SEBI’s Proposal to Overhaul Corporate Governance Norms

SEBI has issued a consultative paper that reviews corporate governance norms in India with a view to overhauling them considering developments in the Indian corporate sector over the last few years. The paper is quite detailed and is expected to generate a great amount of discussion, which would be considered by is SEBI before implementing any revised norms. Suggestions are due on the consultative paper by January 31, 2013.  The purpose of this post is not to consider the detailed recommendations in-depth, but to simply provide some broad observations that would set out the context for a more detailed analysis.

Clause 49 of the listing agreement has been the mainstay of corporate governance in India for more than a decade. Although such norms are expected to be dynamic in nature and consistent with the ever-changing corporate scenario, clause 49 was previously subject to detailed review way back in 2004, even though the revised norms came into effect only in January 2006. Since then, despite significant developments such as the Satyam corporate governance scandal, there was no review of clause 49, and no concentrated efforts were undertaken by SEBI. However, most of the changes or proposals came from the Central Government. Notable among them are the Ministry of Corporate Affairs’ voluntary guidelines of 2009, and substantial insertions on corporate governance issues in the Companies Bill, 2011, which has been approved by the Lok Sabha and is awaiting consideration by the Rajya Sabha. There has been a fear that such a multiplicity in the regulatory process would cause considerable inconsistency between the various regulations regarding corporate governance that have been issued by different regulators.

Given this background, SEBI’s proposals seek to achieve two broad objectives: (i) to bring the provisions of clause 49 on par with the proposals made in the Companies Bill, 2011; and (ii) to make additional recommendations that impose a more stringent regime for listed companies.

On the first count, the consultative paper sets out a detailed comparative analysis of clause 49 and the Companies Bill, 2011, and makes proposals for ensuring parity in the two regimes. It also contains a detailed comparative table, which provides a useful tool to understand the various corporate governance norms in India. Of course, on certain matters the proposed changes go beyond the Companies Bill in the case of listed companies, which is understandable given the large shareholder population in such companies. The proposals, however, proceed on the assumption that the Companies Bill will become operational soon. In case there is any delay on the passage of the Bill, it is necessary to ensure that SEBI’s proposals will be given effect to nevertheless.

On the second count, the consultative paper makes some additional recommendations, which are welcome. As some of us have argued in the past, the current governance norms in India have been borrowed from Western jurisdictions where the corporate structure consists of diffused shareholders with no concentration of shareholding. However, the corporate structure that is predominant in India consists of controlling shareholders.  Given the mismatch of corporate structures, it was argued that the current governance norms do little to protect the interests of the minority shareholders. This critique has been given the required attention in the current round of reforms, with proposals specifically being made to address the corporate structure that is replete in Indian companies. Examples of these proposals include minority shareholder participation in the election of independent directors, detailed treatment of related party transactions, and the like. The proposals on this account are fairly radical, and it remains to be seen how much of it will actually be accepted given that there is likely to be tremendous resistance to greater power to minority shareholders to the diminution of power of the controlling shareholders. The novelty of these proposals lies in the fact that this issue has now emerged to the forefront for discussion and deliberation.

There is certainly a lot in the consultative paper, and if accepted, many of these proposals could result in significant change in the manner in which companies are governed. At the same time, it is important to note that such norms would become effective only if they are properly implemented and enforced by the regulatory authorities. 

CSR in Public Sector Enterprises

The provisions relating to corporate social responsibility (CSR) in the Companies Bill, 2011 have garnered sufficient attention on the topic. Those provisions are largely in the nature of CSR spending. While the Bill is pending in Parliament, the Department of Public Enterpriseshas proceeded to issue a revised set of “Guidelines on Corporate Social Responsibility and Sustainability for Central Public Sector Enterprises” that would become effective from April 1, 2013.

Unlike the Companies Bill and also the previous version of the guidelines applicable to central public sector enterprises (CPSEs) which focused largely on external stakeholders and CSR spending, the new version of the guidelines emphasizes CSR as a way of life and as an integral part of the operations and business of the company. While the current debate in India equates CSR with corporate philanthropy, the new guidelines for CPSEs does more than that and requires companies to follow ethical systems and sustainable management practices.

The guidelines contain detailed provisions on the manner in which CPSEs can carry out their CSR practices, which also mandate every CPSE to carry out a minimum number of external projects “for development of a backward district” that “has the potential of contributing significantly in the long run to socio-economic growth in all the backward regions of the country”.

It is not clear whether there is adequate data to determine the success of implementation of these efforts by CPSEs in the past, but by imposing higher standards of social responsibility and sustainability on public enterprises, the Government is sending a strong signal to the private sector regarding the importance of CSR in India.

Proposed modifications to buyback provisions

SEBI has just placed a discussion paper on its website entitled “Proposed modifications to the existing framework for buy back through open market purchase” for public comments. Comments on the discussion paper have been solicited on or before January 31, 2013.

Upon a review of the current regulations and studying the market dynamics, the key recommendations of the discussion paper are set out below:

1. The merchant bankers should be advised to ensure that a minimum of 50% of the maximum buy-back proposed/disclosed to be bought back.
2. It is proposed that companies complete the buy back in 3 months. To ensure that only serious companies launch the buyback program, it is further proposed that these companies be mandated to put 25% of the maximum amount proposed for buyback in an escrow account.
3. It is proposed that listed companies coming out with buyback programs may not be allowed to raise further capital for a period of two years.
4. In order to ensure that the companies do not launch buyback programs for stabilizing the share price, it is proposed that companies who are not able to buy back 100% of the proposed amount (or the proposed maximum number of shares) may not be allowed to come with another buyback for a period of at least one year irrespective of the mode of approval for buy back.
5. It is also proposed that buy-back of 15% or more of (paid up capital + free reserves) must be only by way of a tender offer method.
6. It is proposed that the issuance of shares pursuant to obligations arising out of Employee Stock Option schemes may be allowed during the buy-back period subject to the following: (a) the shares are not allotted to directors and key managerial personnel of the company; (b) there is no acceleration in the vesting period.
7. It is proposed that the companies shall extinguish/ destroy shares bought back during the month, on or before fifteenth day of the succeeding month subject to the companies destroying the bought back shares in the last month within seven days of the completion of the offer.
8. The current regulations prohibit the promoters of the company in dealing in the securities of the company during the period when buy back is open. It is proposed to extend this restriction to dealing in the securities of the company off–market as well.

Mandatory Offers and Creeping Acquisitions

The Securities and Exchange Board of India (SEBI) passed an orderunder the SEBI Takeover Regulations of 1997 (that existed prior to October 2011) in relation to the shares of Khaitan Electricals Limited (the Target Company). In this order, the SEBI whole time member directed the promoters of the company to make an open offer to the other shareholders on account of certain acquisitions of shares by them in 2006-2007. Along with the open offer consideration, the promoters have been directed to pay interest at the rate of 10% per annum from June 16, 2007 to the date of payment of the consideration.

The key facts of the case are summarized in the gist of the show cause notices issued by SEBI to the relevant promoters of the Target Company:

... consequent to the acquisition of shares [by the promoters] on March 12, 2007, there was increase in their pre-acquisition shareholding (as on March 11, 2007) of -

(a) [Khaitan Lefin Limited (KLL), one of the promoters], individually, from 10,73,415 shares (10.52%) to 19,73,415 shares (17.16%) in the Target Company and KLL failed to make a public announcement to acquire shares in accordance with provisions of regulation 10 read with regulation 14(1) of the Takeover Regulations, 1997 within 4 working days from March 12, 2007;

(b) The promoter group, collectively, from 26,34,639 shares (25.83%) to 39,34,639 shares (34.21%) and the acquirers collectively failed to make a public announcement in accordance with the provisions of regulation 11(1) read with regulation 14(1) of the Takeover Regulations, 1997 within 4 working days from March 12, 2007.

Given these facts, two primary legal issues arose for consideration.

First, whether an acquisition by a single promoter of more than 15% shares will trigger an open offer requirement under Reg. 10 although the promoter group as a whole already held more than 15%. In other words, whether can be independent obligations under Reg. 10 (for individually crossing the 15% threshold) and under Reg. 11(1) (for collectively activating the creeping acquisition trigger of 5% additional shares) in respect of the same set of acquisitions.

Second, in the case of a creeping acquisition, what is the precise timing to be considered for the acquisition of 5% additional shares? Specifically, whether a dilution of shares during the period ought to be taken into account or netted off while considering the 5% limit.

The SEBI order holds against the promoters on both the issues, thereby mandating them to make an open offer.

On the first issue, the SEBI order reasons as follows:

11. Thus, the obligation to make public announcement under regulation 10 gets triggered when the acquisition of the acquirer, individually or collectively alongwith persons acting in concert with him, would cross the threshold limit of 15%. Thus, if individual acquisition of any person in a group (acting in concert) breaches the threshold limit of 15%, such acquirer is under obligation to make public announcement under regulation 10. In my view, there is no ambiguity in the language of regulation 10 with regard to the obligation of an acquirer whose acquisition increases his individual shareholding beyond threshold limit of 15% and no other interpretation can be given to it. …

…

14. … The intent and object behind the obligation with regard to public announcement under regulation 10, 11 and 12 is common. Regulation 10 does not exempt an acquirer from this obligation when he individually breaches the threshold of regulation 10 but his shareholding collectively with persons acting in concert with him is beyond the threshold prior to his individual acquisition as sought to be contended by the noticees. In my view, therefore, no interpretation can be taken in violation of the language of the regulations or to defeat the intent and object thereof.

On the second issue, the promoters argued that the amount of increase in the shareholding due to creeping acquisition must be computed as of the last date of the financial year, i.e. March 31, and that intermediate divestments and dilution must be netted off. This argument was not accepted by SEBI, which adopted the following reasoning:

21. … If the argument of the noticees is accepted, an acquirer may acquire any percentage of shares in a financial year and by the end of that financial year he may reduce it to 5% by sale of holding or otherwise. This is not the intention of the regulation which, since inception, had put a limit on percentage of creeping acquisition and did not allow netting of acquisition and disinvestment for determining the percentage of increase. …

22. I, therefore, am of the view that for the purpose of availing creeping benefit under regulation 11(1), the gross acquisition of the acquirer should not be more 5% in a financial year that starts on April 1st and ends on March 31st. Further, if at any point of time, in that financial year, the acquisition breaches the threshold of 5% creeping acquisition, the obligation to make public announcement is triggered at that time itself. Regulation 11(1) does not allow an acquirer to wait till end of the financial year after such breach.

…

24. In my view, from the definition of the word 'acquirer' under regulation 2(1)(b) and the provisions of regulation 11 of the Takeover Regulations, 1997 it is clear that the obligation to make public announcement is triggered on the date of agreement to acquire or acquisition of shares or voting rights, as the case may be. Thus, the shareholding shall be calculated and reckoned taking into account the shareholding of the acquirer immediately prior to the acquisition. I, therefore, hold that the shareholding of the acquirers as on the date of the acquisition of additional shares should be taken into account to determine whether the acquisition entitles the acquirer to exercise more than 5% voting rights in the Target Company in a financial year ending on March 31st. Further, the 5% increase in the financial year has to be calculated on gross basis without netting the dilution and/or divestment and acquisition. Accordingly, the arguments of the noticees in this regard also cannot hold good.

SEBI’s order is consistent with the text and intent of the 1997 Regulations. Although the facts of the present case gave rise to some issues that required a detailed consideration, the order merely buttresses the position adopted by the Regulations.

The legal difficulties emanating from the above discussion have been partially addressed in the 2011 version of the Takeover Regulations. The first issue regarding the mutual exclusivity of the initial trigger by individual acquirers (now standing at 25%) and the creeping acquisition trigger by the promoters collectively would continue to operate even under the 2011 Regulations, and to that extent SEBI’s order in the present case would continue to be relevant. As far as the second issue on computation of creeping acquisition limits is concerned, the position has been expressly clarified in the 2011 Regulations in Reg. 3(2) Explanation whereby the limit would be computed on a gross basis (without netting off dilutions). In that sense, SEBI’s order seems to suggest that the introduction of this explanation does not change the legal position, but rather clarifies something that was even previously the intention of the Takeover Regulations.