[The following post is contributed by Soham Roy & Akhil Nene, who are 5th year students at the National Law University Odisha]
A non-compete fee is paid to exiting promoters or founders of a company to ensure that they do not compete for a certain period of time with the company they are exiting. Recently, there was considerable controversy surrounding the HDFC Life-Max merger as a result of Rs. 850 crore paid to the promoters of Max Financial services as non-compete fee by HDFC Life. This is despite the fact that the promoters of Max Financial Services will retain a 6.7% shareholding in HDFC Life. The transaction is being implemented through multiple steps and is structured as a scheme of arrangement involving a merger/demerger. Apart from whether a non-compete fee may be paid in a restructuring transaction involving a merger/demerger rather than a takeover, the issue has raised a larger question on the justification of payment of a non-compete fee selectively to a certain set of shareholders.
In the case of takeovers, regulation 8(7) of the SEBI (Substantial Acquisition of Shares and Takeover) Regulations, 2011 (the “Takeover Regulations”) states that a non-compete fee paid to promoter group has to be factored in the open offer price paid to other public shareholders, which essentially means that all shareholders obtain an exit at the same price. The provision was added to the Takeover Regulations on the basis of the recommendations of the Achuthan Committee Report. The Committee opined that public shareholders and the promoters are on the same footing and there should be not be any discrimination between these two groups of shareholders. The Committee was of the view that preferential treatment in the form of a non-compete fee cannot be given to the promoter group as this was against the principle of shareholder equality. The Committee opined that non-compete should flow to the entire shareholder body and not merely to a certain group of shareholders as they were in the nature of compensation for loss of potential value on account of sacrificed business opportunities. Although the payment of non-compete fee is not completely prohibited in the Takeover Regulations, the Securities and Exchange Board of India (“SEBI”) has ensured that all shareholders obtain the same exit price and that no preferential treatment is accorded to one set of shareholders over the others.
It is important to note that the Takeover Regulations do not apply to schemes of arrangement under the Companies Act and hence minority shareholders are not accorded the same level of protection that they would have enjoyed in the case of a takeover.
We argue that the protection given to minority shareholders under regulation 8(7) of the Takeover Regulations should also be extended to minority shareholders in a scheme of arrangement initiated under the Companies Act. The payment of a non-compete fee to a certain group of shareholders in a scheme adversely affects the rights of minority shareholders. This is especially so in the case of a merger or demerger involving listed companies where the minority shareholders constitute a sizable fraction of the shareholding in the company. As in the case of the HDFC Life-Max merger, there could be other merger/demerger schemes wherein a certain group of shareholders obtain extra consideration in the form of a non-compete fee to the detriment of other shareholders. There is a high possibility that the share swap ratio will be affected as a result of the non- compete fee being paid to a certain group of shareholders. Had the non-compete fee not been paid to the promoters, an equivalent amount would have been accounted for in the books of accounts of the transferee company and hence could have translated to a more favourable share exchange (swap) ratio for shareholders. This would have benefited all shareholders and not only a particular group of shareholders.
Moreover, as in the HDFC Life-Max case, one witnesses scenarios where the continuing shareholders in the transferee company in a scheme of merger/demerger are paid a non-compete fee. Such a payment to shareholders who have not completely exited is unfair, and the rationale behind the payment of such a fee is defeated since a these shareholders continue to hold a stake in the new merged/resulting entity. Even if the regulator does not subscribe to the view that payment of non-compete fee to a select group of shareholders is per se prejudicial to the interests of the minority shareholders, the regulator ought to regulate the payment of non-compete fee to exiting shareholders. The regulator could consider abolishing the payment of non-compete fee to shareholders whose existing stake in the transferee company is above a certain threshold. In other words, the payment of non-compete fee is understandable when the promoters of the erstwhile transferor company hold a miniscule proportion of the shares in the transferee company, and not when that stake is material or substantial. The regulator can prescribe this threshold. Through this option, the regulator can protect the interests of the minority shareholders.
Companies often justify the payment of such a fee by stating that such a fee is only paid after it has received the consent of minority shareholders. A SEBI Circular dated November 30, 2015, which applies to all listed companies undertaking a scheme of arrangement imposes some conditions for the payment of non-compete fee to minority shareholders. Paragraph 9 of the aforesaid SEBI circular mandates the approval by majority of the public shareholders in case of certain payments or issue of shares made to the promoters. It is important to realize that the minority shareholders are often under a lot of pressure to let the deal go through without hurdles and therefore they might vote in favour or abstain keeping in mind that the injustice that is accrued to them as a result of the non-compete fee being paid to certain shareholders do not outweigh the benefits of seeing the deal to fruition without hurdles. Deals like this may be renegotiated if the non-compete is not paid to the promoters. The non-compete is only one component of the scheme and it is entirely plausible that minority shareholders may abstain or vote in favour of the non-compete keeping in mind the possibility of the entire deal being renegotiated if the non-compete is not paid to the promoters.
The Achuthan Committee report correctly identified the scope of abuse of non-compete fees. The Committee correctly opined that control was only an incidental benefit of share ownership and there is no basis for the payment of a non-compete fee to a certain select group of shareholders. As a result of the Committee report, the regulator plugged any scope for misuse by way of the Takeover Regulations.
Protection of minority shareholders is one of the most important functions of the regulator. As discussed in this post, payment of non-compete fee to a certain select group of shareholders in a merger is prejudicial to the interests of the minority shareholders. If the payment of such a fee is not abolished, the regulator should at least regulate the payment of non-compete fee to shareholders who have not completely exited. The current situation leaves much to be desired.
- Soham Roy & Akhil Nene