Wednesday, March 23, 2016

Analysis of the options proposed by SEBI for ascertaining “control”

[The following guest post is contributed by Amitabh Robin Singh, who is an Associate at DSK Legal.

In this, he highlights the benefits and also offers a critique of SEBI’s recent proposals to define “control”]

Recently, the Securities and Exchange Board of India (“SEBI”) released a discussion paper to lay down a bright line test for the acquisition of “control” under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (“Takeover Code”). The purpose of this is to lay down an objective test, which will lead to predictability and consistency in the regime regarding the acquisition of control as per the Takeover Code.

Control is defined in the Takeover Code at Regulation 2(1)(e) as follows:

“control” includes the right to appoint majority of the directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders agreements or voting agreements or in any other manner:

Provided that a director or officer of a target company shall not be considered to be in control over such target company, merely by virtue of holding such position.

SEBI goes on to break down the definition into three components, being: the right to appoint the majority of directors, the right to control the management and the right to control the policy decisions of the company.

Further, SEBI lists out the definitions of control as laid down in various legislation such as the Companies Act, 2013 (“Companies Act”), the Insurance Act, 1938 (as amended by the Insurance Laws (Amendment) Act, 2015), the Foreign Direct Investment (FDI) policy for the current year and the Competition Act, 2002 (“Competition Act”). While the Competition Act definition is specific to regulating combinations under Section 5, it can be seen that the use of the words “affairs or management” seems to set a lower threshold than as envisaged in the Takeover Code, seeing that simply controlling the “affairs or management[1] of the enterprise will amount to controlling it.

Also, due to the fact that multiple sectoral regulators have varying definitions of control (such as the Insurance Regulatory and Development Authority of India guidelines on “Indian owned and controlled” companies), may create confusion, and so SEBI would like to mandate an objective test to ascertain when someone is in control of a company. 

Further, the discussion paper goes on to examine how control is defined for other countries such as Germany, Hong Kong and Singapore where there is a tight numerical threshold regardless of the grant of de facto control of the company. It also goes on to mention that countries such as Canada, France and Spain employ the test of ascertaining whether the entity has directly or indirectly, over the majority of the voting power at general meetings or can control the composition of the majority of the board of directors. However, in countries such as the USA and Japan, control is undefined for the purpose of takeovers. Yet other countries possess definitions similar to India’s which are not only concerned about the composition of the board of directors or voting rights but also the ability to control policy decisions.

In view of the above, SEBI has devised two options which are as follows.

The first option contemplates laying down an illustrative list of “protective” rights, which may be granted to an investor without amounting to control. These are opposed to “participative” rights seeing that these protective rights would merely allow the investor to protect the amount invested and ensure its stake is not diluted, but will not allow it to participate in the day-to-day affairs of the company or the policy making process. SEBI is of the opinion that an affirmative vote on something such as changing the “significantly” business activity will be protective and not participative. Once again, the “significance” of a change is a moving target which may inject further subjectivity.

In this option SEBI placed reliance on the decision of the Securities Appellate Tribunal (“SAT”) in the matter of Subhkam Ventures (I) Private Limited v. SEBI (“Subhkam”), wherein SAT opined that “control, according to the definition, is a proactive and not a reactive power.” SAT went on to use the metaphor of a car to define control by saying that one needs to be in the driver’s seat to be in control and be in control of the steering, accelerator, gears and brakes to be in control. Where a party is only reacting instead of taking the initiative on matters, it will not amount to control of the company.

In the Subhkam order, there were 22 rights listed out by SAT that figured in the relevant agreement that it deemed to be protective and not amounting to control of the company. SAT further laid down that the investor merely wants to ensure that the company does not undergo a paradigm shift from its present path without the affirmative vote of the investor.

In light of the above decision, SEBI has proposed the idea of having a list of certain illustrative protective rights which would not amount to control subject to certain conditions such as that the investor who possesses the protective rights should hold at least 10% or more in the investee company. (In the Subhkam case the relevant agreement provided that the rights that accrued to it would fall away upon the investor ceasing to hold 10% or more in the company.)

While grant of such protective rights will be subject to obtaining the approval of the public shareholders of the investee company, these rights will also be required to be incorporated in the Articles of Association of the company post such approval.

Also, it is proposed that every company should formulate a policy to ascertain which transactions are “material” for the purpose of affirmative votes on “material divestment” and “material acquisition”. The discussion paper also recommends a policy to define “outside the ordinary course of business” for the purpose of the illustrative list of rights where activities such as having an affirmative vote on related party transactions which are not “in the ordinary course of business”.

While this test does attempt to shore up the definition of control, a problem that may arise here is that there will still be an element of subjectivity figuring in the equation. This is because SEBI can only prescribe an indicative list of affirmative votes that will be protective rather than participative in nature. It will be impossible for an exhaustive list to be laid down that will encompass every single voting matter due to the fact that new rights may be evolved and worded in different ways which would be read subjectively and in different lights and through different prisms. Hence, this option will result in more cases ending up before the regulator and may not be as productive as envisioned, with investments still getting mired in disputes as to whether control has been acquired or not.

The second option that SEBI has proposed in the discussion paper is to adopt a flat numerical threshold to ascertain control. Seeing that under the Companies Act a special resolution requires a three-fourths majority, an investor holding more than 25% will be able to block special resolutions. Hence, SEBI deemed it prudent that 25% be the threshold for triggering control in listed companies.

SEBI also raised an interesting point here that under the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, a listed company is required to compose its board of at least one-third of the directors on the board being independent directors if the chairman is a non-executive director and must have half of the directors on the board being independent directors if the chairman is an executive director (there was a similar provision in the erstwhile form of the listing agreement). Hence, appointing the majority of the directors may be a highly remote possibility in the case where the chairman in non-executive and not possible in a case where the chairman of the board is an executive director. Therefore, SEBI proposed that the definition read as the right to exercise 25% of the voting rights regardless of considerations of de facto control and/or the right to appoint the majority of non-independent directors.

While this option does lay down a more objective and “bright line” test to ascertain control, one issue in such a case may be where the investee company is starved for funds and issues/sells shares to an investor in distress, the investor may still hold only 24% or less of the equity of the company and also stay below the director threshold, but it may have affirmative votes on a bouquet of matters that will tantamount to control, but will fall outside the purview of the Takeover Code due to the fact that the definition itself precludes the concept of de facto control. The rights granted to an investor in such a case may put the investor in the driver’s seat and allow it to proactively steer the policies of the company. Hence this may lead to “effective control” as contemplated in Subhkam without tripping the definition of control in the Takeover Code and consequentially having to launch an open offer.

As it can be seen, while both options proposed by SEBI may have their own lacunae, they also both represent a substantial step forward in providing predictability and clarity in the regime defining “control” for the purposes of Takeover Code, which is imperative for improving the ease of doing business in India.

- Amitabh Robin Singh

[1] Emphasis provided

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