Convertible Instruments and “Control” Under the Competition Act

Earlier this week, the Competition Commission of India (CCI) passed an orderinvolving a transaction between the Reliance Industries group and the TV18 group of companies.

What otherwise appears to be a complex transaction can be described in a nutshell as follows. About 40% shares of Network18 and (indirectly) TV18, both of which are listed companies, are held by Mr. Raghav Bahl and his affiliates. It is proposed that the said 40% shares will be transferred to a group of private limited companies, which are collectively referred to as the “target companies”. In turn, Independent Media Trust (IMT), a trust established exclusively for the benefit of Reliance Industries Limited (RIL), would subscribe to Zero Coupon Optionally Convertible Debentures (ZOCDs) of the target companies.

The reason why the transaction had to be tested against the touchstone of the Competition Act is because both the RIL group and the TV18 group are said to be involved in similar businesses, viz:

- supply of television channels;

- event management services; and

- broadband Internet services through 4G technologies and the contents accessible through such services.

IMT’s application to the CCI was cleared, as it was found that the transaction is not likely to give rise to adverse effect on competition in India. This conclusion was arrived at after considering the nature and size of the market on all three counts listed above, and the participation of the RIL group and TV18 group in those markets. While the substance of the transaction and its effects on competition were resolved with relative ease, it is the CCI’s observations on a jurisdictional matter that may have the effect of rocking the boat on the interpretation of the expression “control”, a term which never ceases to provoke debate and discussion.

Let us first absorb the position adopted by the CCI through its own words:

14. In terms of the Investment Agreement, holder of each ZOCD has the option to convert the ZOCDs into equity shares of the target companies with voting rights at any time during a period of ten years from the date of subscription. Since the conversion option contained in each ZOCD entitles the holder to receive equity shares of the target companies, the ZOCDs are shares within the meaning of sub-clause (i) of clause (v) of Section 2 of the Act and the subscription to ZOCDs amounts to acquisition of shares of the target companies.

15. In the event of conversion of all the ZOCDs, IMT would hold more than 99.99 percent of the fully diluted equity share capital of each of the target companies. Acquisition of such a right to convert the ZOCDs into equity shares, at any time before the expiry of ten years from the date of subscription, confers on IMT the ability to exercise decisive influence over the management and affairs of each of the target companies and the same amounts to control for the purposes of the Act. Therefore, in the facts and circumstances of the instant case, the subscription to the ZOCDs amounts to acquisition of control over the target companies for the purposes of the Act. Since control over the target companies is being acquired by IMT, the subscription to ZOCDs in-turn would also result in indirect acquisition of control over Network18 and TV18 as these companies would be under the control of the target companies.

[emphasis added]

Two aspects become clear. First, the very fact that the holder of a convertible instrument has the ability to convert the securities into equity shares itself amounts to control on the ground that the holder has the “ability to exercise decisive influence over the management and affairs” of the company. In other words, even if the actual conversion is distant into the future, the mere possibility (or to borrow the usage in the context of hostile takeovers under Delaware law, the “omnipresent specter”) that the holder could convert into equity is sufficient to constitute control. Second, such control is acquired at the time of investment into the convertible instruments at the outset, and not deferred until the time that the conversion actually occurs. In other words, what matters is the mere possibility of control and not the actual availability or exercise of control. This approach arguably pushes the boundaries of what amounts to control, and may even result in unintended consequences if adhered to scrupulously.

A number of issues arise:

1. Query whether it was necessary for the CCI to have made these observations regarding control because it ultimately derived jurisdiction through section 5(a) of the Competition Act which applies when there is an acquisition of control, shares, voting rights or assets. In other words, mere acquisition of shares may trigger the said provision, and “shares” is defined under the Act (section 2(i)(v)) to include “any security which entitles the holder to receive shares with voting rights”, thereby ensnaring convertible securities such as ZOCDs.

2. This discussion also accentuates possible incongruities in the concepts of acquisition of shares and control under the competition law (regulated by CCI) on the one hand and takeover law (regulated by SEBI) on the other, although a large-sized M&A transaction involving a takeover is likely to trigger both sets of laws simultaneously.

First, while the competition law seems to be triggered merely upon the acquisition of shares (which includes convertible instruments), the mandatory open offer obligations under the SEBI Takeover Regulations arise only when the acquisition of shares entitles the acquirer to exercise voting rights beyond prescribed thresholds (Reg. 3). In other words, the acquisition of voting rights is crucial from the perspective of the Takeover Regulations, while it is not so for competition law.

Second, there is a distinct time difference regarding the operation of the triggers under both the laws. While the Competition Act gets triggered upon acquisition of convertible securities, the mandatory open offer obligations under the Takeover Regulations get triggered only upon conversion. This is expressly clarified in Reg. 13(2).

Third, the definitions of “control” also vary between the Competition Act and the Takeover Regulations, although the fluid nature of the concept may allow for some judicial or regulatory harmonization of the concept across the two sets of laws. It remains to be seen whether SEBI will take the cue from the extended application of “control” set out in the present order of the CCI. However, it is important to bear in mind that the concepts need to be applied in the context and recognizing the purpose of each legislation rather than universally.

Some of these issues will add to the complexity of structuring significant takeover transactions that will likely trigger both the sets of laws.

3. Finally, simply by way of analogy, it is interesting to note that the foreign investment policy of the Government of India and the RBI does not even recognize optionally convertible instruments such as ZOCDs as equity instruments in the first place. Optionally convertible instruments are treated as debt and swept into the external commercial borrowings policy. It cannot be any farther from exercising control over a company.

Depreciation and Sale-and-Lease-back Transactions

One of the most important deductions permissible under income tax law in relation to capital assets is depreciation. Under the general scheme of the Income tax Act, particularly section 32, depreciation is allowed to an assessee who is the owner of a capital asset used for the purposes of business. The criterion of “ownership” is given a slightly more liberal scope under tax law. Assessees can make use of this relaxed understanding in structuring their transactions so as to gain the benefit of depreciation. One such device used is that of sale and lease back transactions. Such transactions often come under the scrutiny of revenue authorities as being not genuine. In this context, the question of claim of depreciation in the case of leasing transactions assumes importance. A couple of recent decisions have provided some measure of clarity in this regard.

In IndusInd Bank v. ACIT, ITA 6566/Mum/2002, a Special Bench of the Tribunal had to consider whether depreciation would be allowed to the lessor or to the lessee. The facts were that the assessee, a bank, entered into an agreement with another company under which the assessee was lease out a boiler to the company for a specific fixed period, subject to payment of lease rent. After the expiry of the period, the asset was to be sold to the company. The assessee bank claimed depreciation on the boiler. The Assessing Officer did not accept this claim on the ground that the transaction was merely a paper transaction. At best, according to the assessing officer, the transaction could be categorized as a finance lease and not an operating lease.

The Special Bench noted that in substance, a finance lease is akin to a loan from the lessor to the lessee. After examining the decision of the Supreme Court in Asea Brown Boveri v. IFCI 54 Taxman 512 (SC), and Association of Leasing & Financial Services Companies v. Union of India , and relying on Accounting Standard – 19, the Special Bench noted the broad features of a finance lease as under (para 5.14 of the order of the Bench):

-         A finance lease is non-cancelable, and there is a fixed obligation on the lessee for payment of lease rent for the period of the lease. If the lease is terminated prematurely by the lessee, the lessor is entitled to recover his investment along with expected interest.

-         A finance lease is always for a fixed period. This period is calculated by taking into consideration the economic life of the asset; and is settled in such a way so as to fully recover the investment of the lessor together with interest.

-         The lessor is interested in the recoupment of his investment with interest in
the shape of rentals over the period of lease, and not really with the asset itself or its user.

-         The lessee bears the responsibility of costs of insurance, repairs, maintenance etc. The features of bailment are absent. An operating lease, on the other hand, has the features of bailment. In a finance lease, the responsibility of the lessee is not restricted only to taking “as much care as a man of ordinary prudence would” as warranted under section 151 of the Contract Act, but extends beyond this threshold.

-         The equipment is chosen by the lessee, but the payment to the supplier is made by the lessor. Thus, the lessee chooses the assets, takes delivery, enjoys the
use of the asset, and bears the risks and costs of its wear and tear, taxes/charges in relation to the asset etc. The risks and rewards incidental to ownership vest with the lessee and not with the lessor. The lessor simply holds the title of asset by way of security for recouping the investment and interest.

The Special Bench further noted that in the case of an operating lease, a lessor can claim depreciation; however, in the case of a finance lease, only the lessee would be entitled to claim depreciation. The Tribunal noted that even for the purposes of tax law, “In a lease transaction also there can be only one owner of the asset, that is, either the lessor or lessee and not both of them or either of them at their discretion. Whereas in the case of operating lease, it is the lessor who is the real owner of the asset, but in case of finance lease, it is the lessee who is to be regarded as the real owner of the asset. Ex consequenti only the lessor can claim depreciation in case of an operating lease and the lessee, as to who should be conferred the benefit of deprecation allowance.”

Further examining the terms of the agreement between the parties, the Special Bench held that the lease agreement was a paper transaction to cover up the reality. The bench noted, following the decision of the Supreme Court in Sundaram Finance Limited v. State of KeralaAIR 1966 SC 1178, “The true effect of a transaction may be determined from the terms of the agreement considered in the light of the surrounding circumstances. In each case the Court has, unless prohibited by the statute, power to go beyond the document and to determine the nature of transaction, whatever may be the form of the document…”

The Delhi High court also recently considered the question of when an agreement should be considered as a finance lease and when it should be considered as an operating lease. The Court reaffirmed that the question could not be decided by merely looking at the title, nomenclature or label given to the agreement: the terms and conditions of the Agreement are relevant but not conclusive. Surrounding circumstances can look at. The court followed Sundaram Finance, which in turn had relied on the following observation of Lord Esher MR in Re Watson “…When the transaction is in truth merely a loan transaction, and the lender is to be repaid his loan and to have a security upon the goods, it will be unavailing to cloak the reality of the transaction by a sham purchase and hiring. It will be a question of fact in each case whether there is a real purchase and sale complete before the hiring agreement. If there be such a purchase and sale in fact and afterwards the goods are hired, the case is not within the Bills of Sale Act. The document itself must be looked at as part of the evidence, but it is only part, and the Court must look at the other facts and ascertain the actual truth of the case.”

At the same time, these observations must not be treated as giving complete freedom to the revenue to ignore the wording of the contract between the parties: the Madras High Court recently clarified (CIT v. M/s High Energy Batteries, T.C. 579/2005, decided on 17^th April, 2012; a decision in the context of a reopening of assessment where the Revenue’s stance was that a sale and lease back transaction was not genuine), “Given the freedom to enter into agreements with parties and guided by commercial considerations, even to invoke the theory of tax evasion, the Revenue must have sufficient material to draw an inference of what had been shown as an understanding on an agreement between the parties, is not, in fact, so.”

It is thus clear from these decisions that the distinction between operating leases and finance leases (clarified by the Supreme Court in ABB’s case) is relevant in income tax law as well, and suitable care needs to be taken in structuring transactions and drafting the agreements to avail of appropriate tax benefits.

SEBI Tightens Consent Order Norms

In 2007, SEBI issued a Circularcontaining guidelines for consent orders and composition of offences on matters involving violations of securities laws. This was also accompanied by a detailed set of FAQs.

Since then, SEBI has issued several consent orders, including in some high profile cases. Due to criticism that the consent order mechanism was operated in an ad hoc manner and lacked transparency (matters which were also briefly discussed on this Blog), SEBI undertook the task of streamlining the system. Consequently, SEBI has, “[o]n the basis of experience gained and with the purpose of providing more clarity on its scope and applicability”, modifiedthe Circular of 2007. A press release containing the salient features of the amended Circular is contained here.

The most significant change is that SEBI has introduced several exclusions to the operation of the consent order process. In other words, the consent order mechanism will not be available in case the violations involve specific categories, including the following:

- Insider trading;

- Serious fraudulent and unfair trading practices;

- Failure to make an open offer under the takeover regulations;

- Front running;

- Manipulation of net asset value or other serious mutual fund defaults;

- Failure to address investor grievances; and

- Failure to make disclosures in offer documents that materially affect the rights of investors.

There is also a residual category where the applicant can be denied the consent order mechanism for any other type of default if that applicant is non-compliant with any order passed by SEBI against it.

It appears that SEBI’s objective is to exclude serious types of violations listed above at the outset rather than to leave the discretion to the various authorities managing the consent order process. This introduces objectivity and transparency in the process, which were arguably missing in the erstwhile guidelines. However, this also has the effect of substantially limiting the scope of the consent order mechanism to minor offences that are technical in nature and do not substantially affect investor rights. In such circumstances, alleged violators in serious cases may be unable to resort to the consent order mechanism and will be compelled to go through the entire enforcement process. SEBI has nevertheless retained some leeway by providing that “[n]otwithstanding anything contained in this circular, based on the facts and circumstances of the case, the [High Powered Advisory Committee]/Panel of [Whole Time Members] may settle any of the defaults listed above”. In the ultimate analysis, the above serious violations are not altogether excluded absolutely, but the authorities under the consent order process will have to exercise discretion and justify the existence of circumstances as to why a settlement may be permitted in a given case where such serious violation is involved.

The process has been made stringent in other ways as well. For example, if a violation has been made within two years from the date of any consent order, then a consent application may not be entertained for such violation. Further, an applicant who has already obtained two consent orders may not apply for another within three years from the last order. There is also a time limit for filing consent applications, which is 60 days from the service of show cause notice to the applicant.

While the reforms will have the effect of streamlining the process and making it more transparent, it is also likely to substantially reduce the availability of the process to persons who have been charged with securities law violations. The key outcome of the reforms appears to be that the consent order process will now be largely available for minor technical violations, but not for the more serious ones.

The Delhi High Court on Foreign Awards and Implied Exclusion of Section 34

We have discussed on several occasions the scope of the proposition in paragraph 32 of Bhatia International that the parties may “expressly or impliedly” exclude the applicability of Part I of the Arbitration Act in cases in which it would be otherwise applicable. The Court has previously held that Part I is not impliedly excluded merely by choosing a foreign substantive law (Indtel Technical Servicesand Citation Infowares), but may be if it is coupled with the designation of a foreign seat of arbitration (Dozco India v Doosan), or if the parties expressly choose a foreign seat and a foreign lex arbitri (Videocon). The Court appears also to have impliedly rejected the proposition that the mere designation of a foreign seat of arbitration excludes Part I, because the seat in Bhatia International was Paris, and the seat in Yograj was Kuala Lumpur. Even if Bhatia can be explained on the basis that the Court relied on the language of article 23(2) of the ICC Rules, Yograj clearly found that it was the application of Rule 32 of the SIAC Rules 2007 that excluded the Indian Act, suggesting that the designation of Singapore as the seat did not of itself lead to this result.

Muralidhar, J. last week considered these issues in Indiabulls Financial Services v Amaprop Ltd. In 2005, Amaprop invested in the shares of a subsidiary company of Indiabulls and was granted a Put Option enabling it to compel Indiabulls to acquire those shares at a predetermined price. The contract contained the following provisions on governing law and dispute resolution: (a) the contract is to governed by New York law, with an exclusion of renvoi (Section 12.10(a)); (b) each party accepted the non-exclusive jurisdiction of the courts in New York (Section 12.10(b)) and (c) all disputes shall be settled by arbitration in New York in accordance with the Rules of the American Arbitration Association, without prejudice to the right of any party to make an application for injunctive relief (Section 12.11).

Amaprop exercised the Put Option in 2010 at the predetermined price, but an application filed by Indiabulls with RBI to make the transfer at this price was refused. Amaprop commenced arbitration under the contract. The Tribunal’s award directed Indiabulls to make a fresh application to the RBI to transfer at a certain price, and left open the possibility that the difference between the option at the RBI-permitted price and the Option Price would form the basis of a money award for Amaprop. Amaprop brought an action in New York to confirm the award and obtained an anti-suit injunction in respect of Indian proceedings.

Thereafter an application was filed by Indiabulls under section 34 to set aside the New York award on the ground that it was contrary to Indian public policy in ignoring the provisions of the Foreign Exchange Management Act, 2000 and RBI Circulars. Amaprop took a preliminary objection on the basis that the parties had impliedly excluded the application of Part I of the Indian Act.

There is a strong case for the view that Bhatia International itself requires reconsideration, and that the selection of a foreign seat is the clearest indication that the parties intended to exclude Part I – but these points are concluded by authority and will remain so unless the Supreme Court overrules Bhatia International and Venture Global in BALCO. Therefore the analysis is whether, as a matter of construction, it can be said that the parties intended that Part I of the Indian Act should not apply. At first sight, there is little to suggest this, beyond the selection of a foreign seat of arbitration and a foreign proper law, and Supreme Court authority in Yograj and perhaps Bhatia itself suggests that that does not suffice. There is, of course, Dozco v Doosan, since the parties here also chose a foreign proper law.

Muralidhar, J. reaches the conclusion that Part I was excluded on a different basis. First, the learned judge rejects the suggestion that giving the New York courts non-exclusive jurisdiction indicates that the parties did not intend to exclude the jurisdiction of the Indian court. For this purpose, the Court cites the well-known decision of the Court of Appeal in Deutsche Bank v Highland Crusader. However, the context in which that case was decided was the prior decision of the Court of Appeal in Sabah Shipyard v Government of Pakistan, where the court had granted an anti-suit injunction restraining certain proceedings in Pakistan even though England was the subject of a non-exclusive jurisdiction clause. Sabah was subsequently criticised, notably by Mr Rapahel, and in Deutsche Bank, Toulson LJ explained that the conclusion in that case was correct only because it could be shown, independently, that commencing proceedings in Pakistan was vexatious and oppressive. Although there is an observation in that case that bringing proceedings in a certain forum may be vexatious or oppressive even if the chosen forum was given only non-exclusive jurisdiction, the thrust of the Court’s analysis was in fact that such a finding is unusual and requires material independent of the jurisdiction clause. To the extent the Delhi High Court relies on this case to hold that giving New York non-exclusive jurisdiction is not inconsistent with excluding the jurisdiction of the Indian court, it may be correct, but it can go no further.

Secondly, Muralidhar, J. held that the contract itself indicates that the intention of the parties was that an arbitral award would be tested only in a New York court, because of the reference to the New York court in section 12.10 and the conduct of the parties when proceedings were commenced in New York. Thirdly, the Court refers to the fact that New York was the seat of arbitration, and to Rule 57(2) of Dicey and Morris, which, of course, is the correct analysis but may be contrary to what the Supreme Court has held in NTPC v Singer and Bhatia International.

Two other points are of interest. The first is the finding that it was open to Indiabulls to raise non-compliance with Indian law in the New York court under the rubric of public policy. It is not clear if this is possible, because it is ordinarily accepted public policy in the New York Convention is a reference to the public policy of the enforcing State. The second is that this case appears to implicitly accept that parties can impliedly exclude certain provisions in Part I without excluding the remainder. That is because section 9 would not have been impliedly excluded in this case, since section 12.11 of the contract allowed the parties to approach other courts for interim relief – and yet, section 34 was.

SEBI Notifies Regulations on Alternative Investment Funds

Last year, SEBI had issued a concept paper on comprehensive regulation for alternative investment funds (AIFs). The proposal to set up a separate framework was approved by SEBI at its board meeting held last month. This proposal has now been operationalised by the promulgation of the SEBI (Alternative Investment Funds) Regulations, 2012, which were notifiedyesterday.

These new regulations are expected to affect private equity, venture capital and other investment firms by introducing a registration requirement with SEBI. An AIF is defined quite broadly in Reg. 2(b) to mean any “fund established or incorporated in India” which is a “privately pooled investment vehicle which collects funds from investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors”. A number of specific investment funds such as mutual funds, collective investment schemes, family trusts, ESOP trusts, etc. are expressly excluded.

There are three categories of registration depending on the nature of the fund and the risk to investors (based on leverage, complexity in trading strategies, etc.). Limitations are also placed on the manner in which the AIFs are operated. A summary is contained in the notification link above, and a previous discussion of the regulations’ impact is contained in the first two links above (to previous posts on this Blog).

Black Money: Corporate Entities and Securities Markets

The Government yesterday tabled its White Paper on Black Money in Parliament. Billed as the first document to comprehensively tackle the issue, it cites various studies and is replete with data. However, it has already been subjected to criticism from various quarters owing to the lack of details and clarity in solutions to deal with the issue. This post, however, briefly touches upon the role of corporate entities and the securities markets in perpetuating the flow of black money as contained in the White Paper.

The White Paper finds that financial market transactions are used as conduits to route black money using the modus operandi of “round tripping”. For instance, it notes:

2.4.9 The illicit money transferred outside India may come back to India through various methods such as hawala, mispricing, foreign direct investment (FDI) through beneficial tax jurisdictions, raising of capital by Indian companies through global depository receipts (GDRs), and investment in Indian stock markets through participatory notes. It is possible that a large amount of money transferred outside India might actually have returned through these means.

The use of participatory notes (P-Notes) for investments back into India appears quite stark. Since P-Notes are issued by entities outside India, often through multiple-layered holding structures, Indian regulators are faced with difficulties in ensuring transparency and in identifying the ultimate beneficial owners. Despite progressively stronger KYC norms imposed by SEBI to track beneficial ownership of P-Notes, it has had mixed success, primarily owing to the difficulties associated with extraterritoriality of the investment activities in P-Notes. For previous discussions on regulating P-Notes, please see here, hereand here.

The White Paper also comments upon the use of complex corporate structures through tax havens to mask financial transactions.

2.9.1 Corporate structuring is a legitimate means of bringing together factors of production in a way that will facilitate business and enterprise and help the economy. However, an artificial personality can also be created of a corporate entity to conceal the real beneficiaries. Opaque structuring through creation of multiple entities that own each other and the secrecy granted by certain jurisdictions facilitate such misuse.

…

2.9.4 With increasing realisation about the harmful effect of ownership being concealed behind complicated corporate ownership structure, such structure is coming under scrutiny. In the Indian context, it is one of the reasons for the fact that tax authorities are not able to take action in cases where money is prima facie brought back to India through round tripping and other legitimate means and it is expected that efforts taken by India in this regard as also global pressure will provide a check on these tendencies.

The White Paper further fuels the ongoing debate on issues of taxation by referring to the Vodafone case. Again, given that corporate holding structures are established on a cross-jurisdictional basis, regulating the entire chain is an onerous task.

It is quite clear from the report that the issue of black money is quite complex and requires a multi-pronged strategy to deal with. While the White Paper is a first step in documenting the various aspects of the issue, it might required a more concerted action as it involves multiple laws and regulations enforced by multiple regulators.

The Changing Nature of Public Listed Companies

During the week that the Facebook IPO has captured the attention of market observers, the Economist has carried a couple of pieces (here and here) that raise questions regarding the interest and viability of public listed companies with diffused shareholding (epitomized by the Berle and Means corporation). The statistics shown by the Economist are quite stark:

The number of public companies has dropped dramatically in the Anglo-Saxon world—by 38% since 1997 in America and by 48% in Britain’s main markets. The number of initial public offerings (IPOs) in America dropped from an average of 311 a year in 1980-2000 to just 81 in 2011 (chart 2).

Going public no longer has the glamour it once had. Entrepreneurs have to wait longer—an average of ten years for companies backed by venture capital, compared with four in 1985—and must jump through more hoops. Lawyers and accountants are increasingly specialised and expensive; bankers are less willing to take them public; qualified directors are harder to find, since even “non-execs” can go to prison if they sign false accounts.

However, it appears that modified forms of the public listed corporation, of the varieties prevalent in economies in Asia, remain unaffected. Examples include the state owned enterprises (SOEs) in China and family enterprises in India. As the Economist report notes:

The rise of new economic powers has further changed corporate organisation. In the 1990s it seemed that emerging-market companies would take the Western public company as their model. In fact they have embraced two slightly different corporate forms: SOEs and family conglomerates. These companies list on the stockmarket but do little to constrain the power of the state or of family shareholders.

...

... Family businesses account for about half of listed companies in the Asia-Pacific region and two-thirds in India. Families exercise tight control of their empires—and limit the power of other shareholders—through a variety of mechanisms such as family-controlled trusts (which have more power than boards), appointing family members to managerial positions and attaching different voting rights to different classes of stock. Diversified family firms are good at taking a long-term view, diverting money from cash cows to new industries that might take a long time to produce results. They are also good at dealing with the government failures that plague emerging markets. It is remarkable how fast even India’s lumbering government can move if a Tata or an Ambani calls.

The report further discusses the merits and disadvantages of public listing of corporate securities. Overall, an interesting analysis.

JP Morgan’s Trading Losses: Regulation and Governance

There has been a great deal of debate surrounding JP Morgan’s hedging losses announced last week. There is some mystery surrounding the nature of the transactions involved, without full clarity yet on the amount of losses. Andrew Ross Sorkin has a brief explanation of the episode in the New York Times:

... Here’s an overly simplistic primer, but you’ll probably get the idea: The company’s chief investment office originally made a series of trades intended to protect the firm from a possible global slowdown. JPMorgan owns billions of dollars in corporate bonds, so if a slowdown were to occur and corporations couldn’t pay back their debt, those bonds would have lost value.

To mitigate that possibility, JPMorgan bought insurance — credit-default swaps — that would go up in value if the bonds fell in value.

But sometime last year, with the economy doing better than expected, the bank decided it had bought too much insurance. Rather than simply selling the insurance, the bank set up a second “hedge” to bet that the economy would continue to improve — and this time, traders overshot, by a lot.

This episode has given rise to renewed debate on matters of regulation of the financial services sector as well as corporate governance.

On the regulatory side, the key question relates to whether it will strengthen the hands of regulators around the world to more closely scrutinize the financial services sector. The US has already taken giant steps through enactment of the Dodd Frank Act, but the current development would have an impact on the scope, nature and implementation of the Volcker rule which curbs proprietary trading by banking institutions.

There are a number of issues on the governance side as well. For example, it raises questions regarding oversight of the company’s board and whether they ought to have exercised greater vigilance regarding activities undertaken by the chief investment office. Arguably, more effective risk management systems might have mitigated the effects of such transactions. Lastly, this has also triggered the debate regarding executive compensation, on this occasion pertaining to the specific issue of claw back of excessive compensation to affected officers of the company.

While the enormity of JP Morgan’s balance sheet size appears to have dwarfed the losses from the hedging transactions, their impact on the mode of regulating Wall Street and on governance concerns rings loud and clear.

Impact of SEBI Order on Governance of Exchanges

The concept of demutualization of stock exchanges has given rise to some questions regarding the governance of demutualized exchanges. That concept requires exchanges to separate ownership and governance from that of its trading members. Some issues pertaining to demutualization have come up before SEBI in its investigation into the affairs of the United Stock Exchange of India Limited (USE). SEBI issued a recent orderwarning USE “to be more cautious and perceptive in the discharge of its function and the regulatory duties”. It also required USE to amend its articles of association (which is the subject matter of discussion in this post).

SEBI found concentration of volumes in trading on the USE through two trading members, with one of them Jaypee Capital Services Limited being a promoter of USE. An analysis of SEBI’s order on the issue of trading concentration can be found in Mobis Philipose’s columnin The Mint; but this post focuses on the observation of SEBI regarding the board rights of the key shareholders of USE. Specifically, it relates to an insertion in the articles of association of a clause that provides for specific quorum, whereby no board meeting shall be constituted unless at least one director representing Jaypee Capital, BSE and Federal Bank (being the key shareholders) are present. SEBI found such a quorum requirement to impinge upon the governance of the stock exchange. The SEBI member observes:

I note that such kind of special arrangements as did by USE is not in the interests of independent functioning of the stock exchange. The Special Articles i.e., Part II of AoA has overriding effect over its General AoA and these rights to certain shareholders appear to be detrimental to the interest of other stakeholders. These are inconsistent, imprudent and contrary to the best corporate governance practices. In my opinion, such special arrangements surely constrain the independent functioning of the Stock Exchange. … I note that these defaults on the part of USE not only reflect bias on the part of the Exchange towards certain shareholders, but also reveals that such provisions in AoA are against the spirit of demutualization of stock exchanges.

This suggests that even a customary provision for quorum in shareholders agreements (that may be incorporated in the articles of association) can be found to go against the independent governance of a stock exchange. In that sense, the impact of SEBI’s order is to impose high standards of governance in an exchange, which may obviate special clauses in favour of particular shareholders that are common in other types of companies.

Moreover, this may be contrasted with cases involving other companies, where such protective provisions in shareholders’ agreements and articles of association in favour of particular shareholders are treated more liberally. For instance, in the controversy involving the definition of “control”, the Securities Appellate Tribunal (SAT) had held that not only such quorum provisions but even affirmative voting rights (or veto) rights would not confer “control” on the shareholder so as to trigger mandatory takeover offer requirements (although that ruling has been somewhat disturbed by a consent order on appeal before the Supreme Court).

The key take away from this order of SEBI is that shareholders’ agreements and articles of association of stock exchanges may be subject to closer scrutiny by regulators who appear averse to special rights in favour of any particular shareholder.

Paper on CSR in India

While the Companies Bill, 2011 is still pending in Parliament, the provision on corporate social responsibility (CSR) spending continues to be one of the contentious issues. It is not clear what form that provision will take during the next round of the lawmaking process. The oddity of the CSR proposal in the Indian context is its mandatory nature, which has been somewhat diluted in the 2011 Bill to make it quasi-mandatory or “hybrid” in nature.

Given this situation, a paper titled India’s Mandatory Corporate Social Responsibility Proposal: Creative Capitalism Meets Creative Regulation in the Global Market by Caroline Van Zile looks at the debates in CSR generally, and also its evolution in the lawmaking process in India. The abstract is as follows:

This Comment traces the legislative, socio-political, and legal history of a truly unusual and innovative legislative proposal recently raised in India: mandatory corporate social responsibility (CSR) spending for all businesses. While many commentators criticized the proposal for falling outside of the traditional western conception of CSR, this note suggests that what might seem retrograde or unusual to westernized companies can more productively be viewed as India’s attempt to navigate a difficult divide, unique to BRICS countries. India is under intense pressure from its populace to address growing inequalities and deficiencies in infrastructure; at the same time, it is facing perpetual international pressure to keep its economy highly liberalized, with little taxation. The CSR proposal represents the Indian parliament’s attempt to create a novel policy to serve both goals; such attempts at innovation, which do not simply import western laws or governance regimes, should be encouraged.

This adds to the burgeoning academic literature on CSR in India. See also Directors as Trustees of the Nation? India’s Corporate Governance and Corporate Social Responsibility Reform Efforts by Afra Afsharipour.

Wrotham Park and the scope of the "hypothetical negotiation" measure of damages

Perhaps the most obvious instance of the sophistication of English commercial law is the range of remedies it has, depending on the precise nature of and tailored to each cause of action. The most common remedy is, of course, compensation for loss, which attempts to place the claimant in the position in which he would have been had the term (in the case of contract) not been breached; an award of restitution for unjust enrichment is also well-known, with the difference that this “disgorges” the defendant’s gain, as opposed to compensate the claimant’s loss. The English courts have also made an award of restitution (ie stripping the defendant’s gains) for wrongs.

An award that does not easily fit these categories is what is known as the Wrotham Park award of damages. The remedy was devised to deal with a problem that, if not well-known, is by no means uncommon: a defendant breaches a right a claimant has and derives substantial profit, without, however, causing any financial loss to the claimant. An action for compensation for breach of contract would ordinarily only lead to nominal damages; an action for restitution for unjust enrichment would ordinarily fail because the enrichment, if any, would not be “at the expense” of the claimant. In those cases, which most often arise in relation to trespass of rights in land, the English courts have held that the claimant is entitled to the price a reasonable man would have paid him for authorising what the defendant in fact did. This means, effectively, that the court awards the claimant what he would have received in the “hypothetical negotiation” between the parties before the trespass began. In this negotiation, it is not open to the defendant to plead that he would not have entered into the agreement (for the object is to ascertain the value of the right he breached), but it is open to the defendant to show that he had a “trump card” – ie, an alternative means of doing what he did, which would naturally reduce the amount he would have paid the claimant for obtaining permission.  

As the name suggests, this award acquires its name from the well-known decision of Brightman J. in Wrotham Park Estate Co Ltd v Parkside Homes Ltd [1974] 1 WLR 798. In that case, the claimant was the beneficiary of a covenant in respect of certain land that prohibited any buyer from undertaking any development work without its permission. This covenant was for the benefit of the adjoining estate owned by the claimant and it was not disputed that it ran with the land. Parkside Homes, a developer, began to construct homes on the land despite a warning from Wrotham Park that it was the beneficiary of the covenant. Wrotham Park brought proceedings for an injunction, but did not seek interlocutory relief because it did not wish to give a cross-undertaking in damages. The suit was finally decided in its favour, Brightman J. holding that what Parkside did constituted a breach of covenant. Since, as Brightman J. held, a mandatory injunction would have been inappropriate because it would have led to the demolition of a number of homes, it was necessary to consider what damages could be awarded in substitution of the injunction. Brightman J. referred to a number of cases in which such an award had been made, of Watson, Laidlow & Co. Ltd. v Pott, Cassels and Williamson (1914) 31 RPC 104, is especially instructive. In that case, a patentee brought a suit for infringement in respect of territory in which it was shown that he could not have effectively competed. To the argument that the patentee could therefore not have an award of damages, Lord Shaw said this:

…wherever an abstraction or invasion of property has occurred, then, unless such abstraction or invasion were to be sanctioned by law, the law ought to yield a recompense under the category or principle, as I say, either of price or of hire. If A, being a liveryman, keeps his horse standing idle in the stable, and B, against his wish or without his knowledge, rides or drives it out, it is no answer to A for B to say: ‘Against what loss do you want to be restored? I restore the horse. There is no loss. The horse is none the worse; it is the better for the exercise.’ I confess to your Lordships that this seems to me to be precisely in principle the kind of question and retort which underlay the argument of the learned counsel for the appellants about the Java trade.… in such cases it appears to me that the correct and full measure is only reached by adding that a patentee is also entitled, on the principle of price or hire, to a royalty for the unauthorised sale or use of every one of the infringing machines in a market which the infringer, if left to himself, might not have reached

Readers will notice that this award requires the court to construct a “hypothetical negotiation” between the parties, and for that purpose, a difficult question that had arisen was the scope of the “trump card” rule. The “trump card” rule reflects common sense – the amount a defendant with no alternative but to trespass would pay is higher than the amount a defendant with several other means of achieving his object would pay. But is it open to a defendant to say that he could have achieved the same object without infringing the claimant’s right, and therefore that only nominal damages can be awarded? At first instance, Judge Seymour recently said yes. Reversing, the Court of Appeal has explained the scope of the rule, in London Borough of Enfield v Outdoor Plus Limited.

This case is of particular interest because of the somewhat peculiar facts at play. Simplifying it for the purpose of analysis, Outdoor entered into an agreement with a Mr Shah to erect an advertising hoarding on his premises. Inadvertently, the concrete support for the hoarding (though not the hoarding itself) was erected on adjoining land which belonged to the London Borough of Enfield, the claimant. This went on for more than ten years and Outdoor made significant profit by entering into agreements with third parties to display advertisements. Once this was discovered, the Borough brought an action for an award of the reasonable licence fee Outdoor would have had to pay the Borough had the use of its land for erecting the support for the hoarding been authorised. At first instance, Judge Seymour accepted the defendant’s case that it would have paid nothing because it could have erected the support on Mr Shah’s land. At first sight, this seems analogous (and perhaps is) to the reasoning of Patten J. in Sinclair v Gavaghan [2007] EWHC 2256, and a straightforward application of the trump card. But what the defendant was really saying was that it would not have trespassed – which it is not open to it to say. Henderson J., with whom Mummery and Tomlinson, JJ., concurred, says this:

I fully accept that any ability on the part of a trespasser to achieve the object of the trespass by alternative means is a factor which must be taken into account in the hypothetical negotiation. The alternative must, however, be one which is consistent with the trespass and which can co-exist with it.  An alternative cannot be taken into account if it would eliminate the trespass itself, because that would again negate the very basis of the exercise. In Sinclair v Gavaghan there was no conceptual difficulty about taking into account the alternative means of access to the Yellow Land which were available to the defendants, because they were true alternatives to the more convenient route through the Red Triangle, and the defendants could therefore pray them in aid when notionally negotiating a fee for use of the Red Triangle access.  By contrast, what the defendants wish to do in the present case is to rely on the possibility of placing the hoarding entirely within No. 67, not as an alternative to the admitted trespass, but as a means of eliminating it.  Such a procedure cannot be legitimate, because it would subvert the basis of the negotiation.

In short, the alternative is relevant to the question of valuation, but is not a tool by which the defendant can argue (in effect) that it would have chosen not to trespass – the object of the exercise is not to determine if the defendant would have trespassed (for it did), but the reasonable value it would have had to pay the claimant had it chosen to do what it did, with prior authorisation.

Confidentiality Agreements in M&A Transactions: Lessons from Delaware

Background

Amongst legal documents in an M&A transaction, the confidentiality agreement plays an important role, as it does in other types of investment transactions (such as private equity), especially when it involves a public listed company. There are two key aspects of interest in any confidentiality agreement, which are also often the bone of contention in negotiations: (i) the scope of information that must be kept confidential; and (ii) various exceptions which may be invoked by the party receiving information and hence placing it outside the application of confidentiality obligations.

While confidentiality agreements are essentially within the purview of contract law, there is limited specificity in India in terms of principles laid down either in statutory law or judicial decisions as to the applicability and enforcement of confidentiality obligations in M&A transactions. Hence, a recent (and perhaps significant) pronouncement of the Delaware Chancery Court in Martin Marietta Materials Inc. v. Vulcan Materials Company (Martin Marietta) could throw some light on the manner in which confidentiality agreements are to be drafted and negotiated by legal practitioners. This decision rules on both of the key aspects discussed above, i.e. (i) the definitional aspects of confidential information and (ii) the availability of one of the exceptions to confidentiality.

Facts

The transaction originated as a potential friendly (negotiated) merger between Martin Marietta and Vulcan, both of whom were in the same business. As part of the transaction, both companies negotiated two confidentiality agreements, one a general non-disclosure agreement (referred to as the “NDA”) and another, a common interest, joint defense and confidentiality agreement (referred to as the “JDA”), for sharing of information to facilitate an analysis of the antitrust implications of the merger. Although the confidentiality agreements contained standards clauses relevant to M&A agreements, they did not contain the customary standstill provision (which would prevent a party from making an unsolicited takeover offer on the other party).

After prolonged negotiations, the merger proposal fell through on account of resistance from Vulcan. By then, a substantial amount of information had been shared by Vulcan, which was in Marietta’s possession. Following the failure of merger talks, Marietta initiated a hostile takeover offer on Vulcan combined with a proxy contest. As part of the takeover offer documentation and filings made with the US Securities Commission (SEC), Marietta included information that was subject to confidentiality obligations owed to Vulcan. This included the fact of previous negotiations between the parties towards a possible merger, and also other corporate and financial information regarding Vulcan.

While Marietta approached the Chancery Court seeking a declaration that it can use the information received from Vulcan without a breach of confidentiality obligations, the application was opposed by Vulcan which sought to enjoin Marietta’s hostile takeover.

Issues and Decision

The key issues considered by the Delaware Chancery Court, and its decision, are summarized in the court’s own terms:

This case presents interesting questions regarding the meaning of confidentiality agreements entered into by two industry rivals at a time when both were intrigued by the possibility of a friendly merger and when neither wished to be the subject of an unsolicited offer by the other or a third-party industry rival.

May one of the parties – especially the one who evinced the most concern for confidentiality and who most feared having its willingness to enter into merger discussions become public – decide that evolving market circumstances make it comfortable enough to make a hostile bid for the other and then without consequence freely use and disclose publicly all the information that it had adamantly insisted be kept confidential?  In this decision, I conclude that the answer to that question is no and that, consistent with Delaware’s pro-contractarian public policy, the parties’ agreement that the victim of any breach of the confidentiality agreements should be entitled to specific performance and injunctive relief should be respected.

Here, I find that, although the confidentiality agreements did not include an express standstill, they did bar either party from:

• Using the broad class of “evaluation material” defined by the confidentiality agreements except for the consideration of a contractually negotiated business combination transaction between the parties, and not for a combination that was to be effected by hostile, unsolicited activity of one of the parties; 

• Disclosing either the fact that the parties had merger discussions or any evaluation material shared under the confidentiality agreements unless the party was legally required to disclose because: (i) it had received “oral questions, interrogatories, requests for information or documents in legal proceedings, subpoena, civil investigative demand or other similar process”; and (ii) its legal counsel had, after giving the other party notice and the chance for it to comment on the extent of disclosure required, limited disclosure to the minimum necessary to satisfy the requirements of law; or

• Disclosing information protected from disclosure by the confidentiality agreements through press releases, investor conference calls, and communications with journalists that were in no way required by law.

The breaching party engaged in each of these contractually impermissible courses of conduct.  Because the victim of the breach has sought a temporally reasonable injunction tailored to the minimum period of time that the breaching party was precluded by the confidentiality agreements from misusing the information it had received or making disclosures that were not legally required in the sense defined in the confidentiality agreements, I grant the non-breaching party’s request, which has the effect of putting off the breaching party’s proxy contest and exchange offer for a period of four months.

The first issue pertains to the scope of confidential information. The NDA provides that each party shall use another party’s confidential information (termed in it as “Evaluation Material”) “solely for the purpose of evaluating a Transaction”, and a Transaction is defined as “a possible business combination … between [Martin Marietta] and [Vulcan] or one of their respective subsidiaries”. The key issue was whether the expression Transaction was limited to a negotiated merger between the two companies or whether it can be extended to include a hostile takeover as well. A restrictive meaning of the expression would work in favour of Vulcan as the use of the information for a hostile takeover would be a breach, while an expansive meaning to include a hostile takeover would work in favour of Martin Marietta as the use of confidential information would then be for the purpose of the Transaction. The Chancery Court considered a textual interpretation of the relevant clause, including the argument of Vulcan that since the Transaction was defined to be “between” the two companies, it necessitates a voluntary contractual transaction between them (as opposed to a transaction that is against the will of one of the companies as usually occurs in a hostile takeover). But, the court appears to be persuaded rather by the extrinsic evidence, being the history and evolution of negotiations between Martin Marietta and Vulcan that led to the conclusion of the confidentiality agreements.

The second issue pertains to whether the use of confidential information by Martin Marietta as part of the takeover offer documentation was “as legally required” so as to fall within the exception under the confidentiality agreements.  This involves an interpretation as to the scope of the legal requirement exception in confidentiality agreements. While Martin Marietta argued that the disclosure of information in takeover documentation was required by the relevant disclosure rules of the SEC, Vulcan argued that it does not include any party “taking discretionary action to self-impose a disclosure requirement” as an acquirer is entitled to exercise discretion whether to proceed with an offer or not (without any form of imposition that requires disclosures). Even here, the court did not only consider the relevant language in the confidentiality agreements, but it also looked at the extrinsic evidence of negotiations between the parties so as to conclude that Vulcan’s position deserves support.

Analysis

The Martin Marietta decision is important as it instills life into otherwise mundane clauses of confidentiality agreements, which have acquired overtones of standardization characterized by the exceedingly generous use of templates. It necessitates precise drafting of clauses by transaction lawyers so as to obviate any ambiguity. For example, in the Martin Marietta case, some amount of ambiguity was caused by the lack of uniformity in the definition and scope of confidential information between the two confidentiality agreements, i.e., the NDA and the JDA, although both were between the same parties and pertained to the same transaction.

The Martin Marietta decision is also significant due to the emphasis it places on the history of the drafting and negotiation process as a matter of extrinsic evidence. The court placed weight on the manner in which the clauses were drafted and iterated by the parties during negotiations, and also the enthusiasm displayed by one of them (Martin Marietta) to ensure formidable confidentiality obligations that indeed went on to haunt it in the end when it found itself on the other side of the equation. The lesson: as confidentiality obligations are often reciprocal, what is good for one party will also be good for the other; one must be prepared to be bound by the same terms that it seeks to be benefited by.

Overall, despite the fact-specific nature of the decision, Martin Marietta offers some lessons for M&A practitioners in dealing with confidentiality agreements.

For a further analysis of the decision, please see the Harvard Corporate Governance Blog, the Deal Professor and the Race to the Bottom Blog.

Corporate Governance in MFIs

In order to achieve greater scalability, the microfinance sector has witnessed the emergence of for-profit microfinance institutions (MFIs) that are managed on similar lines as companies. They attract investors and lenders and they even list on the stock markets. That creates a dilemma as far as boards of MFIs are concerned, as they are required to manage two interests: one being the investors and the other being the customers (who are represented by the needy sections of society). The question of how the boards of MFIs have been able to address this dichotomy merits no easy answer, as this sector continues to evolve in terms of regulatory and governance issues.

In this background, it is interesting to note a keynote address by RBI’s Deputy Governor Mr. Anand Sinha at a recent FICCI workshop. The address, titled Strengthening Governance in Microfinance Institutions (MFIs) – Some Random Thoughts highlights some of the key governance issues affecting the microfinance sector. Here are some excerpts:

11.  Many analysts attribute the current crisis to the irrational exuberance of some MFIs who entered the segment with the sole emphasis on business growth and bottom lines.  They perhaps did not take due cognisance of the vulnerability of the borrowers and the potential socio-political ramifications their aggressive approach could possibly lead to.  The competition among MFIs led to these institutions chasing the same set of borrowers, by free riding on [self-help groups (SHGs)] and loading them with loans that borrowers, possibly, could not afford.

…

19.  There were serious deficiencies observed in the governance framework of some of the MFIs.  The corporate governance issues in the MFI sector were exacerbated by some of the ‘for profit’ MFIs, dominated and controlled by promoter shareholders which led to  inadequate internal checks and balances over executive decision making and conflict of interests at various levels. Other undesirable practices such as connected lending, excessively generous compensation practices for senior management, founders/ directors and failure of internal controls leading to frauds precipitated the crisis.   Some of the MFIs chased high growth trajectory at the expense of corporate best practices. The listing and trading of the shares of the ‘for profit’ MFIs generated a set of incentives which attracted capital looking for high returns whereas the capital suited for catering to the needs of the poor has to be patient capital. This disconnect led to further worsening of the situation.  What is more disturbing is that there were enough warning signals of trouble in making over an extended period of time but the MFIs, at least  some of them, carried away by their immediate success, failed to pay heed.

Ever since the listing of SKS Microfinance that was followed by the turmoil in the microfinance sector in Andhra Pradesh due to a stringent legislation being introduced, I have been interested in studying the governance issues pertaining to MFIs. I have attempted to address some of these in a paper titled Microfinance and the Corporate Governance Conundrum, the abstract of which is as follows:

Microfinance evolved as an instrument to reduce poverty and bring about sustainable development. As an alternative to traditional means of finance such as banking and insurance (which failed to meet the needs of poorer sections of society), microfinance was pioneered by self-help groups, non-governmental organizations and other non-profit institutions. However, with a view to building a scalable model that engenders overall sustainable development, the microfinance sector has witnessed the emergence of for-profit institutions that are structured along the lines of the modern business corporation. These microfinance companies adopt market-based mechanisms to raise capital that is employed in financing the poor and less-privileged.


From a corporate governance perspective, microfinance companies and their boards of directors are faced with the classic dilemma. On the one hand, it is recognized that the principal goal of microfinance is to reduce poverty; to that extent the interests of borrowers (or customers) as principal stakeholders becomes paramount. On the other hand, a shareholder-centric approach operates as a major countervailing factor by compelling microfinance companies to generate profits to service investors and maintain stock price. The current discourse in corporate governance does not appear to satisfactorily address the predicament of boards of microfinance companies. This is due to the fact that investors and stock markets judge them against standards imposed by corporate governance norms and practices that are generally applicable in the corporate sector.


This article argues that the employment of conventional concepts and doctrines in corporate governance to for-profit microfinance companies does not adequately address the issues specific to such companies. It calls for a paradigm-shift that necessitates examination of corporate governance in microfinance companies through an altogether different lens. After considering the available empirical evidence and analyzing qualitative data generated from case studies and field interviews, it seeks to develop separate parameters for measuring the correlation between corporate governance and performance of microfinance companies, such that the overarching goals of reducing poverty are not diluted.