Friday, August 1, 2014

Consequences of Inaccurate Shareholding Disclosures

Both the SEBI (Substantial Acquisition of Shares and Takeovers Regulations), 2011 (the Takeover Regulations) as well as the SEBI (Prohibition of Insider Trading) Regulations, 1992 (the PIT Regulations) require a timely disclosure of acquisition or change in shareholdings beyond certain thresholds by substantial shareholders and promoters. Such disclosure requirements are also captured in clause 35 of the listing agreement. The consequences of inaccurate disclosures came up in a decision of the Securities Appellate Tribunal (SAT) that was issued yesterday.

In the case involving GHCL Limited, SEBI has passed an order against the company, its company secretary, chairman and several promoters in connection with disclosures of shareholdings made by them. SEBI’s allegation was that the promoters “wrongly and illegally projected their shareholdings far in excess of their real shareholding by taking into consideration shareholdings of third parties as part of their own shareholding in an illegal manner”. The company had included shares of other parties as the promoters had informed it that the promoters had a mutual understanding with those other parties who held shares in the company in their own right (but to include those shares in the disclosures in the name of the promoters).

The decision of the SAT and its various grounds are set out below with some commentary as relevant.

Inaccurate Disclosures

In arriving at its decision, the SAT paid specific attention to the policy and philosophy behind shareholding disclosures:

18. … Next, the purpose underlying the requirement of making regular and true disclosures by a company as regards the shares which the promoters may come to hold from time to time is to bring about greater transparency in the functioning of the companies. It is through such disclosures that the investors take an informed decision in a given situation to invest in the scrip of that company or even to exit. This is extremely important for the growth of a healthy capital market. … Thus, true and correct disclosures as to the exact shareholding pattern of promoters assume greater significance.

Hence, SAT found that the company as well as the chairman and company secretary bore the primary responsibility to ensure proper disclosure in consonance with the applicable SEBI regulations.

Comment: The importance of disclosure and the need to sanction against its lapses is understandable. Readers may recall that the sensitivity of disclosures became quite apparent during the Satyam corporate governance scandal whereby the pledge of shareholding by the promoters was not made known to the markets. As a result, the Takeover Regulations have been amended to require disclosures of pledges as well, as discussed here. See also, chapter V of the current version of the Takeover Regulations.

Fraudulent and Unfair Trade Practices

What appears to have been a case of mis-disclosure got elevated to a case of fraudulent and unfair trade practice. The appellants were therefore also charged under the SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Markets) Regulations, 2003 (the PFUTP Regulations). The relevant statutory provisions relating to fraudulent and unfair trade practices are as follows:

SEBI Act, 1992

12A.    Prohibition of manipulative and deceptive devices, insider trading and substantial acquisition of securities or control. – No person shall directly or indirectly ---

(a)        use or employ, in connection with the issue, purchase or sale or any securities listed or proposed to be listed on a recognized stock exchange, any manipulative or deceptive device or contrivance in contravention of the provisions of this Act or the rules or the regulations made thereunder; …

PFUTP Regulations

Prohibition of certain dealings in securities

3.         No person shall directly or indirectly –

(a)    buy, sell or otherwise deal in securities in a fraudulent manner; …

The SAT found that the present mis-disclosure was not a result of an inadvertent error, but due to deliberate and conscious actions on the part of the promoters. Hence, it concluded that “the present case would undoubtedly amount to unfair trade practice, if not a fraud played upon the market”.

As for the interpretation of the aforesaid legal provisions, SAT explained as follows:

22. Similarly, a simple reading of section 12(A)(a) of the SEBI Act, 1992 read with Regulation 3(a) of the PFUTP Regulations, 2003 as reproduced above clearly reveals that it is not only the fraudulent or manipulative buy or sale of securities which is prohibited but any dealing in securities “otherwise” also may be illegal and hence amounts to fraud on the market. The expression “…otherwise deal in securities…” occurring in Regulation 3(a) read with section 12A(a) of SEBI Act, 1992 is vide enough to cover cases like the one in hand where general investors are sought to be drastically misguided by the promoters of the Company by inclusion of the third parties’ shares which the promoters admittedly do not own. The law is absolutely clear on this and there is no ambiguity as sought to be projected by the appellants. Whatever is not included in the Regulation has to be excluded in the interpretation.

Comment: The aforesaid interpretation supplied by SAT appears to be too wide. In this case, there is nothing from the decision to suggest that the promoters either bought or sold shares when the inaccurate disclosure was in force. Hence, it is unclear as to how Reg. 3(a) of the PFUTP Regulations can be attracted. Even the use of the expression “otherwise deal” ought to be read ejusdem generis with the “buy” and “sell”. The mere existence of incorrect disclosures, however deliberate, cannot without more be deemed to be a fraudulent or unfair trade practice. If this interpretation were to stick, then every deliberate non-disclosure or mis-disclosure of shareholding by substantial shareholders or promoters could potentially amount to a fraudulent or unfair trade practice. It is not clear if such is the intention.

Reliance on Legal Advice

The categorical stance of the SAT is that the company’s or promoter’s reliance on legal advice in making the disclosure is not an excuse for facing the consequences. It stated:

23.       The Appellants should have acted more diligently and responsibly and should not have been guided by mere legal opinions. It is settled law that legal opinions are only advisory in nature and not binding on anyone. Therefore, no legal infirmity can be attributed to the impugned order which holds all the appellants guilty of violating the PFUTP Regulations, 2003 and imposes monetary penalties on them.

Comment: The SAT decision reinforces the point that violators of securities laws cannot escape blame by simply passing it on to their legal advisers. They ought to take full responsibility, and cannot seek any excuse or safe harbour in civil penalty cases.

Persons Acting in Concert

Finally, SAT found that Reg. 7(1A) of the Takeover Regulations were not attracted in the present case. It justified its finding as follows:

40.       Moreover, Regulation 7(1A) requires an individual acquirer to disclose regarding any change in its shareholding if it goes 2% up or down and for the purpose of calculating such change of 2% shareholding, the shareholding of “person acting in concert” may not be clubbed unless they admittedly act in concert. Therefore, clubbing of the shareholdings of various promoter entities, without proving that they were persons acting in concert with each other by cogent and convincing evidence is untenable in law and such a finding is liable to be quashed and set aside qua the appellants in these 10 appeals as far as the violation of Regulation 7(1A) of FUTP Regulations is concerned.

As a matter of law, the SAT also clarified that Reg. 7(1A) of the Takeover Regulations are in pari materia with Regs. 13(3) and 13(5) of the PIT Regulations, due to which there is no violation of the latter as well.

On these grounds, the SAT affirmed a violation of Section 12(A)(2) of the SEBI Act and the PFUTP Regulations, but it set aside SEBI’s finding of a violation of Reg. 7(1A) of the Takeover Regulations.

In all, the decision underscores the importance of disclosures and warns against simply relying on legal advice to exclude regulatory sanctions. However, it appears to stretch matters a bit far by concluding that a deliberate mis-disclosure of the present kind also amounts to a fraudulent and unfair trade practice.

Thursday, July 31, 2014

Guest Post: Comments on SEBI’s Crowdfunding Paper

[The following post is contributed by Debanshu Mukherjee, a Senior Resident Fellow at Vidhi Centre for Legal Policy, New Delhi]

Last month, SEBI had issued a Consultation Paper on regulating Crowdfunding in India. Vidhi Centre for Legal Policy, a New Delhi based independent and not-for-profit think-tank prepared a detailed response to the Paper and submitted it to SEBI earlier this month.

Crowdfunding, if regulated appropriately can provide an excellent funding alternative for early-stage ventures and cash-strapped small businesses. However, given its vulnerability to ‘regulatory arbitrage’ and fraud, the regulatory framework needs to strike the right balance between protection of investors and promotion of entrepreneurship.

Here’s a summary of some of the key arguments advanced in the Vidhi response:

- Eligible Investors: The consultation paper proposes to allow only a limited class of investors (‘Accredited Investors’) to participate in crowdfunding. Crowdfunding, by definition, is typically aimed at raising funds through relatively small contributions from a large number of people (the ‘crowd’), and not from a small group of sophisticated investors. Since most ‘Accredited Investors’, particularly the Qualified Institutional Buyers (QIBs), are unlikely to invest in early stage ventures (given their exhaustive screening and diligence related requirements), many of those investors may not be interested in crowdfunding at all. The proposed definition of eligible investors should be modified to allow greater participation from retail investors.

- Number of Investors: Limiting the number of potential investors to 200 could severely limit a venture’s fundraising attempts. Given that most QIBs are unlikely to invest through the crowdfunding route, the other categories of investors need to be sufficiently large in number to raise any substantial amount. While allowing a large number of investors to participate in crowdfunding may increase the transaction costs and cause administrative difficulties for the issuer company, such issues can be dealt with by restricting the rights given to shareholders through issuance of shares with differential voting rights and providing for a trustee/nominee to represent the shareholders’ interests. Appropriate amendments to the Companies Act, 2013 and the relevant rules thereunder will be required to facilitate this.

- Disclosure Requirements: A typical venture resorting to crowdfunding is likely to be at a very early stage of its operations and may not have the resources to produce (on its own or by hiring external advisors) the necessary information required for enabling the investors to make an informed decision. Moreover, in the absence of proper legal advice at the time of making disclosures, the issuer company may be at the risk of disclosing intellectual property which could otherwise be legally protected under the laws of patent, etc. It is here that the role of the crowdfunding portal becomes crucial. The crowdfunding portal could hire specialists to enable the issuer to make the necessary disclosures without undermining its legal interests (especially   in relation to product-details and business methods). The portal could then factor the cost of generating this information in its fee (to be recovered after the funding is complete).

- Rating: Though not specifically addressed in the SEBI paper, the crowdfunding regulations may require issuers to obtain a ‘compulsory rating’ from a registered financial analyst about the financial viability of the venture. The regulations may prescribe the methodology for the rating service and require the service providers to be registered with SEBI. In the absence of other traditional intermediaries (investment banks, underwriters, etc.) it is important that independent analysts or business specialists lend their reputation to the issuer company to signal the investors about the viability of the venture. Alternatively, the start-up community could be urged to organise itself voluntarily and develop a self-regulatory system for rating issuers on crowdfunding platforms. Given that many ventures may not have the financial resources to obtain such rating, the cost should be initially borne by the portal (and factored in its fee).

- Funding Portals:  Whilst SEBI understandably proposes extensive regulation of platforms that facilitate crowdfunding, some requirements might be potential deterrents for competitiveness and efficiency in crowdfunding. For instance- limiting the category of entities that can establish funding portals to stock exchanges, depositories, technology business incubators (TBIs) and association of private equity/angel investors is counter-productive. Given that internet and technology companies have defined the crowdfunding experience so far and increased regulations would only require enhanced innovation, capabilities and systems to manage risk control and data protection, the aforesaid entities should qualify as eligible entities for establishing funding portals. Further, networks of entities with past experience and expertise in identifying, funding and incubating potentially successful social ventures/SMEs, should also be permitted. Finally, in order to promote diversification, enhanced capital flows and greater resilience in crowdfunding, SEBI should examine additional measures, including, inter alia, promoting investor education, ensuring inter-operability of funding portals, centralizing the verification of accredited investors and addressing moral hazard concerns.  

- Secondary Sales: In conventional capital markets, it is the existence of a robust secondary market (a stock exchange) that encourages investors to invest in the primary market, i.e., the initial offer. In the absence of an ‘informationally efficient’ secondary market (where the prices of the securities reflect their fair value), investors may not be able to exit at a desired time.  Retail investors are particularly prone to facing personal exigencies, which may require them to liquidate their holdings at any time and exit the venture. Any uncertainty about exit options may discourage investors from making the initial investment in the first place. While a full-fledged secondary market for securities issued through crowdfunding may not be permissible given the regulatory framework for stock exchanges, the discussion forums/ social networks on the funding portal may be used as a platform to facilitate information exchanges between potential buyers and sellers. Any transfer of shares facilitated through such forums may be subjected to separate pricing and anti-manipulation guidelines to ensure that the prices are not manipulated.

As long as the regulatory regime provides for sufficient safeguards to prevent frauds, raising equity capital through crowd-funding may go a long way in unlocking the true potential of early-stage ventures. Having said that, crowdfunding transactions are susceptible to frauds and regulatory arbitrage. Regulatory arbitrage occurs when the regulated entities take advantage of the variations between two or more regulatory regimes by subjecting themselves to a system that involves lesser costs or compliances. Allowing companies to raise funds through crowdfunding may create such arbitrage opportunities for transactions which could otherwise be subjected to SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009, SEBI (Collective Investment Scheme) Regulations, 1999, the AIF Regulations or the Foreign Contribution (Regulation) Act, 2011. In view of the above, issuance of securities through crowdfunding may be introduced in a phased manner to gauge its suitability for the Indian markets. Companies in sectors with dynamic entrepreneurial activity could be allowed to raise money through crowdfunding on a pilot basis (for instance, in the technology sector), before introducing this on a wider scale.

Vidhi’s detailed response to the SEBI paper can be downloaded from its website:  (the report is prepared by a Vidhi team comprising Debanshu Mukherjee, Shubhangi Bhadada, Aditi Singh and Ketan Paul).

- Debanshu Mukherjee

Comparative Paper on M&A: Transaction Structures, Law & Practice

Professor John Coates has a new paper titled Mergers, Acquisitions and Restructuring: Types, Regulation, and Patterns of Practice that is available on SSRN. The abstract is as follows:

An important component of corporate governance is the regulation of significant transactions – mergers, acquisitions, and restructuring. This paper (a chapter in Oxford Handbook on Corporate Law and Governance, forthcoming) reviews how M&A and restructuring are regulated by corporate and securities law, listing standards, antitrust and foreign investment law, and industry-specific regulation. Drawing on real-world examples from the world’s two largest M&A markets (the US and the UK) and a representative developing nation (India), major types of M&A transactions are reviewed, and six goals of M&A regulation are summarized – to (1) clarify authority, (2) reduce costs, (3) constrain conflicts of interest, (4) protect dispersed owners, (5) deter looting, asset-stripping and excessive leverage, and (6) cope with side effects. Modes of regulation either (a) facilitate M&A – collective action and call-right statutes – or (b) constrain M&A – disclosure laws, approval requirements, augmented duties, fairness requirements, regulation of terms, process and deal-related debt, and bans or structural limits. The paper synthesizes empirical research on types of transactions chosen, effects of law on M&A, and effects of M&A. Throughout, similarities and differences across transaction types and countries are noted. The paper concludes with observations about what these variations imply and how law affects economic activity.

The paper provides a helpful analysis of various transactions structures and the legal regulations surrounding them. The analysis highlights how the Indian situation either compares or contrasts with that prevailing in the US and the UK.

Monday, July 28, 2014

SEBI: Infrastructure Investments and Portfolio Investments

Infrastructure Investment Trusts

Last last year, we had discussed the SEBI Consultation Paper on Infrastructure Investment Trusts. While the move towards the establishment of infrastucture investment trusts (InvITs) was welcome, certain issues such as tax treatment remained to be ironed out. Now that the tax treatment has been addressed in the Budget 2014, SEBI has published a draft of the SEBI (Infrastructure Investment Trusts) Regulations, 2014 for public comments. Only a short window of 7 days was available for comments, which expired on July 24, 2014. For a more detailed discussion of the implications of this draft as well as a comparative analysis, see The Firm – Corporate Law in India.

Foreign Portfolio Investors

The legal regime surrounding foreign institutional/portfolio has undergone a change with the enactment of the SEBI (Foreign Portfolio Investors) Regulations, 2014. In this regard, SEBI has issued a detailed set of Frequently Asked Questions (FAQs) which deal extensively with the legal and operational aspects for foreign portfolio investors (FPIs). This is particularly useful for industry players as well as the regulators in the implementation of the new regime, and makes the process entirely transparent.

“Inversion” Takeovers

Standard treatises on mergers & acquisitions (M&A) contain the usual benefits or rationale for why a company would take over another. These include growth, size, synergies, and so on. One of the significant benefits of takeovers could also be tax synergies such as setting off the losses of one company against the losses of another. Similar benefits may be available with respect to unabsorbed depreciation and other capital allowances in the loss-making company.

In recent times, a whole new tax rationale has been driving M&A activity in relation to US companies, and that is to achieve relocation of U.S. businesses into other jurisdictions so as to minimise the effect of exorbitant U.S. taxes. This is accomplished through “inversion” deals. “Inversions” are described in the Wall Street Journal as follows:

Inversions enable a U.S. company to lower its tax rate. In these deals, a U.S. company buys a foreign target and adopts its home country’s domicile, or the combined company establishes a holding company in a country with a low tax rate. U.S. companies can lower their tax rate to the single digits from as much as 35% through an inversion.

An explanatory video is also available through the M&A Law Prof Blog.

Inversion deals have become quite common in the pharmaceutical and healthcare sectors, with Ireland and the Netherlands becoming common destinations for U.S. companies to relocate to. The deal that has been making waves is U.S. company AbbVie’s proposed acquisition of Shire PLC for US$ 54 billion (as discussed here and here).

Inversion deals give rise to greater concerns in countries such as the U.S. where not only are tax rates high but even the global income of U.S. companies are subject to taxation. There are potentially two ways to deal with this issue. One would be to impose legal restraints on inversion deals, a matter that the U.S. government appears to be seriously considering. The other is a more permanent solution to streamline and minimise the adverse impact of taxation on U.S. businesses.

The issue of reincorpoation and corporate migration is not limited to taxation concerns. Reincorpoations may occur due to other reasons, including onerous regulation in home jurisdictions. Hitherto, concerns had been expressed even in the Indian context due to policy paralysis and overarching legal regulations that led to a few companies relocating from India to other jurisdictions such as Singapore. Now that the Companies Act, 2013 permits Indian companies to amalgmate into foreign companies in reciprocating territories, relocations could very well be implemented through that method.

While inversion deals and cross-border mergers could provide sufficient flexibility to companies to manoeuvre around burdensome taxation or other regulation, equally there exists the concerns as to whether it leaves too much room to engage in tax or regulatory arbitrage through competition amongst various jurisdictions that might lead to a “race to the bottom”.