Friday, April 18, 2014

SEBI Announces the Specifics of Revised Corporate Governance Norms

It was nearly a decade ago in October 2004 that the Securities and Exchange Board of India (SEBI) announced substantial revisions to the corporate governance norms contained in clause 49 of the listing agreement that applies to all public companies listed on an Indian stock exchange. The revisions, however, took effect only from January 1, 2006. Since then, there have been some specific amendments to the norms but very little substantial change so as to alter the philosophy of governance mechanisms in India.

While the 2004 reforms to corporate governance were markedly stringent compared to the previous position, those norms operated under significant constraints. One of the criticisms of that approach that some of us had raised (e.g. in this paper) was that the corporate governance norms in India were largely adopted from the Western markets such as the US and the UK, and that those norms were inadequate to deal with the specific governance problems in Indian companies where shareholding was concentrated among the controlling shareholders (or promoters). The Indian situation necessitated a mechanism that provided greater protection to minority shareholders in public listed companies. Although initially there did not seem to be sufficient momentum to bring about radical changes to corporate governance mechanisms in India, the intervening governance scandals such as Satyam provided the necessary impetus for a paradigm shift. This was aided by the enactment of the Companies Act, 2013 that introduced sea change in governance norms.

It is in this context that SEBI yesterday announced new corporate governance norms through a replacement of clause 49 of the listing agreement that will become effective from October 1, 2014. These revisions bring the SEBI norms in line with the requirements of the Companies Act, 2013.

The new clause 49 represents an important milestone in the evolution of corporate governance norms in India. It essentially (perhaps for the first time) confronts the type of governance problems that are prominent in India, i.e. where minority shareholders require protection in the backdrop of the dominance of promoters in companies. Several examples abound in the new clause 49: (i) express recognition of the role and protection of minority shareholders; (ii) greater participation of shareholding in the process of corporate democracy; (iii) stringent regulation of related party transactions, including by requiring a “majority of the minority” voting process.

Finally, one might even say that SEBI’s corporate governance norms have truly become “Indianized”, thereby offering the potential for more effectively enhancing governance norms and practices with the result that the Indian markets would be in a position to command a better governance premium and enable more efficient capital raising by Indian companies. If successful, the new corporate governance package introduced in India might very well be the harbinger of governance reforms in several Asian economies that suffer from the same corporate governance problems as India due to concentration of shareholding. 

Of course, at this stage, it is only possible to glean the broad approach and philosophy of the new corporate governance norms. They mandate a closer analysis of the specifics, which will follow in due course. More importantly, however, substantive regulation is only as good as the effectiveness of its enforcement (or lack thereof). It is likely that the more reputable companies do not require regulation to follow enhanced governance practice – they might commit themselves to higher standards nevertheless. The true test will lie in the ability of the regulation and its enforcement to ensure compliance (both in letter and spirit) by the entire cross-section of listed companies. This, only time will tell.

The implementation of the provisions of the Companies Act, 2013 and the new clause 49 (commencing October 1, 2014) over an initial period of time will certainly provide an important framework for empirical studies (both qualitative and quantitative) to be conducted in determining the effectiveness of these revised norms as well as their implementation.

Monday, April 14, 2014

Further Tax Scrutiny of Mergers

In the last few years, mergers of companies (undertaken through schemes of arrangement that require the approval of the High Court) have been subject to greater scrutiny by the tax authorities. One example of a merger that was strongly objected to by the tax authorities is the case involving Vodafone Essar Gujarat Limited (discussed here), although the scheme was sanctioned on appeal to a division bench of the Gujarat High Court.

More recently, the manner of raising objections before the court have been streamlined through a circular of the Ministry of Corporate Affairs (MCA) dated January 15, 2014, which provides that the Regional Director (RD) functioning under the MCA ought to consolidate all objections from various governmental authorities that may have a view on the scheme. A specific mention has been made to the Income Tax Department (ITD) whereby the RD is required to notify the ITD of a scheme and to incorporate the ITD’s comments in the report filed before the court considering the scheme. However, the MCA circular specifically states that “if no response from the [ITD] is forthcoming, it may be presumed that the [ITD] has no objection to the action proposed …”.

In order obviate any doubt and to ensure that the ITD’s voice is heard by the court, the Central Board of Direct Taxes (CBDT) has issued a letter dated April 11, 2014 requesting all Chief Commissioners of Income Tax to ensure that the ITD places all comments relating to a scheme before the court, especially when schemes have adverse tax implications to the revenue. Referring to the receipt of notice from the RD, the letter emphasizes the role of the ITD:

It is emphasised that this is the only opportunity with the Department to object to the scheme of amalgamation if the same is found prejudicial to the interest of Revenue and therefore, it is desired that the comments/objections of the Department are sent by the concerned CIT to Regional Director, MCA for incorporating them in its response to the Court, immediately after receiving information about any scheme of amalgamation or reconstruction, etc.

Although this new development is largely procedural in nature, it represents an effort on the part of the ITD to ensure that its objections are properly placed before the court. From an M&A structuring perspective, the taxation aspects would therefore have to be dealt with clearly so as to withstand scrutiny by the tax authorities, as Lubna Kably also analyzes.

Further, as previously discussed, this procedural position may change substantially under the section 230(5) of the Companies Act, 2013 once that provision is brought in force because it requires the company to directly provide notice of a scheme to various government departments (including the income tax authorities) without requiring any intermediation on the part of the RD.

Sunday, April 13, 2014

A Study on Ownership Concentration in Indian Companies

The shareholding pattern of Indian companies has been the subject matter of academic studies, which have consistently shown that Indian companies are controlled substantially by controlling shareholders (or promoters) who hold a significant percentage of shares in public listed companies. The promoters range from business families to the state and to multinational corporations (MNCs). For a sampling (only) of previous studies, please see Rajesh Chakrabarti, Shaun Mathew and George Geis.

A more recent study examines the ownership concentration levels over the last decade. In their paper “Ownership Trends in Corporate India 2001-2011: Evidence and Implications” (available on the NSE Working Paper Series or on SSRN), Professor Bala N. Balasubramanian and Mr. R. V. Anand undertake a detailed empirical survey. The abstract of their paper is as follows:

The first decade of the new millennium saw dramatic changes in the ownership patterns in major listed corporations in India. Two developments were striking: promoters, especially in the domestic private sector, bolstered up their holdings to ensure continued entrenchment; and institutional investors significantly increased their holdings, especially in the private sector management-controlled companies segment. In both cases, these increases were achieved at the cost of retail non-institutional shareholders, whose holdings correspondingly recorded a steep fall. This paper documents this evidence, seeks to identify their underlying rationale, and assesses their implications for corporate equity investment and governance in the country.

The findings in this paper are important. On the one hand, SEBI’s efforts have been focused on creating a diversification of shareholding in the markets. Its regulations on mandating a minimum public float of 25% (10% for government-owned companies), which it has stringently enforced, is representative of this regulatory approach. More generally, the continued strengthening of the regulatory framework (both substantive law and its enforcement) has been with a view to enhance investor protection so as to enable more investors to participate in the stock markets. However, the empirical findings in the above paper point in the diametrically opposite direction. Ownership levels are becoming more concentrated than diffused, thereby defying the theory that better investor protection will result in greater dispersed shareholding by a larger number of investors. Moreover, retail investors do not seem to have gathered the requisite confidence in increasing their direct participation in the stock markets. While these findings are focused on ownership concentration trends in Indian companies, they may have a broader story to tell about the effectiveness of securities regulation, investor protection measures and corporate governance.

Saturday, April 12, 2014

Companies Act, 2013: Directors’ Duties and Liabilities

The NSE Centre for Excellence in Corporate Governance (CECG) has issued its most recent quarterly briefing titled “Directors’ Duties and Liabilities in the New Era”. The executive summary is as follows:

- Since directors and the board play a pivotal role in corporate governance, the law foists duties and liabilities on them;

- The Companies Act, 2013 has brought about a paradigm shift by considerably enhancing directors’ duties and liabilities;

- The directors’ duties are now codified and extend to considering the interests of stakeholders other than shareholders;

- Directors are, however, entitled to various protective measures in the form of mitigating factors either conferred upon them by law or through practical mechanisms they may establish.

This would not have been possible without the excellent inputs and suggestions received from members of the CECG at various points in time during the drafting process.

Thursday, April 10, 2014

Enhanced Disclosure of Mutual Fund Voting Policies

Generally, shareholders of a company may exercise their voting rights in any manner in which they deem fit. They are not even obliged to exercise their corporate franchise and may instead choose to abstain rom attending and voting at company meetings. This legal position may engender passivity and shareholder apathy, which have been prevalent in Indian companies for several decades.

While law or regulation cannot compel shareholders to exercise their votes on companies, they can be exhorted to do so. In this vein, SEBI in 2010 required mutual funds (which subject to registration with SEBI) to disclose their voting policies. By introducing transparency in mutual fund voting, the idea is that such investors cannot simply adopt a passive attitude and must decide whether or not to vote and, if so, how.

In a more recent development, SEBI has issued a circular making the disclosure of mutual fund voting policies more stringent. The key matters encompassed in the circular are as follows:

1. Asset management companies (AMCs) must record and disclose specific rationale supporting their voting decision (for, against or abstain) with respect to each vote proposal.

2. AMCs must publish summary of the votes cast across all its investee companies and its break-up in terms of total number of votes cast in favor, against or abstained from.

3. AMCs must make disclosure of votes cast on their website (in spreadsheet format) on a quarterly basis, within 10 working days from the end of the quarter. Further, AMCs shall continue disclosing voting details in their annual report. A revised format for disclosure has been prescribed.

4. Further, on an annual basis, AMCs must obtain Auditor's certification on the voting reports being disclosed by them. Such auditor's certification shall be submitted to trustees and also disclosed in the relevant portion of the Mutual Funds' annual report & website.

5. Board of AMCs and Trustees of Mutual Funds shall be required to review and ensure that AMCs have voted on important decisions that may affect the interest of investors and the rationale recorded for vote decision is prudent and adequate. The confirmation to the same, along with any adverse comments made by auditors, shall have to be reported to SEBI in the half yearly trustee reports.

These measures will certainly enhance more responsible exercise of voting rights by mutual funds. In fact, SEBI’s circular explicitly states that mutual funds/ AMCs must be encouraged “to diligently exercise their voting rights in the best interest of the unitholders”. This is representative of the dual agency problem prevalent in the case of institutional investors. On the one hand, the investee company managers ought to manage their companies for the benefit of their shareholders. Where a shareholder is an institutional investor (as in the case of a mutual fund), such investor must in turn manage its investment for the benefit of the unitholders who are the ultimate investors. This explicit recognition of unitholders’ best interest imposes a significant onus on AMCs and their managers to act cautiously and responsibly in exercising voting rights on investee companies, and it is not longer possible to adopt a passive attitude when it comes to corporate voting.

Such responsible voting decisions would also enhance activism among institutional shareholders, a phenomenon that has become altogether real in the Indian context. Although SEBI’s circular applies directly only to mutual funds, the attitude adopted by mutual funds may also influence other institutional investors as to the manner of their exercise of the corporate franchise. The rapid development of the proxy advisory industry has already begun to further aid institutional activity in corporate meetings and voting.

Wednesday, April 9, 2014

Compensating Investor Losses in India

Posted on SSRN is a new working paper titled “The Protection of Minority Investors and the Compensation of Their Losses: A Case Study of India” that I have authored.

The abstract is as follows:

Any legal system may potentially deploy two separate but related models to ensure the accuracy of disclosure in the capital markets. First, it may possess legal institutions in the form of regulatory bodies with power to make regulations regarding disclosures and to enforce those regulations through powers of sanction conferred upon them. Second, it may adopt the model that relies upon the courts to grant remedies to investors who are victims of inaccurate or misleading disclosures thereby suffering losses.

This paper tests the efficacy of the two models in their application to India. The exploration of India is interesting and helpful because India’s capital markets have witnessed exponential growth in the last two decades. At first blush, it might be simple to attribute this to India’s legal system through civil liability and its enforcement through the judiciary. Counterintuitively, though, India’s common law legal system operating through the judiciary has not played a vital role in the development of the capital markets through a rigorous civil liability regime. Delays in proceedings due to alarming pendency levels in litigation before Indian courts and skyrocketing costs in initiating litigation are some of the factors that have disincentivized investors from relying upon the civil liability regime for enforcing their compensation claims.

At the same time, other factors have been at play. India’s capital markets regulator, the Securities and Exchange Board of India (SEBI) has been instrumental in formulating policies and regulations governing capital markets, and its actions have been rapid and dynamic to suit the needs of the changing markets, by operating through the power of sanctioning various market players.

The paper concludes with the finding that while the general approach in most common law markets is for courts to play a significant role in the development of the capital markets through the process of compensating investors for losses, the success of India’s capital markets growth has hinged upon the regulatory process rather than the courts.

This paper represents the legal position as of February 2014, and does not include subsequent developments such as the notification of further sections of the Companies Act, 2013 with effect from April 1, 2014 and also the re-promulgation of the Securities Laws (Amendment) Ordinance, 2014. These developments, however, do not affect the principal outcomes discussed in the paper.

Guest Post: CCI Amends Merger Control Regulations

[The following post is contributed by Karan Singh Chandhiok, Head of Competition Law and Dispute Resolution, Chandhiok & Associates, Advocates and Solicitors; and Vikram Sobti, Senior Associate with the firm. The authors may be contacted at and respectively]

On 28 March 2014, the Competition Commission of India (CCI) issued a notification amending the existing merger control regulations in India, namely the Competition Commission of India (Procedure in regard to the transaction of business relating to combinations) Regulations, 2011 (Combination Regulations).

The latest set of amendments is the result of an annual exercise that is undertaken by the CCI to update the merger control regulations. 

Some of the important amendments introduced are set out below:

a.         CCI to look at the substance of transactions: The antitrust regulator in India has tightened the screws on mergers and acquisitions to ensure that the parties do not avoid seeking mandatory premerger approval by adopting innovative and complex structures to their transactions. The amendment clarifies that the requirement of filing notice with the CCI shall be determined by the “substance of the transaction” and not by the structure of the transactions.

b.         Notification of transactions taking place outside of India: Schedule I to the Combination Regulations provides a list of transactions that normally do not require prior notification and approval from the CCI; and are treated as not having an appreciable adverse effect on competition in India.  Entry 10 to Schedule I of the Combination Regulations, which exempts transactions that take place “entirely outside India with insignificant local nexus and effect on markets in India”, has now been deleted. This follows from the regulator’s practice of requiring parties to make a premerger notification where the combining parties satisfy the turnover or assets thresholds set out in the Competition Act, 2002 (the Competition Act) and the transaction does not benefit from the target based exemption.[1]

c.         Amendment to Form I and Form II:

i.          Form I (short form filing): The amended short form filing with the CCI now requires wider disclosure of any horizontal overlap or vertical relationships between the business of the parties to the transaction. Previously, this information was sought only in the context of horizontal overlaps or vertical relationships that are arising post-merger. Moreover, the parties will now have to provide details of merger filings made by the parties in other jurisdictions, along with the status report of such filings.

ii.         Form II  (long form filing) requires the parties to provide the details, in terms of value of assets and aggregate of turnover, as per the audited annual accounts of immediately preceding two financial years, instead of the immediately preceding financial year.

d.         Increase in filing fee: The fee for filing Form I under the Combination Regulations has been increased by 50% from INR 1,000,000 (~USD 16,667) to INR 1,500,000 (~USD 25,000), whereas the fee for filing Form II has been enhanced by 25% from INR 4,000,000 (~USD 66,667) to INR 5,000,000 (~USD 83,000). This is the second time that the CCI has raised its filing fees and are amongst the highest charged by any regulator in India.

e.         Right of appeal: The CCI has now deleted regulation 29 that allowed parties to the proceedings before the regulator to prefer an appeal against an order of the CCI relating to combinations to the Competition Appellate Tribunal. This regulation was unnecessary given the statutory right to appeal provided under section 53B of the Competition Act. The statutory right to appeal is not restricted as the erstwhile regulation 29 to a “party to the proceedings”, instead, section 53B confers a right on any person to appeal against an order of the CCI in respect of combinations. However, the Competition Appellate Tribunal in a recent appeal has limited the scope of this right by introducing the concept of ‘locus standi’. 

Whilst the majority of these amendments are on procedural matter, their immediate impact will be to clear the air on issues that repeatedly caused confusion and may have led to transactions going unreported with the commission. The ‘substance over form’ amendment demonstrates this approach of the CCI. In essence, this should mean that in any transaction where there is a change of control or one party is able to influence the strategic decisions of the other through contract or otherwise, such transactions should be notified to the CCI. Another example of transactions that would be captured by this amendment would be where one party is acquiring shares over time, but the manner of such a staggered acquisition has already been documented. 

The most important amendment, however, remains the deletion of entry 10 in schedule I. The “local nexus” entry had raised false expectations amongst stakeholders on the scope of the exemption; and it is not unthinkable that several transactions may have gone unreported to the CCI with the parties being in the mistaken belief that their transaction could benefit from the exemptions. Given the regulator’s strict view on compliance and its penchant for imposing high penalties, the latest set of amendments will lead to better regulatory compliance, even though they will add to deal timings and cost.

- Karan Singh Chandhiok & Vikram Sobti

[1] In March 2011, the Ministry of Corporate Affairs of the Government of India introduced a ‘Transaction Based Exemption’ which exempted transactions where the target whose control, shares, voting rights or assets are being acquired has either assets of the value of not more than INR 2.5 billion (~USD 41.5 million)  in India; OR  turnover of not more than INR 7.5 billion (~USD 124 million) in India.

Tuesday, April 8, 2014

Delaware Standard for Controlled Company Mergers

Delaware courts have long been considering disputes pertaining to mergers between companies and their controlling shareholders. Not only do such mergers involve related party transactions but they are also used as a means to squeeze out the minority shareholders of the target who are cashed out as part of the merger. In one of the first decisions that permitted minority shareholders to bring fiduciary duty class actions in such transactions, the Delaware Supreme Court applied the “entire fairness” standard that is quite onerous on the controlling shareholders (see Weinberger v. UOP, Inc., 457 A. 2d 701 (Del. 1983)). Subsequently, the court adopted a more nuanced approach in Kahn v. Lynch Communication Systems Inc., 638 A. 2d 1110 (Del. 1994).

After some lapse of time, the issue was reconsidered by the Delaware Chancery Court last year in In Re MFW Shareholders Litigation, 67 A. 3d 496 (Del. Ch. 2013), which applied the more deferential “business judgment rule” standard so long as the transaction was subject to certain precautionary measures that ensured sufficient protection to the minority shareholders. Last month, this ruling of the Chancery Court was upheld by the Delaware Supreme Court in Kahn v. M&F Worldwide Corp., which represents the settled legal position on the issue.

In this case, through a merger, MacAndrews & Forbes Holdings, Inc. (“M&F”), a 43% shareholder of M&F Worldwide Corp. (“MFW”) sought to acquire the remaining shares of MFW thereby effectively taking the company private. Two protective conditions were included as part of the transaction process, i.e. that (i) the merger be negotiated and approved by a special committee of independent MFW directors (the “Special Committee”), and (ii) the merger be approved by a majority of shareholder not affiliated with M&F (i.e. non-controlling shareholders).

The importance of the question presented before the Delaware Supreme Court is evident from the following passage:

This appeal presents a question of first impression: what should be the standard of review for a merger between a controlling stockholder and its subsidiary, where the merger is conditioned ab initio upon the approval of both an independent, adequately-empowered Special Committee that fulfills its duty of care, and the uncoerced, informed vote of a majority of the minority stockholders. The question has never been put directly to this Court.

After considering the legal position in these circumstances, the court affirmed the availability of the business judgment standard of review. This standard is summarised as follows:

To summarize our holding, in controller buyouts, the business judgment standard of review will be applied if and only if: (i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority. [footnote omitted]

Although this standard appears deferential to boards and controlling shareholders, it is available only if the precautions set forth above are exercised carefully (which is subject to scrutiny by the courts). In establishing this standard, the court appears to have introduced a fair amount of certainty that corporations and their advisors can rely upon while structuring controlled company mergers and squeeze out transactions. As noted on the Delaware Corporate & Legal Services Blog, the decision “is an important milestone in Delaware corporate jurisprudence, providing definitive guidance on how a company can structure a going-private merger so that, in the event of a lawsuit brought by shareholders against the board of directors, the court applies the deferential business judgment rule to the board’s decision and not the more stringent entire fairness standard.”

Although the Delaware position represents a significant contrast to the manner in which squeeze out transactions are regulated in India, some lessons may be useful. The use of a committee of independent directors, which has hitherto been rare in India, is beginning to gain some prominence and may be utilised effectively for squeeze out transactions. Similarly, a “majority of the minority” (MoM) vote is now recognised for related party transactions under section 188 of the Companies Act, 2013. Although a plain vanilla squeeze out transaction may not necessarily fall within the definition of a related party transaction for that purpose, the use of an MoM vote will certainly enhance minority shareholder protection. The regulation of squeeze outs in India has received limited attention under the Companies Act, 2013, and is likely to continue to vex the companies, shareholders, regulators and courts alike.

Sunday, April 6, 2014

Possible Liberalization in FDI Pricing Guidelines

Despite the progressive opening up of the Indian economy to foreign investment in 1991, there has been tight control over the entry and exit prices for foreign investors into and from investments in Indian companies through the foreign direct investment route (FDI). While the initial approach was to benchmark the transaction prices to the erstwhile formula prescribed by the Controller of Capital Issues (CCI), more lately (since 2010) the benchmark was altered to the discounted cash flow (DCF) valuation. While unlisted company investments were subject to these benchmarks, listed companies were entitled to the benefit of market efficiency and prevailing stock exchange prices that provided proxies for company valuation. Further relaxations were made more recently in January this year.

Latest reports and analyses (here and here) have alerted us to the possibility that the Reserve Bank of India (RBI) is set to further rationalize the pricing of entry and exit of foreign investment into Indian companies. This is based on a statement in the First Bi-monthly Monetary Policy Statement, 2014-15 by Dr. Raghuram Rajan, Governor of the RBI, as follows:

As regards foreign direct investment (FDI), it has been decided to withdraw all the existing guidelines relating to valuation in case of any acquisition/sale of shares and accordingly, such transactions will henceforth be based on acceptable market practices. Operating guidelines will be notified separately.

This potential change represents an important development in FDI structuring. Hitherto, investors have been hamstrung by unduly stringent pricing norms that have adversely affected the commercials of investment transactions. While entry-pricing norms for FDI have imposed floor prices on foreign investors thereby disabling them from investing at low prices (that may be necessary for specific types such as early-stage investments), the exit pricing norms have imposed caps that disallow foreign investors from exiting their Indian investments at commercially attractive prices. The policy rationale for the pricing norms is understandable – as it is a measure of regulating the inflow and outflow of foreign exchange. However, the rigidity in its implementation acts as a disincentive to foreign investments and not only curbs foreign investors from investing into India but also limits the availability of foreign capital to Indian companies.

The regulatory progression in the recent years coupled with the latest announcement seems to rationalize the policy in a manner that favours foreign investment. It is certainly not the case that FDI pricing must be free from any regulation whatsoever so as to permit the parties to contractually determine any manner of pricing conditions. That might move matters away from the policy goal of regulating foreign exchange, a role that the RBI has discharged quite effectively over the years. However, the pricing norms must be in tune with reality and must provide the necessary flexibility to promote ordinary commercial transactions without imposing unnecessary hindrances.

At the same time, what we currently have is only a broad policy pronouncement. It is necessary to await the details in the form of “operating guidelines” before their efficacy or impact can be judged more specifically.