28 March 2016 EY Regulatory Alert (M&A perspective) SEBI issues discussion paper on 'Control' Executive summary This alert summarizes the recent discussion paper ( DP ) released by SEBI on 14 March 2016 proposing to amend the definition of Control prescribed under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011. SEBI has provided two options for defining Control and has sought public comments. While one option is a subjective criteria based on a negative list, the other is an objective test based on threshold shareholding percentage.
Background and facts The SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011( Takeover Regulations ) prescribe that an acquirer acquiring substantial shares or voting rights i.e., 25% or more, has to make an open offer to the public shareholders of the target company, Further, it states that irrespective of the shares or voting rights acquired, the acquirer also has to make an open offer upon acquiring control of the target company. The Takeover Regulations define Control based on vested rights which broadly include: - the right to appoint a majority of directors; or - the right to control the management; or - the right to control the policy decisions by one or more person who are persons acting in concert and such rights can be exercisable directly or indirectly. The above rights may accrue to any person by way of shareholding, management rights, shareholding agreements, voting agreements etc. Bhagwati Committee which was constituted to review the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1994, recommended a broad definition of control and opined that it should be left to SEBI to decide whether there has been an acquisition of control on the basis of facts of each case. Thereafter, the Takeover Regulations Advisory Committee (TRAC), in its report dated July 19, 2010 also reiterated the above views of the Bhagwati Committee. In light of the broad and open definition of Control, SEBI as per the erstwhile Takeover Regulations, in the matter of Subhkam Ventures (I) Pvt. Ltd had taken a view that the rights conferred upon the acquirer, through the agreements, amounted to 'control' over the target company. However, Hon'ble SAT, in its judgment dated January 15, 2010, rejected SEBI's view stating that none of the clauses of the agreements, individually or collectively, demonstrated control in the hands of the acquirer. Hon ble SAT had provided certain principles for determining control on the lines that Control is a proactive power, taking the initiative, positive power, being in a driving seat and does not include reactive power or an affirmative vote. This brought some clarity. However, the Supreme Court, in its judgment dated November 16, 2011, disposed of the appeal by keeping the question of law open. It also clarified that the SAT order will not be treated as a precedent. Need for Bright lines on Control Market representations: Due to the broad and inclusive nature of the definition of Control and it being further left open for SEBI to decide on a case to case basis, the determination of acquisition of Control was found to be stuck in multiple litigations. Many representations were made by market participants to SEBI to provide a list of rights which would not amount to acquisition of Control under the Takeover Regulations. However, few also believed that an exhaustive list is not possible. Reference to other laws: SEBI has acknowledged that several laws in India define Control in different manner, resulting in ambiguity and confusion in the market. International scenario: The DP indicates that SEBI has also analysed and considered definitions of Control internationally. Some of the countries do have definition in terms of the specified voting rights irrespective of de facto control. Further, SEBI has noted that certain countries have also included the ability to
control the composition of board members, exercise control over voting rights at general meetings, exercise influence over the company s policies/shareholder meetings etc. In view of the above, SEBI has felt the need to bring in Bright lines for Control by providing two options. Options for defining Control Option 1:- Framework for protective rights: Under this option, the principle is that: - veto rights not amounting to acquisition of control may be protective in nature rather than participative in nature. - such rights may have the purpose of protecting investor s investments or prevent dilution of his shareholding. - However, the investor should neither have the power to exercise control over the day-to-day running of the business nor the policy making process. - Having rights in decisions involving a significant change in the current business activity or that apply on exceptional circumstances would also be treated as a protective right. Per the above principle, SEBI has prescribed an illustrative list of rights that are protective in nature. Protective Rights - Rights which do not amount to exercise of "control", neither individually nor collectively, with any other right listed below:- a) Appointment of Chairman/ Vice Chairman as a nominee/representative of the investor who does not hold any executive position and does not have any casting vote. b) Appointment of Observer observer of the Board who does not have any voting or participation rights. c) Covenants specified by lenders which are customary to the lending business and the loan is provided strictly on commercial basis. Further, such lender should be in the business of lending such as banks, NBFCs, etc d) Commercial Agreements - The rights conferred on parties to a Commercial Agreement would not amount to control provided that: - the commercial agreement should not be one-sided. - The Board of the target company has approved the decision to enter into such an agreement - The Board of the target company / target company should have the right to terminate such agreement and have the right to enter into similar arrangement with any other party. e) Veto/Affirmative Rights - Veto rights in matters that are not part of the ordinary course of business or involve governance issues would be considered as protective in nature and would not amount to exercise of control over the target company:- i. amendments to MOA and AOA of the target company which adversely impact the investor s rights; ii. any alteration to the capital structure of the company in any way including, buyback, reduction of capital, merger, demerger, arrangement or compromise with its creditors or shareholders or effecting any scheme of amalgamation or reconstruction, etc. iii. effecting any change in the statutory auditors of the company; iv. material divestment, transfer or disposal of an undertaking or material subsidiary of the target company. v. related party transactions other than those entered into in the ordinary course of business and which are on arms length basis. vi. material acquisition of any companies, bodies corporate, business, undertaking or joint ventures.
vii. viii. ix. assuming or incurring any indebtedness or providing any loans or issuing any guarantees or creating any security in excess of the thresholds permissible without special shareholder approval under the Companies Act, 2013. winding up of the company or making a general assignment for the benefit of the creditors of the company and/or the subsidiaries or admitting in writing the inability of the company to repay its debts when they become due. write-off of any of the receivables, loans and advances, investment or investments or inventories outside the ordinary course of business; f) Quorum rights for meetings involving the matters listed above. If two meetings are not quorate, the next meeting would be deemed to have quorum despite the absence of the investor nominees. The grant of the above rights are subject to the following conditions:- a) The investor bestowed with the rights mentioned above, must invest at least 10% or more in the target company. b) Every company should formulate a policy defining the parameters that will be "material" or "outside the ordinary course of business" for certain specified clauses from above. c) Further grant of above rights is subject to obtaining the public shareholder's approval (majority of minority). d) Such rights shall also be incorporated in Articles of Association of the company after obtaining shareholders approval. e) In case of IPOs, the existing agreements would need to be cancelled/modified or suspended till the approval of public shareholders (majority of minority) is taken postlisting of shares. Option 2:- Adopting a numerical threshold Under this option a numerical threshold of 25% is specified level for trigger of Control in Indian listed entities. The above threshold is based on: - International practices and considering current regulatory environment in India; - Companies Act, 2013 which recognises any holding in excess of 25% as the threshold at which special resolutions can be blocked; - threshold for triggering open offer under Takeover Regulations is also 25%; Further, with respect to control being exercised through the right to appoint majority of directors, Regulation 17 of SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 mandates that: - at least one-third of the board of directors shall comprise of independent directors where the chairperson of the board of directors is a non-executive director, and - at least half of the board of directors shall comprise of independent directors where the listed entity does not have a regular non-executive chairperson. Thus, there would a large number of listed companies in which at least half of the board members are independent and thereby, right to appoint majority of directors would not be applicable to such cases. Therefore, an entity having the right to appoint majority of nonindependent directors may be considered to be in control of the company. In view of the above, the definition of control under the Takeover Regulations may be amended such that control is defined as: (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.
Pros and Cons of the two options Option 1:- Framework for protective rights Pros - Investor having the protective rights would continue to be a public shareholder; and acquisition of the said rights would not amount to acquisition of control under the Takeover Regulations. Cons - The list being indicative in nature, acquisition of other rights would be examined on the basis of the facts and circumstances of the case. - In case such rights are deemed to be participative in nature, it would amount to acquisition of control and necessitate an open offer under regulation 4 of the Takeover Regulations. - This approach may lead to further complexities in assessment of control and lead to ambiguity in interpretation. Option 2:- Adopting a numerical threshold Pros - This option would reduce the uncertainty in the assessment of acquisition of control and bring clarity. - Further, the extent of influence by the investor over the board of directors would also be ascertainable in all cases. Cons - the acquisition of control through other means such as contractual rights, etc. would not covered within the ambit of open offer requirements under the Takeover Regulations. Comments As contracts, agreements and arrangements between investors, promoters and other parties have become highly sophisticated; determination of Control for the purpose of trigger of open offer requirements has been a highly debated issue in recent years. While one needs to wait and see in what form and shape the definition is finally crystallised based on public comments, SEBI s attempt to define Control is a very welcome step. Both of the proposed options should reduce ambiguities in future transactions for private equity. At the same time, impact of right to appoint majority of nonindependent directors being considered as a trigger of Control needs to be carefully considered. SEBI has sought public comments on the options to determine Control by April 14, 2016.
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