namely: make calls on shareholders in respect of money unpaid on their shares and to forfeit shares in case of non payment; make contracts, execute negotiable instruments and borrow money on behalf of the company; invest up to specified limits in the shares of other companies; authorize buy-back of company’s shares; declare interim dividend; issue debentures; invest the funds of the company; make loans, guarantee or provide security for loans; approve amalgamation, merger, takeover or reconstruction; diversify business of the company; make political contributions; appoint or remove key managerial personnel or take note thereof; appoint internal and secretarial auditor; note disclosure of director’s interest and shareholding; buy or sell investments of the company up to prescribed limits; invite or renew public deposits and review or change existing terms and approve quarterly, half-yearly and annual financial statements and results of the company
The board may delegate its powers to borrow, invest funds and make loans up to certain specified limits and subject to conditions, as it may deem fit, to the committee of directors or the managing director or any principal officer of the company.

2.5 Resolutions

It is a formal expression of an opinion adopted by votes and a formal record of the action taken by the shareholders and the board of directors of a company. Resolution at a board meeting is passed by simple majority. Resolution is passed at a shareholders meeting as either an ordinary or a special resolution.
Ordinary resolution, to be passed, requires a simple majority of members who are present and entitled to vote on the resolution. This shall also include the vote of the chairman of the company, if appointed. Voting on this resolution is generally done by show of hands (voting by poll is the other option that can be exercised) by the members present personally or by proxy and each member has one vote irrespective of the shareholding. The resolution passed by the majority is legally binding upon the minority and the company.
A resolution is a special resolution when the notice calling the general meeting or other intimation given to the members specifically mentions the same. Such a resolution, in order to get passed, requires that the number of votes (whether on show of hands or poll) cast by the members in favor of the resolution (by voting or by proxy) exceed three times the number of the votes, if any, cast against the resolution. Some of the actions which require a special resolution are alteration of the memorandum/articles of the company, change of name of the company and reduction of share capital.
For cases where certain important resolution(s) has/have to be passed urgently for effective functioning of a company and it is not convenient for the directors to hold a board meeting, the option of passing of a board resolution by circulation has been provided for under the Act.

2.6 Audit of accounts

Auditors of a company are appointed for a term of five years in AGM through an ordinary resolution. Subsequently, their appointment is ratified in every AGM during the five year term. The company, in a general meeting, may remove auditors before the expiry of their term by circulating a special notice, passing a special resolution and seeking prior approval from the Central Government. Auditors are required to make a report to the members of the company in respect of the financial statements (balance sheet, profit and loss account, cash flow statement, statement of changes in equity if applicable and notes) examined by them at the end of each financial year.

 

3. Incentives for Start-Ups in India

Any Indian entity (regardless of whether it is a subsidiary of a foreign company) shall be eligible to be recognized as a “Start-up” if it satisfies three ingredients: (i) it’s turnover does not exceed €3.1 million, (ii) 7 years have not passed since its incorporation and (iii) it is engaged in working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation. In order to be recognized as a “Start-up”, the Indian entity shall have to make an online application over the mobile app or portal set up by Department of Industrial Policy and Promotion. After obtaining recognition, the Indian entity shall be eligible for various benefits such as (i) tax holidays for three consecutive financial years and (ii) exemption from inspections under 6 Indian labour laws.