Saturday, August 9, 2014

Squeeze Outs: Analyzing the Cadbury Decision

[Professor Vikramaditya Khanna and I have co-authored the following post]


In India, several transaction structures are available for controlling shareholders to squeeze out minority shareholders. These include the compulsory acquisition mechanism, scheme of arrangement and reduction of capital. Out of these, the most commonly used method is the reduction of capital. That is not at all surprising given that the reduction method provides the most efficacious result for controllers, while at the same time conferring the least protection to the minority.

Courts tend to approve proposals for reduction of capital as long as the controllers are able to establish fair process and fair price (determined in the manner discussed in this post). Although minorities do have the power to challenge such proposals, they have rarely been successful in seeking greater scrutiny. At most, they have been able to persuade the court to order a reexamination of the price by appointing a separate independent valuer. Even in those circumstances, disputes have not been satisfactorily resolved, and valuations continue to be disputed.

This story played out most recently in the decision of the Bombay High Court in Cadbury India Limited wherein the court approved a squeeze out through a reduction of capital at a price determined by an independent valuer appointed by the court. In doing so, the court rejected the objections of the dissenting minorities. This case is important for it analyzes the legal position regarding squeeze outs through reductions of capital, and elaborately sets forth the principles upon which the court would either interfere or refuse to do so. It also represents the culmination of a bitterly fought squeeze out litigation lasting five years.

In this post, we analyze the Cadbury decision and explore its impact on minority shareholders in squeeze outs through reduction of capital. Its fact pattern is quite typical of squeeze outs effected via reduction of capital.

Cadbury: The Facts

Cadbury India was a public listed company, being a subsidiary of Cadbury Plc, UK. As a result of several takeover offers made by Cadbury Plc and buyback offers by Cadbury India, the public shareholding of the company fell below the minimum required for continued listing. Hence, the company was delisted from the stock exchanges. At a time when the Cadbury Group held 97.583% of the equity share capital of Cadbury India, with the remaining 2.417% held by the minorities, the company initiated a capital reduction scheme to buy out the minorities. The price offered was supported by the reports of two independent valuers, M/s. Bansi S. Mehta & Co. and M/s. SSPA & Co., which both valued the shares of Cadbury India at Rs. 1,340 per equity share. The special resolution required for such a reduction scheme under the Companies Act, 1956 was duly passed, and the company sought the sanction of the Bombay High Court to the same. It was then duly subjected to challenge by the dissenting minorities.

The uniqueness of Cadbury lies in the fact that the court first ordered the appointment of another valuer to conduct the valuation afresh (albeit with the parties’ support) and then proceeded to announce a legal standard that made it difficult for the minority to challenge this valuation. Although the result appears somewhat curious, the High Court’s order appointing the valuer suggests it arose out of a compromise whereby the company was keen to “cut short the controversy” so long the independent valuation was to be treated as binding. However, the court retained some leeway to interfere with such report in case of “any grave infirmity in it”. Accordingly, Ernst & Young (E&Y), the court-appointed valuer, returned an initial valuation of Rs. 1,743 per equity share, which was subsequently revised upwards to Rs. 2,014.50 per equity share. This too was challenged by the objecting minorities who demanded a price of at least Rs. 2,500 per share.

Decision of the Court

G.S. Patel, J engages in a detailed analysis of the existing case law regarding the court’s jurisdiction in overseeing a scheme of reduction of capital resulting in a squeeze out, particularly on the question of valuation. He found:

4.7       Carefully read, these decisions seem to me to suggest that before a Court can decline sanction to a scheme on account of a valuation, an objector to the scheme must first show that the valuation is ex-facie unreasonable, i.e., so unreasonable that it cannot on the face of it be accepted; alternatively, that it is discriminatory; or that it has not been approved by a sufficient majority or at a minimum, that a substantial number or percentage voted against it at an extraordinary general meeting. None of these are demonstrated in the present case. …

On the question of whether there was prejudice against a class of shareholders, the court found that an overwhelming majority of the non-controlling shareholders voted in favour of the resolution. Out of a total of 7,51,120 non-controller shares voted at the meeting, only 12,784 voted against the resolution, thereby indicating that a “majority of the minority” (MoM) was in favour of the capital reduction. This appears to have weighed heavily with the court, which observed that the “tyranny of the majority” must be balanced with “the essential democratic discipline without which the functioning of any company would degenerate into mere chaos and anarchy” (at para. 5.25).

Nevertheless, the court exercised its discretion in examining whether the scheme was fair, just and reasonable on the lines enumerated by the Supreme Court in Miheer H. Mafatlal v. Mafatlal Industries Ltd., AIR 1997 SC 506. The court’s conclusion on its oversight of valuation is quite categorical and it refused to be drawn into a microscopic examination of the valuation reports and the processes or methodologies followed. The court stated:

5.9       It is not possible for a Court to go into the exercise of carrying out a valuation itself. That, as the Supreme Court said in Miheer H. Mafatlal, is not the Court’s remit. Courts do not have the expertise, the time or the means to do this. I do not believe that they are expected to do it. What the Court’s approach must be to examine whether or not a valuation report is demonstrated to be so unjust, so unreasonable and so unfair that it could result and result only in a manifest and demonstrable, inequity or injustice. This injustice must be shown to apply to a class. This has not been done. It [is] always possible that there may be two views on any approach to accounting and valuation. The fact that the objectors prefer one valuation or method, or prefer their own valuation, is no answer. … [footnote omitted]

In doing so, the court has set a high standard to be satisfied by the objecting shareholders to overturn a valuation proposed by the company. Evidently, the objectors in Cadbury were not only in a miniscule minority of non-controlling shareholders, but they were unable to discharge the burden of successfully challenging the valuation. Given these circumstances, the court approved the capital reduction at the price of Rs. 2,014.50, based on the revised E&Y report.

Helpfully, the court also laid down certain “general principles of universal application in such matters”. Although these are too many to discuss individually within the confines of this post, they represent certain thumb rules for when and how courts must exercise their discretion in reductions of capital, especially on matters of valuation.

Observations and Analysis

At one level, the Cadbury decision is consistent with the prevalent legal position, which is represented by limited intervention of the court in a capital reduction scheme that has received an overwhelming majority of the shareholders, including an MoM vote. Similarly, courts are hesitant to interfere in valuations proposed by the company except in extreme circumstances. Nevertheless, this decision is crucial as it explicates the legal position not only with reference to the specific facts of Cadbury but also with a view to enumerate the legal principles in detail for reference in future cases as well. Given that these are essentially matters of discretion to be exercised by courts reviewing capital reduction schemes, Patel, J embarks on the process of carefully setting out guidelines for the exercise of that discretion so as to induce elements of transparency, certainty and clarity. In doing so, as mentioned earlier, the court also sets a high threshold for objecting shareholders to satisfy before reductions of capital are successfully challenged.

While it is difficult to disagree with the court’s analysis and conclusions on the facts of the present case where there was both an overwhelming MoM vote as well as three different valuations that were adequately supported, we are concerned that the broader ramifications of the ruling may confer inadequate protection to minorities in a squeeze out. Hence, while the conclusion in Cadbury is unassailable, the attenuation of the court’s jurisdiction in capital reduction schemes resulting in squeeze outs is worrisome.

At the same time, it is somewhat intriguing that Cadbury displays a selective intervention by the court. While the court refused to provide a higher price to the minority over the Rs. 2,014.50 per share recommended in the E&Y report, that price itself was 50% above the Rs. 1,340 per share as originally approved by the shareholders by special resolution. It appears that the court was willing to make judgments about the valuation assumptions and give effect to a compromise arrived at between the parties to abide by a neutral court-appointed valuation. One wonders whether the stubbornness of the minorities compelled the court to refrain from interfering with the revised E&Y valuation.

Cadbury must also be seen in the light of the broader issue concerning minority protection in squeeze outs. In a working paper entitled “Regulating Squeeze Outs in India: A Comparative Perspective”, we argue that the current state of protection under Indian law for minorities in squeeze outs is fairly weak. This is buttressed by comparisons with other jurisdictions such as the U.S., the U.K., the European Union and Singapore where minorities are conferred much superior protection. We briefly discuss below the inadequacies of the current regime and some suggestions for reform:

1.         Independent Board Approval: In India, squeeze outs do not require the approval of independent boards of directors. This could be useful as independent boards carry the burden of examining whether transactions are carried out on an “arm’s length” basis. Additionally, the increasingly stringent rules governing related-party transactions under the new company law do not apply to squeeze out transactions thereby denying that protection to minorities.

2.         MoM Vote: Although the court has used a MoM vote as one of the factors in sanctioning capital reduction, we are not sanguine about whether such a voting requirement would be effective in protecting the minorities. For example, some of the larger minorities may dictate the voting process and support a squeeze out even though it may not benefit the minority shareholders as a whole.

3.         Regulatory Oversight: Another option would be for a regulator such as the Securities and Exchange Board of India (SEBI) to exercise greater oversight on squeeze outs. However, under current law, once a company is delisted  SEBI’s oversight powers are eliminated and any squeeze out is outside of SEBI’s jurisdiction. One potential reform we explore could be for SEBI’s supervisory and regulatory power to continue for a specified period following a delisting so as to guard against any exploitative squeeze outs.

Here, we identify only some of the issues and suggest some of the reforms so as to provide a flavor for the types of concerns and dynamics that emanate from squeeze outs.

While Cadbury undertakes the task of streamlining the court’s discretion in squeeze outs through reduction of capital, in our view this solution is at best temporary in nature. In any event, this ruling is subject to any appeal to a higher court. Moving forward there is a need for greater certainty to be introduced through legislative reform. Parliament has missed the opportunity to clarify this area of the law in the Companies Act, 2013, and hence the uncertainties are likely to continue in the new regime as well.

- Vikramaditya Khanna & Umakanth Varottil

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