Saturday, December 24, 2016

ESOP Shares and the Computation of Open Offer Triggers

Under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (“Takeover Regulations”), an acquirer must make a mandatory open offer to acquire the shares of the remaining shareholders when the acquirer acquires shares (with voting rights) beyond prescribed thresholds. Since the triggers are based on the acquisition of shares with voting rights, questions could arise whether shares issued by a company to an ESOP Trust under the SEBI (Share Based Employee Benefits) Regulations, 2014 (“SBEB Regulations”) would be considered for purpose of computing the triggers. This question came up in a request for informal guidance made by Capital Trust Limited to the Securities and Exchange Board of India (SEBI).

One of the promoters of Capital Trust holds 43.26% shares in the company. The company wishes to issue new shares to its ESOP Trust (set up for the benefit of the employees) and simultaneously wishes to convert certain pending warrants issued to the promoter into equity shares. Taken on a post-diluted basis after considering the issue of shares to the ESOP Trust, the increase in the promoter shareholding will be 4.99%, i.e. within the 5% creeping limit that would trigger the requirement for the promoter to make an open offer. The company requested SEBI’s informal guidance on two counts: (i) whether the shares allotted to the ESOP Trust would be taken as increase in share capital for the purpose of calculation of the conversion of warrants into equity shares; and (ii) whether the issue of shares to the promoter upon conversion of warrants is below the creeping acquisition limits prescribed in regulations 3(2) and 3(3) of the Takeover Regulations.

In response, SEBI issued an informal guidance on December 22, 2016. On the first question, SEBI examined the SBEB Regulations and found that under regulation 3(5) thereof the trustees of an ESOP trust are prohibited from voting on shares held by them “so as to avoid any misuse arising out of exercising such voting rights”. In other words, shares held by an ESOP Trust would effectively be disenfranchised.

This then leads to the answer to the second question on whether the mandatory offer requirements under the Takeover Regulations are triggered. Consequentially, SEBI found that the issue of shares to the promoter would exceed 5% of the voting rights in the company, and hence the promoter would be required to make an open offer to the other shareholders by virtue of creeping acquisition.

Although SEBI’s informal guidance is not explicit as to its reasoning, this outcome ensued because the shares held by the ESOP Trust would not be counted towards the computation of voting shares in the company. Since, in determining the open offer triggers, only the shares with voting rights are considered both in the numerator and denominator, the shares held by the ESOP Trust would be effectively disregarded for this purpose. Hence, the percentage of voting shares issued to the promoter would be computed without taking into account the shares issued to the ESOP Trust, and the issuance of such shares will exceed 5% thereby extending beyond the creeping acquisition limits and triggering and open offer.

In all, given that there is a prohibition on voting by trustees of an ESOP Trust, it is not possible circumvent creeping acquisition limits by structuring an issue of shares to the ESOP Trust, as the present informal guidance from SEBI categorically establishes.


Murlee Jain said...

Here we need to understand one more thing that does it mean shares held by esop trust do not habe voting rights. If yes can we call them shares with differential voting rights again if yes do we need to see if company complied with rules for issuance of differential voting rights shares under the provisions of companies act. Will it be more appropriate to say that shares held by esop trust do carry voting rights but trustees are prohibited from exercising those voting rights.if not will it require similar treatment while calculating minimum public shareholding of 25 percent. Also will the percentages shown in shareholdin patterns and while making disclosures under insider trading regulations will also need to be altered accordingly.

Umakanth Varottil said...

@Murlee Jain. Your comment raises an important distinction. In this case, the shares issued by the company are ordinary voting shares, and not non-voting or differential voting shares. To that extent, arguably the company does not have to comply with the rules and regulations relating to shares with differential rights. But, what is relevant is that so long as the shares are held by trustees of the ESOP Trust, then they shall not exercise voting rights. In other words, the prohibition over exercise of voting rights accompanies the nature of the holders of the shares and not the underlying nature of the shares themselves. This prohibition over voting would cease to exist when the trustees transfer the shares in favour of others (e.g. employees).

As regards the implications of this conclusion under other regulations such as for minimum public shareholding and insider trading regulations, it would depend on the wording of the respective provisions, i.e. whether it provides for shares or securities in general or shares with voting rights. For example, even within the SEBI Takeover Regulations, there is a distinction between disclosure requirements and open offer requirements. For disclosures under regulation 29, it is necessary to consider shares as well as convertible instruments (as defined in regulation 2(v)), but when it comes to open offer the principle criterion is voting rights (regulation 3). Hence, in the present informal guidance that relates to open offer obligations, SEBI has emphasized on the exercise of voting rights rights by the acquirer and the computation thereof.

Judging from SEBI's conclusion, it is clear that voting rights will have to computed keeping in mind shares held by different types of shareholders and whether such shareholders are entitled to exercise voting rights or not. In other words, the determination is based not only on the nature of the shares themselves, but on the the nature of the holder of the shares. From a practical standpoint, this can be problematic because not only will the nature of shareholders change from time to time when shares are traded or transferred, but it would be cumbersome for acquirers or the company to keep track of when and how the various open offer thresholds are breached on an ongoing basis.

Anonymous said...

@umakanth sir:

Just a general question-

I understand that, in light of the SBEB Regulations, during the period under which the shares are held by the trustees of the ESOP trust, they shall not exercise any voting rights.

Jurisprudentially, and on a reading of Section 47 of the Companies Act, 2013, the ESOP Trust is a member of the company, and hence, can the trustees of the ESOP Trust, be deprived of their right to vote?

Thanks a lot!

Umakanth Varottil said...

@Anonymous. That is an interesting question. While under the Companies Act, 2013, the ESOP Trust does have the power to vote on the shares held by the trustees, the prohibition arises due to the SBEB Regulations. In that sense, if there is a breach of the prohibition by the trustee, the question would then relate to what the consequences of such a breach are. It will certainly amount to a breach of the SBEB Regulations, which would invite consequences or sanctions pursued by SEBI, but whether the exercise of voting rights can be invalidated would be a different question.

Anonymous said...

@umakanth sir:

If I may ask sir, what are your views on the question of whether the exercise of voting rights can be invalidated? Thanks a lot..

Umakanth Varottil said...

@Anonymous. Given that the bar against exercise of voting rights is contained in the SBEB Regulations, the consequences are likely to be those arising from a non-compliance with those Regulations, and in my view it might be difficult to invalidate the exercise of the voting rights.

Lagna said...

"While under the Companies Act, 2013, the ESOP Trust does have the power to vote on the shares held by the trustees, the prohibition arises due to the SBEB Regulations."

Can the regulations override the mandate of the Act?

Umakanth Varottil said...

@Lagna. While the trustees do have the power to vote on the shares under the Companies Act, the contrary requirement imposed by SEBI under the SBEB Regulations only apply to trusts that wish to obtain the benefit of the SBEB Regulations. In other words, SEBI cannot compel the trustees not to vote, but if they do vote, then they run the risks that the ESOP arrangement falls outside the purview the SBEB Regulations.