Summary: This blog examines the concept of “deemed public company” and recommends changes in the legal architecture to deal with large private companies with significant exposure to public funds.
Introduction and Objective
The distinction between public and private companies has been the central theme of Indian corporate law. Traditionally, private companies have very light-touch regulations in relation to their corporate structuring, management, establishing transfer restrictions, compliance requirements, and regulatory oversight, whereas public companies have stricter compliance burdens, regulatory oversight, and governance norms due to their ability to access public funds.
The rationale for this distinction was that while private companies, being closely held entities with restricted membership, posed limited systemic risk, public companies, with their wider shareholder base and public fundraising capabilities, warranted closer supervision by the regulator to protect investor interests.
It was found that many corporates were misusing their “private company” status and operating in a manner akin to public companies. They had substantially grown in size using public funds and created a complex corporate structure to retain control and influence, ultimately enjoying the lighter regulatory regime meant for small closely held businesses.
It was this practical complexity and misuse of the legal status of “private company” that prompted the need to introduce the concept of deemed public company (“DPC”) to bridge the regulatory gap. This blog analyses the evolution of the concept of DPC from the Companies Act, 1956 (“1956 Act”), to the Companies Act, 2013 (“2013 Act”), and discusses the relevance and need for reimagining the concept in the current legal/economic environment.
The Legislative Journey: From Innovation to Abolition to Revival
The concept of DPC was first introduced in 1960 through Section 43A in the 1956 Act. The legislature had recognised that certain private companies had outgrown their classification and needed to be subjected to public company regulations. Through the introduction of DPC, the legislature aimed at creating the concept of hybrid companies, a type that was a mix of both private and public companies.
As per Section 43A of the 1956 Act, a private company would be deemed to be a public company if at least 25 percent of its share capital was held by one or more public companies. The proviso to the section also provided that when such private companies would be deemed to be public companies, they could continue to maintain restrictions on share transfer in their articles of association and even have less than seven members. Therefore, the intent of the section was to only subject such companies to higher compliance requirements of a public company while still being able to maintain the operational flexibility of a private company, including, inter alia, restrictions on free transferability of shares. This would ensure that such companies met enhanced regulatory oversight based upon their scale and public impact.
An amendment to Section 43A in 1974 introduced a turnover threshold, wherein a private company exceeding the prescribed turnover threshold, i.e., INR 25 crores, would also be deemed to be a public company. A significant change came with the Companies (Amendment) Act, 2000, which rendered the entire section inapplicable, thereby effectively abolishing the concept of DPC.
However, though in a more diluted form, the concept of DPC was revived in the 2013 Act, through Section 2(71), which defines public companies and states that private companies which are subsidiaries of public companies would be deemed as public companies. This revival of the section acknowledged that certain private companies, particularly the subsidiaries of public companies, required enhanced oversight regardless of their incorporation as a private company.
Confusion Caused by Inadequate Drafting
The character and nature of a DPC assumes importance when viewed in the light of compliance under the 2013 Act and the regulations thereunder. Under the 2013 Act, a public company is, inter alia, required to:
- have a minimum of seven members, under Section 3 of the 2013 Act;
- have a minimum of three directors, including at least one woman director, under Section 149(1) of the 2013 Act; and
- provide for free transferability of shares, under Section 58(2) of the 2013 Act.
As there is limited jurisprudence relating to DPCs under the 2013 Act, the jurisprudence under the 1956 Act may prove useful in understanding whether a DPC is required to comply with the above requirements.
Under the 1956 Act, the Supreme Court clarified that a DPC could incorporate restrictions on the right to transfer shares in its articles of association. Importantly, it also held that the number of members in a DPC could be fewer than seven.[1] This holding may stem from the fact that the proviso to Section 43A (1A) of the 1956 Act expressly provided for both membership falling below seven and restriction on the shareholders’ right to transfer shares. However, since the 2013 Act omits such a provision, it is unclear whether this omission reflects a legislative intent, thereby necessitating clarity on whether such compliances are to be done by a DPC under the 2013 Act.
From a constitutional perspective, the Supreme Court in Darius Rutton Kavasmaneck v. Gharda Chemicals Limited held that “The fundamental right to form an association implies the right to form the association on such terms and conditions are not in conflict with any law or public policy. No doubt, the State can, by law, impose restrictions on such rights on the basis of the considerations mentioned in Article 19(4), but such restrictions must be reasonable.”[2] Thus, it appears that DPCs may still restrict share transferability in the absence of a specific provision providing for free transferability of the shares of DPCs under the 2013 Act.
With respect to the requirement of having at least three directors, there is scarce jurisprudence in relation the compliance obligations for DPCs. However, a combined reading of Section 2(71) and Section 149(2) of the 2013 Act suggests that DPCs should appoint at least three directors under the 2013 Act. Unlike transfer restrictions, this requirement does not appear to raise any constitutional concerns. This aspect needs to be clarified in the next round of amendments to the 2013 Act.
Reimagining Legal Architecture
In light of the foregoing, we recommend broadening the scope of the current law by introducing additional criteria under which private companies may be treated as public companies for compliance requirements under the 2013 Act.
First, to prevent holding companies with listed subsidiaries from indirectly controlling the public funds and to safeguard such interests, private companies with one or more listed subsidiaries can be brought within the fold of DPCs.
Second, drawing from the RBI’s scale-based regulation for NBFCs,[3] private companies that meet certain thresholds for asset/net worth size and borrowings from public institutions could be treated as DPCs. To ensure continued flexibility for borrowings to meet legitimate business needs, the government may consider allowing companies to maintain a debt-to-equity ratio of 1:1, subject to an overall cap of INR 250 crores, beyond which such companies should be deemed as public companies.
The present language of Section 2(71) of the 2013 Act leaves little scope for prescribing the above criteria by way of delegated legislation. Given the need to revise these criteria in a dynamic world, it is advisable that this provision be suitably amended to enable the Ministry of Corporate Affairs (“MCA”) to fix and revise these norms from time to time. In the interim, the MCA may notify rules under Section 129A of the 2013 Act[4] by mandating private/unlisted companies meeting prescribed thresholds to prepare, audit, and file their financial statements with the Registrar of Companies on a half-yearly basis.
Conclusion
While there are many private companies that are small and closely held with limited public exposure, there are also those that control large business empires of listed companies and have systemic risk due to borrowings, operations, and public interest attached to them. For such private companies, lawmakers need to reimagine the legal architecture. While the changes proposed in this blog may seem to dilute the advantages of being a private company, in fact, they ensure that companies of a certain scale and significance are subjected to greater regulatory supervision and disclosure requirements. This would strike a healthy balance between ease of doing business and protecting stakeholder interests, rendering greater flexibility and transparency without restricting legitimate business activity.
[1] Needle Industries (India) Pvt. Ltd. v. Needle Industries Newey (India) Holding Ltd., (1981) 3 SCC 333, para number 147 and 148.
[2] Darius Rutton Kavasmaneck v. Gharda Chemicals Ltd., (2015) 14 SCC 277, para number 44 and 45.
[3] Annexure 1, RBI Master Directions on NBFCs, 2023.
[4] Inserted vide Companies (Amendment) Act, 2020.