Budget Impact

This year’s budget, termed by the media as a populist one, has received mixed reactions from the corporate sector. At the same time, it has not gone well with the stock markets, which fell following the budget announcements.

The entire set of budget materials is available here. Now, we look at some of the key implications of the budget on the corporate sector as well as financial markets:

Corporate Sector

1. Corporate tax rates have been left untouched, although there were some predictions of a possible reduction in rates. Further, there has been no change in the rate of surcharge either.

2. Dividend distribution tax has been streamlined to benefit holding company structures. Hitherto, dividend distribution tax (DDT) was payable by a company that distributes dividend to its shareholders. Where a holding company or parent receives the dividend income from the subsidiary, and then distributes dividend to its shareholders from its profits, it has to pay DDT, which would include as a component the amount distributed that represents the dividend income it received from the subsidiary (that has already been taxed in the hands of the subsidiary). This caused multiple levels of taxation on the same income.

However, the budget seeks to remove this anomaly by allowing the parent to set off the dividend received from a subsidiary so long as the subsidiary has paid DDT, and the parent company is not a subsidiary of another company. In other words, set-off is available only to the ultimate holding company, and not to the intermediates ones in a multiple holding company structure.

Although at first blush this appears to be a beneficial provision, it does have its set of limitations. For instance, in a multilayered holding structure (which is quite typical in infrastructure, real estate, and other companies), the DDT set-off is available only to the ultimate holding company and not intermediate holding companies. Hence, the same income is subject to multiple levels of taxation at intermediate levels, thereby not failing to fully eliminate the double taxation problem. While the proposal encourages holding company structures, it limits tax benefits to single holding companies and not multilayered structures (which would still be tax inefficient).

Further, set off is available only to a “holding company”, implying that such company should either hold shares in excess of 50% in the subsidiary (from which it receives dividends) or should control the board of the subsidiary. If the recipient of the dividend is not a holding company (e.g. if it holds 49% shares), then the set-off is not available. Hence, this benefit would not be available in cases of joint venture and other strategic arrangements where parties may not establish a holding-company relationship.

3. Short term capital gains on sale of shares is increased from 10% to 15%, in an apparent move to encourage investors to stay invested in the longer term.

Financial Markets

1. Market for Corporate Bonds has witnessed further measures for expansion in this Budget. Exchange-traded currency and interest rate futures will be launched. A transparent credit derivatives market with appropriate safeguards will be introduced. Additional measures include the option in domestic convertible bonds of separating the embedded equity option from the bond and possibility of separate trading of the two instruments, and development of a market-based system for classifying financial instruments based on their complexity and implicit risks.

These efforts would make the Indian financial markets more robust and liquid. At the same time, since derivatives trading is inherently risky, the nature of the safeguards that will be put in place assume great importance.

On this point, Ajay Shah has an article in the Business Standard.

2. Permanent Account Number will be the sole identification for all participants in the securities markets, subject to appropriate thresholds.

3. Pan Indian Market for Securities is to be created with cooperation from states. This is essential because stamp duty (for issuance of shares and for transfer of debentures) falls within the domain of the state legislatures in accordance with the Constitution. As states enact differing rates of stamp duty on such transactions, it causes significant difficulty in easily executing stock and bond transactions where investors are located across the nation. Uniformity in stamp duty rates on securities markets is a welcome step as it would dispense would ambiguities in costs of such financial transactions. Further, it would also benefit state governments by doing away with the need for companies to resort to “location shopping” by executing transactions in stamp-duty friendly states.

4. Securities Transaction Tax will be allowed as a deductible expenditure against business income rather than only as a rebate against tax liability (which benefit was restrictive in nature). Further, securities transaction tax (STT) on options have been streamlined to deal with two situations, i.e. where the option is exercised, and where it is not.

5. Commodities Transaction Tax will be introduced on transactions in commodity futures on the same lines as STT on options and futures.

6. Tax Deduction at Source (TDS) will not apply to listed corporate bonds issued in demat form—another measure to boost the bond market.

Other Aspects

Certain additional services have been brought under the service tax net. These include, services provided by stock/commodity exchanges and clearing houses, and customized software, to bring it on par with packaged software and other IT services.

The Budget has been disappointing to the corporate sector on a few counts:

(a) REITs did not receive any attention in the Budget. This leaves taxation of REITs in doubt. As we have discussed earlier on this blog (here and here), the market for REITs is unlikely to receive any impetus unless there is clarification on aspects of their taxation.

(b) Software Technology Parks (STPs) that are entitled to tax holidays until March 31, 2009 have failed to obtain an extension of the holiday to subsequent years. This is despite strong please from the IT industry. Although tax holidays under the SEZ policy are available for future periods, it is difficult for most small and medium IT sector players that were beneficiaries of the STP scheme, to establish SEZs for all their projects and hence the IT sector is likely to be at a disadvantage due to this.

Finally, the Finance Minister has indicated the need to manage foreign capital flows more actively. He stated that the “Government will, in consultation with the RBI, continue to monitor the situation closely and take such temporary measures as may be necessary to moderate the capital flows consistent with the objective of monetary and financial stability.” This implies that the Government will maintain a keen eye on aspects like foreign direct investments (FDI), foreign institutional investors (FIIs), external commercial borrowings (ECBs), foreign currency convertible bonds (FCCBs) and similar schemes, and announcements may be expected from time to time on policies governing these aspects depending on the foreign exchange position as monitored by the Government and the RBI.

Overall, the Budget has not witnessed significant benefits being conferred on the corporate sector or financial markets, though there have been some areas of stimulus for growth. That perhaps explains the mixed reaction from corporates and the markets.

Taxation Issues in Short Selling

An earlier post on this blog had discussed the introduction of short selling in the Indian market and its implications on the market. Today’s Hindu Business Line has an article that refers to lack of clarify in the taxation regime with respect to short sales. Obviously, there seem to be several loose ends to tie, and the authors hope that the forthcoming Budget and the Central Bureau of Direct Taxes (CBDT) would provide necessary clarification on these aspects.

However, a couple of the issues have already received clarification from the CBDT in a circular issued on February 22, 2008.

Corporate Governance Study

Research in areas of corporate governance involving Indian companies has not been substantial, compared to that in its emerging market counterparts such as China. However, a recent study that has been commissioned by the IFC Global Corporate Governance Forum in consultation with SEBI and the National Institute for Securities Markets (NISM) is likely to bridge the gap.

Here are the excerpts from IFC News:

“As part of this collaboration, a business investor dialogue is being organized to facilitate discussions between the private sector, domestic and international investors, and the Securities Exchange Board and to shed light on that state of governance in Indian companies. Issues to be explored include the effectiveness of various governance structures, the role of the board, disclosure, and enforcement.

The event will give participants an opportunity to make recommendations for improving corporate governance among enterprises. Discussions around research on the state of corporate governance in India’s listed companies will be conducted by Professor Vic Khanna of the University of Michigan, Professor Bernard Black of the University of Texas, and Professor N. Balasubramanian of the Indian Institute of Management in Bangalore.

The ongoing research includes surveys of 500 publicly traded companies, representing various sectors in the country's six largest cities. This research is supplemented by publicly available information. The data analysis seeks to identify the connections between various aspects of governance, company performance, and profitability.

The event aims to identify challenges facing companies, offer possible measures for improvement, and provide an opportunity for local and international business leaders and investors to share views and experiences on the investment climate in India. It also aims to generate discussions and obtain policy recommendations from an assembly of local business representatives and investors.”

Two of the professors conducting this study have already researched the effect of corporate governance norms on stock prices of Indian companies, a matter we covered in an earlier post on this blog.

Should Insider Trading be Permitted?

An affirmative answer to this question will almost always be dismissed as outlandish. But, Henry Manne, who is considered the father of law and economics, has argued for deregulation of insider trading for the last 40 years.

His ideas have encountered a barrage of criticisms from other legal scholars. Further, as far as I am aware, there is no jurisdiction around the world that consciously adopts the policy of freely permitting insider trading. Manne makes the argument in true law and economics style: (i) insider trading allows persons with non-public information to trade in shares thereby driving prices of shares nearer to their real value (and supporting true price discovery), and (ii) insider trading is a form of compensation to insiders (primarily senior managers) and hence their monetary compensation can be reduced thereby saving cost to the company. Like most others, I find this line of reasoning unconvincing—although it may increase overall efficiency of the capital markets by encouraging price discovery and reduced compensation, it fails to recognize issues of distribution of gains among the different participants. In other words, insiders (who have an information advantage) will gain more than other investors who trade with insiders without parity of information.

However, that Manne and his ideas continue to engage attention is borne by the fact that his legacy is now being captured in a collection. Here is a foreword by Professor Stephen Bainbridge that sets out Manne’s line of reasoning. Although set in the US context, it makes interesting reading for those of you who are enthusiastic about the legal and economic aspects of insider trading and more generally in capital markets and securities regulation.

Analysing Foreign Currency Exchangeable Bonds (FCEBs)

When it came to borrowings in foreign currency, Indian companies hitherto had two options, namely (i) external commercial borrowings (ECBs) where they borrow monies in foreign currency, or (ii) foreign currency convertible bonds (FCCBs) where they issue bonds denominated in foreign currency that are convertible into shares of the issuer company.

About a week ago, the Ministry of Finance granted Indian industry a third option (but only in fulfillment of a Budget promise made last year), which is foreign currency exchangeable bonds (FCEBs). The Ministry issued a notification on February 15, 2008. I have been meaning to study this over the last few days, but finally got down to doing so only today.

I located a summary of the notification on LawFuel which is less technical than the notification itself. Although it appears that this type of instrument is fairly common internationally, it is unique to the Indian markets, and presents some interesting elements that we shall see.

Under this option, an issuer company may issue FCEBs in foreign currency, and these FCEBs are convertible into shares of another company (offered company) that forms part of the same promoter group as the issuer company. In other words, if company A issues FCEBs, then the FCEBs will be convertible into shares of company B that are held by company A and where companies A and B form part of the same promoter group. There is a fundamental difference between an FCCB and an FCEB whereby in the case of an FCCB offering, the bonds convert into shares of the company that issued the bonds, while in the case of an FCEB offering, the bonds are convertible into shares not of the issuer company, but that of another company forming part of its group.

There are a couple of other mechanical matters that are of interest. In an FCCB, when the holder exercises the option to covert, the issuer company will issue fresh shares to the holder in exchange for the bonds. However, in case of FCEBs, when the option is exercised, there is no issuance of fresh shares. What occurs is a transfer by the issuer company of the shares it holds in the listed (offered) company to the holder in exchange for the bonds. Further, although the FCEBs are issued on the strength of the underlying shares held by the issuer company, it does not automatically means that the shares are pledged in favour of the FCEB holder. In the event of bankruptcy of the issuer company prior to conversion, the position of the FCEB holder would be only that of an unsecured creditor, and to that extent, this structure is not bankruptcy proof so far as the issuer company is concerned.

Pros and Cons

In doing a pros and cons analysis, one finds several advantages in this scheme. First, it provides an additional avenue for Indian companies raising funds from overseas. Second, it helps companies unlock the value of their holdings in other companies. Simply stated, it allows companies (such as holding companies or investment companies) that hold shares in other group companies (which are listed on the stock exchange) to leverage on the value of their investments by borrowing on their strength. Third, it helps companies raise financing without further dilution. For instance, instead of a listed company issuing further shares to raise capital, one of its promoter entities may issue FCEBs on the strength of its holding in the listed company and fund the listed company with the proceeds of the FCEB offering. This way, the promoter entity’s shareholding in the listed company would not be diluted at all, unlike in the case of direct capital raising by the listed company. Fourth, there seem to be no perceived disadvantages from a taxation standpoint (although some doubts have been raised on some technical issues regarding taxation: see The Hindu Business Line).

The principal disadvantage of FCEB route lies in its scope. It is permissible only in certain areas and to the extent that ECBs and FCCBs are permitted. Changes effected to the ECB/FCCB policy last year (that are perceptibly linked to capital controls and the need to stem the rising Rupee) have restricted such borrowings only to very limited types of activities. This has resulted virtually in a demise of these routes, unless and until they are resuscitated by further policy change. Further, proceeds of FCEBs cannot be used for investment in the real estate sector or in capital markets.

Therefore, unless and until foreign currency borrowings are permissible for Indian companies in a wider array of activities and with lesser restrictions, it is unlikely that the route will be utilised in any meaningful way by Indian companies. Until then, it will remain on the rule book without implementation, and to that extent this single disadvantage pretty much overshadows all its benefits that are largely on paper. At the same time, any positive changes to the policy on foreign currency borrowing will spring this route into action.

Indian Sovereign Wealth Fund: Now a Possibility

Sovereign wealth funds (SWFs) have become the flavour of the day. Not only are the SWFs of various countries investing billions of dollars in companies around the world, they are generating a significant amount of skepticism from regulators in host countries urging greater transparency.
As far as India is concerned, initial indications from the Reserve Bank of India have implied reluctance on the part of the Indian Government to set up its own SWF. Earlier posts on this blog (Will We Witness an Indian Sovereign Wealth Fund? and The Case for an Indian SWF) had discussed the pros and cons of an Indian SWF and had argued for the establishment of one.

The Economic Times reports that the Government is seriously looking at the option of an Indian SWF:

“The government is considering a sovereign investment fund with an initial corpus of $5 billion to acquire companies abroad. The investment fund may also be used to bolster the country’s energy security by acquiring coal mines and oil and gas blocks abroad.

Prime minister Manmohan Singh has issued a directive to the finance ministry in this regard, and an announcement is likely in the Budget, an official said.

According to officials, one of the options available to the government is to create a special purpose vehicle (SPV), which will borrow funds from RBI in the form of long-term securities in foreign currency and lend the same to Indian companies at lower rates. Thus, RBI and the government will be able to earn more on forex reserves, which currently fetch average returns of 3.5-4%.”

See also, the report in VC Circle.

Guest Contributor: Somasekhar Sundaresan

It is my pleasure to introduce our guest contributor, Mr. Somasekhar Sundaresan

Practice Focus: Capital Markets, Securities Laws, Banking and Non-banking Financial Services and Mergers and Acquisition involving listed companies.

Somasekhar has extensive experience and expertise in the practice and evolution of securities laws in India. While primarily a transactional lawyer, he is intensely involved in regulatory and contentious work involving securities laws, and has been involved in some of the highly celebrated cases relating to regulatory action in the Indian securities market. He has also acted as Counsel before the Securities and Exchange Board of India (India’s SEC), the Securities Appellate Tribunal, and the Supreme Court of India in serious and high-profile securities law matters.

Prior to being in practice as a lawyer, Somasekhar was an Assistant Editor in the Business Editorial Section of The Times of India, India’s largest morning broadsheet.

Somasekhar now writes a fortnightly column on business laws titled Without Contempt in the Business Standard, the Indian affiliate of Financial Times. Somasekhar is also an active member of the Capital Markets Committee of the Federation of Indian Chambers of Commerce & Industry.

Competition Act and Merger Regulation

Today’s Economic Times carries a column by Jaishree Vyavaharkar & David Jacobs of Baker & McKenzie analyzing the provisions of the Act and the recent draft regulations on business combinations, with specific reference to implications on foreign investors.

Here are some excerpts:

“A fundamental concern for foreign investors was the lack of domestic nexus in the Act. Effectively, deals which had little or nothing to do with India could trigger a requirement to notify. This issue has now partly been resolved by the new regulations which stipulate that at least two companies to a transaction must each have a minimum of Rs 200 crore of assets (approximately $50 million) or Rs 600 crore of turnover (approximately $150 million) in India.

However, whilst deals that fall below this threshold would not raise competition concerns, it is not clear whether they would still require notification. It is hoped that this is simply a matter of drafting and that the CCI will clarify this point in the final regulations.”

One of the prominent criticisms of the Act and draft regulations is the excessive time given for approval of combinations, that could potentially chill M&A transactions. The authors deal with this issue too:

“For M&As, timing is crucial. Merging companies are keen to obtain clearance quickly, especially when the deal has little or no impact in the jurisdiction. A long waiting period means that the deal is in limbo until clearance which, for many deals, can be detrimental and even fatal. The 210-day rule was unusual as mandatory and suspensory regimes do not usually have long waiting periods (although there are exceptions such as Slovakia (60 working days). In the EU, a deal must be cleared within 25 working days (extendable to 35) or within a further 90 working days (extendable to 105). In the US, a deal will be cleared within 30 days if there are no issues or within a further 30 days.”

They conclude with the following observations and questions:

“Despite the challenges, foreign and local businesses should take advantage of their experience in other jurisdictions to tackle the new Indian merger control regime with some confidence. More generally, although there is much speculation and scepticism of how the Act will work, uncertainty remains as to how the CCI will actually enforce the law. Does it have both the appetite and the resources to implement a truly effective competition regime? Or will it adopt a more liberal and flexible system? Will cartel enforcement be a priority, as it is in the EU? Will the leniency regime, that offers discounts on fines to companies that admit to participating in a cartel, really incentivise businesses to come forward? Against the backdrop of a thriving Indian economy, it remains to be seen how foreign and local businesses, as well as the CCI, will rise to the challenges of a new and potentially rigorous competition regime.”

(Previous posts on this blog relating to this topic: here and here)

Northern Rock: Bank Nationalisation

As the Economist reports, Britain’s Government has decided to nationalise the ailing Northern Rock Bank, after unsuccessful efforts to sell it to a private player.

The strategy followed recently by the Reserve Bank of India in the case of ailing Indian Banks has been somewhat different. It has usually exercised its powers under the Banking Regulation Act, 1949 (Section 45) (with appropriate sanction from the Central Government) to effect a merger of ailing banks with other healthy banks.

Some of the recent examples of this approach are:

1. United Western Bank - IDBI;
2. Ganesh Bank of Kurundwad - Federal Bank;
3. Global Trust Bank - Oriental Bank of Commerce.

Stolen Information and Stock Trades: Is it Insider Trading?

This question has come up before the United States Court of Appeals for the Second Circuit, in New York. Interestingly, this involves stealing of information by hacking a computer system. Here are the brief facts as reported in the New York Times:

“[T]he evidence indicates that on Oct. 17, 2007, someone hacked into a computer system that had information on an earnings announcement to be made by IMS Health a few hours later.

Minutes after the breach of computer security, Mr. Dorozhko invested $41,671 in put options that would expire worthless three days later unless IMS shares plunged before that. The next morning the share price did plunge, and Mr. Dorozhko made his money by selling the puts.”

The question of law that makes the case tricky is summarised in the report:

“This situation exists because of a strange anomaly in American securities laws. A person who legally obtains insider information — as a corporate official or an investment banker, for example — will almost certainly break the securities law if he or she trades on the basis of that information before it is made public.

But it is far less clear that someone who illegally gets their hands on such information will have violated the securities laws by trading on it. The securities law used to bring insider trading charges — Section 10(b) of the 1934 Securities Exchange Act — talks of “a deceptive device or contrivance,” and it is not clear that there is any deception involved in simple theft.”

It is likely to be even more onerous for a regulatory authority or prosecutor to establish a case in similar circumstances under the Indian insider trading law – being the SEBI (Prohibition of Insider Trading) Regulations, 1992 – as that applies only to trading by insiders or to disclosure of information by insiders. Further, Indian law does not have a broad-brush antifraud provision in the nature of Section 10(b) of the US Securities Exchange Act, 1934 within which to fit such a case. That being said, it is still open for a case to be brought under other legislations, such as for fraud or even for hacking under the Information Technology Act, 2000 (which are beyond the purview of this blog).

Guest Contributor: Gauri Manglik

It is my pleasure to introduce our guest contributor, Ms. Gauri Manglik.

Gauri is an associate at Amarchand & Mangaldas & Suresh A. Shroff & Co. where her work includes capital markets, private equity and other corporate advisory work.

Gauri graduated in the top 5% of the Masters of Law (LLM) class from the University of California - Los Angeles, specialising in corporate and securities law and obtained a B.A. LL.B. (Hons) from the National Law School of India University in 2003.

Gauri's prior work experience, inter alia, includes teaching securities laws at the WB National University of Juridical Sciences, Kolkata and undertaking an extensive research project for the Ministry of Finance, Government of India. She has several publications in leading law journals to her credit. She was recently invited to present one of her papers on Securities Laws at the EALE 2007 Conference in Copenhagen.

Hostile Takeovers in India: Opportunities and Challenges (Part 2)

After dealing with the history of hostile takeovers in India and possible regulatory obstacles, Shaun’s article moves on to deal with what I find is an interesting analysis of the availability of some of the key takeover defences in the Indian context. I highlight some of his observations (and also intersperse some of my own) below:

1. Poison Pill

A poison pill is a shareholder rights plan whereby a company distributes special stock warrants to its shareholders that entitle them to purchase shares of the company at a substantial discount in the event of a hostile takeover attempt, to the exclusion of the raider. The purpose of this defence is to substantially dilute the shareholding of the company to such an extent as to make the acquisition prohibitively expensive to the hostile acquirer. Although the Takeover Code does not proscribe the issue of such stock warrants, the SEBI (Disclosure and Investor Protection) Guidelines, 2000 (the DIP Guidelines), specifically Chapter 13, impose several restrictions on the issuance of warrants. First of all, issue of warrants at a discount is not possible at the warrants have to be priced at a minimum price determined in accordance with the DIP Guidelines with reference to the market price of the shares (paragraph 13.1.2). Secondly, such warrants can be outstanding only for a period of 18 months after which they would automatically lapse (unless exercised) (paragraph 13.2). Companies will find it difficult to return to shareholders every 18 months to seek a renewal of the shareholder rights plan. For these reasons, the poison pill does not work efficiently as a defence in the Indian context.

2. Staggered Boards

A staggered board of directors is considered to be another effective takeover defence, whereby 1/3rd of a company’s directors retire each year, and hence the entire board can be changed only once in 3 years. This works as an effective defence in some jurisdictions, Delaware in particular. Therefore, if a raider wishes to redeem the poison pill by capturing the board, it would have to wait at least 2 annual retirement cycles before it can obtain the ability to appoint a majority on the board. It may seem that since Indian companies also follow the staggered boards approach to appointment of directors (Section 256 of the Companies Act, 1956), it may seem that this operates as a perfect defence to takeover. But, there is one fundamental difference. Unlike under Delaware law, shareholders have the power to remove all the directors of the company without cause in a single shareholders’ meetings (Section 284 of the Companies Act). Hence, a hostile acquirer who acquires shares or voting rights that enable it to obtain a simple majority in a shareholders’ meeting can substitute the entire board, thereby paralyzing the staggered board defence.

3. White Knight

Another form of takeover defence that is not elaborated in the article, but nonetheless does exist, is the white knight defence. When a company is faced with a hostile acquirer, it often approaches another friendly entity to acquire shares in such target company so as to ward off the hostile acquirer. This is one defence that seems entirely permissible within the contours of the Takeover Code, as the Code permits competitive bids in the wake of a takeover offer. It is always open to the target company or its promoters to bring in a white knight, and this route was successfully utilized by the promoters of the GESCO real estate company when there was a hostile bid on it by the Dalmia group. The white knight was the Mahindra group that was recruited by the promoters to keep the Dalmia group at bay. To me, it seems that among the traditional takeover defences, the white knight is one that is available without doubt to a target company or its promoters in the event of a hostile acquisition of an Indian company.

4. Other Takeover Defences

Shaun’s article also deals with certain other defences such as scorched earth tactics (which is a form of a suicide pill) where the target company retaliates in the event of a hostile bid with actions that destroy the value of the company and make it unattractive to the hostile acquirer. For example, this could be achieved by selling the crown jewels of the company at a substantially low value. Such transactions may not only require the approval of shareholders (Section 293 of the Companies Act, 1956), but may also leave open the possibility of shareholder suits if it can be established that the company (being the board of directors) have not acted in good faith. The article identifies other defences including embedded defences – provisions in the articles of association entitling an incumbent to be a chairman for life, contractual provisions that trigger undesirable consequences in the event of a change in control, and the like.

In the Indian context, the most successful defence against hostile takeovers is the high stakes that promoters hold in their companies. Often, promoters also gradually shore up their stake (through the creeping acquisition route) to fend hostile bids. High promoter stakes make it difficult for raiders to take control without bringing the promoters to the negotiating table.

Finally, after dealing with takeover defences, Shaun analyses the shareholding pattern of large listed companies, and finds that although promoters hold large stakes thereby effectively defending themselves against hostile takeovers, there are several top Indian companies where the promoter holding is not high enough to preclude a takeover. One of the reasons why such companies have not been exposed to hostile takeovers yet may be explained by India’s favourable economic climate, where stock prices continue to grow thereby leaving few targets for hostile bidders (as such bidders usually pursue undervalued stocks). But, in the event that share prices were to fall, Indian companies will likely face the prospect of hostile acquisitions primarily by foreign acquirers, and therefore hostile takeover activity is a distinct possibility in the Indian scenario, which companies will have to face up to. The article concludes with some prescriptions for regulating hostile takeover activity in India.

This article is extremely relevant to the takeover field in India as it throws light on a hitherto under-researched area. Shaun’s findings are based not only on a research of the legal position on the books, but also on the basis of interviews of practitioners in the field. I would recommend it to all those having an interest in the M&A sector in India – it makes useful contribution from both academic and practical perspectives.

The article can be downloaded from LexisNexis or Westlaw.

Hostile Takeovers in India: Opportunities and Challenges (Part 1)

Hostile takeovers of companies (otherwise referred to as the market for corporate control) is a rather well-known phenomenon in the corporate sphere. The 1980s (a.k.a. the deal decade) were famous in the US for large hostile transactions that set fire to lawyer ingenuity resulting in the development of various takeover defences. Hostile takeovers continue to pose a threat to companies – even as the story of the Microsoft offer for Yahoo unfolds with a hostile takeover looming large in the wake increasing resistance by the Yahoo board.

Despite their prominence elsewhere, hostile takeovers have been largely alien to Indian listed companies that have rarely witnessed raids by hostile acquirers. This may lead one to believe that the Indian legal system – with the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2007 (the Takeover Code) being the legislation on point - is friendly to incumbent shareholders and management and is unfriendly to raiders. However, a reading of the Takeover Code would reveal that it does not prohibit hostile takeovers, and even more, it in fact imposes various restrictions on incumbent promoters and management once an open offer is made, thereby enhancing the leverage available to the hostile acquirer. This poses an interesting question. Why then are hostile acquirers a rarity in the Indian context, despite a favourable regime under the Takeover Code?

This question has been examined by Shaun Mathew, an attorney with Wachtell, Lipton, Rosen & Katz and a Harvard law graduate, in a well-researched article titled “Hostile Takeovers in India: New Prospects, Challenges, and Regulatory Opportunities” that has been published in the Columbia Business Law Review (2007 Colum. Bus. L. Rev. 800) (available here). The article begins with an analysis of the Takeover Code and the broad shareholding pattern of top listed companies in India. Shaun then deals with the history of hostile takeover activity in India and alludes to the four large raids that were made on Indian companies in the last 25 years. These are:

1. Swaraj Paul’s failed bid for Escorts and DCM (1984);
2. ICI’s attempt to takeover Asian Paints (1997);
3. India Cements/ Raasi Cements (1998); and
4. The Dalmia group’s purchase of stake in GESCO’s real estate company (2000).

Unsurprisingly, the attempts failed for one reason or the other, except for India Cements’ successful acquisition of Raasi Cements.

The article then deals with the possible regulatory obstacles to hostile takeovers. First is the Takeover Code, which as discussed above does not present any direct hindrance to hostile acquisitions. Second is the foreign investment policy of the Government of India and the Reserve Bank of India (RBI) that deal with acquisition of shares by foreign acquirers. Even these have been largely liberalised in 2006 (by a Press Note – the relevant paragraph is 2e) enabling foreign acquirers to buy shares in Indian companies without the approval of the Foreign Investment Promotion Board or the Reserve Bank of India (RBI) even in case of an unsolicited offer made under the Takeover Code. Foreign acquirers may buy shares in Indian companies without prior approvals, except in specified sectors or where sectoral caps are exceeded, so long as the price is at or above the prevailing market price of the shares.

The next part of the post will deal with the article’s analysis of takeover defences in India and the impact of the level of promoter shareholding on hostile takeovers.

Competition Act: Cementing Law and Policy

Rahul Singh, who will be contributing to this blog, has written in Livemint about the adverse effects of the delay in notification the provisions of the Competition Act. To enunciate this point, he uses the example of the rise in cement prices, which had to be arrested through the threat of takeover by a state government.

Another aspect that Rahul alludes to is the role that consumers must play in the implementation of competition law and policy:

“The agency to detect and enforce the competition law against unscrupulous companies must also partly lie with the consumers. After all, ordinary consumers are the ones shelling out their hard-earned money in order to purchase goods and services. This is exactly what the new competition law envisages. Unlike the ambiguous Monopolies and Restrictive Trade Practices Act, 1969 (proposed to be replaced), the new legislation stipulates an empowered role to be played by ­consumers.

In order to get over the diffused power of consumers, they need incentive to file cases. A robust mechanism ensuring compensation promises to do the same. Companies, of course are loath towards this. They wish to carry on business as usual. This is perhaps the strongest reason why business lobbies have successfully stalled implementation of the competition law so far.”

Contributor: Rahul Singh

It is my pleasure to introduce our new contributor, Mr. Rahul Singh.

Rahul Singh (http://www.rahulsingh.org) is Asst. Professor of Law at the National Law School of India University, Bangalore where he teaches Competition Law & Policy, Securities Regulation, WTO and Jurisprudence.

He also lectures as a visiting faculty at numerous other places, including, the Indian Institute of Management (IIM), Bangalore, IIM Kozhikode and Christ College of Law, Bangalore. Currently, he has an invitation to teach at the University of California, Berkeley, USA.

He is a member of Competition Commission of India’s Advisory Committee on Regulation. He is also on the board of advisor and consultant with several corporations.

He graduated with a Master of Laws (LLM) degree from the Harvard Law School where he was a Myer Dana & Etta Dana Scholar. He also holds a Bachelor of Arts and Laws (BA, LLB Honors) degree from the National Law School of India, Bangalore where he was awarded four Gold Medals by the Hon’ble Chief Justice of India for exceptional academic excellence (University Rank) as well as for being the “Best Student”.

His prior work experience, inter alia, include working as a corporate lawyer in the New York City with an information technology firm, a research assistant at the Harvard Law School and Harvard Business School, and a Judicial Clerk with Mr. Justice V.N. Khare (the then Hon’ble Chief Justice of India).

His areas of specialization include Competition Law & Policy, Securities Regulation, WTO and Economic Analysis of Law. He has been profiled by national newspapers such as the Times of India and the Indian Express. He has several publications in leading law journals to his credit.

SEBI Reigns in Art Funds

Art funds have become a popular alternative investment avenue in India (see news reports in Moneycontrol India and Rediff Money).

In a communication titled Message for Investors, SEBI has announced that art funds are collective schemes and will therefore fall within the purview of SEBI regulations. Here is the relevant extract:

“This message is issued by SEBI in the interest of investors with regard to their investments in Art Funds, funds/schemes launched by companies or any entity formed for the purpose. From the analysis of the characteristics of ‘art funds’ these are ‘collective investment schemes’ as defined under section 11AA (2) of the SEBI Act, 1992. The schemes/funds have been launched / floated by these entities without obtaining a certificate of registration in accordance with the SEBI (Collective Investment Schemes) Regulations, 1999 (the Regulations).

In terms of section 12 (1B) of the SEBI Act, 1992 no “person” shall sponsor or cause to be sponsored or cause to be carried on a collective investment scheme unless he obtains a certificate of registration from the Board in accordance with the regulations.
Regulation 3 of the Regulations permits only a ‘Collective Investment Management Company’ having certificate of registration from Board to launch collective investment scheme. Thus, only a company which has been granted certificate of registration by the Board in accordance with the Regulations can launch or sponsor a collective investment scheme. In other words, for a collective investment scheme to raise money from the public it is prerequisite that the entity must (a) be a company and (b) registered with SEBI as a Collective Investment Management Company.”

The “Par” Has Lost Its Value

Indian company law includes several concepts that have become archaic. Efforts have been made to address this issue and to modernize company law – some the recent ones include a Concept Paper prepared by the Ministry of Company Affairs in 2004 and the JJ Irani Committee Report presented in 2005. However, these changes are yet to see the light of day.

This blog will periodically carry a discussion on some of the areas of Indian company law that necessitate modernization and review in the context of international practices. Some of these changes have already been contained in various recommendations to overhaul the Indian Companies Act, while others have not been addressed at all. The first among these relates to the concept of “par value” of shares.

Par value of shares (which is also commonly referred to as “nominal value”) is the minimum value or floor price at which shares can be issued by a company. While law encourages companies to issue shares at a price that is higher than the par value (the difference being known as “premium”), it abhors issue of shares are less than par value (the difference in this case being known as “discount”). Par value is a 19th century English concept that has found its way into the Indian Companies Act, 1956.

The ostensible justification for imposing par value on shares is two-fold: first, that it protects creditors a company and second, that it protects existing shareholders. Since shareholders will be obligated to bring in capital at least to the extent of the par value of the shares, it provides protection to creditors as they are able to assess the level of capitalization of a company. This would be particularly relevant where shares are partly paid, in which case shareholders would have a liability towards the company to the extent of the unpaid capital. As for existing shareholders, par value provides protection in that the company is prohibited (or substantially restrained) from issuing capital at a price less than the par value. By providing assurance of a minimum floor price on further capital issuances, it sets in place a kind of anti-dilution protection (as is currently in vogue though by contractual means).

Although par value may indeed have provided benefits to shareholders and creditors historically, its significance has eroded in modern company law. Consequently, several jurisdictions such as the United States (principally Delaware) and even Commonwealth countries such as Australia, New Zealand and Singapore (which largely drew their company law from England) have abolished par value on shares and shifted to a no-par value regime. Presently, England, several continental European countries and other countries such as India continue to follow the par value concept for issuance of shares.

Let us examine some of the adverse effects of par value. First, there is no clarity on a benchmark par value. Under the Indian Companies Act, companies are largely free to determine their own par value. In practice, the numbers range from Rs. 100 to Rs. 10 to even as low as Rs. 1 per share, depending on the nature of the company. For listed companies going for a public offering, however, SEBI does prescribe norms whereby companies will be permitted to fix low par values only if the price in the offering is above certain thresholds. Multiple par values in the markets create confusion to investors as they are unable to compare companies and their shares prices where their par values are different.

Second, since companies are largely free to fix their own par values, the protection it renders to shareholders and creditors is illusory. This is especially so when par values are so minimal as to not afford any protection at all.

Third, par value on shares introduces inflexibility in financing options for companies, especially those that are experiencing deterioration in their financial condition. Such companies may often require financial restructuring which involves induction of fresh capital at low prices. Existing law proves to be a hurdle as Section 79 of the Companies Act imposes onerous conditions (such as obtaining the approval of the Company Law Board) to issue shares at a discount, thereby making this option unviable. Par value hinders efficient restructurings or turnarounds of companies and thereby affects proper functioning of the industrial economy.

Fourth, the par value regime involves additional complexities on the accounting front. Share issuances at a premium require categorization of capital as par value and premium in the accounts and financial statements of the company. While that itself may not present significant problems, any restructuring of capital at a later stage will involve accountants having to make adjustments for both the par value and the premium. A no par value regime would be elegant in as much as it simplifies accounting matters considerably.

A no par regime will help overcome the disadvantages listed above, and allow for uniformity and homogeneity in shares of a class (all without par value). All shares will represent a proportionate part of the share capital of a company of the relevant class, and no more. The simplicity of the no par value regime outweighs the benefits of a par value regime and Indian company law ought to be move towards abolishing par value of shares.

On Being a Corporate Lawyer

The Harvard Law School Corporate Governance Blog carries a post regarding a lecture by John C. Coates titled “On Being a Corporate Lawyer” that he delivered on being appointed the John F. Cogan, Jr. Professor of Law and Economics. A webcast of the lecture is also available.

Coates talks about trends in current corporate law practice and shares his thoughts on what the future holds. Having been a partner at a top corporate law firm in the US and later a leading corporate law academic, Coates is well placed not only to deal with structures of law firms and their management practices, but also the interplay between law firms and corporates on the one hand (representing the demand side) and law schools and law students on the other hand (representing the supply side).

Some of the key points he makes regarding current practices in corporate law practice are:

- Law firms lack size compared to their peers in other service industries, such as accountants and other consultants;
- M&A activity hardly exists among law firms; the established players continue to stay on the top for a very long period of time;
- Although lawyers help their organize their clients’ affairs, they themselves are largely disorganized;
- Established relationships still dominate legal practice; law firms rarely get fired altogether by a client;
- Law firms are paid less than the value of the service they provide; they command substantially higher fees that are never usually paid due to the billable hour method followed (rather than a percentage of transaction commanded by investment banking firms, for instance);
- The lack of higher fees is also reflected in overworked lawyers (again a function of the billable hour method where lawyers need to put in longer hours).

As for the future, he envisions greater mergers and acquisitions of law firms. One of the ways in which acquisitions will be accomplished is through payment for acquisitions by stock, which means that law firms would possibly list themselves on stock exchanges, not so much to raise cash for their operations, but to use stock as currency for acquisitions. An IPO of a law firm is not unusual, as it has already occurred in Australia and is likely to occur in the UK not too long in the future. Concerns that Coates raises is for law firms to deal with the leverage issue – successful firms will be those that deal with this issue well – and ways to allow lawyers to preserve intellectual attachment to their work and to ensure retention.

Coates also alludes to the intense competition among law firms for hiring top graduates from recognized law schools, and that the fact that the supply of good-quality lawyers is not increasing at a pace enough to meet with the rising demand.

Although the lecture is set in the backdrop of corporate legal practice in the US, a substantial part of Coates’ observations would apply to Indian legal practice as well.

Limited Liability Partnerships: Some Developments

While it is reported that the Limited Liability Partnership Bill is likely to be cleared during the Budget session of Parliament, there have been some interesting developments that will make limited liability partnerships (LLPs) attractive, at least to some types of business.

The first relates to multi-disciplinary partnerships (MDPs). The Economic Times reports:

“India can soon boast of its own homegrown multidisciplinary majors like Ernst & Young and PwC, comprising professionals like Chartered Accountants, Company Secretaries, engineers, architects and MBAs under one roof, to cater to the rapidly-globalising corporate sector.

Professional institutes like Institute of Chartered Accountants of India (ICAI), Institute of Company Secretaries (ICSI) and Institite of Cost and and Works Accountants (ICWAI) have initiated steps to work out arrangements to form multi-disciplinary partnerships (MDPs), though the big booster would be a formal go-ahead to limited liability partnerships (LLPs), the bill for which is likely to be cleared in the budget session of parliament.”

This would enable professionals to establish multi-disciplinary practices thereby enabling them to provide different types of services to clients under one roof. However, from a legal standpoint, this may require amendments to the legislations governing these professions, such as the Chartered Accountants Act, 1949, the Company Secretaries Act, 1980 and the like.

As to whether lawyers will be a part of MDPs, the news report states:

“However, there are some crucial issues that stand in the way of such MDPs. Currently, the Bar Council has not agreed to be a part of such firms and absence of legal eagles would certainly be a big miss.

Senior corporate law advocate U K Chaudhary said while Bar Council had no objection to LLPs between lawyers, it was yet to permit them to join other professionals in MDPs. "However, I feel that lawyers should be allowed to be part of such multi-disciplinary firms as this would open a whole opportunity for them," Chaudhary added.”

A second development relates to the availability of tax benefits to LLCs. The proposal allows LLPs to choose whether to tax the LLP itself as an entity or to tax its partners directly. Another report by the Economic Times:

“The ministry of corporate affairs has recommended in a Cabinet note that it is an international practice to let LLPs choose the mode of taxation, based on how they are structured. If an LLP’s operations are de-centralised and the partners act autonomously, their income could be taxed in the hands of the partners.

If the LLP has centralised operations and assets, then the LLP itself could be taxed. Outside investors, who form cross-border LLPs with Indian professionals, would prefer taxation at the partner-level instead of at the LLP-level as that would mean taxation only at one level.

If the LLP itself is taxed, the foreign partner in a cross-border partnership may end up paying tax in his country for his income from the partnership registered in India even if the LLP’s entire income has already been taxed in India.

Also, if the LLP generates income here as well as abroad, the entity will have to pay tax here even for the income that is generated abroad. Taxing individual partners will ensure that these disadvantages are eliminated. Taxation at the partner level means paying taxes in the respective countries by the partners for whatever income they get from the LLP. A partner in one country need not bear the burden of taxation in another.”

We could expect announcements on this front in the forthcoming Budget.

Tax Benefits for REITs Likely

An earlier post on this blog had stated that the success of REITs in India would depend upon the availability of tax benefits to the REIT vehicle in the form of a tax pass-through.

The Economic Times reports that SEBI has made out a case to the Government seeking that REITs be taxed in the same manner as mutual funds. The news report states:

“The income-tax law now provides for a pass-through status for mutual funds and the income earned by the funds is tax-free. But depending upon the nature of the fund, any income distributed by the mutual fund attracts a distribution tax. The maximum rate of dividend distribution tax is fixed at 25%. However, unit holders do not have to pay tax on their dividend income. Sebi has recommended extending a similar tax treatment to REITs. This would mean granting them a pass-through status and exempting all income earned by REITs from tax.

Investors holding REIT units should also be spared from paying tax on dividends. Income distributed by the REIT would attract dividend distribution tax. Sebi, in its draft guidelines, has suggested that REITs should distribute not less than 90% of their net income after tax as dividends to the unitholders.”

Similarly, it is expected that capital gains tax would be chargeable on transfer of units in REITs similar to a transfer of units in a mutual fund. These tax benefits are likely to take shape in the upcoming budget, which would constitute an additional step in the establishment of a regime for REITs in India.

Minimum Public Float in Listed Companies

An area that has left an ambiguous trail over the years has been the amount of public shareholding that is required in a company at the time that it embarks on a listing and thereafter on a continuous basis. Numbers for public shareholding limits have, in the past, ranged from 60% to 40% to 25% and finally to 10%.

After a chequered history, the rules have finally resulted in its current position, which are briefly set out here. There are two key time periods during which determination of public shareholding becomes important. The first is when the company undertakes listing of its shares. Rule 19(2)(b) of the Securities Contracts (Regulation) Rules, 1957 (SCRR) provides that at least 25% of a company’s securities shall be offered for listing at the time of its initial public offering. However, this number can be reduced to 10% subject to 3 conditions, viz.: (i) minimum offer is for 20 lakh securities, (ii) size of the offer is a minimum of Rs. 100 crores, and (iii) the issue is undertaken through the bookbuilding process with allocation of 60% of the issue to qualified institutional buyers. It may be emphasized that these percentages of shares are those to be “offered” to be public – the question of how many shares are actually taken up and allotted are not relevant.

Once listed, companies are required to maintain a minimum public float during the period of listing. This is governed by the provisions of the listing agreement that companies enter into with stock exchanges. Clause 40A of the listing agreement provides that listed companies shall maintain a public float of 25%. However, this number may be reduced to 10% in two circumstances, viz.: (i) a company has offered at least 10% shares to the public (but less than 25%), or (ii) a company has more than 2 crore shares outstanding or its market capitalization is at least Rs. 1,000 crores.

It is clear therefore that the requirements or criteria for public float (i) at the time of listing and (ii) thereafter on a continuous basis are different. Further, not only are these requirement inapplicable to government companies, infrastructure companies and BIFR companies, but SEBI too has powers to waive or relax the applicability of these provisions.

In order to overcome these anomalies, the Ministry of Finance has issued a discussion paper imposing a uniform public float limit of 25% at both stages, i.e. at the time of listing of shares and thereafter on a continuous basis. The paper sets out the history of public float requirements in India and also succinctly lays down the policy rationale for these requirements (these are not being reproduced here, and interested readers may follow the aforesaid link to the document to obtain a better understanding).

The crux of the changes proposed is as follows, as quoted from the discussion paper:

“(a) The standards for initial listing and continued listing may be prescribed in the SCR Rules.

(b) The standards for initial and continuous listing may be uniform, as the objective is same.

(c) The public offer envisaged at initial listing is of no consequence unless the public are actually allotted shares. The SCRR may speak in terms of allotment to public, not just public offer.

(d) As of now, the word ‘public’ is not defined. If ‘public’ means ‘non-promoters’ and includes FIs, FIIs, MFs, employees, NRIs/OCBs, private corporate bodies, etc., the floating stock would be insignificant. A view needs to be taken on this.

(e) For a company to be listed and continue to be listed, it must have a public stake of 25%.

(f) If for any reason, the public holding reduces below 25%, the promoters, management and company may be jointly and severally be liable to bring the public holding to 25% within 3 months, in the manner prescribed by SEBI, failing which appropriate enforcement action, including delisting, may be taken.

(g) There should not be any discrimination between a Government company and non-Government company. The powers of the stock exchange to relax any of the conditions of listing with the prior approval of SEBI in respect of a Government company needs to be withdrawn. Similarly, the powers of SEBI to relax listing requirements may be withdrawn.”

Apart from establishing a uniform limit of 25%, the proposal addresses other important issues, such as the relevance of actual “allotment” of shares to the public to the extent of 25% and not mere “offer”, the removal of discretion from regulatory authorities like SEBI to relax requirements, introducing a definition of “public” which is currently non-existent and the withdrawal of exemptions available to government companies.

While this is an important step, issues still remain as to how effective this change would be. One crucial factor would be whether the uniform requirement of 25% public holding will apply to existing companies (in addition to new offerings). In that case, several companies (including those that made offerings of large sizes over the last 8 to 10 years) that have a current public float of only 10% (but less than 25%) will have to increase their public float to 25%. This would perceptibly amount to a large exercise and it is not entirely clear if the market will be in a position to absorb either further equity offerings by so many of these companies or sales by promoters to the public so as to hike up the public float to 25%.

On the other hand, if existing companies are to be spared this new change, then this proposal has only minimal impact, as these companies will continue to be governed by their previous public float requirements of 10% (to be reckoned on a continuous basis). Then the new rule will fail in its purpose in obliterating differences in public float limits.

There seems to be a need for a delicate line to be drawn at a policy level. Comments are invited by the Finance Ministry on this proposal by February 28, 2008.

(For press reports, see: Economic Times & Livemint)