Monday, December 31, 2007

REITs on the Anvil

Real estate investment trusts (REITs) are similar to mutual funds. However, unlike mutual funds that usually hold securities, the underlying assets held by REITs are constituted by real estate properties. Investors in REITs can participate in returns from these real estate investments.

The last couple of years have seen a boom in the real estate sector, and several Indian real estate companies have successfully accessed capital from the markets with multi-billion dollar issuances of shares. However, Indian laws and regulations did not provide investors with the ability to invest in a vehicle such as the REITs, which enables investors to hold a diversified portfolio of real estate investments (that are not confined to one real estate company or group only). There was also the risk of exportation of the capital markets for REITs with companies either having listed, or planning to list, their properties through issuances of REIT securities in overseas markets such as Singapore and other Asian stock exchanges. SEBI has seized the opportunity to introduce an Indian REITs regime so that Indian companies can raise funds domestically by issue of REITs securities without resorting to international capital markets.

In an announcement made on December 28, 2007, SEBI has issued a draft of the SEBI (Real Estate Investment Trusts) Regulations, 2008 that allows for establishment (and registration with SEBI) of real estate investment trusts and real estate investment management companies. Comments have been invited on the draft from the public by January 10, 2008.

The key features of the draft Regulations are reported in The most important aspect of the draft relates to valuation of properties. Traditionally, valuation of real estate has been a contentious matter, especially in relation to issuance of securities by real estate companies. Consequently, SEBI has devoted considerable attention (and an entire Chapter VI of the draft Regulations) to ensure proper and independent valuation of properties to be held by a REITs scheme so that investors are provided with a reasonably accurate picture regarding the value of the properties held by the scheme. The report of such valuer is required to contain details regarding the manner in which the properties were valued, all of which would make the valuation methodology transparent and readily available to investors. While the draft Regulations lay down the statutory framework regarding property valuation, more effort would be required at a peer level among valuers to set out working rules and norms for valuation of properties so that the regulations are given effect not only in letter, but also in spirit.

There are other issues (that fall outside the direct ambit of the draft Regulations) that need to be ironed out before REITs can be implemented in practice. First, there are several industry-specific problems underlying the real estate sector. One important legal issue is the absence of clear title and the existence of incomplete contracts that plagues several real estate transactions in India. This enhances risks borne by investors in REITs. Therefore, it is imperative that there be stringent disclosure norms for issuance of securities by REITs that make it mandatory for issuers to qualitatively disclose these risks to investors. In other words, the offer document requirements to be prescribed by SEBI for REITs should encompass all industry-specific issues and matters that are associated with the real estate sector.

There is also a need for clarity on the position regarding taxation of REITs themselves as well as their investors, as also any stamp duty implications on the issue and transfer of the REITs securities. This is required to ensure smooth implementation of the regulations.

While SEBI’s announcement of REITs cannot be more timely, there is evidently a need for a comprehensive review of all aspects that have a bearing on REITs transactions before the mechanism can be put in place, so as to make its implementation successful.

Related stores: Business Standard, Financial Times, Hindu Business Line (SEBI announces guidelines for REITs and Making the REIT move)

Friday, December 28, 2007

Promoters’ Contribution; SEBI Ruling in the Reliance Power Case

In its order passed yesterday, the Securities and Exchange Board of India (SEBI) ruled that shares acquired by the promoters of Reliance Power Limited (RPL) pursuant to a scheme of amalgamation approved by the High Court of Bombay would be eligible for computation of promoters’ contribution under the SEBI (Disclosure and Investor Protection) Guidelines. SEBI however imposed the condition that the promoters’ contribution of 20% is to be locked-in for a period of 5 years from the date of allotment in the IPO.

The order states:

From the above Clause 4.6.2 it is noted that in case of public issue by unlisted companies, securities which have been (acquired by) the promoters during the preceding one year, at a price lower than the price at which equity is being offered to public shall not be eligible for computation of promoters’ contribution. Clause 4.6.4 creates an exemption to this requirement in case of the shares which are acquired pursuant to a Scheme of Merger/Amalgamation approved by a High Court.

We note that the Scheme of Amalgamation came into effect on 29-09-2007 when the Scheme was filed with the Registrar of Companies. On September 30, 2007, 50,00,00,000 equity shares of Rs. 10 each were allotted by RPL to REL and another 50,00,00,000 shares of Rs.10 each were allotted to AAA Project Ventures Pvt. Ltd . We find that these equity shares so allotted pursuant to the Scheme of merger/amalgamation approved by the Hon’ble High Court would be eligible for computation of promoters’ contribution in terms of Clause 4.6.4 of DIP Guidelines.

As for another issue that arose in the proceedings, i.e. whether there has been a violation of Section 293(1) of the Companies Act, 1956 in relation to the transfer of certain projects from another company to RPL, SEBI rightly held that it does not have the mandate to administer provisions of the Companies Act and hence has no jurisdiction to conclude a finding under that section.

Thursday, December 27, 2007

Contractual Mergers a Possibility

Presently, accomplishing a merger of two or more companies involved a fairly detailed process that lasts about four to six months, if not more. Under Sections 391 to 394 of the Companies Act, 1956, apart from the approval of the shareholders (and sometimes creditors) the merger also requires the sanction of the appropriate High Court (and often multiple High Courts).

However, there is likely to be simplification in the procedure. The Economic Times reports that the Government is proposing to introduce a system of ‘contractual mergers’ which does away with the requirement of obtaining the sanction of the High Court. Approval of the shareholders would continue to be a pre-requisite for mergers. There seem to be checks and balances introduced to avoid abuse of this process – the simplified procedure is available only to specific types of merger transactions where public interest is not expected to be affected. The news report states:

The new norms for M&As between group companies will cover mergers between a parent and a subsidiary as well as mergers between two unrelated private companies where public interest is minimal. The logic is that if outsiders are not involved, it is unfair to subject the internal matter of a group or of two private companies to the rigours of an elaborate process designed for public limited companies where the public and other stakeholders are involved.

This proposal is consistent with developments across the globe. For instance, in the Delaware (which has the maximum concentration of incorporations in the United States), all mergers are contractual and do not require sanction of the court. Affected parties are however free to challenge merger transactions ex post if there is a breach of law. Other nations, including several Commonwealth countries such as Singapore and New Zealand are gradually moving in the same direction.

A significant advantage that the court sanction under Sections 391 to 394 of the Companies Act provides is that the order of the court operates in rem and therefore enables parties to give effect to a smooth transfer of all assets, liabilities, contracts, licences, employees, litigation and so on by virtue of the court order. Often, parties resort to a court scheme rather than elaborate bilateral negotiations and transfers in order to avail of this advantage. It remains to be seen whether the proposed ‘contractual’ merger option takes into account the aspect of the merger operating in rem, failing which parties may still continue to resort to the court procedure (regardless of the cost and delay) in cases where transfer of assets and liabilities become complex without a court order.

Department of Economic Affairs Internships; For Law Students Too

The Economic Times carries a story that the Department of Economic Affairs (DEA), which is part of the Ministry of Finance, has devised an internship programme to enable interaction between its officials and students pursuing higher studies in the field of economics, finance and management.

It offers interesting options for law students as well. The news report states:

Also, students with at least 80% marks in 12th standard, pursuing five-year integrated course in law from the National Law Schools at Bangalore, Bhopal, Hyderabad and Kolkata, are also eligible for the scholarship if they are in the fourth or fifth year of study.

Expanding Investment Horizons for Trusts

Historically, investment avenues for funds held by trusts have been limited. This is on account of Section 20 of the Indian Trust Act, 1882 which contains very specific instruments in which trusts can invest. These are in the nature of risk-free instruments such as government securities, bank deposits and the like, and does not include risk instruments such as stocks and derivatives. Of course, there is the overall enabling provision in Section 20(f) that enables the trust instrument to specify any other types of investment. This avenues has recently been used by drafters of trust documents to widen the scope of permissible investments by trust. Apart from this, Section 20(f) also enables trusts to make other investments as may be authorised by the Central Government by notification in the official gazette, or by any rule prescribed by the High Court in this behalf. These may be cumbersome as the process involved could be time consuming.

By a recent Government decision, there is a proposal to allow trusts to invest in the stock markets. The Union Cabinet has decided to amend Section 20 of the Trust Act, and an amendment is expected to be moved in the Budget Session of Parliament. The reports:

The government on 24 December allowed all trusts to invest in securities, including shares and bonds of listed companies, a move that would further boost the booming market.

For this purpose, an amendment in the Indian Trusts Act, 1982 will be moved in Parliament in the next session to enable the government notify a class of securities as eligible for investment by trusts, said a government statement issued after the meeting of the Union Cabinet here.

A Finance Ministry official told PTI that after the amendment to the Act, the government would allow all trusts set up under the Act, which include private and public trusts like educational trusts, to invest in shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities.

Also, see report in the Economic Times.

This is a welcome move as it not only provides fresh avenues for trust investments but would also result in growth of the stock markets as moneys invested in fixed deposits and government securities would now flow into the stock markets.

Climate Change Disclosure

In an article titled “Making Impact Disclosure Mandatory” that appeared in the The Hindu Business Line on December 06, 2007, I have argued for imposing mandatory requirements on climate change disclosures by companies. Despite the wide range of risks and opportunities that climate change presents to the corporate sector, the level of disclosure to investors and deliberation of corporate policies in this area are abysmally low.

Climate change, described as a problem with scientific origins, has recently acquired significant political overtones. A less deliberated aspect of climate change, however, is its impact on the corporate sector, and particularly on investors who are primary stakeholders in companies.

As businesses become increasingly vulnerable to climate change, there is a corresponding surge in investor interest for obtaining information pertaining to corporate exposure to these risks. As for the availability of such information, it appears, there is currently a wide gap. The appetite for corporate information on climate change is essentially whetted by socially responsible investors who seek to ensure sustainable development while earning returns, and who thereby exhort companies in which they have investments to improve their environmental and social governance practices.

That apart, climate change information is crucial even to hard-nosed financial investors, whether institutional or retail, as factors such as global warming and green house gases are likely to have a long-lasting impact on the way companies are managed, and consequently on shareholder value.

Since voluntary efforts are proving to be inadequate, regulators may well have to sound a clarion call for mandatory climate change disclosures.

Mandatory disclosures will not only help investors in obtaining better information about climate change risks and opportunities affecting their investments, but would also impel those companies that have fallen behind into action to put in place risk management policies and practices to deal with the situation, as failure to properly address climate change could affect their attractiveness with investors.

M&A: Tackling Ambiguity in Deal Documentation

M&A lawyers are accustomed to drafting and negotiating contracts that contain complex terms and conditions relating to the performance of obligations by parties and remedies for their breach. It is not out of place for acquisition agreements to contain clause A that operates “notwithstanding any other provision contained in this Agreement”, and for clause B to operate “subject to the terms and conditions stipulated in clause A”. A multiple application of such clauses that either supercede other clauses or are subservient to them sometimes results in ambiguity in the interpretation of the contract.

One such contract recently came up for interpretation by the Delaware Court of Chancery. The case involves the leveraged buyout of United Rentals Inc. (URI) by Cerebrus, a well-known private equity firm. On July 22, 2007, URI entered into a Merger Agreement with certain Cerebrus entities whereby Cerebrus agreed to acquire the entire share capital of URI for US$ 34.50 per share in cash, for a total transaction value of approximately $7 billion. However, before the transaction could be consummated, Cerebrus reneged from the contract, and on November 14, 2007, notified URI that it would be unable to proceed with the transaction. On November 19, 2007, URI filed an action in the Delaware Chancery Court seeking specific performance of the contract by Cerebrus. This relief was denied by the court in its order dated December 21, 2007.

The Merger Agreement contained two clauses that are relevant for the present purposes. The first is Section 9.10, which is the specific performance clause that enables each party to require the other party to specifically close the transaction. However, this section is expressly stated to be “subject to Section 8.2(e)” of the said agreement. Section 8.2(e), which is the termination clause, provided for circumstances under which either party can terminate the agreement for a break-up fee of $100 million. More importantly, Section 8.2(e) is expressed to be “notwithstanding anything to the contrary in this Agreement”.

This poses several questions: (i) what was the intention of the parties while stipulating both a termination clause as well as specific performance clause (each of which runs contrary to the other)?; (ii) in case of a conflict, which provision would supercede?; (iii) if the break-up fee was to be the sole remedy (as it is an overriding provision), what was the point in having a specific performance clause at all? – Would it not be a redundant provision?

On a simple reading of the contract, it appears that Section 8.2(e), which provides for termination and break-up fee, would override Section 9.10 that deals with specific performance. This means URI’s remedies would be limited to the break-up fee and not specific performance.

In its judgment, the Delaware Chancery Court through Chandler, Chancellor, applied a three-pronged test as follows:

[L]ike the three heads of the mythological Cerberus, the private equity firm of the same name presents three substantial challenges to plaintiff’s case: (1) the language of the Merger Agreement, (2) evidence of the negotiations between the parties, and (3) a doctrine of contract interpretation known as the forthright negotiator principle. In this tale the three heads prove too much to overcome.

First, the language of the Merger Agreement presents a direct conflict between two provisions on remedies, rendering the Agreement ambiguous and defeating plaintiff’s motion for summary judgment. Second, the extrinsic evidence of the negotiation process, though ultimately not conclusive, is too muddled to find that plaintiff’s interpretation of the Agreement represents the common understanding of the parties. Third, under the forthright negotiator principle, the subjective understanding of one party to a contract may bind the other party when the other party knows or has reason to know of that understanding. Because the evidence in this case shows that defendants understood this Agreement to preclude the remedy of specific performance and that plaintiff knew or should have known of this understanding, I conclude that plaintiff has failed to meet its burden and find in favor of defendants.

The court further went on to add:

One may plausibly upbraid Cerberus for walking away from this deal, for favoring their lenders over their targets, or for suboptimal contract editing, but one cannot reasonably criticize the firm for a failure to represent its understanding of the limitations on remedies provided by this Merger Agreement. From the beginning of the process, Cerberus and its attorneys have aggressively negotiated this contract, and along the way they have communicated their intentions and understandings to URI. Despite the Herculean efforts of its litigation counsel at trial, URI could not overcome the apparent lack of communication of its intentions and understandings to defendants. Even if URI’s deal attorneys did not affirmatively and explicitly agree to the limitation on specific performance as several witnesses allege they did on multiple occasions, no testimony at trial rebutted the inference that I must reasonably draw from the evidence: by July 22, 2007, URI knew or should have known what Cerberus’s understanding of the Merger Agreement was, and if URI disagreed with that understanding, it had an affirmative duty to clarify its position in the face of an ambiguous contract with glaringly conflicting provisions. Because it has failed to meet its burden of demonstrating that the common understanding of the parties permitted specific performance of the Merger Agreement, URI’s petition for specific performance is denied.

(See report in New York Times)

This decision clearly indicates the need for clarity, precision and the lack of ambiguity in drafting commercial contracts in general, and on M&A transactions in particular. Of course, there are constraints under which parties and their lawyers operate – lack of time for proper negotiations, interest of the parties to keep legal costs at a minimum and sometimes genuine misunderstanding between parties and their advisors as to deal terms. However, within these constraints, parties should maximize their efforts to arrive at clear terms that do not result in parties having to resort to litigation and require courts determine their real intention.

Wednesday, December 26, 2007

About this Blog

Welcome to the Indian Corporate Law Blog!

At the outset, it is appropriate to set out the goals and objectives of this blog, and what it seeks to encompass. Very simply, it is nothing more than a humble effort to track key developments in the sphere of corporate law in India and to foster discussion and deliberation on issues as they emerge. It will also serve as an informal knowledge base for news and ideas on topics in Indian corporate law. Effort will be made to address issues both from academic and practice standpoints.

As to the scope of the blog, the title “Indian Corporate Law” somewhat underplays its real breadth. It is intended to cover all areas of the law that affect the operation of companies in India; in a sense, it subsumes all laws that play a role in business and commerce. It would therefore include laws such as company law, contract law, securities laws, foreign investment laws, property law and the like. While the blog is intended primarily to focus on Indian laws, it would not be out of place to follow similar developments internationally as those may have implications for India as well, thanks to the increasing interconnectivity in markets across jurisdictions owing to globalization.

Hope you enjoy and benefit from reading this blog.