SEBI’s Further Order in the Sahara Case

SEBI yesterday issued a detailed and well-reasoned order in the case involving the offering of optionally fully convertible debentures (OFCDs) by two Sahara companies. It found that the Sahara companies had offered OFCDs to millions of investors in the garb of a ‘private offering” without complying with the requirements applicable to a public offering of securities.

Although the order itself is 99 pages long, it contains a useful summary of conclusions (at para 27.2), which is extracted below:

1. OFCDs are hybrid instruments, and are ‘debentures’.

2. The definition of ‘securities’ under Section 2(h) of the SCR Act is an inclusive one, and can accommodate a wide class of financial instruments. The OFCDs issued by the two Companies fall well within this definition.

3. The issue of OFCDs by the two Companies is public in nature, as they have been offered and issued to more than fifty persons, being covered under the first proviso to Section 67(3) of the Companies Act. The manner and the features of fund raising under the OFCDs issued by the two Companies further show that they cannot be regarded to be of a domestic concern or that only invitees have accepted the offer.

4. Section 60B deals with the issue of information memorandum to the public alone. Therefore the same cannot be used for raising capital through private placements as the said provision is exclusively designed for public book built issues. When a company files an information memorandum under Section 60B, it should apply for listing and therefore has to be treated as a listed public company for the purposes of Section 60B(9) of the Companies Act. Further, Section 60B has to be read together with all other applicable provisions of the Companies Act and cannot be adopted as a separate code by itself for raising funds, without due regard to the scheme and purpose of the Act itself. The same evidently has never been the intention of the Parliament.

5. The two companies, in raising money from the public, in violation of the legal framework applicable to them, have not complied with the elaborate investor protection measures, explained in Paragraph 25 above. This, inter alia, also means that the rigorous scrutiny carried out by SEBI Registered intermediaries on any public issue by a public company have been subverted in the mobilization of huge sums of money from the public, by the two Companies.

6. The two Companies have not executed debenture trust deeds for securing the issue of debenture; failed to appoint a debenture trustee; and failed to create a debenture redemption reserve for the redemption of such debentures.

7. The two Companies have failed to appoint a monitoring agency (a public financial institution or a scheduled commercial bank) when their issue size exceeded `500 cr., for the purposes of monitoring the use of proceeds of the issue. This mechanism is put in place to avoid siphoning of the funds by the promoters by diverting the proceeds of the issue.

8. The two companies failed to enclose an abridged prospectus, containing details as specified, along with their forms.

9. The companies have kept their issues open for more than three years/two years, as the case may be, in contravention of the prescribed time limit of ten working days under the regulations.

10. The two companies have failed to apply for and obtain listing permission from recognized stock exchanges.

Although the case involved an egregious set of facts, the SEBI order leaves no stone unturned in establishing the case of violation on the part of the Sahara companies. Despite being an order of first instance by a regulatory authority, it is replete with in-depth judicial analysis of various concepts under corporate and securities laws, including the meaning and scope of financial instruments such as OFCDs, debentures and hybrid securities, and the interpretation of various provisions of the Companies Act and Securities Contracts (Regulation) Act, all of which have been supported by relevant case law.

Preferential Allotment of Securities in Unlisted Companies

The Ministry of Corporate Affairs (MCA) has announced draft rules that will, when promulgated, substitute the Unlisted Public Companies (Preferential Allotment) Rules, 2003. This will make the process of issue of securities more stringent for unlisted public companies. The Indian Legal Space blog has a nice comparison of the existing rules and the proposed changes.

Some of the key features of the draft rules and their impact are as follows:

Disclosures

Unlike the existing regime, the draft rules require companies to issue an offer document with prescribed disclosures (Annexure I of the draft rules contain a list of 32 disclosures). This significantly enhances disclosure requirements for securities offerings by unlisted companies, and would make even private placements cumbersome and costly. While it increases overall transparency in offerings of securities, the need for such extensive disclosures for offerings of securities to specific individuals or institutions is perhaps overstated. Moreover, there is no clarity regarding the liability of the company and its directors for statements made in such offering document, although the Supreme Court has recently indicated the availability of criminal laws to deal with misstatements in offering documents in private placements.

The offer document is also to be approved by shareholders through a special resolution. This is also an onerous requirement as it might limit the flexibility of the company to alter the document once it has been approved by the shareholders. In addition, this will also impose complexities in timing and sequencing of compliances to effect a private placement transaction.

Timing

The draft rules stipulate two conditions regarding timing: (i) the gap between the opening and closing of the issue should be limited to 30 days; and (ii) the minimum gap between the closing of one issue and the opening of another issue must be 60 days. This is possibly intended to deal with ambiguities that exist in the definition of a private placement/offering in terms of section 67(3) of the Companies Act, 1956 where an offer is deemed to be made to the public if it is made to 50 persons or more. By setting time limits, the draft rules seek to impose more objective criteria to differentiate private placements from public offerings. For a greater discussion of this issue in the context of section 67(3), please see a previous post.

While objectivity is generally desirable, the idea of artificially delineating one private placement from another through timing may add to the confusion. For example, it may be possible for companies to structure successive private placements although the offering may cumulatively be made to a large body of investors.

Convertible Instruments

The draft rules make convertible instruments an unattractive option for public unlisted companies.

First, the pricing rules for warrants (that presumably apply to other convertibles as well) are rigid. The price for conversion of warrants must be determined before hand. In other words, the conversion price has to be stated up front, and it appears that neither a conversion formula nor a price band would be available. That removes all flexibility for conversion, which would effectively make warrants in public unlisted companies unattractive as an investment option. Note, however, that this is exactly contrary to the trend established by the FDI Policy of the Government of India which has recently moved from a fixed conversion price to a more flexible policy when it comes to investment in convertible instruments by foreign investors.

Second, for any issue of convertible instruments that results in a cumulative amount of Rs. 5 crores or more, the company is required to seek the prior approval of the Central Government. This is a retrograde step as it imposes hurdles to fund-raising activities of companies. It is also likely to evoke problems that existed in the days of the controlled economy prior to 1991, with the Controller of Capital Issues (CCI) acting as the authority that indulged in merit regulation by specifically approving fund-raising by companies. In fact, even the CCI regime applied only to public offerings where the interest of the investing community at large was at stake. The application of a similar regime under current conditions, and that too for private placements seems inexplicable. The draft rules buck the trend as other areas of corporate regulation have recently witnessed attenuation in government regulation.

Dematerialization of Securities

Here again, the flexibility of retaining securities either in physical form or demat form has been taken away, as all securities issued under private placement have to be kept only in demat form.

Overall, the draft rules make private placements in unlisted public companies an onerous task. This may seriously impact financing in such companies. Curiously enough, some of the requirements suggested in the draft rules go even beyond those prescribed for public listed companies where larger interests are affected. These include the requirement for shareholders to approve the offer document, restrictions on pricing for convertible securities, and the like.

It has been suggested that the draft could be the result of various scams involving unlisted companies and also instances of ambiguities in securities regulation (such as those witnessed in the Sahara episode previously discussed). While it is imperative that regulations be framed to address scams and frauds, the imposition of onerous requirements on the corporate sector as a whole to address a few bad apples imposes greater costs than the benefits it produces. The strategy of painting all public unlisted companies with the same brush will be counterproductive.

SEBI Reasserts Views on Put and Call Options

In view of the provisions of the Securities Contracts (Regulation) Act, 1956 (SCRA) and notifications issued thereunder, the validity of put and call options on securities of public limited companies entered into outside the stock exchange has been in doubt. In the last year, however, SEBI has been making its stand clearer: such options are invalid. On two previous occasions involving the MCX Exchange and Vedanta/Cairn Energy deal, SEBI outlawed clauses in agreements dealing with forward contracts such as buyback agreements and put and call options. Last moth, SEBI buttressed its position in an informal guidance sought by Vulcan Engineers Limited.

In Vulcan Engineers, the company approached SEBI to determine whether a preferential allotment of 14% shares to SIMEST SpA, an Italian financial institution, would make the allottee a “person acting in concert” with the largest shareholder of the company, being Terruzzi Fercalx SpA, another Italian company. SIMEST was the beneficiary of a put option whereby it could require Terruzzi to purchase its shares in Vulcan Engineers after a predetermined time. The informal guidance was sought as a matter of interpretation under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997.

In responding to the request, SEBI observed:

(ii) The legality of the … put/call option in the agreement is examined in terms of provisions of Securities Contracts (Regulation) Act, 1956 [SCRA].

(iii) As this option would be exercised in a future date (June 30, 2015 onwards), the transaction under this arrangement would not qualify as spot delivery contract as defined [in] section 2(i) of SCRA. Further, the aforesaid put/call option would not qualify as a legal and valid derivative contract in terms of section 18A of SCRA as it is exclusively entered between two parties and is not a contract traded on stock exchanges and settled on the clearing house of the recognized stock exchange.

(iv) Therefore, in light of the aforesaid provisions of SCRA read with SEBI Notification No. S.O. 184(E) dated 1^st March 2000, the pre-agreed buyback of VEL shares from SIMEST through put/call option is not valid under SCRA. In view of the same, further examination with regard to the guidance sought in the interpretative letter does not arise.

Interestingly, while the informal guidance itself was sought under the Takeover Regulations and not in respect of SCRA, SEBI instead dealt with the (in)validity of the put and call options and refused to proceed to answer the specific questions posed. The same can be said of the earlier instances of MCX Exchange and Vedanta/Cairn Energy where SEBI has been seizing every available opportunity to deal with the options issue quite extensively although that may not have been altogether germane to the principal issues before SEBI.

Such a clear stance adopted by the regulator will likely affect a number of investment transactions in both listed as well as public unlisted companies where the inclusion of put and call options are customary. Some argue (see this column by Sandeep Parekh) that the initial proscription of options in securities has outlived intervening developments in securities markets and their regulation. This is therefore an opportune moment for a regulatory or judicial reconsideration of the policy issues surrounding put and call options and whether they indeed result in speculation (as the original legislation had contemplated).

Update - June 22, 2011: Somasekhar Sundaresan has an interesting analysis in the Business Standards that highlights several unintended consequences that could arise out of SEBI's ruling.

Restraining the Breach of a Negative Covenant

It is common knowledge that an injunction is granted only if the applicant satisfies the court on the three-pronged test of prima facie case, irreparable injury and balance of convenience. While there is controversy over the scope of some of these elements, notably prima facie case, and over the relationship between these elements, there are also circumstances in which an applicant may be able to obtain an injunction without satisfying the three-pronged test. The recent judgment of the Court of Appeal in Araci v Fallon contains a clear exposition of this point.

The case arose out of rather unusual circumstances. As is well-known, the 2011 edition of the Epsom Derby, one of the most prestigious horse races in Britain (“the Derby”) took place on 4 June, 2011. The claimant, Mr Araci, was the owner of one of the favourites (“Native Khan”) which he expected would be ridden by Mr Fallon, a highly regarded jockey. Mr Araci and Mr Fallon had entered into a Rider Retainer Agreement (“RRA”) on 1 April 2011, under which Mr Fallon received £10,000 for undertaking two important obligations: first, to ride Mr Araci’s horse whenever requested by him to do so, and secondly, to not ride a rival horse in any race in which he has been requested by Mr Araci to ride the latter’s horse. In other words, the RRA contained a positive as well as a negative covenant. Invoking these provisions, Mr Araci asked Mr Fallon to ride Native Khan at the Derby. Mr Fallon communicated his refusal to do so on 30 May 2011, and indicated that he intended to ride “Recital”, owned by a rival and also a favourite. Mr Araci promptly sought an injunction to restrain him from acting in breach of the negative covenant.

The judge at first instance dismissed the application, finding that there was an adequate remedy in damages, and that it was unjust in all the circumstances to grant the equitable relief sought. The Court of Appeal, in an instructive judgment, reversed. Jackson LJ began by noticing that the practice of considering the strength of a party’s case on the merits and the balance of convenience is rarely appropriate when an injunction is sought to restrain a clear breach of a negative covenant. This principle goes back to Lord Cairns LC’s classic, albeit obiter, observations in Doherty v Allman:

If parties, for valuable consideration, with their eyes open, contract that a particular thing shall not be done, all that a court of equity has to do is to say, by way of injunction, that which the parties have already said by way of covenant, that the thing shall not be done … It is not then a question of the balance of convenience or inconvenience, or of the amount of damage or of injury – it is the specific performance, by the court, of that negative bargain which the parties have made, with their eyes open, between themselves

The clear rationale that emerges from this passage is that it is inappropriate to require the applicant to demonstrate that the balance of convenience favours the grant of an injunction when the defendant has contractually agreed to refrain from doing the very thing in respect of which the injunction is sought. However, Doherty was a perpetual injunction case and it was not clear whether the same approach would prevail so far as interim injunctions are concerned. In granting an injunction restraining the defendant from playing a musical instrument in breach of a negative covenant, Megarry J. confirmed that it does, because there is “…no reason for allowing a covenantor who stands in clear breach of an express prohibition to have a holiday from the enforcement of his obligations until the trial” [Hampstead and Suburban Properties Limited v Diomedous (1969) 1 Ch 248].

Thus the rule is that an injunction will be granted to restrain a clear breach of a negative covenant unless there are “special circumstances”. In this case, Jackson LJ concluded that Mr Araci did not have an adequate remedy in damages, and Elias LJ made the additional point that it was not even necessary to decide that question, because adequacy of damages is not relevant when an applicant seeks to merely hold the respondent to his negative covenant. Nor did there exist special circumstances making it oppressive to grant the relief sought. Mr Fallon suggested that granting an injunction would adversely affect the public, because some may have made bets on the assumption that Mr Fallon would ride, while for others it would detract from the quality of a major national event. Jackson LJ rejected the first point because a member of the betting public runs the risk of an unexpected change in sporting variables, and the second because there was no risk that the Derby would not take place, although Mr Fallon himself could not participate. Mr Fallon’s loss was disregarded because he had “brought this predicament upon himself by his own deliberate and cynical disregard of a contract.” It was accepted that the position would have been different if the injunction could have affected the event itself.