Thursday, July 31, 2008

Reforms in the IPO Process

Payment Mechanism

Although there were reports about this in the recent past, SEBI yesterday formally notified reforms in relation to the payment process for resident retail investors in IPOs. Under this process, these retail investors do not have to make any payment when they bid for shares in the bookbuilding process, and then wait for refunds in case they do not obtain full allocation on the shares they applied for. Instead, SEBI has devised a method whereby the bank accounts of the investors will be blocked to the extent of the value of the applications they make.

The process is described by SEBI as follows (wherein “ASBA” stands for Applications Supported by Blocked Amount, and “SCSB” for Self Certified Syndicate Bank):

“An ASBA investor shall submit an ASBA physically or electronically through the internet banking facility, to the SCSB with whom the bank account to be blocked, is maintained. The SCSB shall then block the application money in the bank account specified in the ASBA, on the basis of an authorisation to this effect given by the account holder in the ASBA. The application money shall remain blocked in the bank account till finalisation of the basis of allotment in the issue or till withdrawal/ failure of the issue or till withdrawal/ rejection of the application, as the case may be. The application data shall thereafter be uploaded by the SCSB in the electronic bidding system through a web enabled interface provided by the Stock Exchanges. Once the basis of allotment is finalized, the Registrar to the Issue shall send an appropriate request to the SCSB for unblocking the relevant bank accounts and for transferring the requisite amount to the issuer’s account. In case of withdrawal/ failure of the issue, the amount shall be unblocked by the SCSB on receipt of information from the pre-issue merchant bankers.”
This would certainly streamline the application process for retail investors as it would no longer require applicants to wait for refunds in case their applications are not accepted in full.


A detailed post in the Indian Capital Markets blog analyses SEBI’s proposal to introduce hard underwriting. As of now, the concept of hard underwriting exists only in the case of fixed-price public offerings (which are out of fashion these days) and not in the case of bookbuilt public offerings (which have become the norm).

The author gives several reasons why hard underwriting would not be effective in the Indian market conditions, and that efforts instead must be taken to improve some of the other aspects of public offerings by Indian company. The post also details some of the processes involved in Indian IPOs.

Sunday, July 27, 2008

India’s New Competition Law: A Comparative Assessment

Antitrust & Competition Policy Blog points to a new article by Delhi School of Economics Professor Aditya Bhattacharjea on India's New Competition Law: A Comparative Assessment in the Oxford Journal of Competition Law and Economics. The abstract is set out below:

This paper critically examines India's new Competition Act. I begin by examining the working of its predecessor, the 1969 Monopolies and Restrictive Trade Practices Act. Earlier studies, as well as a survey of recent cases undertaken for this paper, show that most cases under that Act involved consumer complaints and contractual disputes unrelated to competition. Very few cartels were prosecuted, the development of a rule of reason for vertical agreements was hamstrung by the legislature, and merger review was terminated in 1991. Thereafter, judgments increasingly tried to enforce "fair" business conduct "in the public interest," often protecting competitors rather than competition. India thus has little relevant experience for the many technical economic criteria in the Competition Act. Although the new Act has several positive features, it is riddled with loopholes that might condone hard-core cartels, predatory pricing, and potentially anticompetitive cross-border mergers, while it also perpetuates the earlier tendency to penalize "unfair" behavior with no bearing on competition. I argue that several institutional limitations will also impair the Act's effectiveness and conclude with a plea for capacity building and phased implementation.

Promoters’ Contribution: SAT Ruling in the Reliance Power Case

A few days ago, the Securities Appellate Tribunal (SAT) passed its order in the Reliance Power IPO Case. This is on an appeal from the decision of SEBI (that we had posted about earlier on this blog).

I thank one of our readers who sent in a review of the SAT decision, which I reproduce below:

Rajkot Saher v. SEBI, Reliance Power Limited

Facts: The promoters of Reliance Power Limited ("RPL") acquired shares at face value through a High Court sanctioned merger 6 months prior to the IPO and by paying for partly-paid shares issued previously to AAA Projects Ventures, i.e., the entity that merged with RPL.

The appellants filed proceedings before SAT to prevent the IPO of RPL primarily because public shareholders were offered 10.1 per cent stake for Rs. 102 billion, whereas the promoters acquired 89.9 per cent stake in RPL by paying Rs. 34.4 billion in the same year. In effect, the promoters acquired 9 times the public shareholders' stake at one-third the price (during the course of the same year).

The SEBI (DIP) Guidelines require that -

(i) shares acquired by the “promoters during the preceding one year [to an IPO], at a price lower than the price at which they were offered to public, shall not be eligible for computation of promoters’ minimum contribution of 20% unless such acquisition is in pursuance of a scheme of merger or amalgamation approved by a High Court” (Clause 4.6.2);

(ii) the promoters’ contribution in a public issue by an unlisted company shall not be less than 20% of the post issue capital (Clause 4.1.1).

Therefore, the High Court sanction permitted the promoters to factor-in the shares allotted through the merger for calculating of the "minimum promoters’ contribution" prior to the IPO.

The appellants contended that
(a) the High Court was “kept in the dark” about the reason behind the merger during the High Court proceedings;

(b) the partly paid-up shares should be considered as acquired only when they were fully paid-up and not considered as part of promoters contribution. Moreover, the price of these shares should match the price offered to the public shareholders, i.e., Rs. 450 per share;

(c) the post-issue capital should also include the share premium paid by the shareholders and not be limited to the face value of the shares. This would require the promoters to contribute 20 per cent of the face value plus the share premium of Rs. 440.

Decision: SAT held that:

(a) “The share premium account cannot be taken as a part of the ‘post issue capital’ because the provisions of the Companies Act make a clear distinction between the two.”

(b) “The provisions of sections 87 (1)(b) and 110 (2) of the Act clearly show that the holders of the partly paid equity shares of a company are its legal members…. ….these shares were also fully paid by the promoters before 15.1.2008, the issue opening date and this met with the requirements of clause 4.9 of the guidelines. In these circumstances, we cannot agree with the appellants that the partly paid up shares should be considered ineligible under clause 4.6.2 of the guidelines.”

(c) “There is no material before us to say that the order of the High Court was obtained by fraud and, in any case, we cannot go behind the order and hold that it was obtained by keeping the High Court in the dark”.

(d) “The case of the appellants is that the innocent public shareholders were cheated by RPL. We cannot accept this. RPL had furnished all the relevant and detailed information in the Red Herring Prospectus as required by law…..On the basis of the information furnished in the prospectus, the public shareholders had taken an informed commercial decision when they applied for shares in the IPO. In these circumstances, we fail to understand as to how RPL can be faulted after it had furnished information as required by law in the Red Herring Prospectus”.


(1) SAT has (in effect) given its implicit approval to promoters to use partly-paid pre-IPO structures. Partly-paid shares allow promoters to freeze valuations at past date and inject the unpaid portion at the time of an IPO even though valuations would be substantially higher at that time. The partly-paid shares that are later fully paid up would also be accounted for the minimum promoters' contribution.

(2) The High Court merger route provides another option for the promoters to merge existing promoter group companies at valuations that are far lower than that offered to the public – thereby by giving the promoters a larger stake at lower price.

(3) SEBI will not question the propriety of the High Court’s order and “cannot go behind the order”. Sure enough, a merger of promoter group companies will not be contested in court – but SEBI needs to evaluate whether the target that merges with the “merged entity” should also meet the pre-IPO eligibility criteria and has business case for merger? The pre-IPO merger option could potentially be used to affect valuations, i.e., transferring the merged entity a value substantially higher than its book value.

(4) Is “disclose and get away” the right approach? Although SEBI should not overturn valuations, it must put under the scanner accounting and valuation aspects that may be employed by promoters.

Tuesday, July 22, 2008

Warrants to Foreign Investors

The Economic Times reports that there is a proposal within the Government to bring the issue of warrants by Indian companies to foreign investors within the automatic route where foreign direct investment is otherwise permitted under the automatic route.

This move, if crystallized through a formal policy pronouncement, will dispel some of the confusion that has been recently caused whereby companies are now required to obtain the approval of the Foreign Investment Promotion Board for issue of warrants though their activities are under the automatic route (for purposes of foreign investment).

Liquidation Preference: How Effective is it?

In a column in the Economic Times, Amrita Singh and Siddharth Shah discuss the relevance of the concept of liquidation preference in Indian investment transactions:

“The progressive liberalisation of the foreign investment regime has provided a major boost to private equity and venture capital investments in Indian companies. With the advent of more sophisticated players in the private equity and venture capital arena, the deal terms also tend to get more complicated and sophisticated.

Many of the terms that are commonly employed in deals by these private equity players in other jurisdictions, may pose significant challenges in the Indian regulatory environment. In the context of deal terms and documentation, investor rights, and particularly provision for liquidation preference has always been an area of much debate and negotiation.

So what is liquidation preference? Liquidation preference is typically defined as the right of the investor (usually holding preference shares), to receive its investment amount plus certain agreed percentage of the proceeds in the event of a ‘liquidation’ of the company, in preference over the other shareholders. Contrary to a common perception equating ‘liquidation’ to ‘winding up’, ‘liquidation event’ is typically defined to include not only winding up of the company but also any ‘liquidity event’, which could include a sale of shares or substantial assets, an acquisition or merger of the company or in some cases even a ‘non-qualified’ IPO.”
They then go on to discuss various difficulties under the Companies Act as well as foreign exchange regulations when it comes to enforcing these liquidation preference clauses.

Although such provisions are becoming increasingly common in private equity and venture capital transactions, their enforceability has not been tested in the Indian context. Perhaps it is best if some of these aspects are clearly provided for in the Companies Act itself. The opportunity is likely to present itself soon for this purpose, as the company law is expected to undergo some change. A legal regime that facilitates investment transactions will aid the growth of private equity and venture capital (as Silicon Valley has proved in the latter case).

Sunday, July 20, 2008

Share Buyback: The Effect of Shareholders' Resolution

In a recent case decided last week, the Securities Appellate Tribunal (SAT) had the occasion to decide on the effect of a shareholders' resolution in the context of a buyback of shares. The SAT decision is available here.

The facts of the case are fairly straightforward. The company involved, D-Link India Ltd, proposed to the shareholders a resolution for the buyback of its shares pursuant to Section 77A of the Companies Act, 1956. Under this provision, such a resolution is valid for a period of 12 months, within which period the company may act upon the resolution. If the company, however, fails to proceed with the buyback, the resolution lapses at the end of the 12-month period.

In this case, D-Link India Ltd failed to initiate any buyback within the 12-month period, due to which its shareholders' resolution lapsed. SEBI initiated action against the company on the grounds that the company never had any intention of buying back its shares, and that the convening of the shareholders’ meeting and the announcement of a buyback was only for the purpose of misleading the investors. Consequently, following the request of some investors who bought shares in the company in anticipation of a buy-back, SEBI passed an order stating that the company violated Regulation 5(1)(a) of the Securities and Exchange Board of India (Prohibition of Fraudulent and Unfair Trade Practices Relating to the Securities Market) Regulations, 1995. Hence, the company was directed not to buy, sell or deal in the securities in any manner directly or indirectly for a period of one month. The company went on appeal to the SAT against such order.

SAT overturned SEBI's order, primarily on two grounds:

1. Shareholders’ Resolution Only Enabling in Nature

The first issue considered was whether the company was under any obligation to proceed with the buyback after its shareholders had passed a special resolution authorising the company to carry out the buyback. In his behalf, SAT noted:

“On a reading of the provisions of section 77(A) of the Act and the relevant provisions of the buy-back regulations … we are of the considered view that a company is under no obligation to buy-back its securities even if its shareholders have passed a special resolution authorizing it to buy-back on the terms and conditions mentioned in the resolution. Section 77(A) of the Act is only an enabling provision and all that it mandates is that no company shall buy-back its own securities unless it is authorized by its articles and also by its shareholders. But even where the shareholders pass a special resolution, it does not become obligatory for the company to buy-back the shares.”
2. Not Misleading Investors

As for the allegation of misleading the investors, SAT was of the considered opinion that there is no material on the record to indicate that the company had no intention to buy back its shares when the shareholders passed a resolution. It held that there can be no inference of the company's lack of intention to buy-back merely because it made no offer to the shareholders to buy back its securities. There has to be some other material or circumstances from which such an inference could be drawn, which was absent in this case. SAT then dealt with in detail the factual circumstances based on which it had arrived at this conclusion.

Lastly, SAT also made an overarching observation relating to the role of SEBI has a securities market regulator, and the scope of its powers in transactions such as buyback of shares by listed companies:

“We wonder how [SEBI] is concerned whether the company increases the investor wealth of its shareholders through the buy-back process or by making investments in infrastructure. This is not a matter which affects the securities market. [SEBI] is primarily a market regulator and its duty is to ensure that the market remains a safe place for the investors to invest. It cannot interfere with the business decisions taken by the company so long as they do not prejudicially affect the securities market.”
Two broad principles emerge from the decision:

1. As regards certain provisions of the Companies Act, such as Section 77, the effect of a shareholders' resolution is that it is only enabling in nature. Merely because shareholders have approved a transaction, it does not thereby become obligatory on the company to effect such a transaction. Such a resolution only provides authority to the board of directors to then decide on the details of the transaction, and even to decide on the essential question of whether the transaction should be given effect to in the very first place. In a sense, such a resolution recognises the primacy of the directors in such a context. Other examples of such resolutions where the board is given the power to effect a transaction (without being obligated to do so) include issue of shares, disposal of an undertaking or substantial assets, borrowing of funds, etc.

2. When it comes to an action relating to fraudulent and unfair trade practices, since there is an element of “mens rea” involved in proving an offence, SEBI as the regulator has the onerous task of proving that element. As noted previously on this Blog, the discharge of such a burden is quite difficult, and mere determination on the basis of circumstances may not be adequate. This often substantially reduces the success rate of the regulator in such actions, with the D-Link case being one such example.

Friday, July 18, 2008

Press Note 1: Changes Expected

Press Note 1 of 2005 issued by the Department of Industrial Policy & Promotion (DIPP) requires foreign companies to obtain the prior permission of the Foreign Investment Promotion Board (and thereby making the automatic route for investment ineligible) if they had a joint venture with another Indian partner in the same field. This condition is applicable for joint venture existing in January 2005 (when the press note was issued). Press Note 1 is the diluted version of a more onerous previous Press Note 18 of 1998.

The Economic Times reports that the Government plans to do away with Press Note 1 thereby making it easier for foreign companies to make investments into India where they have had a previous joint venture. This still appears to be in the stage of a proposal only, and it is not clear what form the ultimate change will take, i.e. whether this requirement will be done away with altogether, or whether it would only be diluted further.

On a separate note, about a year ago I had set out some observations on the need to review Press Note 1 in the light of changed circumstances over the years.

(Update – July 21, 2008: Today’s Economic Times carries an editorial titled “Get rid of Press Note 1”)

Recent Restrictions on Short Selling in the US: Comparing the Indian Position

The steep fall in prices of several US investment banks and financial institutions, such as Bear Stearns, Fannie Mae and Freddie Mac have been attributed to false rumours leading to panic selling, which has been further exacerbated by “naked” short selling. This has necessitated emergency action on the part of the Federal Reserve to rescue these institutions.

Consequently, the SEC has imposed a temporary ban on the practice of “naked” short selling in certain specific stocks (19 of them). The New York Times reports:

“The measures are the S.E.C.’s second attempt in less than a week to combat market manipulation, and they will make it harder to short the stocks of 19 financial institutions, including brokerage firms like Lehman Brothers and Morgan Stanley.

Short sellers borrow shares from brokers or institutional investors and sell them, hoping to buy them back later at a lower price and profit from the difference. The order aims at so-called naked short-selling, or selling shares short without first borrowing the shares or ensuring that they can be borrowed. The commission’s 30-day emergency measure aims to make abusive naked shorting harder by holding the brokers — or anyone involved in processing a short sale — responsible for any failure to deliver the borrowed shares within a mandated three-day period.”
Short selling was introduced in India a few months ago, as we had discussed in detail in an earlier post on this blog (which also sets out the various concepts involved in short selling). It is interesting to note that the Indian regulations on short selling are somewhat more conservative compared to the position in the US. In India, SEBI permits short selling only when transactions are settled through delivery of shares; in other words, naked short sales are prohibited to begin with. Such a cautious approach of the Indian regulators may aid in such situations where instruments such as “naked” short sales are used by market participants to benefit from fall in prices induced by rumours and false information.

Wednesday, July 16, 2008

The Efficacy of Windfall Profits Tax

In an earlier post, we had discussed how the recent spike in oil prices has raised important issues relating to corporate governance in listed public sector companies.

Now, this steep oil price rise has rekindled the debate on the need to impose a windfall profits tax on private oil companies. The matter has even acquired political overtones in the US presidential elections, with one of the nominees, Barak Obama, supporting the imposition of such a tax.

This issue has now reared its head in India as well (perhaps for the first time, to my knowledge). Here too, it has unsurprisingly assumed political proportions. However, there is yet no clear opinion on whether such a tax would be efficient, and as to what could possibly be the implications of such a tax from an economic and legal standpoint. In a previous article, the Hindu Business Line sets out the issue (as follows):

“With global crude oil prices touching new highs, a debate has been triggered on measures to deal with the situation and partially insulate the consumers from the impact.

One such suggestion has been imposition of a windfall profits tax on private/joint venture oil-producing companies and private standalone refineries earning profits through import parity pricing policy.

The Left and other political parties such as the Samajwadi Party have been pressing for levy of such a tax citing examples of countries where the tax has been introduced.”

The article then sets out both points of view on the matter:

“A windfall profits tax is levied on oil companies because of the profits they earn as a result of the sharp increase in oil prices. Industry trackers feel that imposition of such a tax would merely mean extending the burden sharing of high crude prices on standalone refiners, and would not help much in cushioning the retail consumers. Besides, it would send a wrong signal for those who are looking at investing in oil and gas exploration in the country.

However, the contrary argument is that with high crude oil prices, the product prices also go up, which is measured by gross refinery margins and this is where the refiners gain, thus the refiner should share the burden. Public sector players say that if the tax is levied in lieu of the subsidy burden which they have to bear then it may be acceptable, otherwise it serves no purpose.”
However, more recently, the Hindu Business Line carries a column by Raghuvir Srinivasan that launches a scathing attack on the proposal for windfall profits tax. He argues:
“A windfall profit tax on oil companies now would be illogical and an unwise economic measure; those arguing in favour should look at the experience of other countries that have imposed such a tax in the past, specifically the US, where it did more harm than good to their economy.

So, what is all this talk of a windfall profit tax then? Such a tax is certainly not going to help bring down pump prices of petrol or diesel. What it will do though is cause immense damage to the already faltering oil companies and lead the government into complex litigation. The rationale for such a tax is completely suspect and can be challenged in the Courts. This is territory not traversed by the government before and could lead to needless complications in an election year.”
This issue is still at the early stages of evolution in the Indian context, but certainly has the potential to throw up interesting legal challenges if pressed forward.

The True Nature of a Stock Swap

A stock swap is a transaction where an acquirer acquires shares of another company and, instead of paying cash for such acquisition, discharges consideration by issuance of its own shares. Business World has surveyed experts on the question as to whether a stock swap amounts to a “sale”. The response is as follows:

Yes : 33%
No : 10%
Maybe : 57%

A summary of the reasons for each answer has been set out in the survey (link provided above).

It appears that the answer "maybe" is probably more appropriate, as a lot would depend on the exact features of the transaction as well as the real intention between the parties. There can be no generalisation as to these matters, especially in a legal sense, as expressions such as "stocks swap", “reverse merger”, etc. are not statutorily defined, but are rather terms that emanate from market practice.

Tuesday, July 15, 2008

Competition Commission & Global Mergers

There has been a coordinated and consistent move by industry to ensure that merger regulations that have been proposed by the Competition Commission do not cover global mergers whose implications in India are not substantial. We have discussed this issue in the past on this blog (here, here and here). In fact, the draft regulations do contain some de minimis exceptions that seemingly placate industry concerns.

However, adopting a somewhat contrarian approach, in an article in the Economic & Political Weekly titled Are Merger Regulations Diluting Parliamentary Intent?, the authors Manish Agarwal and Aditya Bhattacharjea argue that such exceptions brought in through the draft regulations dilute the intention of the legislature in enacting the Competition Act (and the amendments in 2007). The authors state:

“These merger regulation provisions, in particular, the mandatory notification requirement and the lack of a “domestic nexus” criterion for foreign mergers have been sore points for the domestic as well as international business communities. It has been argued that the mandatory notification system will require notification of foreign mergers with little or no nexus to India and add to the cost of doing business as well as strain the resources of the CCI. The amendment Act has sought to address this concern by providing for a domestic nexus test. Accrodingly, the thresholds for worldwide turnover or assets have been amended, so that only those combinations where at least Rs. 500 crore of the combined worldwide assets or at least Rs. 1,500 crore of combined worldwide turnover of the merging parties is in India, would come under the purview of the Act. However, this amendmednt has not been well received in business and legal circles.

In order to address this and other procedural objections and to outline its approach towards merger review, the CCI published draft combinations regulations in January 2008, which list certain categories of transactions that will be treated by the CCI as not likely to cause an appreciable adverse effect on competition in India. They include a modified two-firm domestic nexus test according to which combinations in which at least two parties do not each have a minimum of Rs. 200 crore of assets or Rs. 600 crore of turnover in India will be considered benign. …”
The authors subject this modified two-firm domestic nexus test to an economic analysis and advance arguments that there could be scenarios where mergers could fall below the thresholds stipulated above, but would still raise significant competition concerns. Such arguments are certain to be met with stiff resistance from industry circles.

Monday, July 14, 2008

Vodafone Income Tax Case

The acquisition of shares in Hutch Essar by Vodafone from Hutchison in a multi-billion dollar M&A deal last year has resulted in a dispute on the taxability of capital gains on the transaction. This dispute is currently pending before the Bombay High Court, with a decision being awaited. The court’s verdict is expected to have serious implications on costs involved in implementing M&A transactions in Indian companies, especially when the buyer and seller are overseas entities.

In this behalf, CNBC-TV18 has an interesting discussion about the possible arguments in the case, and also the impact of the decision on future M&A deals. The background is described in the opening part of the discussion as follows:

“It is a landmark case that will severely impact the Mergers & Acquisitions (M&A) landscape in India. No matter which way it goes, the Vodafone versus IT department tax case will have an indelible impact on the M&A landscape of India. Last year British Telecom giant Vodafone paid Hong Kong based Hutchison International over USD 11 billion to buy Hutchison’s 67% stake in Indian telecom company Hutchison Essar. The transaction was done through the sale and purchase of shares of CGP, a Mauritius based company that owned that 67% stake in Hutch Essar.

Since the deal was offshore, neither party thought it was taxable in India. But the tax department disagreed. It claimed that capital gains tax most people paid on the transaction and that tax should have been deducted by Vodafone whilst paying Hutch. The matter went to court and was heard over the last two weeks.

Vodafone argued that the deal was not taxable in India as the funds were paid outside India for the purchase of shares in an offshore company that the tax liability should be borne by Hutch; that Vodafone was not liable to withhold tax as the withholding rule in India applied only to Indian residence that the recent amendment to the IT act of imposing a retrospective interest penalty for withholding lapses was unconstitutional.

Now the taxman’s argument was focused on proving that even though the Vodafone-Hutch deal was offshore, it was taxable as the underlying asset was in India and so it pointed out that the capital asset; that is the Hutch-Essar or now Vodafone-Essar joint venture is situated here and was central to the valuation of the offshore shares; that through the sale of offshore shares, Hutch had sold Vodafone valuable rights - in that the Indian asset including tag along rights, management rights and the right to do business in India and that the offshore transaction had resulted in Vodafone having operational control over that Indian asset. The Department also argued that the withholding tax liability always existed and the amendment was just a clarification.”
See also a previous news report about the case in the Business Standard.

Saturday, July 12, 2008

Security for External Commercial Borrowings: Liberalised Regime

The Reserve Bank of India (RBI) has announced a series of measures to liberalise the regime for Indian borrowers to create security in favour of lenders in case of external commercial borrowings (ECBs). Now, borrowers are only required to obtain the ‘no-objection’ from the authorized dealers (AD) rather than to obtain the prior approval of the RBI for certain types of security (as was the practice until now).

The relevant Circular issued by the RBI yesterday notes:

“3. As a measure of rationalization of the existing procedures, it has been decided to allow AD Category – I banks to convey ‘no objection’ under the Foreign Exchange Management Act (FEMA), 1999 for creation of charge on immovable assets, financial securities and issue of corporate or personal guarantees in favour of overseas lender / security trustee, to secure the ECB to be raised by the borrower.

4. Before according ‘no objection’ under FEMA, 1999, AD Category – I banks may ensure and satisfy themselves that (i) the underlying ECB is strictly in compliance with the extant ECB guidelines, (ii) there exists a security clause in the Loan Agreement requiring the borrower to create charge on immovable assets / financial securities / furnish corporate or personal guarantee, (iii) the loan agreement has been signed by both the lender and the borrowers, and (iv) the borrower has obtained Loan Registratoin Number (LRN) from the Reserve Bank.”

Management Buyouts (MBOs): Possibilities and Challenges

Earlier this week, The Hindu Business Line carried a detailed column on various business and financial aspects of management buyouts (MBOs), particularly as such deals are being witnessed (albeit infrequently) in India. Simply stated, management buyouts involve the acquisition of a division of a company or the shares in a company, in each case by the managers who have been handling the affairs of such division or company. Such acquisitions take place when owners desire to sell off a division or a company or even close or liquidate it, while the managers on the hand envision future growth potential and are willing to place their bets on improving the performance of the division or company by acquiring it. Since managers may not possess adequate resources to effect such an acquisition, they are often compelled to seek financing or even a strategic partnership for this purpose.

Structuring the Deal

At a general level, there are two broad structures that are followed in giving effect to an MBO transaction:

1. Partnership with Private Equity (PE) Players

In this structure, since managers are not able to self-fund an MBO transaction, they only acquire a small stake in the target, with the remaining major stake being taken up by private equity players who may partner with the managers. Managers are usually required to take as much stake in the business as they can afford to, so that their future is tied into that of the business as a method of properly incentivising these managers who are responsible for running the business. Providing additional stake in the form of ‘earn-outs’ may be another method of incentivising the managers.

So far, such types of MBO transactions have been more popular in the Indian context, at least where acquisitions of shares are involved (for reasons we shall see later). The Hindu Business Line column observes:

“Traditionally, Management Buy Outs (MBOs) involved the management wanting to purchase a controlling interest in the company and working along with financial advisors to fund the change of control.

Today, MBO activities involve promoters divesting their stake in a firm by selling out to PE players willing to finance the asking price. The PE players are flexible enough to enter into a partnering relationship with the existing management. This sort of arrangement is basically just a stake buyout and not a classical MBO.

It is common in scenarios where owners want to hive off entities with poor results and the management lacks funds to hold on to the entity (and their jobs) and are, in turn, bailed out by the PE firm.”
This type of MBO transaction is akin to a standard private equity deal involving execution of appropriate investment or shareholders’ agreements between the promoters (here the erstwhile managers) and the private equity investors. These agreements define the rights and obligations of the parties going forward in relation to the target, including in relation to transfer of shares (and restrictions on those) as well as to management and governance of the target (such as board composition, affirmative voting rights and the like).

2. Classic Leveraged Structure

In the international context, the MBO structure followed more commonly is the classic leverage structure that is also popular in the case of leveraged buyouts (LBOs) (where the acquirer may not necessarily belong to the existing management, but could be a third party acquirer of the target company or business).

(a) Share acquisitions

Investopedia defines an LBO as follows:

“The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital.”
In this structure, the acquirers (being the managers) will acquire the entire stake of the target (or at least a large portion of it), for which they will obtain debt financing from lenders or financiers. Managers may also have to commit some capital, but that is relatively minor compared to the large finance obtained through leverage. Here, unlike in the case of private equity type transactions, the managers do not have to cede shareholding to an outside entity such as the private equity players. However, as security for the repayment of the financing obtained by the managers, they would offer as security the assets of the target company.

To illustrate this transaction, manager M may acquire the entire shares of target company T. To finance this, M obtains a loan from bank B. As security for repayment of the loan borrowed by M, company T will create a security over all its assets in favour of bank B.

This classic leveraged structure for MBOs for acquisition of shares in a target company faces almost insurmountable challenges in India. Section 77(2) of the Companies Act, 1956 provides:

“No public company, and no private company which is a subsidiary of a public company, shall give, whether directly or indirectly, and whether by means of a loan, guarantee, the provision of security or otherwise, any financial assistance for the purpose of or in connection with a purchase or subscription made or to be made by any person of or for any shares in the company or its holding company …”
By virtue of this provision, the target company cannot provide security (which is construed to be ‘financial assistance’) to the lenders so as to provide finance to the managers to acquire shares in the target company. Any contravention of this provision could not only lead to the security being considered void, but would also expose the target company to punishment in the form of fine. Although the amount of the fine is only a minimal amount of Rs. 10,000, any violation could expose companies to reputation risk.

Section 77(2) is a strict provision with no exceptions (in the context of MBOs and LBOs). The only possible exception that may facilitate such leveraged transactions relates to those involving private limited companies (that are not subsidiaries of public limited companies) as such companies are not within the purview of the prohibition on financial assistance.

In this context, it is relevant to note that the Indian position on ‘financial assistance’ is fairly stringent compared to that in other common law countries. In other common law jurisdictions, there is either no prohibition on ‘financial assistance’ (e.g. most U.S. states, including Delaware) or there are processes to overcome the prohibition through what is referred to as the ‘whitewash procedure’ that is practiced, for instance, in the U.K. and Australia.

The stringency of the ‘financial assistance’ law is the principal reason why leveraged buyouts (whether by management or otherwise) have not acquired popularity in the Indian markets. On the other hand, Indian acquirers have utilised leverage while acquiring companies overseas, especially in the U.K., with prominent examples of such acquisitions being those undertaken by the Tata Group in Tetley, Corus and JLR.

If leveraged transactions are to pick up steam in India, there is a dire need to amend the laws relating to ‘financial assistance’ under the Indian Companies Act. While most other jurisdictions have been progressively liberalising their laws to permit leveraged transactions (with checks and balances being imposed in parallel), the Indian law has remained constant over the years without any indication of change in the near future. It is an appropriate time now to revisit this position.

(b) Business Acquisitions

Although share acquisitions would fall within the purview of the prohibition on ‘financial assistance’, leveraged structures can be utilised for purpose of business acquisitions. This would involve an acquisition by a manager, not of shares in a company, but of the business of the company.

In this structure, manager M will set up a special purpose company M Co. This new company M Co will acquire the business undertaking of company T, for which purpose M Co. will obtain financing from bank B. As security for repayment of the loan, M Co. will secure the assets of the business it acquired from T, which after the acquisition now belongs to M Co. itself. There is no prohibition in respect of such transactions as there is no ‘financial assistance’ for the purpose of acquisition of ‘shares’. What is involved is transfer of a business undertaking and not a transfer of shares.

Leveraging in such business transfers are permissible in the Indian context, but transfers of businesses may not provide as much flexibility as share transfers do, and further may be fraught with several risks and additional costs such as stamp duties, taxes, etc.

Other Issues

Apart from certain fundamental structuring issues discussed above, MBOs give rise to two complexities, viz. (i) information asymmetry, and (ii) conflict of interest. These issues are often required to be handled very carefully in MBO transactions.

As regards information asymmetry, it is clear that managers who are running businesses or companies (they propose to acquire) have greater information about the affairs of the businesses or companies than possibly the owners who may be selling them. Hence, it is necessary to ensure that the acquirers do not have any informational advantage while effecting such transactions, and that all relevant information has been disclosed to the sellers.

These transactions also give rise to a conflict of interest, as managers are on the acquiring side as well as the selling side. Care must be taken to ensure that the interests of the minority shareholders or owners in the selling company are protected and that the sale transaction itself is carried out on arm’s length basis.

Overall, MBO transactions do provide interesting possibilities for buyouts, but there are existing challenges under Indian law which need to be overcome before leveraged structures can be used to give effect to these transactions.

Friday, July 11, 2008

Corporate Governance in Banks

With the recent credit crisis weakening the financial position of several banks world-over, the question that is being repeatedly posed is whether the boards of directors of these banks could have foreseen the oncoming crisis or whether they should have taken steps to forestall a slide in their financial position. Fingers are being pointed not only at the executive management of these banks, but also at other independent board members.

In a recent column in the Economic Times, TT Ram Mohan laments the lack of adequate financial expertise among directors of banks that may have possibly led to their downfall. He notes:

“UBS, one of the world’s largest banks and among the biggest losers in the subprime crisis, is replacing four of its directors. The bank’s objective, according to its new chairman, is to strengthen the board with independent members with top-class financial or audit experience. The departing members include three outsiders with experience respectively in rail equipment, chemicals and information technology.

Lehman’s audit committee and risk committee has a theatre impresario as member. Citi has a former head of the CIA in the same roles — no doubt, the bank believes that experience in surveillance gained at the CIA has broader applications. Northern Rock’s chairman at the time of its collapse was a zoologist — presumably, this was meant to guard against wild bets on the part of management.”
He also questions the effectiveness of independent directors, even if they do possess the requisite expertise:

"One of the big improvements in corporate governance in recent years is said to be the institution of independent director. Boards are expected to have independent directors who will act as a check on management. But the idea that management, in its wisdom, would assemble the required expertise has taken some hard knocks. Many banks, it turns out, have big names aplenty. Banking expertise is sadly wanting.

To be sure, board expertise does not ensure that tough questions will be asked. Board members may have expertise but they may be unwilling to challenge and confront management. Anybody who has sat on boards knows that any attempt to probe or criticise can inject a jarring note into the proceedings. The superannuated souls who grace many a board prefer the quiet life."
Such concerns about the ineffectiveness of independent directors on such bank boards have also been raised elsewhere in the past. Two posts on the Finlay on Governance Blog are noteworthy. These are Did Bear Stearns Really Have a Board? and Cayne and Greenberg: Two Peas in a Very Dysfunctional Bear Stearns Boardroom Pod.

In an Indian context, the issue of expertise on bank boards has already been addressed by law. Section 10A of the Banking Regulation Act, 1949 requires that no less than 51% of the directors of every banking company should possess expertise in the area of accountancy, economics, banking, finance, law and such other areas. Indian banks’ boards are to be predominantly comprised of persons with financial or banking background. Further, when it comes to corporate governance, the banking sector is subject to greater regulation compared to other companies. For instance, the Reserve Bank of India (RBI) applies further checks and balance by ensuring a maximum term of 8 years for a bank director and also by possessing powers to reconstitute the board of directors and to approve the appointment and removal of directors in certain situations.

All these point towards the fact that corporate governance in banks (being in the financial sector) has very different implications compared to companies in other sectors. In India, banks are subject to the governance requirements prescribed by clause 49 of the listing agreement as well as those prescribed by the RBI. Other countries follow a slightly modified approach – e.g. Singapore has two sets of codes for corporate governance, one for banks and financial institutions and another for other companies. This approach takes into account the different governance requirements for different types of companies.

Lastly, as to independent directors, there conceptually seems to be a misplaced over-reliance by regulators, commentators and the media on this institution as if it is a panacea to all ills. That is perhaps not to be. Independent directors are only board members (and are not involved in the day-to-day management) who can provide strategic direction and oversight of the company’s affairs. There is still considerable debate over the effectiveness of independent directors in corporate governance, although conventional wisdom suggests that independence in the decision-making process on board will make it objective, impartial and diligent. What is required is to apply substance over form while examining the role of board members, whether independent or otherwise. A Note in the Harvard Law Review published a couple of years ago (119 Harv. L. Rev. 1553 (2006)) aptly sums up this point:

“Clearly, there is room for improvement. This Note rests on the premise that reliance on independence standards, if properly linked to the core functions implicated by those standards, can lead to practicable structural reforms that promote more effective corporate governance. The key is to reenvision independence as an institutional norm applicable to every director, rather than as an individual norm applicable only to formally independent directors. As such, the goal is to craft a functional conception of director independence that balances the normative goals of independence-based reforms against the behavioral constraints faced by modern boards. …

This Note’s conceit is that, by recasting independence as an institutional norm that prizes function over form, greater clarity can be brought to bear on the persistent problems of corporate governance. Assuming Adam Smith remains correct in his estimation of what managers are likely to do with “other people’s money”, this approach offers one method of enhancing the board’s ability to limit the damage caused by the separation of ownership from control. For when independence becomes the touchstone of the entire board—rather than the lonely province of the “independent” outsider – monitors, mediators and managers alike can shoulder its burdens and share in its promise. And whatever else regulators, courts, or commentators may say on the subject, it remains the independent board that stands the best chance, and bears the heaviest responsibility, of assuring investor confidence in the corporation.”

Tuesday, July 8, 2008

Bulk Deals and Order Matching

The availability of income tax exemptions (on long term capital gains) for share transactions that are executed through stock exchanges have caused otherwise negotiated share sale and purchase deals to be implemented through the stock exchange mechanism. This would require parties to bear only the securities transaction tax (STT) at rates which are negligible compared to the erstwhile capital gains tax that would have applied to such deals.

In his blog, Professor J R Varma has an interesting post that deals with some practical issues that arise while putting a negotiated bulk deal through the stock exchange mechanism. Specifically, there is the likelihood of a leakage of some shares owing to orders that are placed at the same time by other purchasers in the market. Professor Varma notes:

“It is quite clear that it is possible to do a large trade on the exchange at any price if one is willing to burn through the whole order book and thus share part of the “control premium” with these orders. For example, suppose the current market price is 100 and there are sell orders at prices ranging from 100-110 for a total of say 500,000 shares. The promoter puts in a limit sell order for 100 million shares at a price of 127 and the acquirer immedately thereafter puts in a market buy order for 100 million shares. The market order would first burn through the entire pre-existing order book of 0.5 million shares and then execute the remaining 99.5 million shares against the sell order of the promoters at 127. The only problem is that 0.5 million shares would have been bought at prices above the market price of 100 and this is a small price to pay in relation to the tax that is saved.”
The other problem identified relates to fraudulent and unfair trade practices under the SEBI Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Market Regulations, 2003. This would arise if the market places sell orders at high prices in anticipation of acquirers executing bulk deals on stock exchanges. Professor Varma notes here:
“The first problem is that if the whole world can see that this is what is going to happen, it makes sense for anybody who holds Ranbaxy stock to put in limit sale orders at a price of 125 or 126 to take advantage of the bulk deal whenever it happens.

I am not sure how regulators would look at this issue, because on the one hand, the trade of 100 million shares is a genuine and legitimate trade. On the other hand, it does create a false market and does artificially inflate the price for a short period of time. To this extent, it does appear manipulative.”
While there may be a possible exposure to the regulations that prohibit fraudulent and unfair trade practices, it is often extremely difficult for regulators to succeed in an action under these regulations, for the element of ‘mens rea’ is a necessary ingredient of an offence under those regulations, and proving ‘means rea’ especially in secondary market transactions is an onerous task.

Wednesday, July 2, 2008

Website on Takeover Code

Acquisitions of shares or control of a publicly listed Indian company are governed by the provisions of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 (a.k.a. the Takeover Code). Although this piece of regulation is only about a decade old, it has been tested several times in transactions and before SEBI, the appellate tribunal and courts owing to its intricate set of legal provisions.

In an attempt to break down these complexities and to aid readers of the Code in an easy-to-use manner, a new website ( has been launched. This is essentially for the benefit of companies, investment banks as well as regulators. Business Standard has a report highlighting some of the key features:

“The portal, dubbed as a one-stop online solution for intricacies of Indian takeover laws, through its research-led content, aims to inform investors and stakeholders about the complexities of takeover laws in India and make the process of acquisition compliances-efficient and transparent by harnessing the power of the Internet.

Sebi's takeover code is considered as one of the most complicated in Indian legal jurisprudence.

Consequently, many corporates fail to comply with such complexities leading to imposition of penalties and interpretative disputes and litigations, Vijay said.

Takeovercode.Com intends to simplify the complexities involved with its elaborative compliance reporting, innovative and useful calculators to perform a plethora of functions and advanced search engines to provide up-to-minute information on takeovers, he added.”