Monday, March 21, 2016

Choosing between a blurred line and a bright line: SEBI proposes an objective test for “control”

[The following post is contributed by Vinod Kothari of Vinod Kothari & Co.

The subject matter of this post is current given that SEBI is in the process of engaging in a public consultation based on its proposals. We are likely to carry a series of posts on this issue so as to capture a varied set of views and approaches.]

If the ruling of the Securities Appellate Tribunal (SAT) in Subhkam and the subsequent decision of the Supreme Court leaving the matter undecided left a gap in the law, it is good that the Securities and Exchange Board of India (SEBI” has decided to complete the “subh-kaam” (good work) after nearly five years.  The proposed rule through a Discussion Paper seeks to define “control” in the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (the SAST Regulations) to mean acquisition of 25% voting rights, or the right to appoint a majority of non-independent directors. The proposal also seeks to provide that negative control, that is, protective rights typically conferring veto rights to a non-majority substantial shareholder will not be taken as meaning control.  If the proposal is accepted, India, like several other countries in the world, will be moving from the concept of a de facto approach towards control to a de jure approach. While the de jure or objective approach, termed as the “bright-line” test, has the advantage of greater certainty, it is ironical that the move towards the objective, voting control based approach comes at a time when several technology sector companies have demonstrated that voting controls and the ability to derive economic benefits may be completely dissociated.[1]

Historical setting of the existing definition of “control”

An acquisition of “control” by an acquirer over a listed entity commonly triggers a mandatory bid or open-offer requirement. That is, the acquirer is mandated to make a matching offer to the minority shareholders too, to provide to the minority shareholders a level playing field. In India, the SAST Regulations contain two triggers for a mandatory bid. Reg. 3 pertains to first-time acquisition by an acquirer, either by itself or with persons acting in concert (PACs), crossing the threshold of 25% voting power. Reg. 4 triggers the mandatory bid requirement on acquisition of “control” by the acquirer. “Control” is defined in Reg. 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.

The definition above, an inclusive one, defines control of two types: (a) right to appoint a majority of directors (say, management control), or (b) right to control policy decisions (say, policy control). Either of these controls may arise either by virtue of shareholding, that is, voting strength, or by way of management rights, or shareholders’ agreements, or otherwise. The last expression “or otherwise” makes the instrumentality of exercising control open-ended. Therefore, the manner in which the control will be attained does not matter; what matters is the factum of control either over management, or over policy-making.

Reg. 3 incorporates the de jure or objective rule, linking the mandatory bid requirement with 25% voting power. Reg. 4 does not look at voting rights at all – it focuses on the de facto or control over policy-making, either by controlling the management of the entity, or otherwise.

As is evident from the above, India has adopted a “mixed approach”, that is, a combination of the objective and the subjective approaches.

Globally, while some countries have used the economic or subjective model, many other countries have used the objective model. The relative merits and demerits of each approach have been a subject matter of debate[2]. The OECD Competition Committee discussed the two approaches at the roundtable on the Definition of Transaction for the Purpose of Merger Control Review held in June 2013, relevant extracts whereof have been reproduced hereunder:

An objective approach typically relies on percentage thresholds for share acquisitions, such as the acquisition of a 50% interest or of a 25% interest in the target. Objective criteria make the system more predictable and transparent. However, it is possible to structure their transactions “around” the thresholds to avoid notification and review. At the same time, setting an objective threshold too low to make avoidance strategies more difficult could impose unnecessary costs on all sides involved, as it could capture too many transactions that are highly unlikely to have any adverse effects on competition.

“Economic” criteria are more directly aligned with the mechanism through which a transaction might harm competition, by focusing on whether a transaction will enable a firm to acquire the ability to exercise some form of influence over a previously independent firm. Different legal systems define different levels of intensity of influence, such as “decisive influence,” “significant influence,” “material influence,” or “competitively significant influence.” These definitions capture the reason for possible competitive concerns more directly than objective criteria and therefore “target” more effectively potentially problematic transactions. They also make it more difficult to game the system. At the same time, though, they require more case specific interpretation. They[3] can therefore create uncertainty and make the process less transparent. Guidelines by competition authorities, informal guidance, and consistent decision making can to some extent address potential problems in this respect.”

It appears that the objectives of competition law are better served by a subjective definition, whereas those of takeover triggers, requiring open offer, may choose a more certain, objective standard. Therefore, the UK Takeover Code defines “context” of takeover offers to mean acquisition of 30% or more voting rights, irrespective of whether de facto control exists. However, section 26 of the UK Enterprise Act, 2002, pertaining to combinations, continues to use three tests for control, with de facto control being the focal point.

The existing mixed approach in India has its roots in the recommendations of the Bhagwati Panel, which recommended in 1997, that the takeover regulations should contain an inclusive definition of the term ‘control’ which would serve to indicate the circumstances when compliance with the provisions of the Regulations would be necessitated, even where there has been no acquisition of shares, so that SEBI would not be on an uncharted sea in investigating whether there has been change in control. The Committee explained that control of a company is interlinked with its fortunes and any change in control could not be without impact on company's policies and business prospects and is, thus, linked to investors’ interest. And, given that investor protection is a mandate of SEBI, takeover which entails change in control should necessarily be the concern of SEBI.

The Takeover Regulations Advisory Committee set up under the chairmanship of Mr. C Achuthan, concluded that a holding level of 25% of voting rights permits the exercise de facto control. The existence or nonexistence of control over a listed company would be a question of fact, or at best a mixed question of fact and law, to be answered on a case to case basis. Acquisition of de facto control, and not just de jure control should expressly trigger an open offer. The Committee had recommended the definition of “control” be modified to include “ability” in addition to “right” to appoint majority of the directors or to control the management or policy decisions would constitute control.

The SEBI proposal

The SEBI Discussion Paper proposes, as one of the options, to amend the definition of “control” in the SAST Regulations as follows:

“(a) the right or entitlement to exercise at least 25% of voting rights of a company irrespective of whether such holdings gives de facto control
and/or

(b) the right to appoint majority of the non-independent directors of a company”

The definition of “control” is linked with Reg. 4 of the SAST Regulations. As already mentioned above, Reg. 3, as it stands currently, invokes a public offer requirement on acquisition of 25% voting rights. Defining “control” also as acquisition of 25% voting rights creates an overlap between Reg. 3 and Reg. 4, and would largely make Reg. 4 unnecessary.

Accounting standards dealing with consolidation have a far clearer, though subjective, definition of control, being significant influence, and shared control, which have stood the test of time. Control is ability to control policy-making, whereas significant influence is the ability to influence decision-making. Where control is shared by two or more entities, it is deemed to be a case of a joint venture. There are illustrative shareholding levels – for instance, 20% to 49% to be an indication of significant influence, but the shareholding level is itself not decisive, as the shareholdings simply create a rebuttable presumption of an influence.

The proposed rule defines 25% voting rights to be the bright line of control – whereas there are several cases of passive investors where an investor acquires 26% voting rights merely to be able to block special resolutions. The other shareholder may be holding 74%, and therefore, has clear control on policy-making, as the right to appoint or remove directors needs only a simple majority vote. The 74% shareholder very clearly controls the entity – therefore, it is a clear contrast with the reality to regard the 26% owner to be controlling the entity, since it is not even a case of a shared control. While it may be perfectly alright to relate the mandatory bid requirement to acquisition of 25% or more voting rights, but defining “control” to mean crossing the bright line of 25% may have serious repercussions on several other laws that may tag themselves to the definition given in the SAST Regulations. In fact, it may be much better to retain the definition of control containing the de facto test, but to delink the mandatory bid requirement from the acquisition of control, and retain the existing threshold pertaining to shareholdings alone.

The other proposal, named as Option 1 in the SEBI Proposal, is actually clarificatory, as it seeks to lay down illustrative situations where negative control or protective clauses in shareholders’ agreements will not be regarded as “control”. There has never been a doubt, except arising out of SEBI’s own appeal against SAT ruling in Subhkam case, that negative control is not a control. If the driver driving a car is the one controlling the car, the passenger sitting in the backseat is well within his rights to caution or reprimand the driver, if he is driving too fast, or too badly, or stop him from going in the wrong direction. Such an exercise of shareholder right is, by no stretch of argument, a case of control. On the contrary, it is quite likely that the list of protective rights that SEBI seeks to lay down, though illustrative, will be read literally by regulators as well as practitioners, who may tend to think that all that is not covered by the illustrative list may be falling on the other side of the bright line, and therefore, may be construed as “control”.

Impact of the proposed change on other regulations

The proposed amendment of definition casting a statutory presumption of control on holding of 26% voting rights may affect definitions used in several other regulations as well. While the Companies Act 2013 continues to use the subjective, factual control-based definition presently there in the SAST Regulations, the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 (the ICDR Regulations), which define important terms such as “promoters”, import the definition of “control” from the SAST Regulations. If the 26% owner of equity is regarded as controlling an entity, it will also imply that such a shareholder will also be a deemed promoter of the entity.  The definition of “promoter” in the ICDR Regulations is, in turn, relied upon by several of SEBI’s regulations. Indeed, even the Companies Act definition of a “promoter” may be influenced by the characterization of the 26% equity owner as promoter in filings with the stock exchanges. In short, there may be a substantial ripple effect of the change of definition of “control” under the SAST Regulations.

Conclusions

The so-called gap in the law that the SEBI Proposal seeks to fill, frankly, is illusory, as practitioners generally do not regard protective rights as amounting to control at all. The factual determination of control, irrespective of shareholding strength, is an investigative power that regulations have had over the years, and continues to be basis of the Companies Act definition of “control”, as also the basis of accounting standards. On the contrary, a purely rule-based bright line, given the trend set by technology companies dissociating economic benefits of ownership from voting rights, may not be desirable in our system, which has relied upon a principles-based approach, rather than rule-based approach, as the basis of implementation of law.

- Vinod Kothari 



[1]Google, Facebook, Alibaba, etc. use dual class shares, whereby the general shareholders will derive dividends and other economic benefits, but the ability to manage companies will stay with the so-called management shares, or class B shares. In case of listed entities, there are some jurisdictions that permit companies to have non-proportional voting rights, USA being the prominent among them. Other countries are currently contemplating similar enabling statutes. See a write-up on the issue here: http://indiacorplaw.blogspot.in/2014/09/dual-class-share-structures.html.

[2] Among scholarly writings on the subject of bright-line versus subject tests for “control” in relation to takeovers, see V. Umakanth, at http://law.nus.edu.sg/sjls/articles/SJLS-Jul-15-208.pdf. 

[3] http://www.thetakeoverpanel.org.uk/wp-content/uploads/2008/11/code.pdf

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