Minority Shareholder Protection in M&A

The Economic Times examines a recent trend whereby companies have preferred asset sales or business sales (also known as “slump sales”, an expression that bears uniqueness to India, as I am yet to come across that expression elsewhere) over takeovers thereby shortchanging minority shareholders of the seller companies. The argument goes: by structuring the deal as a business sale, all that is required is an ordinary resolution of the shareholders, which is not difficult to muster where promoter shareholding is significant; moreover, minority shareholders are deprived of the exit option otherwise available under the takeover regulations. While that is certainly understandable, and I am myself fairly sympathetic to that line of argument, this is a function of the manner in which M&A transactions are subject to regulation.

While teaching M&A, one of the aspects I stress is that parties are usually able to structure transactions in different ways to achieve similar commercial goals (or end-games). However, it is often the case that regulations are structured to address the means rather than the end. That provides sufficient leeway to parties and their advisors to structure deals in a manner that is least susceptible to shareholder veto or that provides minimal protection to minority shareholders (in that it does not enable them to participate in the benefits of the deal on par with promoters or management).

To illustrate, a typical M&A deal involving a public listed company can structured either as a sale of business or slump sale (regulated principally by contract), a scheme of arrangement (governed by sections 391-394 of the Companies Act, 1956) or a takeover (regulated by SEBI through the takeover regulations). Although it is not possible to use any scientific metric or parameter that indicates whether one type of structure is optimal to minority shareholders as opposed to others, some qualitative assessments can certainly be attempted, as follows:

1. A business sale is perhaps least effective for minority shareholders, as a simple majority of shareholders can approve the transaction. Since the voting requirement is a majority of “those present and voting”, it is not even necessary that the controlling shareholders hold more than 50% shares, or sometimes even anywhere close to that, in the company to exercise effective control.

2. A scheme of arrangement provides greater protection to minority shareholders. For example, there is a requirement for approval by “classes of shareholders”, which makes the classification exercise quite crucial. The required threshold for shareholder approval is also higher: majority in number holding 3/4^th in value of shares. More importantly, the scheme and the process are subjected to close scrutiny by courts. Nevertheless, one downside of the scheme from the minority perspective is that, once approved, it is binding even on dissentient shareholders. There is no exit route, as Indian corporate law does not provide for automatic appraisal rights (in the form of buyout of dissenting shareholders) as does exist in jurisdictions such as the US (Delaware) and New Zealand. In theory, an Indian court can order a buyout of dissenting shareholders under section 394(1)(v) of the Companies Act, but I am not aware of such discretion having been exercised in practice, at least not in any of the high-profile schemes of arrangement.

3. The most significant right that a takeover provides is the option to minority shareholders to exit on same terms as controlling shareholders or promoters. In the Indian context, however, this right may be somewhat diluted because the acquirer only needs to accept a minimum of 26% shares from public shareholders. In any event, the takeover regulations are structured primarily with a view to protecting the interest of minority shareholder through the exit and other rights.

Given the current state of regulation, the choice of structure is left to the companies, their management and promoters. Courts and regulators usually tend not to disturb the choice, except in extreme circumstances. This concern also appears to be somewhat universal. For example, even in the US context, there has been a history of companies using business sales and asset sales in order to achieve the same result as a statutory merger (or amalgamation as we understand) without providing shareholders either approval rights or appraisal rights or both. More often than not, courts have accepted the structures and denied the arguments of minority shareholders to treat the transactions as de facto mergers (that would have provided minority shareholders the same rights as in a statutory merger). The other example is the use of statutory merger or amalgamation structures to squeeze out minority shareholders, where the US (Delaware) courts have been more sympathetic to the concerns of minority shareholders than courts in the Commonwealth (in countries such as India, UK and Singapore). We have had occasion to discuss the squeeze outs issue in the past.

Coincidentally, I just read an extremely insightful paper that compares minority shareholder rights under a scheme of arrangement and a takeover: Jennifer Payne, “Schemes of Arrangement, Takeovers and Minority Shareholder Protection”, 11 Journal of Corporate Law Studies 67 (2011) (an earlier version of the paper is available on SSRN). The paper seeks to address issues of the kind discussed in this post, although the author concludes that the different levels of protection available to minority shareholders are justified because the purpose of minority protection is different under the two structures.

Andhra Pradesh High Court on Reduction of Capital: More Uncertainty?

In an earlier post, I had highlighted some observations of the Bombay High Court in Re Organon, and had commented on whether the decision of the Single Judge in that case stood easily along with the observations of a Division Bench in Sandvik. The decision in Sandvik can perhaps be read to mean that when an overwhelming majority of non-promoter shareholders votes in favour of the scheme, then the presumption of fairness is even further strengthened. This does not mean that the presumption of fairness is rebutted by there being no overwhelming majority of non-promoter shareholders. Consequently, the observation in Re Organon that Courts “cannot withhold sanction to the special resolution for reduction of capital, unless there is some patent unfairness regarding the fair value of the shares or there is lack of an overwhelming majority of non-promoter shareholders who vote in favour of the resolution…” should not be taken to imply that this is being read in as a requirement. Hopefully, this aspect will be clarified in subsequent decisions. In another development in this area of law, the Andhra Pradesh High Court also seems to have adopted a ‘minority friendly’ view in Chetan G. Cholera v. Rockwool (India) Limited, [2010] 102 SCL 93 (AP):

“In modern times, entities incorporated offshore with transborder operations and global dealings with sole aim of accumulating profits for the benefit of the promoter groups mainly are coming into existence in plenty. In the case of Rockwool one shareholder AIM with more than 90% controls and manages the company. AIM is not a company incorporated in India and it is a company incorporated in Mauritius and its holding company is Dubai based… A foreign company therefore to obtain total control and management of a company, which was initially promoted by Indians, can successfully use the present procedure. In other words, a company that achieved high growth and high net-worth and in a position to share its profits among all the small investors can go into the hands of few individuals or a group helping them to amass wealth. Is it in tune with the Indian Constitutional values so loudly proclaimed in Preamble and Parts III & IV of Constitution of India…

... it would not be sufficient for Court only to adhere procedural and substantive aspects of a scheme of arrangement or compromise. The scrutiny must be beyond the provisions of the corporate law. State cannot ignore the preamble of the Constitution, which assures to secure a Socialist State to citizens, benefits under Articles 38 and 39 and other directive principles. The Court must not lose sight of the fact that Regulatory Bodies have been established under the Acts of Parliament like SEBI to safeguard the interests of the investors. All companies offering shares to public are required to allot required quantity to retail investors. In addition to this, retail investors are provided investor friendly methods, procedures and safeguards for buying and selling securities and prevent fraud by overenthusiastic corporate brokers. All this would be rendered illusory if promoters - with a view to bypass small investors; come forward with petition to reduce share capital. In every case, it cannot be assumed that majority shareholders protect and safeguard class rights. The majority shareholders if they belong to one group or family can never be interested in safeguarding and protecting the class rights of minority. In such cases, all aspects of the matter have to be gone into. Complying with Delisting Regulations, Buyback Regulations and other Regulations of SEBI as well as provisions of Companies Act may not by themselves be sufficient to grant approval to special resolution for reduction of share capital. When such special resolution is engineered by the promoter group controlling majority shareholders and it is found that such reduction is intended only to deny rights of minority shareholders or small investors, the Court can even pass orders rejecting confirmation of the minute and/ or modifying the scheme of arrangement for reduction of the capital, in such a manner that small investors derive the benefit expecting which they invested their money in the company.”

On the facts of the case, as in Organon, the scheme was approved. But observations such as these – besides being incorrect – are only likely to increase uncertainty in this area of law. It is hard to understand exactly what was ‘so loudly proclaimed’ in the Preamble and in Parts III and IV of the Constitution that motivated these observations. The relevance of the reference to ‘foreign companies’ and ‘transborder operations’ is also doubtful. Further, how can adhering to both 'procedural and substantive' considerations ever not be sufficient? When will it be said that the promoter has ‘engineered’ the reduction to ‘deny rights’ to small investors? When will one determine whether small investors have received the benefit ‘expecting which they invested their money’? One would think that shareholders – whether majority or minority – would rather have some certainty in the law. With respect, one can only hope that we can see some concrete legal tests being developed in this regard, rather than the broad generalizations made by the Andhra Pradesh High Court.

Section 100 revisited: In Re Organon

We have discussed the law on reduction of share capital under Section 100 of the Companies Act previously. A recent decision of a Single Judge of the Bombay High Court has an interesting observation in this regard. In Re Organon (India) Limited [2010] 101 SCL 270 (Bom), Kathawalla J. observes after discussing the previous cases (including British & American Trustees [1894] AC 399, Re Panruti AIR 1960 Mad 537, Miheer Mafatlal [1996] 11 SCL 70, Sandvik Asia [2009] 92 SCL 272):

“This Court is bound by the decision of the learned Division bench (in Sandvik) and cannot withhold sanction to the special resolution for reduction of capital, unless there is some patent unfairness regarding the fair value of the shares or there is lack of an overwhelming majority of non-promoter shareholders who vote in favour of the resolution…” [emphasis added]

It is unclear whether Sandvik is actually an authority for the underlined portion above – it seems that the Court in Organon has read in an additional requirement of an “overwhelming majority” of “non-promoter shareholders” to vote in favour of the resolution.

In an earlier article, Mr. Somashekhar Sundaresan had noted that the effect of Sandvik was that, “Private equity investors holding small stakes without serious rights could easily be thrown out by management using such resolutions. In family-run companies, a segment of the family that holds a minority stake could get thrown by the rest of the family. All that one would need is a special resolution…” Now, if the observation in Organon is to be read as laying down the law on the point, the effect of Sandvik could easily be watered down. A mere special resolution would not be enough – that special resolution would need an overwhelming majority of non-promoter shareholders backing it. This is almost tantamount to giving a veto power to the non-promoter minority shareholders. Interestingly, on the facts of the case, this had no effect on reduction of share capital – of the more than thousand non-promoter shareholders, only one had objected. Nonetheless, the observation (in the form of the statement of law which the Court states it was applying) would perhaps require reconsideration by a larger Bench.