SEBI’s brightline tests: ‘Control’ controversy put to rest?
Arindam Ghosh, Partner (Khaitan & Co.)
Moin Ladha, Associate Partner
Securities Exchange Board of India (“SEBI”) at its meeting on 12 March 2016 approved the proposal for initiation of public consultation process regarding Brightline Tests for Acquisition of ‘Control’ under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (“Takeover Code”). Thereafter through its discussion paper dated 14 March 2016 (“Discussion Paper”), SEBI invited public comments to the proposed policy framework to set out brightline tests for acquisition of Control.
The requirement to have clarity on the concept of Control had been discussed by the Bhagwati Committee and the Takeover Regulations Advisory Committee (TRAC) prior to providing their views and recommendations on the takeover regulations on earlier occasions. Given the multitude of events and actions that would have to be considered before arriving at a decision in any particular case the committees had opined that it is best done on the facts and circumstances of each case. In keeping with this, the definition of Control in the Takeover Code (as well as the erstwhile regulations) provides broad contours which constitute control without specifically excluding actions or factors that would not fall within its scope. There have been numerous occasions when interpretational issues have arisen due to this. SEBI has therefore set the ball rolling on an attempt to further define the concept of Control and to put to rest the perpetual controversy surrounding the issue.
While doing so SEBI has analysed how the issue has been historically dealt with under the takeover scenario so far, the way the term Control has been construed in various other legislations in India and also the way other countries have codified it in their respective jurisdictions. The Discussion Paper floated by SEBI includes two options to effectively implement a better approach towards the concept of Control from a Takeover Code perspective. These being the (i) Numerical Approach and (ii) Framework for Protective Rights.
The Number Game:
Over the years it has been seen that the threshold for making an open offer for providing an exit the public shareholders has changed. In the 1990s the threshold was pegged at 25%. This was subsequently reduced and has currently come back the full circle in terms of the recent provisions. A numerical threshold of 25% voting rights being the only factor for determining Control would involve the risk of the threshold being easily circumvented by acquiring slightly less than the specified percentage and yet retain de facto control otherwise.
In such cases acquisition of a single share lesser than the 25% threshold would deprive the public shareholders of an exit opportunity which would otherwise be available in change in control situations and could defeat the fundamental objectives of the Takeover Code.
Moreover, considering the recent and continuing initiatives of the Government in making India a viable destination, having a numerical threshold could be viewed as a restriction. Companies engaged in capital intensive sectors that continue to be run by the original promoters or professionally managed would be the most affected. This is because the investors, despite their holdings crossing specified thresholds due to their investment in the target company, may not be keen to be in control.
Again, from an investor point of view in certain cases, investors with investments in the target company prior to listing which results in breaching the specified thresholds post listing would lead to compulsorily requirement to dilute their holdings.
Protective Vs Participatory rights:
As a second option under and in line with the decision of the Securities Appellate Tribunal in the case of Subhkam Ventures (I) Pvt Ltd, SEBI has proposed an illustrative list of protective rights that will not amount to acquisition of control subject to (i) the respective investor investing at least 10% in the target company; (ii) the company formulating a policy defining “material’ and “outside the ordinary course of business” and obtaining public shareholder’s approval in respect of such rights and (iii) incorporating these rights when granted in the Articles of Association of the company.
The following illustrative list of rights have been categorised as protective in nature:
- Appointment of chairman/vice chairman: Right to appoint a chairman or vice chairman being a nominee of an investor, provided such person does not hold any executive position nor does he have a casting vote.
- Appointment of observer: Investor being able to appoint its nominee as the observer without having any voting or participation rights.
- Covenants specified by lenders: Banks/ non-banking financial companies (NBFC) may have customary covenants subject to it having granted the loan to the target company strictly on commercial basis.
- Commercial Agreements: Rights conferred on the parties to a commercial agreement provided (a) they are for mutual commercial benefit of both parties, and (b) the decision to enter into such agreement has been approved by the board of the target company, (c) the board of the target/target company have the right to terminate such agreement and right to enter into similar arrangement with any other party.
- Veto/Affirmative Rights: SEBI has provided an illustrative list of veto/affirmative rights in matters that are not part of the ordinary course of business or involve governance issues. These are with respect to any alteration of the capital structure of the company, material divestment, transfer of disposal of an undertaking or material subsidiary of the target company, amending the memorandum and articles of the company which adversely impact the investor’s rights etc. being rights that are considered as protective in nature and would not amount to exercise of control over the target company.
- Quorum rights: For meetings involving the illustrative list of veto/affirmative rights, if two meetings are not quorate, the next meeting would be deemed to have quorum despite the absence of the investor nominees.
The basic principle to be followed here is that the above mentioned list of rights are protective in nature rather than participatory. The aim is to allow the investor to have these rights in order to protect the investment or prevent dilution of the investor’s shareholding. Therefore, the rights in decisions involving significant change in the current business of the company are proposed to be treated as a protective right.
The list of indicative rights cannot be expected to cover each and every situation wherein an investor may seek protective rights without having any intention to acquire Control.
Some of the challenges that are thrown up pertaining to the above are as follows:
- As regards exemptions available to banks/ NBFCs generic references to customary rights granted to Lenders could be subject of misuse. On the other hand, limiting these rights to entities engaged in lending business, for instance banks / NBFC’s could be very narrow.
- While including a right for the board of the company is necessary such right being unilateral would make the option practically unviable.
- 10% threshold for availing the exemptions may not work in a company with a very large market capitalisation. Considering the funds involved in such cases an investor holding 5% voting rights would also expect such protection and without flexibility built in as to the percentage the investor would be left with no rights and at the mercy of the promoters.
- Lastly since investors would have made investments based on certain protective rights, cancellation/modification/suspension of the same at the time of an initial public offering and requirement for a subsequent shareholder approval would act as a major deterrent. A better approach would be to include complete disclosure in the offer documents to enable shareholders make an informed decision. This option independently may result in more cases ending up before the regulator and may not deliver the intended results, with investments still getting stalled in disputes as to whether control has been acquired or not.
Conclusion
In light of the above discussions, finding a right balance with an illustrative list read with a definition that captures the scope of the term control would be key. Towards this, having an independent numerical threshold or a framework for protective rights which is all inclusive may be counterproductive since it may be open to circumvention and misuse thereby avoiding the making of an open offer for providing an exit to the public shareholders – this would be against the fundamental objectives of the Takeover Code.
A mix of both these options would possibly be a better approach as this would deal with situations where either option is attempted to be misused by a party. Whilst approving this amendment one will also need to be mindful of the possible impact it may have on the other SEBI regulations. Therefore while the definition of control should retain the existing broad language, the same should also include an indicative list of rights that do not amount to control. Another possible step that could boost investor confidence and retain long term players would be a clarification to the effect that this amendment would only have prospective effect and not affect rights existing at the date of it being notified.
To sum up, there are several challenges and issues around the proposal but SEBI’s attempt to resolve the controversy around the concept of Control for the purpose of Takeover Regulations is undoubtedly an impressive step towards improving the ease of doing business in India.