This article has been written by Ms. Preksha Bothra, a 4th year BA LLB student from BMS College of Law, Bengaluru.

Introduction

In India, subsidiary companies are often established to facilitate the expansion of a business by allowing a parent company to operate in different locations, with different product lines or services, or under different brand names. However, it is common for subsidiary companies to hold shares in their parent or holding companies, and this can create certain issues and challenges that need to be addressed.

In this article, we will discuss the reasons why subsidiary companies should not hold shares in their holding companies, the legal and regulatory framework governing such transactions, and the implications of non-compliance with these rules.

Why Subsidiary Companies Should Not Hold Shares in Their Holding Companies?

There are several reasons why it is not advisable for subsidiary companies to hold shares in their holding companies. These include:

1. Legal Restrictions: The Companies Act, 2013 prohibits a subsidiary company from holding shares in its holding company. Section 19(2) of the Act states that “no company shall, either by itself or through its nominees, hold any shares in its holding company.” This provision is aimed at ensuring that the financial interests of the subsidiary company are not tied up with those of its holding company, and that the subsidiary company is able to operate independently.
2. Conflicts of Interest: If a subsidiary company holds shares in its holding company, it can create conflicts of interest. For example, if the holding company is facing financial difficulties, the subsidiary company may be reluctant to take any action that could harm the value of its own shareholding. This could result in the subsidiary company taking actions that are not in the best interests of the holding company or its other shareholders.
3. Distortion of Financial Statements: If a subsidiary company holds shares in its holding company, it can distort the financial statements of both companies. For example, if the holding company reports a profit, it could be due to the subsidiary company’s investment in its shares, rather than the actual performance of the business. This could mislead investors and stakeholders and could lead to legal and regulatory issues.
4. Loss of Control: If a subsidiary company holds shares in its holding company, it can lead to a loss of control. For example, the holding company may be able to influence the subsidiary company’s decisions through its shareholding, even if it does not have a controlling stake. This could result in the subsidiary company being unable to operate independently and could harm its reputation and financial stability.

Legal and Regulatory Framework Governing Subsidiary Companies Holding Shares in Holding Companies

As mentioned earlier, the Companies Act, 2013 prohibits subsidiary companies from holding shares in their holding companies. This provision is aimed at ensuring that the subsidiary company is able to operate independently and that its financial interests are not tied up with those of the holding company.

In addition to this, the Securities and Exchange Board of India (SEBI) has also issued regulations governing related party transactions, which includes transactions between holding and subsidiary companies. Under these regulations, if a subsidiary company holds shares in its holding company, it would be considered a related party transaction, and would require approval from the board of directors and shareholders of both companies.

If a subsidiary company violates the provisions of the Companies Act or SEBI regulations, it could face legal and regulatory action, including fines, penalties, and even criminal liability.

Implications of Non-Compliance

Non-compliance with the provisions of the Companies Act or SEBI regulations can have several implications for subsidiary companies. These include:

1. Legal and Regulatory Action: As mentioned earlier, non-compliance could result in fines, penalties, and criminal liability. This could harm the reputation and financial stability of the subsidiary company, and could result in legal and regulatory action against its directors and officers.
2. Loss of Investor Confidence: If a subsidiary company is found to be in violation of the law or regulations, it could lead to a loss of investor confidence. Investors may view the company as risky or unreliable, which could harm its ability to raise capital or attract new investors.
3. Harm to Relationships with Holding Company: If a subsidiary company holds shares in its holding company in violation of the law or regulations, it could harm the relationship between the two companies. The holding company may view the subsidiary company as untrustworthy or may feel that its financial interests are not aligned with those of the holding company. This could harm the business relationship between the two companies, and could result in the holding company looking for alternative subsidiaries to work with.
4. Financial Instability: If a subsidiary company’s financial interests are tied up with those of its holding company, it could lead to financial instability. If the holding company experiences financial difficulties, it could harm the subsidiary company’s financial stability as well. This could result in the subsidiary company being unable to meet its financial obligations or even going bankrupt.

Indian Cases related to Prohibition on Circular Ownership of Shares

The Indian courts have consistently upheld the prohibition on circular ownership of shares and have held that such ownership is against public policy. 

In the case of Union of India v. Hindustan Development Corporation (1988), the Supreme Court of India held that the prohibition on circular ownership of shares was intended to prevent the formation of monopolies and to ensure that each company operates independently. The court also held that the prohibition on circular ownership of shares was a fundamental principle of company law and was intended to promote corporate governance.

In the case of Haridas Mundhra v. Union of India (1972), the Supreme Court of India held that the prohibition on circular ownership of shares was intended to prevent conflicts of interest between the holding company and the subsidiary. The court observed that if a subsidiary holds shares in its holding company, it could become a means of controlling the holding company and could lead to a conflict of interest between the two companies. The court held that such ownership was against public policy and could not be allowed.

In the case of LIC v. Escorts Ltd. (1986), the Supreme Court of India held that the prohibition on circular ownership of shares was intended to ensure that the holding company retained control over the subsidiary. The court observed that if a subsidiary held shares in its holding company, it could lead to a dilution of control by the holding company. The court held that the prohibition on circular ownership of shares was a fundamental principle of company law and was intended to promote good corporate governance.

Conclusion

In conclusion, it is not advisable for subsidiary companies to hold shares in their holding companies. This practice is prohibited by the Companies Act, 2013 and could create conflicts of interest, distort financial statements, and harm the subsidiary company’s ability to operate independently. Non-compliance with the law and regulations could result in legal and regulatory action, loss of investor confidence, harm to relationships with the holding company, and financial instability. Subsidiary companies should ensure that they comply with the law and regulations governing their operations, and should work to establish their financial independence from their holding companies. The Indian courts have consistently upheld this prohibition on circular ownership of shares and have held that such ownership is against public policy. The prohibition on circular ownership of shares is intended to promote good corporate governance and ensure that each company operates independently.