SAT on Disclosures Regarding “Promoters”

The Securities Appellate Tribunal (SAT) has issued its decision overturning an order of SEBI’s adjudicating officer that had found Enam Securities to have violated securities laws in connection with the IPO of Yes Bank.

One of the key issues in contention was whether Rabobank ought to have been disclosed as a “promoter” of Yes Bank. On facts, while the application to the Reserve Bank of India (RBI) for a banking licence recognised Rabobank as a co-promoter of the issuing bank, the prospectus filed with SEBI pursuant to which securities where issued did not disclose Rabobank as a promoter. After analysing the provisions of the erstwhile SEBI (Disclosure and Investor Protection) Guidelines, 2000, SAT came to the conclusion that the disclosure was indeed appropriate. It noted:

The appellant has been successful in demonstrating as to why Rabobank was shown as a co-promoter in its application for banking license with the RBI.  Simply because Rabobank was shown as a copromoter of Yes Bank for getting a banking license from the RBI will not ipso facto make it a promoter for the purposes of DIP guidelines or other regulations issue by the Board. To bring Rabobank within the promoter category, it must satisfy the definition of promoter as given in the DIP guidelines. There is no general definition of promoter in the DIP guidelines.

Although the SAT’s reasoning largely involves analysis of the erstwhile DIP Guidelines, they are likely to continue to have some impact under the SEBI (ICDR) Regulations that currently govern disclosures.

The fact that SEBI had not raised its concern while reviewing the draft red herring prospectus or other subsequent filings regarding the company seemed to weigh heavily on SAT:

If the Rabobank falls within the promoter category, we fail to understand how such a vital aspect escaped notice of the regulator while clearing the DRHP where Rabobank is not shown as a promoter.  We also fail to understand as to why the regulator continued to accept financial statements, quarter after quarter, year after year, without Rabobank being shown in the promoters’ category and why no action was initiated against Yes bank for making incorrect disclosure in the financial statements. In this background, no fault can be found with the merchant banker of exercising due care and diligence when Rabobank was not shown in the promoter category. 

Such an approach likely places a heavier burden on SEBI to scrutinize draft offer documents more carefully when filed with it.

SAT also did not find a failure on the part of Enam Securities on other aspects of the IPO process involving Yes Bank, including on discretionary allocation of shares in the qualified institutions category and other alleged irregularities in the allotment process.

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. 

The Concept of an “Interested” Shareholder

Yesterday’s board meeting at SEBI was not expected to generate any substantial decision owing to the impending change of guard at the regulatory institution. True to expectations, key matters such as amendment to the Takeover Regulations and implementation of the Jalan committee report on stock exchanges and other market infrastructure institutions were deferred. However, SEBI expressed its policy stance on a significant matter, which, if accepted, will denote a paradigm shift in Indian corporate jurisprudence.

The relevant paragraph of the press release of SEBI’s board meeting is as follows:

4. Recommendation to MCA on related party transactions:

SEBI will recommend to the Ministry of Corporate Affairs to suitably amend Clause 166 of the Companies Bill, 2009 to disallow interested shareholders from voting on the special resolution of the prescribed related party transaction. This will protect small and diversified shareholders in listed companies from abusive related party transactions. This view was taken based on the learning from the investigation in the matter of Satyam Computer Services Limited.

Following the Satyam episode, numerous recommendations were made for strengthening the regime governing “related party transactions” (RPTs), particularly in listed companies. This is not surprising given the corporate structure of Indian companies, where group holding structures, pyramiding and tunneling are commonplace with significant influence wielded by controlling shareholders (or promoters). Given such structures, RPTs are inevitable.

However, the current legal regime appears to focus almost entirely on disclosure of RPTs. For example, there is great emphasis on disclosure of related party transactions in financial statements of companies, and most of the detail regarding disclosures is governed by the relevant accounting standards. There is little prohibition or restriction on the ability of companies to carry out RPTs. Moreover, there are arguably inherent deficiencies in current law being able to capture RPTs, and particularly with controlling shareholders. First, controlling shareholders are not subject to conflicts of interest. Unlike directors, company law allows controlling shareholders to vote on resolutions even in situations involving conflicts. Second, company law does not foist controlling shareholders with duties (such as fiduciary duties). In that sense, they can exercise their voting powers in their own interests rather than in the interest of the company, as they are not in any fiduciary capacity.

SEBI’s proposal in yesterday’s board meeting seeks to address the first issue above, i.e. to impose conflict of interest on shareholders. This is a welcome move because it addresses the realities of Indian corporate ownership structures where RPTs are rampant. In the post-Satyam scenario, the issue of RPTs has perhaps received less attention than it deserves. Spotlight has been thrown on other matters of corporate governance such as board independence, and role and liability of auditors. The proposals have arguably resulted in a scenario by which, if the recommendations of the Task Force are accepted, there would be regulatory micromanagement of corporate boards in India. SEBI’s current proposal does well to renew the focus back to the issue of RPTs.

Of course, like any legislative proposal, the devil lies in the detail. Questions will arise as to how to define an “interested shareholder”, “related party transactions” and whether there should be thresholds of materiality, and the like. If the proposal is accepted, these issues will have to be carefully framed and legislated.

Curiously enough, the impetus for introducing the concept of an “interested” shareholder has emanated from SEBI (as the securities regulator) rather than at the legislative level (involving company lawmakers). SEBI’s efforts have been consistent even in past practice where it required interested shareholders to abstain from voting: e.g. when it granted certain exemptions under the Takeover Regulations, when it issued the Delisting Guidelines (which require 2/3rds majority of disinterested shareholders), and in certain other orders it has passed where it expressed the desire to see disinterested shareholding voting (see one instance here). While SEBI possesses the power to regulate listed companies (and has been exercising this power as indicated above), its plea to the Ministry of Corporate Affairs signals an interest in universal applicability of the rule to even unlisted companies.

This proposal raises interesting issues involving corporate jurisprudence, but whether it will pass muster in Parliament is yet another matter.

(Update - February 18, 2011: Please also see Somasekhar Sundaresan's column in the Business Standard)