Buybacks and open offer - recent decision of SAT

Recently, on 21^st November 2011, the Securities Appellate Tribunal (SAT) held that the increase in percentage holding of a person consequent to buyback of shares does not amount to acquisition and thus cannot result in an open offer. This is, in my view, a correct legal interpretation of the law (as also argued by me in an earlier post here). But SEBI had, in practice, taken a view that such increase does amount to acquisition. On this basis, actually an assumption taking an unwritten law for granted, it granted exemptions, selectively and subject to certain conditions, from applicability of relevant provisions including open offer. Further, where such “acquisitions” triggered the open offer requirements and the “acquirers” did not make such offers, SEBI passed adverse orders (including the present one which is now reversed by SAT). It even inserted a proviso in the Regulations exempting increase in certain cases such “acquisitions” (briefly discussed earlier here) thereby implicitly assuming that such increases were “acquisitions”.

My earlier post here discusses this issue in more detail where some arguments are given why such increase should not amount to “acquisitions”. But, briefly, the issue is as follows. The Regulations place several obligations on an acquirer of shares such as making of disclosure of acquisition, making an open offer, etc. Acquirer is defined as a person who “acquires or agrees to acquire” shares, voting rights, etc. If the acquirer acquires 5% or more shares, he has to make certain disclosures. If he acquires 15% or more (under the 1997 Regulations), he has to make an open offer. And so on.

In case of buyback of shares, there is an involuntary or passive increase of percentage holding, if a person does not participate in it. For example, a person holding, say, 60% shares and does not participate in a 20% buyback of shares then, post-buyback, his percentage holding would be 75%. Thus, his percentage holding would have increased by 15 percentage points without his having acquired a single additional share. In my view, by any stretching of the term “acquirer”, this does not amount to acquisition of shares by an acquirer which should result in an open offer. One may argue that the intention of the law may be that such increases should also result in an open offer. One may also say a person holding, as in above example, 60% shares, may initiate a buyback, and then not participate in it thereby ensuring that his percentage holding increases. However, intentions or potential misuses cannot be allowed to stretch the interpretation of the law. It would smack of arbitrariness and as also discussed later leave several loose ends. Nevertheless, instead of simply making an amendment to the law, though several opportunities were available when other amendments were made, SEBI initiated and persisted in adopting a practice of taking a stand that such increases amounted to exemptions.

The SAT rejected this attempt in fairly clear and emphatic words. In the case under consideration, consequent to a buyback, the holding of the Promoters increased from 62.56% to 75%. While there are other aspects and issues in the case, the essential question before the SAT was whether this increase should result in an open offer.

The SAT relied on the definition of an “acquirer” under the Regulations as well as in a legal dictionary. It held that a passive increase in percentage holding pursuant to a buyback cannot amount to acquisition. It observed (emphasis supplied in all extracts):-

“In this context the word ‘acquire’ implies acquisition of voting rights through a positive act of the acquirer with a view to gain control over the voting rights. In the case before us, it is the admitted position of the parties that the appellants (promoters of the company) did not participate in the buy back and that there was no change in their shareholding. The percentage increase in their voting rights was not by reason of any act of theirs but was incidental to the buy back of shares of other shareholders by the company. Such a passive increase in the proportion of the voting rights of the promoters of the company will not attract regulation 11(1) of the takeover code. The argument of the learned counsel for the Board that merely because there is increase in the voting rights of the appellants, regulation 11(1) gets triggered cannot be accepted.”

Does such an increase amount to an “indirect” acquisition? This argument too was rejected by observing:-

“He also referred to the definition of ‘acquirer’ in regulation 2(b) of the takeover code and strenuously contended that a passive acquisition of the kind we are dealing with is indirect acquisition and, therefore, the provisions of regulation 11(1) are attracted. We have no hesitation in rejecting this argument outright. The words ‘directly’ and ‘indirectly’ in the definition of ‘acquirer’ go with the person who has to acquire voting rights by his positive act and if such acquisition comes within the limits prescribed by regulation 11(1) it would only then get attracted. Passive acquisition as in the present case cannot be regarded as indirect acquisition as was sought to be contended on behalf of the Board.

The SAT also rightly highlighted another absurdity involved. If the view that passive increase may also amount to acquisition, then even a non-controlling shareholder holding, say, 14% may find the requirements of open offer getting triggered off if he does not participate in a buyback and finds his holding increased to, say, 16%. The SAT observed:-

“Again, a non-promoter shareholder may increase his percentage of shareholding without participating in the buy back over which he has no control. In such an event he would be burdened with an onerous liability to make a public announcement. It is well settled principle of law that a provision ought not to be interpreted in a manner which may impose upon a person an obligation which may be highly onerous or require him to do something which is impossible for no action of his.”

Other difficulties in taking such an interpretation were highlighted. At the end, the SAT, in quite emphatic words, held that “we are of the firm opinion that passive acquisition does not attract the provisions of regulations 11(1) of the takeover code.”

Once such an interpretation is accepted, the following situations, arising out of buyback and under the 1997 Regulations, need to be considered:-

1. If a person’s holding increases to 5% or more, will disclosure be required?
2. If a person holding 5 or more% finds his holding increased by 2% or more, will disclosure be required?
3. If a person holds less than 15% finds his holding increased to 15% or more, will an open offer be required?
4. If a person holding 15% or more finds his holding increased, will such increase be counted as part of creeping acquisition or will he be entitled to acquire a further 5% in a financial year ignoring such increase?
5. If a person holding 55% or less finds his holding increased beyond 55%, will he be deemed to have violated the Regulations?

-        And so on.

Applying the decision of the SAT, the answer to each of the aforesaid questions appear to be in the negative.

However, while this was the position under the 1997 Regulations, the question is whether it will also hold good under the 2011 Regulations. The curious thing is that while the corresponding wording in the definition of “acquirer” under the 2011 Regulations remains exactly the same, the Regulations have made further provisions on the assumption that such a passive increase amounts to acquisition. It has exempted two types of such increases (from below 25% to 25% or more, and more than the creeping acquisition if holding is already more than 25%) if certain conditions are satisfied. It is submitted that considering that even the 1997 Regulations did contain such a provision, the ratio of the decision of the SAT should hold good.

One will have to wait and see whether SEBI appeals to the Supreme Court and, if yes, what view the Supreme Court holds. It is also possible that SEBI may amend the Regulations.

In conclusion, one cannot help expressing disapproval of adopting a practice-makes-law approach of SEBI which results in the law becoming opaque and even arbitrary where the law is interpreted not in accordance with what has been framed in due process and duly notified or in accordance with well accepted rules of interpretation but according to “intention” and/or the present internal preference or practice of SEBI.

p.s.:- This is in continuation and conclusion of my earlier post here on the SAT decision. 

Rescission and Repudiatory Breach

When C and R enter into a contract which is breached by R, C can either claim specific performance of the contract, or elect for the breach to have discharged the contract and claim damages. However, in cases where the latter option is chosen, it has been recognized since Johnson v Agnew that the contract continues to remain valid until the date of the repudiatory breach and is discharged only prospectively. It in only when C seeks to set aside the contract on grounds of fraud or misrepresentation that the contract is rescinded ab initio, and is deemed never to have been in existence. However, one issue that has continued to cause some confusion, partly due to the influence of civilian authority (in particular, the concept of fundamental breach), and partly because of some controversial decisions, is whether the magnitude of the breach influenced the contractual remedy. In other words, if the breach was of a term which formed an important part of the contract, could that be taken as a ground to rescind it ab initio? In Howard-Jones v Tate, the UK Court of Appeal has vehemently answered this question in the negative, reasserting the distinction between rescission and repudiatory breach forcefully laid down by Lord Wilberforce in Johnson v Agnew.

The dispute involved the purchase of a warehouse and some buildings from the respondent by the claimant, and a condition of the contractual agreement was-

"The seller [Mr Tate] shall at his own expense and no later than six months from the Completion Date:

(a) provide a new directly metered single phase electricity supply to the building [the warehouse] forming part of the Property;

(b) provide a separately metered water supply (mains) to the building forming part of the Property." [emphasis supplied]

On the alleged non-performance of this condition, the claimant sought to rescind the contract, the respondent arguing that damages were an adequate remedy for the non-performance, if any, and that rescission ab initio was inappropriate. It was against this backdrop that the Court of Appeal was called on to consider the very interesting conflict between Johnson v Agnew and Gunatunga v DeAlwis, a decision of the Court of Appeal never cited by subsequent case-law.

In Agnew, Lord Wilberforce, in his archetypal style, had provided a clear summary of the law on rescission and repudiatory breach. After making some uncontroversial statements on the consequences of breach by the purchaser in a contract for sale, he observed:

At this point it is important to dissipate a fertile source of confusion and to make clear that although the vendor is sometimes referred to in the above situation as "rescinding" the contract, this so-called "rescission" is quite different from rescission ab initio, such as may arise for example in cases of mistake, fraud or lack of consent. In those cases, the contract is treated in law as never having come into existence. (Cases of a contractual right to rescind may fall under this principle but are not relevant to the present discussion.) In the case of an accepted repudiatory breach the contract has come into existence but has been put an end to or discharged. Whatever contrary indications may be disinterred from old authorities, it is now quite clear, under the general law of contract, that acceptance of a repudiatory breach does not bring about "rescission ab initio".

That same year, Lord Diplock in Photo Productions v Securiror also approved the position laid down by Lord Wilberforce in Agnew, and observed that the effect of an election by the innocent party to accept the repudiatory breach and make a claim for damages was that “(a) there is substituted by implication of law for the primary obligations of the party in default which remain unperformed a secondary obligation to pay monetary compensation to the other party for the loss sustained by him in consequence of their non-performance in the future and (b) the unperformed primary obligations of that other party are discharged.” There was no right to treat the contract as never having existed.

On this understanding of the law, the decision in Howard-Jones should have been fairly straightforward. Matters were complicated however, by the decision in Gunatunga. In that case, a contract for sale of property required that vacant possession be provided to the purchaser. The purchaser, aware that the property was not vacant, proceeded to completion of the contract. However, when the property was still not vacant on the designated completion date, rescission and consequential repayment of the purchase price was sought. The claimant’s counsel made two arguments- that there had been misrepresentation, and that a fundamental condition of the contract had not been fulfilled. The Court rejected the first, but accepted the second and allowed rescission. Sir Christopher Slade held that:

The question whether the refusal or failure to perform part of the contract amounts to a repudiation of the whole depends on the construction of the contract and all the circumstances of the case. As Mr Buckhaven [counsel for the defendants] submitted, there must be a refusal or failure to perform something which goes to the root of the contract, before the innocent party can regard himself as discharged from further performance of the contract and entitled to rescind … In my judgment, Mr Buckhaven's well-sustained submissions were unable to circumvent a fatal weakness in the defendants' case, which was not canvassed before the learned judge, namely that the defendants' failure to give vacant possession on August 30, 1991 gave rise to a new and separate right to rescind the contract which was in due course duly exercised by the plaintiff. [emphasis supplied]

Faced with this conflict between Agnew and Gunatunga, the Court in Howard-Jones had one of three options- (i) to hold that Gunatunga was incorrectly decided; (ii) to hold that Gunatunga dealt with an issue different from that in Agnew; and (iii) to distinguish Gunatunga on facts. While Kitchin and Lloyd LJJ (Ward LJ concurring) come very close to adopting the first of these approaches, they ultimately choose to distinguish Gunatunga on facts. Kitchin LJ (¶ 28) suggests that the decision could be per incuriam, while Lloyd LJ (¶39) suggests that it is inconsistent with Agnew. However, both of them conclude that this question does not need to be decided because, unlike in Gunatunga, the condition which was breached here was not a condition to be satisfied on completion, but a condition which was to be fulfilled six months later. Hence, they hold that the breach of such a subsequent condition cannot lead to rescission ab initio. With respect, this distinction seems slightly unsatisfactory. The fact that the condition was one which related to performance which was to occur subsequent to completion, cannot by itself deny rescission. If, following Gunatunga, the condition was such that its breach entitled the claimant to set aside the contract ab initio, the fact that it was breach after the completion and not at the time of completion should not be material. Thus, while the Court is clear is reaffirming Agnew, the reconciliation of Gunatunga is not satisfactory.

However, this is not to say that Gunatunga is necessarily per incuriam. The language adopted by Sir Slade in that case, is more one of failure of consideration, entitling the claimant to restitution. What he seems to say is that the claimant in Gunatunga did not get what he bargained for, entitling him to the repayment of the amount he had paid to the respondent as a restitutionary remedy. One basis on which Gunatunga can be reconciled is by saying that while the facts in Gunatunga entitled the claimant to restitution, the facts in Howard-Jones did not (because the claimant got substantially what he bargained for). The role of rescission in the law of restitution is the subject of much academic debate, with lack of clarity over whether rescission is a restitutionary remedy or is a condition precedent to awarding restitution when there is a contractual relationship between the parties. In other words, what is still not entirely clear is whether the right to rescind a contract is something is granted by the law of restitution, or is something which emanates from the law of contract, and on being exercised, entitles the claimant to restitution. Gunatunga can be understood as a decision which supports the former view, while a strict reading of Agnew could suggest the latter (though not necessarily so).

Admittedly, Kitchin LJ does seem to touch on the restitutionary explanation of Gunatunga, in ¶28 (“Nor is there any suggestion (in Gunatunga) that the plaintiff elected, as an alternative to claiming damages, to sue for recovery of the money paid on the basis that the consideration for the payment had wholly failed”) and ¶30 (“Upon completion, Mr Howard-Jones became the owner of precisely what he had bargained for”). However, one would have hoped for some more discussion of this fascinating issue. No doubt, a conclusive understanding of the place of rescission in the law of restitution was beyond the boundaries of what the Court was called on to decide. However, some clarity on the relationship (if any) between the factual distinction relied on by the Court, and the concept of failure of consideration, would have been welcome.

In sum, Howard-Jones v Tate is very useful for clarifying the distinction between rescission and repudiatory breach, and reaffirming the irrelevance of the magnitude of the breach. However, the controversy over rescission and the law of restitution remains to be resolved another day.

Crowd-Funding and Its Regulation

The concept of crowd-funding seems to have caught on. In one form, it involves small and medium-sized companies raising funding from investors using the Internet (usually social networking sites or specialist crowd-funding websites). While the concept itself is quite wide and allows for fund raising in many different contexts, it is particularly useful for small entrepreneurs and start-ups. But, it does give rise to issues pertaining to securities regulation, especially if monies are raised against issuance of securities that provide investors with some interest in the issuing company.

Based on the US experience, there could two possible issues. The first pertains to whether the issuance of securities through crowd funding would require registration with the securities regulator such as the US Securities and Exchange Commission (SEC). The second is whether the Internet websites that peddle the securities require registration as broker-dealers that are subject to securities regulations. While some of these issues have been a subject matter of academic study (as indicated in this post on the Truth on the Market Blog), both the US Congress and the SEC have been considering, and even taking steps to introduce, exemptions to allow crowd funding so long as the amounts raised are capped (both at an overall level and per investor). 

A recent report in the Hindu Business Line indicates the emergence of the practice in India as well. The primary question under Indian law would be whether this would amount to a public offering in terms of section 67 of the Companies Act that requires a prospectus and associated compliances. If the specific form of crowd funding involves issuance of securities such as shares and debentures, then an offer or invitation made to 50 persons or more could fall within the purview of a public offer. This is particularly so when the offer or invitation is made through the Internet rather than to specified persons. Moreover, this issue has been magnified in the context of the litigation involving companies within the Sahara group culminating with the order of the Securities Appellate Tribunal. If the specific type of crowd funding indeed amounts to a public offering of securities, the secondary question would arise whether the Internet sites through which the funding is raised taken on the character of intermediaries that might require compulsory registration with SEBI. Of course, this is still early days in the Indian context, but these are issues worth considering in advance of crowd funding becoming more prevalent in the Indian markets.

Announcement: NLSIR Public Law Symposium

The following notification from the National Law School of India Review may be of interest to our readers:

"The National Law School of India Review, the flagship journal of National Law School of India University, Bangalore is pleased to present the first NLSIR Public Law Symposium to be held on 10 December, 2011 at the National Law School campus. The theme of the symposium is "Adjudication of Socio-Economic Rights by the Indian Supreme Court", an issue which has seen significant legal developments in the recent past. The symposium will be attended by renowned legal luminaries including Justice Muralidhar, Mr. T. R. Andhyarujina, Mr. Shyam Diwan and Mr. Arun Kumar Thiruvengadam, amongst others.

The discussion will be divided into two sessions. In the first session (scheduled between 10.30 A.M.-12.30 P.M.) the panel will discuss the substantive adjudication of socio-economic rights undertaken by the Supreme Court concerning questions of the ever-widening ambit of Article 21 and the content of the new rights so evolved. The changing nature of the relationship between Part III and Part IV of the Constitution due to such expansion will form an important part of the session. The second session (scheduled between 1.30 P.M.-3.30 P.M.) will focus on the manner in which the Supreme Court has enforced these rights and consider the variety of procedural innovations employed for the same, including PILs and continuing mandamus.

The registration fee for the symposium is Rs. 500 for professionals. There is no registration fee for students. All those interested are requested to register their attendance at the following link: https://docs.google.com/spreadsheet/viewform?formkey=dEdkRTJua21BY2R5Snh1UWl1QXRCREE6MQ.

For any further details regarding the symposium, please contact Krishnaprasad K.V. (Chief Editor, NLSIR) at +91-9916589670 or Ashwita Ambast (Deputy Chief Editor, NLSIR) at +91-9986478265 or email us at mail.nlsir@gmail.com."

SEBI Decisions on Public Offerings, Responsibility Reporting

SEBI’s board has taken decisions on certain matters involving public offerings and business responsibility reporting.

As far as the public offering process is concerned, some reforms have been introduced to promote the capital markets (e.g. increasing the minimum allotment for anchor investors and creating a separate category of disclosures for venture capital funds and other funds that own shares in the company), while others have been included to curb possible abuses (e.g. specifying a maximum tenure of 12 months for warrants issues along with public or rights issues of securities). Further details are available in this Business Standard report.

A key reform pertains to mandatory business responsibility reporting by listed companies as part of their annual reports. This requires companies to report on compliance with the National Voluntary Guidelines on Social, Environmental and Economic Responsibilities of Business issued by the Ministry of Companies Affairs. This is a welcome move as it enhances disclosures pertaining to aspects of business, which may be a useful strategy tool to curb the adverse social impact of corporate activity, as some of us have previously argued. This move is also a significant precursor to the introduction of significant provisions regarding corporate social responsibility in the Companies Bill that is expected to be introduced in Parliament shortly.

Commentary on the SEBI Act

Taxmann has just published a legal commentary on the SEBI Act titled “Agrawal & Baby on SEBI Act”. The book has been authored by two serving officers of SEBI, and has been edited by Amit Agrawal (who also occasionally contributes to this Blog as a guest). Bar & Bench has this report.

SAT on “Unpublished Price Sensitive Information”

The Securities Appellate Tribunal last week passed an order on an insider trading case, in which it lays down some guidelines as to the scope of “price sensitive information” under the SEBI (Prohibition of Insider Trading) Regulations, 1992. The specific question pertains to whether “the decision taken by a listed investment company to dispose of a part of its investment is “price sensitive information” requiring mandatory disclosure to the stock exchanges” under the SEBI Insider Trading Regulations.

FCGL Industries Limited, a core investment company with over 90% of its assets being investments in associated or group companies, decided to acquire certain mines in Australia, for which it required funding. The board of FCGL decided to liquidate its investment in Gujarat NRE Coke Limited constituting 17.716% of its capital in order to fund FCGL’s acquisition of the Australian mines. While both the mine acquisition transaction and share divestment transaction were approved by FCGL at the same board meeting, its press release only specified the mine acquisition without making public the divestment of shares in Gujarat NRE Coke. The adjudicating officer of SEBI found FCGL guilty of violating the insider trading due to non-disclosure of the divestment of shares as they were found to constitute unpublished price sensitive information.  Accordingly, SEBI imposed penalties on the company and its key directors.

On appeal before the SAT, the key question that came up for consideration was whether FCGL’s sale of shares in Gujarat NRE Coke amounts to “price sensitive information”. Reversing the SEBI adjudicating officer’s order, SAT categorically stated that the divestment was not “price sensitive information”. SAT’s reasoning is contained in the following extract:

Regulation 3 of the regulations would stand violated only if the unpublished information was price sensitive in nature. A reading of the definition of “price sensitive information” … would make it clear that the information which relates to a company and which when published is likely to materially affect the price of its securities would be price sensitive. FCGL is an investment company whose business is only to make investments in the securities of other companies. It earns income by buying and selling securities held by it as investments. This being the normal activity of an investment company, every decision by it to buy or sell its investments would have no effect, much less material, on the price of its own securities. If that were so then no investment company would be able to function because every time it would buy or sell securities held as investments, it would have to make disclosures to the stock exchange(s) where its securities are listed. Such decisions of an investment company, in our opinion, do not affect the price of its securities.

SAT’s order seems to suggest that any transaction carried out by a company in its ordinary course of commercial activity will not elevate itself to something that requires disclosure to the market as “price sensitive information”. In the investment context, the reasoning would apply to entities such as broking companies or market makers that are in the business of buying and selling securities on a regular basis. However, SAT seems to provide the same treatment even for investment holding companies, although the investment and divestment activity may only be intermittent in nature in such companies.

At a broader level, this order is also symptomatic of certain phenomena regarding regulation of insider trading in India. Although the substantive law in the form of SEBI’s Regulations have been strengthened over a period of time, their enforcement has been difficult. The interpretation of the Regulations by courts and appellate authorities has been carried out in a manner that provides generous benefit of doubt to the alleged violators. Such a trend is evident in the manner in which appeals from SEBI’s findings on guilt have been overturned by appellate authorities in landmark cases beginning with the Hindustan Lever case in the late 1990s. While other jurisdictions are witnessing a great thrust towards prevention of insider trading, the track record of SEBI is sustaining its orders on insider trading before SAT continues to be far from desirable, as the FCGL order only proves further.

Supreme Court’s Silence on “Control” Under the Takeover Regulations

Early last year, the Securities Appellate Tribunal (SAT) had passed an order in the Subhkam case holding that protective provisions in shareholders’ agreements (such as affirmative rights) adopted by investors do not amount to “control” for purposes of the SEBI Takeover Regulations. Although SEBI had initiated an appeal before the Supreme Court, the matter has now been disposed off by the Supreme Court without a decision on the question of law as that became infructuous due to changes in factual circumstances. Bar & Bench has a report containing the Supreme Court’s order.

While the SAT order had earlier provided relief to the investor community that customarily seeks protective provisions in contractual documentation, the Supreme Court has disturbed the equilibrium by effectively nullifying the broader implications of the SAT order in the following words:

Keeping in view the above changed circumstances, it is in the interest of justice to dispose of the present appeal by keeping the question of law open and it is also clarified that the impugned order passed by the SAT will not be treated as a precedent.

After going around an entire circle, the question of law is now again left open to interpretation. It remains to be seen as to what kind of stance SEBI would adopt both as to past as well as future cases. The issue is more acute under the new Takeover Regulations of 2011 where financial investors can acquire up to 25% of the company without making a mandatory open offer as opposed to the previous 15%.

FDI in the Civil Aviation Sector

With the civil aviation industry in India facing concerns on the financing front, calls are being made to liberalise the foreign investment rules in the sector. Of course, that stance has been subjected to criticism on the ground that the foreign direct investment (FDI) policy should not be utilized to bail out certain players in the industry.

In any event, there are a couple of issues to be considered from an FDI standpoint. The proposal doing the rounds (although there is no formal announcement from the Government) is that foreign airlines will be permitted to hold up to 24% in Indian airline companies. The reason behind such a cap is to ensure that the foreign airline does not obtain negative control by being able to block special resolutions in the company. Given that this would be a strategic investment rather than a financial or portfolio investment, it is not clear if foreign airlines will be willing to take up such a low stake in Indian ventures. Moreover, it is likely that even if its stake is 24% or below, the foreign airline would insist on significant affirmative voting or veto rights (in addition to other customary rights granted in such types of investment), and it remains to be seen whether the regulatory proposal would also take into account the grant of such rights to foreign airlines and, if so, to what extent. 

At a broader level, the discussion of imposing a cap of 24% on foreign airlines appears to run contrary to the intention of the Department of Industrial Policy and Promotion, Government of India, to streamline foreign investment caps such that all limits below 49% would be abolished, as stated in a discussion paper issued in June this year. The current proposal in the airlines sector goes against the streamlining effort.