Friday, July 7, 2017

Non-Disposal Undertaking and its Reporting in the Indian Securities Market

[Guest post by Divyajyot Verma, a student at the Jindal Global Law School]

Non-Disposal Undertakings (or agreements) (“NDUs”) are signed usually by the debtor in favour of the lender in relation to any loan obligation undertaken by the debtor. An NDU helps in ensuring that the debtor does not transfer the shares held by it in a company by way of outside arrangements such that the creditor is left without access to significant assets of the debtor. Usually, the usage of an NDU is prevalent in the stock market as shareholders, predominantly promoters, tend to undertake a loan against their shares in the company and with an understanding with the creditor that they will not alienate or create any other form of encumbrance upon the shares, therefore, creating a negative lien upon them. Typically, the shares are transferred to a new escrow demat account for the purposes of this arrangement, but the beneficial ownership over the shares does not change (remaining with the debtor) and the creditor is also not able to dispose them off to clear off the dues (unlike a pledgee).

In the banking sector, such NDUs are coupled with a power of attorney (“PoA”) thereby appointing a security trustee. The combination of the NDU along with a PoA ensures that there is a positive as well as a negative covenant in the arrangement such that if the debtor (being the shareholder) fails to keep up with its dues against the creditor, the security trustee can exercise his powers under the PoA to alienate the shares in favour of the creditor (or any other person). The alienation of the shares by the debtor is safeguarded by the presence of the PoA and the escrow account under which such shares are held.[1] Such an arrangement has been intentionally designed to avoid the framework of a pledge to ensure that banks do not hold more than 30% of the shareholding of the total paid-up share capital in the company as mandated under section 19(2) of the Banking Regulation Act, 1949[2]. The complex legal arrangement has been formulated to avoid the compliance required under section 19(1) of the Banking Regulation Act as the holding of shares in an arrangement of pledge has a possibility of the bank becoming a shareholder (in case of non-payment of dues) resulting in the company whose shares are so pledged/encumbered to become its subsidiary.

Irrespective of the structure of an NDU, there is no doubt that it creates an limitation of some sort upon the shares of the promoters (especially when it is coupled with a PoA) and it is vital that such information is disseminated adequately in the public sphere. Previously, the Securities Board of India (“SEBI”) had amended its formats under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (“Takeover Regulations”) to ensure that appropriate disclosures are made with respect to NDUs within the scope of “encumbrances” to help investors in taking an informed decision.[3] However, these disclosures were seemingly restricted only to public listed companies and their acquisitions under the Takeover Regulations.

Lately, it has also been noticed that companies are indulging in creating special purpose vehicles for transferring shares through NDUs to avoid compliance with the disclosures requirement as set through in the circular issued on August 5, 2015. The format so provided fell short as there was no way in determining whether the shares of the promoters are encumbered until and unless the promoters themselves declare it so. Despite there being a format in place, NDUs still went unnoticed as they were dependent upon voluntary declaration.

Therefore, through a more recent circular dated June 14, 2017, SEBI has mandated depositories to develop a separate module/transaction type in their system to record NDUs. As a result, a new procedural requirement has been introduced in the depository system whereby depositories are required to electronically display/mandate disclosure of NDU or similar arrangements upon the individual demat accounts of the shareholders. As these agreements are individually entered into between the shareholder/promoter and creditor (and generally through a written agreement), there was never any means to ensure that they are appropriately reflected in the records of the depository system.

Following are some of the guidelines issued in this regard:

- Both parties to the NDU shall have a demat account with the same depository and be KYC compliant.

- Pursuant to entering the NDU, the beneficial owner (BO) along with the other party shall make an application through the participant (where the BO holds his securities) to the depository, for the purpose of recording the NDU transaction.

- The entity in whose favour NDU is entered shall also authorize the participant of the BO holding the shares to access the signatures as recorded in that entity’s demat account.

- The participant, after being satisfied that the securities are available for NDU, shall record the NDU and freeze for debit the requisite quantity of securities under NDU in the depository system.

- Upon creation of a freeze in the depository system, the depository/ participant of the BO holding shares shall inform both parties of the NDU regarding creation of freeze under NDU.

- The depositories shall make suitable provisions for capturing the details of company/ promoters if they are part of the NDU.

- In case the participant does not create the NDU, it shall intimate the same to the parties of the NDU along with the reasons thereof.

- Once the freeze for debits is created under the NDU for a particular quantity of shares, the depository shall not facilitate or effect any transfer, pledge, hypothecation, lending, re-materialisation or in any manner alienate or otherwise allow dealing in the shares held under NDU till receipt of instructions from both parties for the cancellation of NDU

Despite the issuance of such guidelines, SEBI could face several challenges, especially in terms of enforcing the disclosure requirements if parties opt not to make the appropriate disclosure of NDUs through the depository system as now required.

- Divyajyot Verma



[1] Ishaan Chhaya, Non-Disposal Undertaking-Power of Attorney: A Grey Area Surrounding Investments in Non-Banking Companies by Banks. Available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2056194
[2] Section 19(2) of the Banking Regulation Act, 1949: “Save as provided in sub-section (1), no banking company shall hold shares in any company, whether as pledgee, mortgagee or absolute owner, of an amount exceeding thirty per cent of the paid-up share capital of that company or thirty per cent of its own paid-up share capital and reserves, whichever is less:
PROVIDED that any banking company which is on the date of the commencement of this Act holding any shares in contravention of the provisions of this sub-section shall not be liable to any penalty therefor if it reports the matter without delay to the Reserve Bank and if it brings its holding of shares into conformity with the said provisions within such period, not exceeding two years, as the Reserve Bank may think fit to allow.”
[3] SEBI circular as issued on August 5, 2015

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