Thursday, May 30, 2013

Supreme Court on Withdrawal of a Takeover Offer


The Supreme Court earlier this month issued its decision on the takeover offer by Nirma Industries Limited to the shareholders of Shree Rama Multi Tech Limited (SRMTL). The court concurred with the view of the Securities Appellate Tribunal (SAT) and the Securities and Exchange Board of India (SEBI) in disallowing the withdrawal of the offer by Nirma.

In a column appearing on CNBC’s The Firm – Corporate Law in India, Shishir Vayttaden sets out the facts and issues of the case in detail and also offers a critique of the judgment. Here I propose to summarise the key facts, deal with the overall policy issue at hand and also suggest a possible way out for acquirers desirous of retaining some flexibility to withdraw from the offer in case of unforeseen circumstances.

Nirma triggered the mandatory open offer obligations under the previous version of the SEBI Takeover Regulations of 1997 when it enforced a pledge of shares offered by the promoters of SRMTL. Since Nirma’s acquisition of shares exceeded the then prescribed threshold of 15%, it triggered an offer. During the course of the offer, certain revelations were made regarding the financial situation of the target company that became the subject of a financial fraud that significantly reduced the company’s share value. According to Nirma, these facts were not known to it during due diligence conducted prior to the offer. It therefore approached SEBI to withdraw the offer.

As SEBI and SAT (on appeal) refused to permit a withdrawal, Nirma approached the Supreme Court. The Supreme Court largely relied upon an interpretation of Reg. 27 of the Takeover Regulations, 1997 to come to the conclusion that the withdrawal was not permissible. Shishir has dealt with the reasoning of the court in detail in his column, and also pointed to some of the weaknesses of that approach.

Policy Analysis

From a policy standpoint, withdrawal of mandatory offers creates a conflicting situation. On the one hand, takeover regulation considers mandatory offers as sacrosanct as they are intended to offer equality of treatment and exit opportunities for minority shareholders when there is a change in control of the target. In other words, minority shareholders must be allowed to exit on same terms as those who have sold shares to the new acquirer who has obtained control over the target. This is the reason why withdrawals are treated with great circumspection by SEBI.

At the same time, there are situations where a withdrawal must be permitted because the circumstances that triggered the offer or the basis on which the offer was made may no longer exist. Such situations could be varied in nature. The first is impossibility, for example due to the death of an acquirer who is an individual. The second could be circumstances beyond the control of the acquirer, such as a drastic adverse change in the financial condition of the target, similar to the case of SRMTL. Thirdly, there could be situations where the acquirer is unable to perform its obligations under the offer on account of its own circumstances, e.g. inability to complete the offer due to lack of sufficient funds to discharge the consideration to shareholders tendering in the offer. While the first situation clearly makes a case for withdrawal, the third does not merit a withdrawal as that would affect the sanctity of a mandatory offer. It is the second situation, present in this case, which is somewhat tricky as it essentially involves a question of whether or not the acquirer ought to bear the risk of a change in the target’s financial condition. While the Supreme Court’s approach has been to place that risk on the acquirer, Shishir’s critique makes a strong case the other way.

Although the acquirer’s actions are in good faith and deserve some sympathy, a withdrawal of a mandatory offer could result in an incongruous situation unless the underlying transaction that triggered the offer is also unwound. This is because the promoters would have realised the full value on their shares and exited the company leaving the minority shareholders high and dry.

Way Forward

Fortunately, this incongruity has been addressed to some extent in the current version of the Takeover Regulations of 2011, which will likely provide greater leeway to acquirers to structure their transactions such that they are able to avoid any eventuality of the type that arose in the SRMTL case. A new ground has been inserted in the form of Reg. 23(1)(c) of the 2011 Regulations where one of the circumstances where an offer may be withdrawn is as follows:

(c)        any condition stipulated in the agreement for acquisition attracting the obligation to make the open offer is not met for reasons outside the reasonable control of the acquirer, and such agreement is rescinded, subject to such conditions having been specifically disclosed in the detailed public statement and the letter of offer; …

Hence, it is now possible to include a condition in the acquisition agreement that could provide for a “material adverse change” (MAC) clause. In the event that the MAC clause is attracted, the acquisition agreement need not be completed by the acquirer, and that can be a ground for withdrawal of the offer. This scheme of things is also consistent with the policy arguments discussed above. In such a situation, both the acquisition that triggered the offer as well as the offer itself would fail making it an “all-or-none” deal. Since there is no change in control, the principle of equality of treatment is not affected, and minority interests are untouched by this.

One of the lessons from the Supreme Court decision would be for transaction planners to structure the acquisition agreement and the open offer documents (public announcement and letter of offer) such that they protect the acquirer appropriate through MAC clauses and other similar conditional arrangements.

In structuring these arrangements, the key is to note that withdrawal will be permissible only if the circumstances giving rise to the inability of the acquirer to complete the offer is outside its control. Moreover, to take a cue from other jurisdictions such as the UK and Singapore, such circumstances should also be objectively determined and not by way of subjective determination by the acquirer. Furthermore, in similar circumstances, regulators in other jurisdictions have also paid heed to the sanctity of an offer and hence allowed a withdrawal for failure of a MAC clause only if the event is material in the sense that it strikes at the heart of the transactions, almost akin to a frustration of a contract (see UK Takeover Panel Statement 2001/15 involving an offer by WPP Group plc for Tempus Group plc following the events surrounding the September 11, 2001 attacks in the US). However, this standard has been subsequently diluted somewhat, although it remains fairly high.

Wednesday, May 29, 2013

Agreements to Agree

As we have noted on this blog, the common law generally imposes no duty on a contracting party to negotiate in good faith. This is so even when parties ‘agree’ to agree, that is, purport to conclude a contract leaving certain (sometimes essential) terms to be agreed in the future. The House of Lords held in the well-known case of Walford v Miles [1992] AC 128 that such an agreement imposes no obligation on either party to attempt to reach agreement on the terms left open. But this is not the end of the story: in many cases, the courts have been willing to imply a term in order to make the contract effective, for example, by concluding that ‘price to be agreed’ means ‘reasonable price to be determined by the arbitrator’. The entire law on this subject was reviewed by the Court of Appeal in two leading cases, Mamidoil-Jetoil Greek Petroleum Company SA v Okta Crude Oil Refinery and BJ Aviation Ltd v Pool Aviation. There is a valuable summary, in the form of ten (non-exhaustive) principles, of the effect of the numerous authorities at paragraph 69 of Rix LJ’s judgment in the former case. Principle (vii) is that the court will more readily imply a term to make the contract effective “where where one party has either already had the advantage of some performance…

This issue arose recently in the Court of Appeal in MRI Trading AG v Erdenet Mining Corporation LLC, a case that neatly illustrates principle (vii) and, more generally, one factor that persuades the court to imply a term to make a contract effective: part performance of a contract and the existence of a network of agreements of which the supposed contract is part. MRI Trading agreed to sell, and EMC agreed to buy, a certain quantity of copper concentrate in 2005. Disputes arose between then parties and arbitration was commenced at the London Metal Exchange [“LME”]. The parties then drew up a Settlement Agreement dated 30.01.2009 which provided that the arbitration would be discontinued; that MRI would give up all its claims under the previous contract. On its part, EMC agreed that it “shall sell MRI Trading 40,000 WMT of EMC Copper Concentrates in each of 2009 and 2010, all pursuant to new, separate contracts between EMC and MRI Trading…” The present dispute arose out of EMC’s purported obligation to sell copper concentrate in 2010. As envisaged by the Settlement Agreement, a new contract was agreed, which provided that “MRI agrees to buy…and EMC agrees to sell...40,000 WMT of concentrate plus or minus 10 % at EMC’s option”. The crucial clauses of this contract, and the basis of EMC’s contention that there was no contract at all, were 6.1, 9.1 and 9.2. These provided, in summary, that shipping schedule (6.1), Treatment Charge [“TC”] and Refining Charge [“RC”] “shall be agreed during the negotiation of terms for 2010”.

The arbitral tribunal found that the shipping schedule, TC and RC were essential terms of the contract to buy copper concentrate; that since these terms were not agreed, there was no obligation on EMC to sell. Crucially, the Tribunal held that the contract should be construed without reference to the Settlement Agreement, overlooking, as Tomlinson LJ points out at [14], that the Entire Agreement Clause in the contract expressly excluded the Settlement Agreement. Once it came to this conclusion, it could not be said that EMC had received any benefit for the purpose of Rix LJ’s seventh principle: the fact that MRI had abandoned its claims by virtue of the Settlement Agreement was irrelevant because the Settlement Agreement could not be taken into account in construing the Sale Agreement.

The general reluctance of the English courts to interfere with the reasoning of an arbitral Tribunal, particularly when no question of jurisdiction arises, is well-known. Tomlinson LJ notes that two very experienced judges of the Commercial Court (Christopher Clarke J., granting leave to appeal, and Eder J., who decided the appeal) were nevertheless driven to conclude that this award was “obviously wrong” and one that no reasonable Tribunal correctly applying the law on the point could have made. In the appeal, MRI’s principal contention was that the court could not revisit the Tribunal’s conclusion that shipping schedule, TC and RC are essential terms: that is a matter for the Tribunal alone. Tomlinson LJ rejected this submission, essentially because the Tribunal had failed to take the Settlement Agreement into account, and also because the parties had supplied a mechanism to resolve this dispute, should agreement not be forthcoming: arbitration. The Tribunal’s conclusion was also inconsistent with the peremptory language of other portions of the agreement, particularly the Recitals, which placed a positive obligation on the parties to buy and sell, respectively. The Court was therefore willing to imply a term. As Tomlinson LJ explains at [19]:

In my judgment the language used by the parties in both the Settlement Agreement and the 2010 contract shows beyond any doubt that they did not intend that, in the language of Chadwick LJ in the B J Aviation case, they should remain free to agree or to disagree about the TC/RC and the shipping schedule as their own perceived interests should dictate with the result that, should they not reach an agreement, there would be no obligation in respect of 2010 at all.  I have no doubt that, just as in Foley v Classique Coaches and Wessex v Fine Fare [1967] 1 Lloyd’s Rep 53, another decision of this court, a term is to be implied that the TC/RC and shipping schedule shall be reasonable, and in the event of any dispute as to the appropriate charges and schedule the dispute is to be determined by arbitration.

Defining “Control” in Takeover Regulations

The question of what constitutes “control” under the SEBI Takeover Regulations of 2011 is a vexed one. This is because an acquirer could acquire less than the mandatory offer threshold of 25% and still be required to make an offer if it is said to be in control of the target company. Control is defined in an inclusive manner and could result in some amount of subjectivity in its determination. The issue has been surfacing again and again in a few cases, where it is primarily the contractual arrangements between the parties that are under scrutiny, and specifically in terms of the rights conferred upon the investor/acquirer.

In an interesting column last week in the Financial Express, Menaka Doshi points to the background regarding the concept of “control” in the Takeover Regulations and stresses the paradoxical results it can lead to. She also sets out the background to the definition of “control” and the failed opportunity to receive an interpretation from the Supreme Court in the Subhkam case.

While the Takeover Regulations Advisory Committee (TRAC) that recommended the 2011 Regulations reemphasized the need for mandatory offers to be triggered by de facto control situations in addition to de jure control situations, the Committee refrained from making specific recommendations on type of exercise of the control (including the power of the investor/acquirer to say “no” to proposals of target companies). This was because the Subhkam case was pending before the Supreme Court at that stage with a ruling anticipated to clear the air.

The reason why I was drawn to this issue again now is because I was researching in a different context on the question of mandatory offers being triggered by a change in control, and was examining the position internationally. In a handful of jurisdictions that I examined, none of them had a subjective definition of control. All of them had a specific percentage threshold for defining control, similar to the 25% threshold in India. Examples are UK (30%), Singapore (20%), Hong Kong (30%), Malaysia (33%) and European Union (30%). Of course, the US takeover regime does not carry a mandatory offer obligation. India was the only jurisdiction I came across that has a subjective definition of control in addition to a percentage threshold, a point that Menaka too notes. While this will certainly benefit minority shareholders by providing them with an equal exit opportunity through mandatory offers during a change in control, it could also cause uncertainties as we have seen in the few Indian cases.

Interestingly, some other jurisdictions carried a subjective definition of control in their early years and, since it did not work well, migrated to a regime where control is defined through a specific percentage threshold. It would be useful to consider the merits and demerits of both approaches.

The reason for a subjective definition of control is that there can be various shades of control in a target company. That would depend not only on the legal rights conferred upon shareholders holding certain number of shares with voting rights (e.g. 75% to pass a special resolution), but also upon the distribution of shares among shareholders of the target (in a widely distributed shareholding, a small holding may be sufficient to gain control). Therefore, a subjective definition of control would enable SEBI to make a determination based on the facts and circumstances of individual cases. This would ensure that acquirers cannot circumvent their mandatory offer obligations by structuring their transactions through ingenious methods to stay outside the purview the rule. Although this approach could significantly minimise the circumvention or abuse of the rule, it is fraught with uncertainty that could severely impinge upon a free market for acquisition of shares in a listed company if acquirers are put under a constant fear of having to make an offer even though they do not fancy a controlling position in the target.

The element of uncertainty surrounding a subjective definition of control is removed in a specific numerical percentage threshold. A bright-line test such as 25% voting rights in a company, which is a proxy for control, introduces considerable ease in interpretation and implementation both for the regulators and the participants in the takeover market. However, one of the key disadvantages of this approach is that it introduces an element of arbitrariness to the process. While due care may be exercised while fixing the appropriate limit to determine control, it is always possible for persons acquiring shares in the targets to acquire such number of shares so that they stay below the threshold for mandatory offers. Hence, in India, it is possible for a person to acquire 24% shares with voting rights and avoid making an offer to acquire the remaining shares even though such level of shareholding may provide the person with de facto control of the target, especially if the remaining shareholding in the target is diffused.

Given that both the subjective and bright-line approaches have their disadvantages, neither may be considered optimal on its own. After having experimented with the subjective approach during their initial years of takeover regulation, several jurisdictions have reconciled to adopting the bright-line approach.

Only time will tell if India’s approach of combining both a numeric percentage threshold and subjective determination of control will be optimal or counterproductive. Even if there is no case yet to eliminate the subjective concept of control, it would do well for SEBI to delineate its scope as clearly as possible.

Wednesday, May 22, 2013

SEBI Clarifies on Schemes of Arrangement

Following SEBI’s circular of February 4, 2013 imposing stringent requirements for oversight of schemes of arrangement, there were certain issues that required clarification (discussed here and here).

Now, by way of another circular dated May 21, 2013, SEBI has clarified some of the outstanding issues and also made some modifications to the previous circular. In this post, we discuss some of the key items:

1. Applicability of the Circular

SEBI has now clarified that the February 4 circular is applicable to all types of schemes of arrangement including amalgamation, reconstruction and reduction of capital. It is not limited to reverse listings or other schemes that may require an exemption under Rule 19(7) of the Securities Contracts (Regulation) Rules, 1957.

The wide applicability of the circular would mean that all schemes of arrangement will now be closely scrutinized and will require review by the stock exchanges and SEBI.

2. Majority Requirements for Voting

The February 4 circular provided that proposal for a scheme will pass muster 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 requirement has now been done away with.

A more stringent majority requirement as well as voting through postal ballot and e-voting and greater disclosure measures are now limited to schemes of arrangement that are undertaken where promoters are a party or are affected by it. Examples of this are where promoters are allotted further shares under the scheme, or where a group company is a party to the transaction. In such cases, there must be a majority of public shareholders voting in favour of the scheme, in addition to the normal majority required by the Companies Act. The stringent majority requirements therefore apply only to related party transactions undertaken through schemes of arrangement and not to all transactions (which are carried out at arm’s length).

It appears that the earlier circular treated all transactions with the same level of circumspection and imposed high burden on companies that would have made obtaining the requisite majority cumbersome, but now that is limited only to related party transactions that require greater protection for minority shareholders.

3.         Others

Under the revised circular, while valuation reports are required to be submitted in all types of schemes, they are required to be obtained from an independent chartered accountant only if there is a change in the shareholding of the listed company / resultant company. What amounts to change in shareholding pattern is defined with specificity along with illustrations.

The revised circular achieves two results. On the one hand, it clarifies the scope of applicability of the previous circular. On the other hand, it lessens the stringency of the previous circular by making some of the onerous requirements applicable to specific types of schemes where minority interests are likely to vulnerable rather than to all types of schemes.

Tuesday, May 21, 2013

Public Shareholding Norms: Consequences of Non-Compliance

The June 2013 deadline for compliance by listed companies with the minimum public shareholding of 25% is looming closer. The deadline for compliance by public sector (government) listed companies to comply with the 10% minimum public shareholding will follow in August.

Over the last few months, several companies have already reduced their promoter shareholding to meet with these norms. This has been accomplished through various facilities provided by the Government and SEBI to achieve the minimum public shareholding norms. SEBI has also provided specific exemptions and dispensations in certain cases. The latest episode of The Firm has a comprehensive discussion on the manner in which companies have gone about reducing their promoter holdings and the various issues that have arisen in the process.

Despite a rush to achieve these norms, there will certainly be a significant number of companies that are unable to comply with them by the June deadline. SEBI has been steadfast in its stance that it will not extend the time period for compliance.

In these circumstances, a lawyer friend recently raised the issue of the possible consequences of non-compliance by listed companies. In order to consider this, we must note that the minimum public shareholding norms are embodied in Rule 19A of the Securities Contracts (Regulation) Rules, 1957 (SCRR) that was introduced by way of amendment in 2010. In addition, the listing agreement in clause 40A requires companies to comply with Rules 19(2) and 19A of the SCRR.

The first consequence of non-compliance would be a delisting of securities on account a breach of the listing agreement. As we have repeatedly argued before, this would be a paradoxical tool to ensure compliance with listing norms. In case of a delisting, it is the public shareholders who would suffer due to a loss of liquidity and exit opportunity in the markets. Public shareholders would be penalized by failure of the company and promoters to comply with norms that are intended to benefit them. While this regulatory response exists on paper, it must be exercised cautiously after considering the extensive impact it may have.

The second consequence would be penalties levied on the non-compliant companies. Section 23E of the Securities Contracts (Regulation) Act, 1956 (SCRA) provides that in case of failure to comply with the listing conditions, SEBI could impose a penalty not exceeding Rs. 25 crores (rupees 250 million). SEBI could potentially invoke this power in case the public shareholding norms are not met by the deadline.

While these measures exist on the statute books, it is a different matter as to how they might be exercised by SEBI in practice. The past track record indicates certain difficulties in the implementation of corporate and securities laws. For example, when stringent measures of corporate governance were to be introduced by amendments to clause 49 of the listing agreement in 2004, the implementation was delayed several times and they came into effect only on January 1, 2006. These include a tighter definition of board independence and the like. Even thereafter, when SEBI tried to enforce the board independence requirements against several listed companies, primarily in the public (government) sector, it had to drop them subsequently.

To make a comparison, during October and November 2008, SEBI passed a series of orders involving the lack of appointment of the requisite number of independent directors to several government companies, viz. NTPC Limited (Oct. 8), GAIL (India) Limited (Oct. 27), Indian Oil Corporation Limited (Oct. 31) and Oil and Natural Gas Corporation Limited (Nov. 3). The principal ground for dropping the action was that in the case of the government companies involved the articles of association provide for the appointment of directors by the President of India (as the controlling shareholder), acting through the relevant administrative Ministry. SEBI found that despite continuous follow up by the government companies, the appointments did not take effect due to the need to follow the requisite process and hence the failure by those companies to comply with Clause 49 was not deliberate or intentional.

Returning to the public shareholding norms, a lot would depend upon the stance adopted by SEBI for enforcing them after the deadline has expired. While some of it may be known post-June 2013 when the deadline for private sector companies expires, but the real enforcement test may lie if there are violators among the public sector companies, which will be clear subsequently.

Monday, May 20, 2013

Madras High Court on SEBI Circular for Scheme of Arrangement

A few months ago, I had discussed SEBI’s circular of February 4, 2013, which imposes more stringent oversight by SEBI and the stock exchanges on different types of schemes of arrangement.

Shortly thereafter, our guest contributor Yogesh Chande has pointed to issues relating to the scope of the SEBI circular, and specifically whether the circular applies only to such schemes that require exemption from Rule 19(7) of the Securities Contracts (Regulation) Rules, 1957 (SCRR), which principally relates to reverse listings, or whether it applies more widely to all types of arrangements. This ambiguity is caused because although the SEBI circular applies generally to all types of schemes, including schemes among listed companies and even capital reductions under section 100 of the Companies Act, the genesis for the circular can be related to a 2009 circular which is confined to reverse listings and was also repealed by the February 2013 circular.

In an unreported judgment dated April 1, 2013, the Madras High Court holds that SEBI’s circular is applicable only where an exemption is being sought from Rule 19 of the SCRR and not for other schemes. That case involved a merger of two companies both of which were listed on the stock exchanges. The companies made an application to the court for convening meetings under section 391 of the Companies Act. Since this was not a reverse listing, the court clarified in response that the SEBI circular is not applicable. The relevant portion containing the discussion on the point of law on the issue is extracted below:

5. The learned counsel for the applicant contended that the conditions laid down by the Securities and Exchange Board of India vide circular CIR/CFD/DIL/5/2013 dated 04.02.2013 are not applicable to the case of the applicant, as the applicant is not seeking exemption under Rule 19(7) of the Securities Contracts (Regulation) Rules, 1957, as the transferor company listed its shares in the recognised Stock Exchange after complying with the conditions laid down under the Securities Contracts (Regulation) Rules, 1957.

6. On consideration, I find force in this contention. Rule 19 of the Securities Contracts (Regulation) Rules, 1957 stipulates that a public company as defined under the Companies Act, 1956, desirous of getting securities listed with the recognised Stock Exchange are required to apply for the purpose to the Stock Exchange along with its application, document contained under the Rule.

7. A submitted by the learned counsel for the applicant, this already stood complied with, when the stock was listed with the recognised Stock Exchange.

8. The learned counsel for the applicant is also right that Rule 19(7) gives right to the Securities Exchange Board to waive or relax strict enforcement of any of the rules. In the present case, it is not a case where the applicant is to get the stock listed. In the case in hand, what is being done is that the stock which is already listed is being regulated without seeking any exemption, therefore, for the purpose of amalgamation of the companies, the provisions of Rule 19(7) would not be applicable, as no exemption under the rules is being sought therefore, the circular issued in exercise of power under Rule 19(7) will not be applicable to the applicant.

The court has adopted a narrow view of the circular. While it is understandable that the circular refers to Rule 19(7), that does not explain the wider objective of SEBI that is evident in the circular and also in the fact that it covers other schemes of the arrangement such as capital reduction that does not involve any listing of securities without following the usual disclosure process.

As Yogesh mentions in his post, there is some ambiguity regarding the scope of the circular, and this decision also underscores the type of issues that could arise in practice. Given this ambiguity, it is recommended that SEBI expressly state its intention regarding the scope of the circular. By issuing a clarification or a set of FAQs, possible uncertainties regarding the schemes of arrangement, which are a popular form of a transaction in India, can be avoided.

Update - May 22, 2013: SEBI has since clarified that the circular is applicable to all types of schemes of arrangement and not only those that require an exemption under Rule 19(7).

Saturday, May 18, 2013

Enforceability of Put and Call Options: Reality Soon?

Although put and call options are quite common in investment agreements, its enforceability under Indian law has been in serious doubt due to age-old provisions in securities laws which have not been updated to meet with the requirement of the times. I have discussed the issue in detail in this paper and also called “for a reconsideration of the legal regime so that physically settled options that are customary in investment agreements may be treated as valid and legally enforceable”.
Although this issue has been on the anvil for a long time, now there seems to be some tangible movement towards resolution. News reports indicate that the Law Ministry has, based on a proposal from the Finance Ministry, decided to permit options in investment agreements.

It is not clear how the revisions will be effected. It could be done simply by way of a notification by SEBI amending/repealing its earlier notification of March 1, 2000, which put paid to these options. The other alternative would be to amend the Securities Contracts (Regulation) Act, 1956 (SCRA), which is perhaps both unnecessary and more cumbersome given that the intervention of Parliament will be required.

It is too early to be euphoric because the devil is always in the detail!