Showing posts with label preferential allotment. Show all posts
Showing posts with label preferential allotment. Show all posts

Saturday, February 18, 2012

Informal Guidance on Preferential Allotment

SEBI has issued an informal guidance to Strides Arcolabs in connection with the company’s eligibility to issue securities to its promoters on a preferential allotment basis. The information guidance essentially pertains to the interpretation of Reg. 72(2) of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 (ICDR), which reads as follows:
The issuer shall not make preferential issue of specified securities to any person who has sold any equity shares of the issuer during the six months preceding the relevant date.
Explanation: Where any person belonging to promoter(s) or the promoter group has sold his equity shares in the issuer during the six months preceding the relevant date, the promoter(s) and promoter group shall be ineligible for allotment of specified securities on preferential basis.
On 20-21 October, 2011, there was an inter se transfer of shares among the promoters of Strides. This was effected under the erstwhile Takeover Regulations of 1997 (and prior to the new regulations that came into effect on 22 October 2011), and appropriate reporting requirements were complied with. Strides now wishes to issue securities to certain promoters who were the sellers in that transfer, and sought SEBI’s view on the eligibility to issue securities by way of preferential allotment.
In SEBI’s view, the interpretation of Reg. 72(2) and its explanation would not permit Strides to make a preferential allotment of securities to the promoters who earlier sold shares in the inter se transfer among promoters. SEBI’s reasoning is as follows:
The said regulation and its explanation do not differentiate between inter-se transfers made to entities within promoter group and sales made to others. Hence, the term “any person who has sold any equity shares of the issuer” shall also include any person who has made inter-se transfers within the Promoter group. Thus, as per the extant Regulations, if there is any inter-se transfer among the promoter group entities in the prece[]ding six months, then all the persons/entities forming part of “promoter(s) and promoter group” shall become ineligible for allotment of specified securities on preferential basis.
Arguably, this represents a technical approach, and a more purposive interpretation could lead to different results. For instance:
1. The objective of the set of regulations that prescribe specific holding periods for preferential allottees is to prevent short-termism whereby certain investors can take advantage of price movements to sell shares and then obtain them through preferential allotment at more beneficial price. This particularly applies to promoters as they are in a position to control the allotments through their substantial shareholding. Such an objective does not appear to have a place in the context of inter se transfer among promoters because it is just a rearrangement of shareholding among the promoter group without a sale to persons outside the group. While a literal interpretation would lead such a transfer to be a “sale”, a purposive interpretation would not bring it within the mischief that the rule seeks to prevent.
2. The above broad objective of the regulations is also evident from the scheme of Reg. 72(2) and its explanation. For example, the explanation suggests that when there is a sale by any person belonging to the promoter group, then the promoter group itself is disqualified from obtaining shares through preferential allotment for a period of six month. The disqualification appears to operate not just to the individual or entity that sold shares, but to the entire promoter group. In other words, the attribution of an individual seller’s action extends to the entire group, thereby fortifying the position that the promoter group must be treated as a whole. In that case, transfers within the group should be of no consequence, and should not be treated as a sale at all.
3. This approach is not unique to the ICDR Regulations, but also to regulatory frameworks such as the Takeover Regulations that provide specific exemptions from mandatory open offers in case of inter se transfers among promoters so long as specified conditions have been complied with. Such compliances were adhered to even in the Strides case, but that seems to have held no water with SEBI while interpreting Reg. 72(2).

Wednesday, June 22, 2011

Preferential Allotment of Securities in Unlisted Companies

The Ministry of Corporate Affairs (MCA) has announced draft rules that will, when promulgated, substitute the Unlisted Public Companies (Preferential Allotment) Rules, 2003. This will make the process of issue of securities more stringent for unlisted public companies. The Indian Legal Space blog has a nice comparison of the existing rules and the proposed changes.
Some of the key features of the draft rules and their impact are as follows:
Unlike the existing regime, the draft rules require companies to issue an offer document with prescribed disclosures (Annexure I of the draft rules contain a list of 32 disclosures). This significantly enhances disclosure requirements for securities offerings by unlisted companies, and would make even private placements cumbersome and costly. While it increases overall transparency in offerings of securities, the need for such extensive disclosures for offerings of securities to specific individuals or institutions is perhaps overstated. Moreover, there is no clarity regarding the liability of the company and its directors for statements made in such offering document, although the Supreme Court has recently indicated the availability of criminal laws to deal with misstatements in offering documents in private placements.
The offer document is also to be approved by shareholders through a special resolution. This is also an onerous requirement as it might limit the flexibility of the company to alter the document once it has been approved by the shareholders. In addition, this will also impose complexities in timing and sequencing of compliances to effect a private placement transaction.
The draft rules stipulate two conditions regarding timing: (i) the gap between the opening and closing of the issue should be limited to 30 days; and (ii) the minimum gap between the closing of one issue and the opening of another issue must be 60 days. This is possibly intended to deal with ambiguities that exist in the definition of a private placement/offering in terms of section 67(3) of the Companies Act, 1956 where an offer is deemed to be made to the public if it is made to 50 persons or more. By setting time limits, the draft rules seek to impose more objective criteria to differentiate private placements from public offerings. For a greater discussion of this issue in the context of section 67(3), please see a previous post.
While objectivity is generally desirable, the idea of artificially delineating one private placement from another through timing may add to the confusion. For example, it may be possible for companies to structure successive private placements although the offering may cumulatively be made to a large body of investors.
Convertible Instruments
The draft rules make convertible instruments an unattractive option for public unlisted companies.
First, the pricing rules for warrants (that presumably apply to other convertibles as well) are rigid. The price for conversion of warrants must be determined before hand. In other words, the conversion price has to be stated up front, and it appears that neither a conversion formula nor a price band would be available. That removes all flexibility for conversion, which would effectively make warrants in public unlisted companies unattractive as an investment option. Note, however, that this is exactly contrary to the trend established by the FDI Policy of the Government of India which has recently moved from a fixed conversion price to a more flexible policy when it comes to investment in convertible instruments by foreign investors.
Second, for any issue of convertible instruments that results in a cumulative amount of Rs. 5 crores or more, the company is required to seek the prior approval of the Central Government. This is a retrograde step as it imposes hurdles to fund-raising activities of companies. It is also likely to evoke problems that existed in the days of the controlled economy prior to 1991, with the Controller of Capital Issues (CCI) acting as the authority that indulged in merit regulation by specifically approving fund-raising by companies. In fact, even the CCI regime applied only to public offerings where the interest of the investing community at large was at stake. The application of a similar regime under current conditions, and that too for private placements seems inexplicable. The draft rules buck the trend as other areas of corporate regulation have recently witnessed attenuation in government regulation.
Dematerialization of Securities
Here again, the flexibility of retaining securities either in physical form or demat form has been taken away, as all securities issued under private placement have to be kept only in demat form.

Overall, the draft rules make private placements in unlisted public companies an onerous task. This may seriously impact financing in such companies. Curiously enough, some of the requirements suggested in the draft rules go even beyond those prescribed for public listed companies where larger interests are affected. These include the requirement for shareholders to approve the offer document, restrictions on pricing for convertible securities, and the like.
It has been suggested that the draft could be the result of various scams involving unlisted companies and also instances of ambiguities in securities regulation (such as those witnessed in the Sahara episode previously discussed). While it is imperative that regulations be framed to address scams and frauds, the imposition of onerous requirements on the corporate sector as a whole to address a few bad apples imposes greater costs than the benefits it produces. The strategy of painting all public unlisted companies with the same brush will be counterproductive.

Sunday, February 28, 2010

Public Company shares cannot be fettered at all, says Bombay HC

The Bombay High Court has ruled that any pre-emptive rights over shares in public limited companies are patently illegal in view of the principle of “free transferability” enshrined in Section 111A of the Companies Act, 1956 (“the Act”). This revives the debate on enforceability of shareholder agreements and joint venture agreements governing public limited companies.

In the case of Western Maharashtra Development Corporation Ltd. Vs. Bajaj Auto Ltd. (MANU/MH/0109/2010), in an emphatic decision, the Bombay High Court has said that a pre-emptive right would impose a fetter on transferability of shares – a requirement, in the view of the court, envisaged only for private companies and in fact prohibited for public companies, in the scheme of the Act – and therefore “patently illegal”. Setting aside an arbitral award resolving a dispute over price for transfer of shares under a right of first refusal clause between the litigating parties, the court has said that arbitrator ought to have held that the pre-emptive right was completely contrary to law and therefore unenforceable and consequently, the award deserved to be set aside.

The Court ruled thus:-

“53. The provision contained in the law for the free transferability of shares in a public Company is founded on the principle that members of the public must have the freedom to purchase and, every shareholder, the freedom to transfer. The incorporation of a Company in the public, as distinguished from the private, realm leads to specific consequences and the imposition of obligations envisaged in law. Those who promote and manage public companies assume those obligations. Corresponding to those obligations are rights, which the law recognizes as inhering in the members of the public who subscribe to shares. The principle of free transferability must be given a broad dimension in order to fulfill the object of the law. Imposing restrictions on the principle of free transferability, is a legislative function, simply because the postulate of free transferability was enunciated as a matter of legislative policy when Parliament introduced Section 111A into the Companies' Act, 1956. That is a binding precept which governs the discourse on transferability of shares. The word "transferable" is of the widest possible import and Parliament by using the expression "freely transferable", has reinforced the legislative intent of allowing transfers of shares of public companies in a free and efficient domain.

54. The effect of Clause 7 of the Protocol Agreement is to create a right of pre emption between the Petitioner and the Respondent in the event that either of them seeks to part with or transfer its shareholding in MSL. In that event, the party desirous to transfer its shareholding is obligated to furnish a first option to the other for the purchase of the shares at such rate, as may be agreed to between the parties or decided upon by arbitration. The consequence of Clause 7 of the Protocol Agreement, which has been incorporated in the Articles of Association, is to preclude sale to or purchase by the members of the public of the shares, which are offered for sale if the offer is accepted by the Petitioner, or as the case may be, by the Respondent within thirty days of the receipt of the notice. The effect of a clause of preemption is to impose a restriction on the free transferability of the shares by subjecting the norms of transferability laid down in Section 111A to a preemptive right created by the agreement between the parties. This is impermissible. Section 9 of the Companies' Act, 1956 gives overriding force and effect to the provisions of the Act, notwithstanding anything to the contrary contained in the Memorandum or Articles of a Company or in any agreement executed by it or for that matter in any resolution of the Company in general meeting or of its Board of Directors. A provision contained in the Memorandum, Articles, Agreement or Resolution is to the extent to which it is repugnant to the provisions of the Act, regarded as void.”

The decision can have far-reaching and perhaps unintended consequences, not just for joint venture partners and private equity investors, but also for banks, financial institutions and even for regulators and stock exchanges. If a holder of shares of a public company is prohibited from agreeing not to transfer his shares except subject to certain conditions (indeed, in consideration for a reciprocal promise) no fetter or encumbrance of any nature can be permitted.

A pledge of shares by a shareholder would create a fetter on transfer. So would be a non-disposal undertaking given by shareholders to banks to raise funds either for themselves or for the public companies in which they hold shares. The Securities and Exchange Board of India, by subordinate legislation, imposes a “lock-in” on shares held in public companies in certain situations. So do stock exchanges routinely ask substantial shareholders not to transfer their shares for specified periods of time. These measures would be per se illegal too since subordinate law has to necessarily give way to Parliament-made law and cannot impose restrictions higher than the principles laid down by Parliament.

Indeed, the Delhi High Court has held a similar view, refusing to overturn a decision of the Company Law Board, and the Supreme Court did not grant leave to appeal against the Delhi High Court decision. The Bombay High Court has noted thus:

“55. The Delhi High Court had occasion to consider the issue in its decision in Smt. Pushpa Katoch v. Manu Maharani Hotels Ltd. MANU/DE/0867/2005 : 121 (2005) DLT 333 In the case before the Delhi High Court, in a Petition under Sections 397 and 398 of the Companies' Act, 1956, one of the grievances was that three sisters of the Appellant had transferred their shareholding in a Public Limited Company, in violation of a right of preemption contained in a family settlement. The Company Law Board held that the Articles of Association of the Company, which was a Public Limited Company, did not recognize a right of preemption. Since the Company was a Public Limited Company, no fetter could be imposed on the right of the shareholder to transfer his shares, by virtue of the provisions of Section 111A. The CLB rested its decision both on the basis that the preemptive right was not recognized by the Articles of Association and on the foundation that a Public Company could not have a provision recognizing preemptive rights to its members. The Delhi High Court in an appeal arising out of the judgment of the CLB relied upon the judgment of the Supreme Court in Rangaraj (supra) to hold that a restriction which is not specified in the Articles, would not bind either the Company or its shareholders. The Delhi High Court also held that by virtue of the provisions of Section 111A, the right of a shareholder to transfer his/her shares could not be fettered. Mr. Justice A.K. Sikri held thus:

‘The CLB further rightly mentioned that as per the provisions of Section 111A of the Act, there could not be any fetters on the right of a
shareholder to transfer his/her shares. It may be noted that the Legislature has made different provisions for transfer of shares in case of private limited company and public limited company. Section 111, which deals with "Power to refuse registration and appeal against refusal", relates to the private limited companies. On the other hand, provisions of Section 111A dealing with "Rectification of register on transfer" are attracted in the case of public limited companies. While
restrictions can be stipulated in the Articles of Association so far as transfer of shares of a private limited company is concerned, sub section (2) of Section 111A of the Act specifically provides that the shares or debentures and any interest therein of a company shall be freely transferable. Proviso to this Sub-section further stipulates that if a company without sufficient cause refuses to transfer the shares within two months, the transferee may file an appeal to the Company Law Board and "it shall direct company to register the transfer of shares". Since the respondent No. 1 company is a public limited company, the CLB rightly opined that there could be no fetters on the right of a
shareholder to transfer his/her shares. We have already noted that there is no such provision giving pre emptory right to other promoters in the Articles of Association. Even if there was such a provision in the Articles of Association, it would have been ultra vires the provisions of the Act, as no company can provide in the Articles of Association any matter which offends the specific provision of an act (see Re. Denver Hotel Co., 1893(1) Chancery Division 495). No doubt, the four sisters promoted the company and their intention was to make the family property as a hotel and run the same. No doubt, in the Board meeting
held on 16th March 1994 and the Memorandum of Family Agreement it was recorded that any promoter wanting to sell the shares would first offer the same to other promoters. However, at the same time, while incorporating this company, the promoters decided to have a public company limited by shares rather than a private company. They should have understood the implication and consequences of getting a public company incorporated. If they wanted such an arrangement, as recorded in the minutes of the meeting dated 16th March 1994 and the Memorandum of Family Settlement, they should have been wise enough to incorporate a private company and further to provide such a clause in the Articles of Association. After incorporating a public company, it was too late in the day to think of such an arrangement and recording the same in the Board meeting or the family settlement, which could not have any legal basis.’
A Special Leave Petition against the judgment of the Delhi High Court was dismissed by the Supreme Court on 7th April 2006. I am in respectful agreement with the view of the Delhi High Court which reflects the correct position in law.”

The key question that has emerged is whether a person entitled to free and marketable title to a property (the property being shares held in a public company) is necessarily fettered from dealing with such property freely in any manner other than transfer of shares. The court’s opinion underlines a fetter on the owner of such property. A holder of shares in a public company is therefore fettered from enjoying such property to the fullest – a contract to refrain from disposing of the shares in any manner for receipt of a reciprocal promise, has been held to be illegal and unenforceable.

The issue of whether at all a fetter on share ownership in a public company can be contracted has not been considered in detail by the Supreme Court so far – all debate has been around whether an agreement not enshrined in the Articles of Association would be enforceable. One would have to keenly wait and watch this space.

Monday, August 3, 2009

Warrants and Voting

My friend Jayant Thakur posted a critique on July 31 on the recent SEBI Order in the case preferential allotment of warrants to promoters. Umakanth dealt with the element of potential prohibition of voting in areas of conflict of interest on August 1.

Here is a piece I wrote in the Business Standard today, with a slightly different perspective on the concept of preferential allotment and deals with the issue of a potential voting prohibition, a trend already started by SEBI:-


By Somasekhar Sundaresan

The Securities and Exchange Board of India’s (“SEBI”) passed an order last week, nicely articulating why preferential allotment (out of turn allotment other than an evenly-made allotment to all existing shareholders) of warrants to promoters is kosher.

The order was passed after the Bombay high court asked SEBI to deal with the grievances of an investor association that had questioned the policy on issuance of warrants to promoters. The order makes for interesting reading and certain aspects highlighted in the order call for reflection.

Warrants are instruments that entitle the holder to acquire shares at a future date a pre-determined price. Guidelines issued by SEBI regulate the issuance of warrants. The warrant holder has to pay 25% of the exercise price upfront, may exercise the warrant no later than 18 months from issue, forfeit the upfront amount paid if he lets the warrants lapse, and has to suffer a lock-in not only on the warrants but also on the shares arising out of the warrants. Besides, the minimum price at which the warrants may be exercised is regulated – a function of market price average related to the time at which the issuance is approved by shareholders. Four issues in the SEBI order call for analysis.

First, it the case of the eight companies complained of, the amount forfeited by promoters aggregated to Rs. 1515 crores. The amounts were tiny in some cases (Rs. 6.52 crores in the case of Nagarjuna Fertilizers Ltd.) and large in other cases (Rs. 783 crores for Reliance Infrastructure Ltd. and Rs. 377 crores in the case of Aditya Birla Nuvo Ltd.). In order words, a good amount of money went into the listed companies free of cost i.e. without any capital dilution. Therefore, SEBI’s policy on this count has indeed worked well.

Second, SEBI’s order is perfectly legitimate in asserting that when the rules for pricing are made clear, it is open for every company’s board to issue warrants in accordance with the rules. If a fresh issue of warrants is made when the market price is lower, so long as the issuance is compliant, there can be no quarrel on the ground that warrants issued in the past had lapsed. The SEBI order also notes that of the 1108 preferential allotments made between April 2007 and June 2009 from among 4,934 listed companies, 360 cases involved allotment of warrants. Of these, in 100 cases, promoters allowed the warrants to lapse and forfeited the funds paid upfront. Only 13 companies re-issued warrants following non-exercise of earlier warrants.

Third, the investors had alleged that funds ought to be raised only if the company were to be in need of funds, not to shore up promoter holding – an unexceptionable argument. When funds are raised through an initial public offering or a follow-on public offering, a lot of explanation is required to be given by way of an offering circular. In a preferential allotment, the explanatory statement to shareholders has to provide disclosures of the objects of the proposed allotment. However, the rigour and standard of disclosure is not the same. Preferential allotment is indeed widely perceived to have lesser justification in the company’s need for funds and greater justification in the need to keep promoter stake intact or bolstered.

If the board of a listed company thought it fit to raise funds through warrants, it stands to reason that the board comes up with good explanations on how it intends to bridge the gap caused by a lapse of warrants. This aspect has to be gone into in greater detail. One would be surprised if there is any spectacular documentation in the boards’ minutes, of why the board felt funds were needed, how they were chose a course of fund raising, and how they gap in funding is being bridged due to lapse of warrants.

Finally, while rightly holding that banning warrants would be a retrograde step, SEBI has indicated that it would seek views on whether promoters should be debarred from voting on resolutions entailing preferential allotment to promoters. The issue should in fact be addressed by SEBI on a broader footing – whether any interested party or a beneficiary of a shareholder resolution should be permitted to exercise voting rights as a shareholder on the resolution. If the answer is in the negative, there should be no justification to single out promoters for disenfranchisement for preferential allotment. Jurisdictions such as neighbouring Singapore have such rules in their company law.

SEBI has already set a very adverse precedent in the case of delisting – ignoring the promoter’s vote, the votes cast in favour of the delisting proposal by public shareholders (non-promoter shareholders) ought to be at least twice the votes cast by public shareholders against the proposal. Having made a beginning, it is highly likely that SEBI will go down the path of regulating voting rights in various other situations – that will be subject matter of another column altogether