Wednesday, February 6, 2013

Stringent Procedures for Schemes of Arrangement Involving Listed Companies

For the last few years, there has been a perceptible concern on the part of the Securities and Exchange Board of India (SEBI) that companies have been utilizing the facility of schemes of arrangement available under Sections 391-394 of the Companies Act, 1956 to effect various types of transactions, some of which may not be in the interest of minority shareholders. SEBI has sought to introduce several protections in the form of additional oversight.

Its first recent effort in this direction was to introduce clause 24(f) in the listing agreement, which requires listed companies to file the draft schemes of arrangement with the stock exchanges at least 30 days prior to initiating the process with the court. Secondly, it introduced clause 24(i) to constrain the use of innovative accounting treatments by companies by requiring them to produce a certificate of a chartered accountant that the scheme complies with the applicable accounting standards. Thirdly, as regards reverse listings, where a listed company amalgamates or demerges into an unlisted company which then becomes listed through this process, SEBI required the parties to seek an exemption under rule 19(7) of the Securities Contracts (Regulation) Rules, 1957 (SCRR).

It appears that SEBI is not satisfied with the functioning of the current framework and seeks to strengthen it further. It has voiced its immediate concern on the third count above, which is that “in the recent past, SEBI has received applications, seeking exemption, from certain entities containing, inter alia, (a) inadequate disclosures, (b) convoluted schemes of arrangement, (c) exaggerated valuations, etc.” Although the immediate trigger has been in the context of reverse listings (where SEBI’s approval is expressly sought), it has acted to bring about reforms to the entire range of schemes initiated by listed companies.

These reforms have been brought about through SEBI’s circular of February 4, 2013, the salient features of which are discussed below.

Role of the Stock Exchange

The stock exchange will continue to play a significant role in scrutinizing such schemes in ensuring that public investor interests are protected. For this purpose, listed companies must file a copy of the scheme and other documents with the stock exchange 30 days prior to initiation of the scheme process before the court. One of the open issues in this scenario pertains to what happens if the scheme is not approved by the stock exchange. In a technical sense, the stock exchange can only raise objections or provide observations, and does not have approval rights. In the past, stock exchanges have simply refused to approve a scheme, and parties have nevertheless initiated the scheme before the courts after the 30-day period. In one case, the court approved the scheme, subject to obtaining the approval of the stock exchange, but it is possible that courts may nevertheless proceed to grant sanctions to the scheme. This ambiguity has not been addressed in the new circular.

Role of SEBI

One of the significant changes brought about by the new circular is that SEBI now has a direct role in scrutinizing schemes of arrangement. While the stock exchange would provide its own comments, in doing so it has to aggregate SEBI’s comments and views as well. While such an approach is helpful in egregious cases where schemes have been drafted in a manner so as to benefit some parties and (usually) to disadvantage of public minority shareholders, such an overarching supervisory power to SEBI may give rise to significant practical issues. It is not clear as to the extent to which SEBI can scrutinize the scheme. As far as court supervision under Sections 391-394 of the Companies Act is concerned, there is now a rich body of law that clearly scopes the role of the court. Unless such a clear scope is available regarding the exercise of SEBI’s power, it could leave a lot of uncertainty from a transactional perspective. Moreover, there could be a timing issue as well. If both stock exchanges and SEBI have to scrutinize and provide observations, this could be time-consuming, especially if there is a lot of back and forth in terms of request for and exchange of information between SEBI and the companies.


The new circular imposes requirements on listed companies to put out more information regarding the transaction in the public domain, and also to submit additional documents to the stock exchanges. These include details of valuation, fairness opinion by merchant bankers and other financial and related information. This is a welcome move. The downsides of complex and ingenious schemes can be overcome by greater transparency. Better information rights would enable the market to make their choices in an informed manner. If the informational aspects are structured properly, and (even more) enforced strictly, that would reduce the necessity for greater direct oversight of schemes by the regulators as contemplated by other provisions in the circular.

Voting/ Majority

Schemes of arrangement under section 391 of the Companies Act require the approval of different classes of shareholders. This must be satisfied through a numerical majority of shareholders represented by 75% in value of the shares, which is a higher threshold than for other types of shareholder approvals. In case of schemes of reduction of capital, no class meetings are required and a mere special resolution would suffice.

The circular now goes beyond the purview of the Companies Act, and requires that schemes involving listed be considered sanctioned only “if the votes cast by public shareholders in favor of the proposal amount to at least two times the number of votes cast by public shareholders against it.” In other words, in addition to the usual majority the scheme must also receive the approval of 2/3rds of the public shareholders. This is helpful in related-party transactions where the controlling shareholders may have an interest in the transaction. While this would certainly make the scheme procedure more burdensome, there are some process-related issues to be ironed out. For example, the circular is not clear whether such a 2/3rd requirement applies to each class of shares.

Finally, the new set of reforms would apply for all schemes that have not yet been filed with the courts as of the date of the circular (February 4, 2013).

Given that the circular makes the scheme process somewhat more onerous compared to the current situation, it remains to be seen whether the scheme of arrangement as a route to achieve M&A and restructuring transactions would lose favour with companies. Currently, a scheme of arrangement is a fairly popular route in India compared to other countries which have similar provisions, but that might very well change, at least to some extent.

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