In common parlance, transactions entered in the “ordinary course of business” include transactions carried out in the day-to-day course of business to further the company’s business, in line with its charter documents. Black’s Law Dictionary defines ordinary course of business as “normal routine in managing trade or business”.The Law Dictionary defines the phrase as “those activities that are necessary and normal”. Despite frequent usage of the phrase in numerous legislations and mergers and acquisitions agreements (“M&A Agreements”), its interpretation remains a matter of debate. An assessment of whether a transaction is in the ordinary course of business can differ on a case-to-case basis.
Ordinary course of business under the Companies Act, 2013
The Companies Act, 2013 (the “Act”) uses the term “ordinary course of business” in the context of provision of financial assistance (Section 67) and related party transactions (Sections 185, 188 and 189).
Section 67(2) of the Act prohibits financial assistance by a public company to any person in connection with a purchase or subscription of its shares. Section 67(3) of the Act carves out an exception in respect of the lending of money by a banking company in the ordinary course of its business.
Section 185(1) of the Act states that a company cannot advance any loan, guarantee or security to any director of a company, or of a company which is its holding company or any partner or relative of any such director or to any firm in which any such director or relative is a partner. There is an exemption, subject to certain conditions, for a company which in the ordinary course of its business provides loans or gives guarantees or securities for the due repayment of any loan.
Section 188(1) of the Act provides that a company shall not require the approval of the board of directors for entering into a transaction or arrangement with a related party provided that such transaction is in the ordinary course of business and on an arm’s length basis.
Section 189(1) of the Act mandates companies to maintain particulars of all contracts or arrangements entered into by interested directors or with related parties. This does not apply to any contract or arrangement by a banking company for the collection of bills in the ordinary course of its business.
Ordinary course in acquisition agreements
The expression “ordinary course of business” is ubiquitous in M&A Agreements.
M&A Agreements regulate the behavior of target companies in the following manner between signing and closing:
- Conduct of business in the ordinary course: M&A Agreements typically envisage an affirmative covenant where a seller agrees that in the period between signing and closing, the target company will carry out its business in the ordinary course.
- Requiring consent of the buyer for certain actions outside the ordinary course: M&A Agreements will typically mandate that prior written consent of the buyer be obtained for the target company to undertake specified actions that are not in its ordinary course of business between signing and closing.
In addition, M&A Agreements will include a warranty that after a particular date (defined as the Accounts Date, which would be the date after which audited or reviewed accounts are not available), the target company has conducted its business in the ordinary course.
The rationale behind such provisions is to ensure that once definitive agreements are executed following completion of due diligence and on the basis of an agreed valuation, the buyer substantially receives what it has bargained for.
An important remedy in relation to the breach of an ordinary course covenant often resides in the conditions precedent and the termination sections of an acquisition agreement. As a condition precedent to closing, M&A Agreements will require that the seller has duly performed certain covenants, agreements, obligations and undertakings required to be performed under this agreement in material respects. These obligations will include adhering to the ordinary course covenant. Thus, failure of the target to comply with the ordinary course of business covenant may allow the buyer to refuse to close the transaction or terminate the acquisition agreement if that option, subject to any cure rights, has been envisaged.
Indian Case Law
Indian case law interpreting the expression “ordinary course of business” has tended to be in the context of taxation statutes. Certain key principles that emerge from such case law are set out below.
Charter documents are not sufficient
Indian courts have consistently held that the mere fact that an activity was one of the objects enumerated in the memorandum of association is not sufficient for such activity to be considered as being in the ordinary business of the company.
In Seksaria Biswan Sugar Factory Limited v. Commissioner of Income Tax,[1] the Bombay High Court held that every act done intra vires of the company is not necessarily done in the course of business. It observed that “It must be found as to whether the particular act has any connection with the normal business that the company is carrying on and whether it is so related to the business of the company that it can be considered to be performed in the ordinary course of the business of that company.”
Frequency of the activity
In the case of M/s Bharti Televentures Limited vs Addl./Jt. Commissioner of Income Tax[2] the Delhi High Court affirmed that the memorandum and articles of association of the company are not conclusive on the question whether activities of a company amount to carrying on of business, but sufficiently show the intention of the assessee to pursue certain main objects. The court highlighted the importance of the frequency of the activity as such frequency gives rise to a continuous and organized activity. The court further expressed the view that everything associated or connected with the business cannot be said to be incidental to it. Proximity of the activity to the business is not sufficient, but the activity should be an integral part of the business.
Continuity of a transaction over a course of time in the business of the company is an important factor in considering whether an action is in the ordinary course of business. In Somanath Baraman and others v. Raja S. V. Jagannatha Rao[3] it was held that “stray or casual act cannot be called an act done in the ordinary course of business”. The High Court of Andhra Pradesh in this case noted that a “habit system” and continuity is required to satisfy the test of regular or ordinary course of business.
Contribution to business
In Deputy Commissioner of Income Tax, vs Oscar Investments Limited,[4] it was reiterated by the Income Tax Appellate Tribunal, Mumbai Bench, that the objects clause of the memorandum of association of a company is not conclusive for determining the nature of activity as a substantial part of business as it only enables the company to carry out activities specified therein. The pattern or trend of capital employed, utilization of assets and composition of income over a period of years and not merely of one year shall be factors influencing the determination of an activity which is a substantial as a part of business. The tribunal observed that significance and contribution of each activity would play a crucial role in deciding whether the business carried on by the company is in ordinary course and a substantial part thereof, even if such contribution is a negative income. The tribunal further observed that any person carrying on business activity in the ordinary course should have a reasonable knowledge of applicable statutory obligations relevant to such activity. The applicability of regulatory framework to the activities of the company and compliance therewith is an essential factor to determine the nature of activity, i.e., whether such activity is an activity carried on in the ordinary course of business or is an incidental business activity.
Undistinguished common flow of business
The Supreme Court recently held in Anuj Jain Interim Resolution Professional for Jaypee Infratech Limited v Axis Bank Limited and Others,[5] in the context of the Insolvency and Bankruptcy Code, 2016, that “even when furnishing a security may be one of normal business practices, it would become a part of ‘ordinary course of business’ of a particular corporate entity only if it falls in place as part of ‘the undistinguished common flow of business done’; and is not arising out of ‘any special or particular situation’.”
UK Case Law
In Koza Ltd & Anor v Akcil & Ors[6] the meaning of “ordinary course of business” was considered by the Court of Appeal.
Interestingly, the court observed that it does not follow from the fact that a particular activity will benefit the company that it will be in the ordinary course of the company’s business. An unprecedented new venture for a company, though deemed beneficial, would not necessarily be in the ordinary course. Thus, it is necessary to examine the existing business of the company, and decide whether, in the light of all the circumstances prevailing at the time when the activity is embarked on, it can properly be described, objectively, as within the ordinary course. This judgement highlights that any expenditure targeted at protecting and furthering the core business, notwithstanding that it is unprecedented, can be construed in a particular case to be in the ordinary course of business.
In Michael Wilson & Partners, Ltd v Emmott,[7] the Court of Appeal observed that what amounts to payments or disposals in the ordinary course of business is a highly fact-sensitive question. It was noted what is in the ordinary and proper course of business depends on what business is carried on by the company, and how it is carried on. A payment which might be made in the ordinary and proper course of one business may not satisfy that description in the case of a different business. Likewise, a payment which might be made in the ordinary and proper course of a business carried on in one location, may not satisfy that description in the case of the same kind of business carried on in a different location.
The court further observed that it is not helpful to substitute the phrase “ordinary course of business” with synonyms like “routine” or “recurring.” A transaction which is neither of those may also be regarded as being in the “ordinary course of business”.
Certain examples of activities falling outside the ordinary course of business
The International Standard on Auditing (ISA) 550- Related Parties has listed examples of transactions that may be considered outside a company’s normal course of business:
- Complex equity transactions, such as corporate restructurings or acquisitions.
- Transactions with offshore entities in jurisdictions with weak corporate laws.
- The leasing of premises or the rendering of management services by the entity to another party if no consideration is exchanged.
- Sales transactions with unusually large discounts or returns.
- Transactions with circular arrangements, for example, sales with a commitment to repurchase.
- Transactions under contracts whose terms are changed before expiry.
This list should be considered illustrative and is subject to further analysis of specific fact situations.
Conclusion
A guidance note on related party transactions published by the Institute of Company Secretaries of India provides a helpful summary of relevant factors to consider whether an activity has carried on by the business is in the ‘ordinary course of business’:[8]
- Whether the activity is covered in the objects clause of the memorandum of association;
- Whether the activity is in furtherance of the business;
- Whether the activity is normal or otherwise routine for the particular business (i.e. activities like advertising, staff training, etc.);
- Whether the activity is repetitive/frequent;
- Whether the income, if any, earned from such activity/transaction is treated as business income in the company’s books of account;
- Whether the transactions are common in the particular industry;
- Whether there is any historical practice to conduct such activities;
- The financial scale of the activity with regard to the operations of the business;
- Revenue generated by the activity; and
- Resources committed to the activity.
Authors:
Rajat Sethi (Partner) https://www.snrlaw.in/rajat-sethi/
Oorja Chari (Associate)
Footnotes
[1] AIR 1950 Bom 200
[2] ITA 1395/2006 and ITA 1656/2010
[3] AIR 1973 AP 144
[4] 2006 98 ITD 339 Mum
[5] Civil Appeal Nos. 8512-8527 of 2019
[6] [2019] EWCA Civ 891
[7] [2015] EWCA Civ 1028
[8] Guidance note on related party transactions issued by the Institute of Company Secretaries of India.