Securities Laws Archives

Ordinance Empowers SEBI Even More – and Brings Some Ambiguities

An Ordinance was issued on 18th July, 2013 amending
securities laws such as the SEBI Act, etc. Some provisions have
immediate effect while certain others have retrospective effect from
different dates. Some amendments are technical and meant to clear
certain doubts/concerns or strengthen the validity of certain
provisions. A couple of others are a little serious. One grants special
powers of search and seizure to SEBI. Another gives wider powers to
gather information. Yet another provision grants powers to SEBI to
arrest and jail people for strange reasons—if he does not pay penalty,
does not refund monies, or a mere nonpayment of fees, etc. Others like
special courts are meant to expedite prosecution of offenders.

The
important amendments can be briefly described as follows. The Consent
Order process, which presently operates through Guidelines, has now been
given specific legislative sanction. Special Courts are now authorised
to be set up for speedy prosecution of offences. Powers to search and
seize without need for sanction by Magistrate are given to SEBI. Powers
to recover monies from defaulting parties are also given. Disgorgement
of proceeds of unlawful transactions/activities also now has legislative
sanction. The scope of provisions relating to collective investment
schemes (CIS) has been expanded and certain large Schemes are treated as
CIS by a deeming fiction. SEBI also can now collect information from
practically anybody and not from a limited set of persons as was the
position earlier.

Similar amendments are made in regard to some
of these aspects to other securities laws—the Securities Contracts
(Regulation) Act, 1956 and the Depositories Act, 1999.

Some important amendments are discussed in a little more detail.

Collective Investment Schemes
SEBI—as
early as 1999—made fairly stringent Regulations for registration and
regulation of Collective Investment Schemes (“CISs”). It may be
recollected that CISs are schemes that pool monies from the public and
invest in certain businesses. The profits, after expenses, of such
businesses are intended to be divided amongst the investors. Often,
specific assets are earmarked to individual investors so the returns
from such assets are identifiable. The best example of this is mutual
funds, which are of course specifically excluded from the definition of
CIS but are still a good example to understand the concept.

However,
in practice, numerous schemes were introduced for fancy businesses
(teak plantations, goat raising, etc.). Some of them gave false promises
of high returns. Some were simply loans raised but disguised as CISs to
avoid various restrictions of other laws on raising of monies from the
public. Many of these schemes were found, usually too late, to be
outright Ponzi schemes where, on one hand the funds were used to pay
hefty commissions to motivate agents to collect monies and on the other,
the rest of the monies were used to repay interest and principal on
earlier loans. By the time the scam was discovered, most of the recent
investors could recover nothing.

The amendments and Regulations
of 1999 did help in closure of many leading schemes. However, recent
scams, particularly in West Bengal, showed that they had merely
re-invented themselves and, strangely, they were operating fairly
openly. One wonders whether this is not clearly a failure of the
regulator. SEBI did pass some quick orders in such cases recently but it
appears that it was too late.

Nevertheless, this Ordinance
makes certain amendments strengthening the powers of SEBI. The
definition of CISs has been enlarged to include by deeming fiction
certain large-sized schemes. Any scheme/arrangement of pooling of funds
having a corpus of Rs. 100 crore or more is now deemed to be a CIS.
Thus, it will need prior registration and compliance with several
formalities.

However, schemes which are specifically excluded
from the list will remain excluded from this deeming provision also.
Thus, public deposits raised by companies under corresponding
Rules/Directions, funds raised by mutual funds, insurance companies,
etc. will not be treated as CISs.

This deeming fiction, however, appears
to be unduly wide. The requirements for a scheme to become such a CIS
are simple and minimal (i) it has to be a scheme/arrangement (ii) it
should involve “pooling” of funds (iii) the total “corpus” should be Rs.
100 crore or more.

Would it cover investment in capital of private
limited companies? What about Inter-corporate deposits (or even bank
borrowings)? These and several other types of pooling of funds appear
prima facie to be covered by the new definition.

A question had arisen
whether the restrictions of registration, etc. on CISs were applicable
only if the CIS was set up by a company or whether it was applicable if
set up by other persons too. In Osian Art Fund’s case, for example, this
contention was raised and SEBI held that it also applied to entities
other than companies. However, to put this issue beyond doubt, the word
“company” has now been replaced by the word “person” in the Act. This
now makes it clear that the requirement of registration shall also apply
to other entities. The amendment, however, is not retrospective.

Consent Orders
The Guidelines relating to consent orders issued in 2007
enabled numerous cases to be settled without lengthy penal proceedings.
Persons accused of violations of provisions of securities laws, or even
persons who anticipated such allegations, could approach SEBI for
settlement. By payment of a settlement amount and sometimes accepting
certain non-monetary restrictions like debarment, etc. the proceedings
could expeditiously come to an end. Further, the proceedings would end
without admission or denial of guilt by such person.

While the
settlement mechanism was fairly speedy and independent, it attracted
criticism too, part of which was met by recent issuance of the revised
Guidelines. However, serious concerns were expressed over the legal
basis of the consent order guidelines. A PIL was also filed before the
Delhi High Court. If the Guidelines were set aside by the Court as being
without legal basis, hundreds of consent orders passed till now would
have got overturned. A new provision now gives retrospective validity to
the consent order process permitting SEBI to pass such consent orders.
This amendment is effective from April 2007, when the original consent
order Guidelines were issued.

Strangely, the amended provisions
specifically provide that the consent orders shall be in accordance with
Regulations made in this regard. However, no Regulations have been
issued till date and the existing settlement scheme is in the form of
Guidelines. This puts a question mark over all consent orders passed
till date under Consent Order Guidelines. A question arises whether any
Consent Order can be passed till Regulations on Consent Orders are
issued.

It is also provided that consent orders cannot be appealed against. The amendment, being retrospective, will thus invalidate existing appeals or future appeals against any consent order. This may make sense because consent orders are by definition by mutual consent. However, at times, SEBI may reject an application for consent. Discretion remains with SEBI whether or not to accept an application for consent. The Guidelines state that certain types of violations cannot be settled. However, in other cases too, there is discretion with SEBI. Question is whether such discretion is exercised judicially and whether it can be challenged. The new provision, however, provides that no appeal shall lie against the order passed.

The party concerned of course does not lose the right of proceeding with the adjudication or other proceedings in the normal course.

Powers of search and seizure

Till now, SEBI could initiate search and seizure under persons being investigated by making an application to a Magistrate who had jurisdiction over the persons. Certain reporting was also required to be made to the Magistrate. This requirement to apply to and obtain order from the Magistrate has now been dropped. The SEBI Chairman can now issue directions for search and seizure against persons being investigated. The powers of search and seizure have also been made more elaborate.

Powers to collect records from other entities (including telephone records)

Till now, SEBI had powers to seek information from banks or other authorities, etc. for information relating to transactions under investigation. Now the powers have been widened to include “any person”.

Disgorgement of funds

Persons may engage in transactions in contravention with the Act/Regulations and thus make gains or avoid losses. For example, a person may engage in insider trading and make profits or avoid losses. There have been concerns raised whether SEBI has adequate powers to order disgorgement of such gains/losses and direct its use, say, for credit to the Investor Protection Fund.

An explanation now introduced declares that SEBI always had powers to direct disgorgement of profits/losses from persons who have made such profits or avoided losses in contravention of the Act/ Regulations. Further, the amount disgorged shall be credited to the Investor Protection Fund.

It must be noted that disgorgement is in addition to the penalty that can be levied.

Action in case of default in payment of refund, penalty, fees, etc.

In case a person delays or defaults in payment of various types of amounts as he has been ordered or is otherwise required to pay by way of penalty, disgorgement or refund the monies raised or even dues on account of fees payable to SEBI, specific powers to recover such amounts, by attachment and sale of properties have been given.

However, there is a strange power given to SEBI. The person concerned can be arrested and imprisoned for making such defaults. Since power to attach and sell properties is given, the power to arrest and detain seems a little drastic, particularly when they cover even regular dues like fees payable to SEBI.

Conclusion

Powers of search and seizure and arrest and detention are a little scary, particularly considering how widely they are worded. However, it appears strange that instead of examining how powers given in 1999 to regulate/restrict CISs have worked, more powers in broader provisions have been given to SEBI. Based on past experience, persons are scared that the amended provisions will be arbitrarily used especially when governance (implementation and enforcement) is an issue.

Nirav Shah

Minority Shareholder Squeezeout – Multiple, Conflicting, Loosely Drafted Provisions

Companies Act, 2013

The Companies Act, 2013, (“the Act”) is gradually coming into force, with 98 sections duly notified and several set of draft rules circulated for feedback. The target for the Act to fully come into force by end of this financial year seems achievable. But how desirable is such speedy implementation? The common argument for quick implementation is that the new law has been in contemplation/consideration for too long and it is high time we have a modern law. The reality is that each successive version of the Bill has seen major changes/new provisions which, both in terms of drafting and implications, have been inadequately discussed. Worse, and that is one of the issues presented in this article, there are provisions that seem to overlap or are in conflict with other laws. In particular, for some reason, the lawmakers have sought to duplicate requirements that SEBI has already framed. These include provisions relating to Independent Directors, Audit Committee, bonus shares and many others. In subsequent issues, we will discuss such duplicate provisions. To begin with, the vexed topic of ‘Minority Squeeze-out’ is considered here.

What is buy-out vs. squeeze-out?

Simply described, minority Squeeze-out involves marginalising of and buying out of minority shareholders, often forced (hence the word “squeeze”) out of a lower value than fair value. As compared to buyouts which may be mandatory on the offers or but optional for the sellers, a squeeze-out gets greater publicity in case of listed companies though it is common in unlisted companies also. There was a time when companies sought to increase minority shareholding by issuing shares through a public issue. The process of listing ensured a higher issue price. Over a period, with increasing compliance and other requirements and depressed share prices, the status of listing can become burdensome. Worse, unscrupulous managements sometimes pursue acquisition of public (minority) shareholding at depressed value. Forced buybacks were thus seen in many companies (discussed earlier in this column) with minorities being bought off against their will and in many cases, at prices that were lower than fair value. The stratagem used was to carry this out through a court-approved scheme of arrangement/ reduction of capital where often the criteria for approval are different. The ignorant and scattered shareholders usually did not offer vigorous opposition. SEBI and stock exchanges took some belated inadequate action. Certain provisions such as requirement of pre-approval of schemes by stock exchanges were introduced. However, this was not enough and even circumvented.

Be as it may be, finally, the Act now makes certain specific provisions in relation to such minority squeeze-outs.

What do the new provisions in the Act provide?

Firstly, the new Act prohibits buyback of shares through schemes of reduction or arrangement. Thus, companies cannot buy back shares of shareholders through such schemes. Effectively, they will have to resort to the procedure for buyback of shares as prescribed in section 68 of the Act relating to ‘buyback of shares’. This means they will also have to follow the Rules that would be notified by the Central Government (for unlisted companies) and the Regulations as notified by SEBI (for listed companies). The provisions for buyback in the Act/ Rules/Regulations ensure that it cannot be forced upon unwilling shareholders. It is another issue that these provisions are not well drafted. Further, the provisions relating to buyback of shares suffer from several limitations, particularly the size of buyback. Hence, even genuine cases may face difficulties. Nevertheless, one abusive method will come to an end.

Secondly, there are two specific provisions that enable minority buy-outs. Essentially, they provide for purchase of shares of the minority shareholders when more than 90% of the shares are bought by a company or group. When minority shareholders are reduced to below 10%, they have minimal rights, except those provided generally by the Act or the articles of association. They have no powers to veto a general or special resolution. They also cannot file a petition complaining of oppression/mismanagement or initiate class action. The minority may thus want to have an opportunity provided by the majority shareholders to be bought out at a fair price, even if they did not avail of an earlier opportunity.

Sections 235 and 236 deal with such situations. While section 235 is a slightly modified version of the existing section 395 of the Companies Act, 1956, section 236, though overlapping to an extent, provides for a different situation and procedure.

Section 395, as may be recollected, provides for an opportunity and obligation both to an acquirer of 90% or more shares in a company to acquire the shares of the minority. The minority shareholders thus have a chance to exit the company.

Weak drafting

Section 235, however, continues the weak drafting of existing section 395 but with some modifications. It essentially provides that if a scheme or contract to acquire shares of a company is approved by more than 90% of shareholders (excluding shares held by acquirer company), then the shares of dissenting minorities may be acquired by the acquirer on the same terms. This section can be fairly dubbed as a squeeze-out provision since the acquirer can acquire the shares of the minority shareholders without the latter’s consent. The minority shareholders may, however, apply to the Tribunal and the Tribunal may give appropriate directions for relief. It appears that a window of negotiation for a higher price gets opened for the minority shareholders. The acquirer has the option, but not the obligation, to make such an offer to acquire shares of the minority shareholders. The minority shareholders, however, cannot force the acquirer to acquire their shares.

Section 236 is in many ways a variant of section 235 though with some important differences. Generally stated, it provides for an obligation for an acquirer/ persons acting in concert who have acquired 90% or more of the shares in a company to make an offer to the remaining shareholders. The offer has to be on the same terms and has to be valid for a prescribed period of time. Though the drafting is ambiguous at some places, it appears that the remaining shareholders are not under an obligation to sell their shares. Thus, it is not a squeeze-out. There is a provision that provides for negotiation by a specified section of the shareholders for a higher price. It is provided that in such a case, the higher price received by such shareholders will have to be distributed pro rata amongst the other shareholders who did not get such higher price. This is strange in one aspect. If a section of shareholders is given a higher price, the better course is to make the acquirer give such higher price to the other shareholders too.

Contrast with the SEBI Delisting Regulations Sections 235/236 apply to listed and unlisted companies. For listed companies, it is necessary to also consider the SEBI Regulations on delisting (SEBI (Delisting of equity shares) Regulations, 2009 or “the Regulations”). Simply put, the Regulations provide for procedure that Promoters/companies seeking to delist shares from stock exchanges need to follow. These Regulations are relevant in this context because the Promoters holding has to increase to at least 90% for delisting to be successful. The regulations also provide for the steps to be taken after the holding is increased to more than 90%. Some important steps relevant to the present context are as follows:

• The proposed delisting has to be approved by a special resolution. Such special resolution has to be by a postal ballot thus giving all shareholders a better opportunity to participate.

• Further, the resolution can be acted upon only if at least two-thirds of the non-Promoter share-holders approve delisting.

• The Promoters have to make an offer to acquire the shares of non-Promoters.

• A minimum benchmark offer price, based on recent prices and acquisitions by the Promoters, is fixed.

• The offer needs to result in such number of acceptances that would make the holding of the Promoters higher of two figures. The first figure is 90% of the equity share capital. The second is the existing holding plus 50% of the non-Promoters holding. Thus, if the Promoters held 75%, then they should get at least 15% acceptances. If they held, say, 85%, then they should get at least 7.50% acceptances. If this minimum figure is reached, then the Promoters are entitled to delist the shares.

• They are also required to make another offer and, in effect, keep it valid for the next one year, to acquire the remaining shares at the same price. The remaining shareholders have a right, but not an obligation, to offer their shares during this period. In other words, they may choose to remain shareholders, in the unlisted company.

If one compares these Regulations with section 235/236, clearly the Regulations give better protection to the minority shareholders, though they make it difficult for the Promoters to delist the company. The provisions of sections 235/236 and the Regulations are obviously not alternate to each other and both need to be complied with. Thus the stricter of the two provisions would apply. However, there may be a grey area as regards seemingly beneficial provisions. For example, if the provisions in the Act give a right to the acquirer to acquire the remaining shares, can the remaining shares be so acquired, though the Regulations do not provide such a right? One factor involved in interpreting this issue is whether a beneficial provision in the Regulations would override provisions in another enactment.

In any event, even for unlisted companies, section 235/236 are beneficial to those minorities who are reduced to such a number that their voice does not matter. The 90% majority acquirer also has an opportunity to acquire 100% control of the company so as to be able to run the company without any outside involvement. In the author’s opinion the provisions are worded in such a manner that the acquirer may escape from such obligation. Section 235 uses the term “transferee company” (including its nominees/subsidiaries) on whom such obligation is created. Thus, effectively, it will not apply if the acquirer is not a company or if the acquirer is more than one. This may even become a limitation on the acquirer if it seeks to acquire the shares in more than one entity. Section 236 is worded more broadly. However, several protections that are available in the regulations for listed companies are missing. Loose drafting is evident at several places.

Conclusion

To conclude, competition between two regulators to provide better protection to minority shareholders and generally other persons may seem commend-able. However, conflicting provisions may in the long run be counter productive and create hurdles for genuine transactions. Worse, unscrupulous companies may be found to resort to legislative arbitrage, seeking those provisions or methods that avoid both laws or use the ill-drafted one with lesser restrictions. The fact that the Act is carved in stone, in the sense of being very difficult to amend can only make matters more difficult. Ideally, SEBI, with its expertise, experience and resources, should be given a monopoly or at least a priority as far as listed companies are concerned.

Nirav Shah

When Can an Open Offer be Avoided? – Supreme Court Decides

The Supreme Court recently had an occasion to
render an interesting decision (Nirma Industries Limited vs. SEBI
((2013) 33 Taxmann.com 333(SC), dated 9th May 2013) on the Takeover
Regulations. It examined the very rationale of the Regulations. In
particular, the question was when could a person taking over a listed
company avoid an open offer? More specifically, having already paid the
promoters for acquiring the controlling interest in a company, can the
acquirer avoid paying the public for their shares? Can the acquirer be
allowed to withdraw if he later finds that the value of the shares was
substantially lower than he was supposedly aware of?

This
decision has drawn a lot of controversy and criticism. It has been said
that the acquirer, having already suffered by getting over valued
promoters shares, should not be made to suffer again by being required
to acquire shares of the public. Partly this owes to certain peculiar
facts and legal interpretation on certain issues which the Court upheld.
Partly also because it is said that the law creates certain hurdles and
then punishes the acquirer for not being able to cross them. But mainly
on certain substantive grounds. I respectfully differ with contrary
views on certain aspects and submit that the Supreme Court has rightly
required the acquirer to comply with its obligations to the public. The
few areas of legal ambiguity have also been rightly interpreted by the
Court.

The facts are indeed peculiar and on a first glance raise
certain sympathy too. To summarise, certain lenders (collectively
referred herein as “Nirma”) granted certain loans to the promoters of a
listed company (“the Company”) against security of shares of the
Company. When there was default in repayment, Nirma exercised the pledge
and acquired the shares. This resulted in trigger of requirement of
open offer which Nirma initiated. However, on later investigation, Nirma
found that there were allegedly serious misappropriations, etc. in the
Company. Nirma applied to SEBI for grant of exemption from making an
open offer or other alternate reliefs. SEBI refused. The Securities
Appellate Tribunal (“SAT”) upheld this decision. On appeal, the Supreme
Court too upheld the decision. Now, let us consider the background of
the law, then the more detailed facts, the decision of the Supreme Court
and the areas of contention.

What do the Takeover Regulations provide?

The
Takeover Regulations, since their inception, are based on a particular
concept. Whoever acquires a listed company (control or substantial
shares in it) ought to also acquire further shares from the public. The
principle behind this is that members of the public invest in the shares
of such company based on the existing promoter group. If another group
replaces the existing group, the public should have a chance to exit
with them. The other objective is to provide the public shareholders an
opportunity to sell their shares at least at the same price as the
exiting promoters. Curiously, despite several rounds of amendments, the
public shareholders are given step-fatherly treatment in one important
aspect. While the Promoters can sell 100% of their shares at a
particular price, the public shareholders cannot. Only 26% (earlier 20%)
of the share capital needs to be acquired from the public.

What happened in this case?

Nirma
lent a certain sum of money to promoters (“the Promoters”) of the
Company against pledge of shares of the Company. The promoters
defaulted. Nirma exercised the pledge and acquired the pledged shares
that triggered the open offer requirements. Nirma made an open offer at
the prescribed price to the public. However, because of findings of
multiple audits, Nirma realised that there were allegedly huge
misappropriations, understatement of liabilities, etc. Consequently, the
value of the shares was far lower than the open offer price.

Nirma
requested SEBI that it should not be required to make the open offer to
the public. Alternatively, the open offer could be at a lower than the
prescribed price nearer to the actual valuation if the alleged
misappropriations, etc. were factored in the valuation.

SEBI
rejected this request. Nirma appealed to SAT which too rejected it.
Nirma appealed to the Supreme Court, which also dismissed the appeal on
grounds discussed in the succeeding paragraphs.

Grounds why Supreme Court rejected the plea for exemption

Nirma
raised several contentions. One set of them was on legal issues. It
contended that SEBI did have general powers to grant exemption that SEBI
said it did not have. The other set of contentions was that if SEBI had
powers, the facts of the case had enough merits that SEBI ought to have
granted the exemption. The Supreme Court rejected both the contentions.

The first contention was that SEBI did have generic powers to
grant exemption. The specific grounds listed in the Regulations were, it
was contended, not exhaustive and, further, SEBI did not have power to
grant exemption on grounds similar to the specified ones but had broader
powers. The Regulations provided for three grounds for withdrawal of
open offer. First was that statutory approvals for making of the open
offer were refused. Second was that the sole acquirer, being a natural
person, had died. The third clause was “such circumstances as in the
opinion of the Board merits withdrawal”.

The contention of Nirma
was that (since the first two grounds did not apply here) SEBI had wide
and unrestricted powers under the residuary powers under the third
ground. SEBI, however, contended that its powers were ejusdem generis
the earlier powers. The present circumstances were not such that could
place pari materia with the earlier grounds and hence exemption could
not be considered.

The Supreme Court noted that Regulation 27 first provides that “No public offer, once made, shall be withdrawn”.
The exceptions to this thus shall be strictly construed. It also held
that the residuary power to grant exemption had to be considered ejusdem
generis the earlier powers. Since such powers conceived of a practical
impossibility of the open offer going further, the residuary power of
SEBI has also to be restricted to those other situations where the there
was similar practical impossibility. It held that the present
circumstances did not have any such practical impossibility. Nirma had
contended that an earlier specific ground that was deleted ought to have
been considered. This deleted ground provided that the open offer could
be withdrawn in case there was a competing bid. However, the Court
rejected this contention too.

The Supreme Court observed as follows:-

“Applying the aforesaid tests, we have no hesitation in accepting the conclusions reached by SAT that clause (b) and (c) referred to circumstances which pertain to a class, category or genus, that the common thread which runs through them is the impossibility in carrying out the public offer. Therefore, the term “such circumstances” in clause (d) would also be restricted to situation which would make it impossible for the acquirer to perform the public offer. The discretion has been left to the Board by the legislature realising that it is impossible to anticipate all the circumstances that may arise making it impossible to complete a public offer. Therefore, certain amount of discretion has been left with the Board to determine as to whether the circumstances fall within the realm of impossibility as visualised under sub- clause (b) and (c). In the present case, we are not satisfied that circumstances are such which would make it impossible for the acquirer to perform the public offer. The possibility that the acquirer would end-up making loses instead of generating a huge profit would not bring the situation within the realm of impossibility.”

Even on the issue whether the facts warranted exemption on generic grounds, if SEBI indeed had such powers, the Supreme Court answered in the negative. The Court held that Nirma’s real reason for seeking withdrawal was for avoiding economic losses. However, such a ground could not be permitted at the cost of the public shareholders. The Court noted that there were several red flags in the Company such as litigations against the Company, etc. and Nirma took the decision to acquire the shares fully conscious of these. Hence, such ground was also rejected.

The other major ground on general legal principles that a fraud vitiated any contract or obligation was also rejected.

The Court also refused to grant downward revision of price nearer to the value had the alleged siphoning off/understatement of liabilities, etc. were taken into account.

Criticism and support of the decision

The decision has been criticised on certain grounds. It was suggested the Court ought to have interpreted the powers of SEBI broadly and not applied the principle of ejusdem generis. Even if this principle was applied, it ought to have taken a broader view and taken into account the deleted ground also. All in all, it should have held that SEBI did have powers to grant withdrawal.

On merits too, criticism was made that the offeror was already subjected to loss on account of having acquired the shares from the promoters through pledge. Forcing the acquirer to suffer further loss was unfair and also resulted in unintended benefit to the public shareholders. The acquirer was victim of fraud and should not have been victimised further.

It is also stated that the law does not permit extensive due diligence by acquirers because of restrictions in Regulations relating to insider trading. In such a situation where an acquirer is handicapped, he should not be forced to carry out an acquisition when later investigation does throw up a fraud that could have been found through earlier due diligence.

It is submitted that while the circumstances were peculiar, the acquirer cannot escape the liability of making an open offer. This was a case where the acquirer acquired control and not merely 3substantial quantity of shares. The directors representing the erstwhile promoters resigned and Independent Directors were appointed. Further, though the acquisition was really in the form of exercise of pledge, it was a conscious act. Though not specified, it appears to me that these shares could have been immediately sold in the market at the then prevailing higher market price. However, the acquirer proceeded to carry out further investigations that revealed the hidden losses.

Further, effectively, the acquirer acquired shares of the erstwhile promoters but did not want to carry out the inevitable next step of acquiring shares of the public. In effect, the promoters did get money through original lending and exercise of pledge. Having acquired the controlling interest, the acquirer could not avoid the open offer that came as a package deal with it.

It is submitted that permitting exemption from making an open offer would have been a bad precedent and opened litigation in future cases where acquirers would come before SEBI on several pretexts seeking exemption and even benefitting from the sheer delay. It would be extremely unfair to allow acquisition of a controlling interest without making the public offer.

One may also recollect that the public shareholders even otherwise suffer from an inequity in takeover of companies. The promoters get to sell all their shares while only 26% (earlier 20%) of the public shareholding is to be acquired under an open offer.

Perhaps what is needed is change in law relating to pledge of shares. It is true that pledges are subject to misuse since an acquisition may be disguised as a pledge. Usually, however, financial lenders are not interested in acquiring control of a company. Thus, there is a case for amending the law to give some relief. For example, an exemption could be granted in cases where pledge is exercised but the shares so acquired are sold by way of auction within a time frame. The acquirer of shares through such sale would be required to make an open offer. If the lender does not sell within the time frame, the lender should be required to make an open offer.

Nirav Shah

Shareholder Agreements — Bombay High Court Decides

Shareholder groups of listed companies and even public companies often face a nagging problem. Many of them enter into agreements giving rights to each other of different kinds over the shares held by them. These may be in the form of restrictive or pre-emptive rights or rights to purchase the shares under certain terms and conditions. The concern that keeps bothering them is whether such rights and terms are valid under law or void or, even worse, whether these are illegal.

A recent decision of the Bombay High Court (MCX Stock Exchange Limited v. SEBI and Others, WP No. 213 of 2011, dated March 14, 2012) partially sets at rest — at least to the extent a High Court decision can — the concern whether an agreement giving certain options to purchase/sell shares is void and illegal being agreements for futures under the provisions of the Securities Contracts (Regulation) Act, 1956 (SCRA). This should help shareholders and investors of various hues who have entered into such contracts with other shareholders and faced the possibility that they may be held illegal/ void. As will be seen later though, a related issue has been kept open and so the question is not yet fully answered. Also, needless to emphasise, the decision is on facts of the case and one would have to see whether the agreements and surrounding circumstances in each case are such that the ratio of the decision may apply.

To elaborate the issue further, before we go into the facts of the case, the SCRA, to simplify a little, was enacted mainly to regulate stock exchanges and trading on it. For this purpose, it was desired that trading in securities should take place only in regulated stock exchanges. Options, futures, etc. being securities were also required to be traded on stock exchanges. To ensure that parties do not carry out private transactions in such securities including by way of options and futures, such private transactions, subject to specified exceptions, were declared illegal and void. Stock exchanges provide a transparent mechanism for carrying out such transactions in securities also giving safety to counter parties and at the same time, other objectives such as control of undue speculation could be achieved. Hence, transactions through such exchanges were intended to be encouraged.

However, the manner in which the relevant provisions were worded resulted even in a very common set of private agreements being put to question. For example, major shareholders — particularly strategic investors — often enter into agreements whereby one or both are given an option to buy or sell the shares under certain circumstances. Such agreements are rarely assignable to third parties, are not standardised and have unique terms and conditions attached, are not generally severable into small units, etc. In other words, they do not resemble the typical options or futures that are traded on stock markets. However, the conservative view — and often endorsed by SEBI — was that such agreements amount to options/futures and hence may be held to be void and illegal.

The other provision that such private agreements fell foul of was the provisions relating to free transferability of shares. While the essence of private limited companies was restricted transferability of shares, public companies (including listed companies) required free transferability of shares. This, inter alia, enabled buyers of shares being freely able to buy shares — on and off the stock exchanges — without worrying about any restrictions the transferor may be facing. It also ensured that even the company was bound to register the transfer of the shares. Such private agreements providing for options, in a sense, created a restriction on the transfer of the shares. The question once again was whether such agreements fell foul of the law providing for free transferability of shares.

Arguably, the regulator and the law-makers had other reasons too to restrict agreements. These reasons went beyond the above purposes of ensuring trading in securities took place on stock exchanges only or to ensure that there is free transferability of shares for benefit of parties. Restrictions helped achieve other objectives such as limits on foreign holding, avoidance of benami holding of shares, etc. The problem was these provisions of SCRA which had other objectives to serve were also used and applied for such purposes. Thus, instead of making specific provisions to deal with specific concerns, they used the widely framed provisions of the SCRA. This thus resulted in bona fide and fairly common private agreements being subjected to the risk of being held illegal and void.

Coming to the Bombay High Court decision, a Company was formed by a Promoter Group for enabling trading in securities, etc. and thus required registration with the Securities and Exchange Board of India. Since a recognised stock exchange serves certain public purposes and it is not in the pubic interest that the ownership of such stock exchange is concentrated, the law provides that a group of persons acting in concert should not hold more than 5% of the share capital of such company. The relevant Regulations are in fair detail and various issues concerning it were the subject-matter of the Court decision. However, since the focus here is on the issue of validity of certain agreements relating to shares between shareholder groups, the other matters dealt with by the Court are not considered here.

It appears that the Promoter Group originally held significantly more than 5% of the share capital of the Company. To ensure that it is in compliance with the law, a complex restructuring scheme was carried out. To simplify the matter to help focus on the issue of law, the restructuring can be explained as follows. The share capital of the Company was reduced under a court-approved scheme and further shares were issued to persons other than the Promoter Group. Further, certain shares held by the Promoter Group were transferred to other parties. The Promoter Group had entered into an agreement with certain parties holding shares in the Company whereby certain shareholders had an option to sell their shares to the Promoter Group under certain terms and conditions.

The issue was whether such an agreement amounted to options/futures and thus illegal and void. The Court analysed the nature and essence of the agreements and also the law on the subject matter. Firstly, it held that the agreements did not amount to contract of futures. Contract of futures necessarily involved agreements where the agreement to purchase/sale was concluded but only the payment and delivery was postponed. In the present case, since there was an option to sell, there was no current concluded transaction of purchase/sale. In fact, the transaction of purchase/ sale may not even arise in the future if the party did not exercise its option. Thus, the Court held there was no agreement of futures. The Court, however, did not deal with the issue whether the agreement amounted to an option, because this was not part of the allegations under the Notice issued to the aggrieved party. The Court asked SEBI, if it desired to raise that issue, to give an opportunity to the aggrieved party first.

Let us consider some extracts from the decision of the Court to consider the matter in context.

The Court described the nature of the agreements between FTIL (the Promoter) and PNB/ILFS (the counter parties) in the following words:

“The buy -back agreements furnish to PNB and IL&FS an option. The option constitutes a privilege, the exercise of which depends upon their unilateral volition. In the case of PNB, the buy-back agreements contemplated a buy-back by FTIL after the expiry of a stipulated period. But, in the event that PNB still asserted that it would continue to hold the shares, despite the buy-back offer, FTIL or its nominees would have no liability for buying back the shares in future. In the case of IL&FS, La -Fin assumed an obligation to offer to purchase either through itself or its nominee the shares which were sold to IL&FS after the expiry of a stipulated period. In both cases, the option to sell rested in the unilateral decision of PNB and IL&FS, as the case may be.”

Does the agreement amount to a contract of future so as to be violative of the law and hence illegal and void? The Court further analysed and observed as follows:

“In a buy-back agreement of the nature involved in the present case, the promisor who makes an offer to buy back shares cannot compel the exercise of the option by the promisee to sell the shares at a future point in time. If the promisee declines to exercise the option, the promissor cannot compel performance. A concluded contract for the sale and purchase of shares comes into existence only when the promisee upon whom an option is conferred, exercises the option to sell the shares. Hence, an option to purchase or repurchase is regarded as being in the nature of a privilege.
…

77. The distinction between an option to purchase or (repurchase and an agreement for sale and purchase simpliciter lies in the fact that the former is by its nature dependent on the discretion of the person who is granted the option, whereas the latter is a reciprocal arrangement imposing obligations and benefits on the promisor and the promisee. The performance of an option cannot be compelled by the person who has granted the option. Contrariwise in the case of an agreement, performance can be elicited at the behest of either of the parties. In the case of an option, a concluded contract for purchase or repurchase arises only if the option is exercised and upon the exercise of the option. Under the notification that has been issued under the SCRA, a contract for the sale or purchase of securities has to be a spot delivery contract or a contract for cash or hand delivery or special delivery. In the present case, the contract for sale or purchase of the securities would fructify only upon the exercise of the option by PNB or, as the case may be, IL&FS in future. If the option were not to be exercised by them, no contract for sale or purchase of securities would come into existence. Moreover, if the option were to be exercised, there is nothing to indicate that the performance of the contract would be by anything other than by a spot delivery, cash or special delivery. Where securities are dealt with by a depository, the transfer of securities by a depository from the account of a beneficial owner to another beneficial owner is within the ambit of spot delivery.”

Finally, it concluded, with the following words, that the agreement was not in the nature of a futures contract:

“80. In the present case, there is no contract for the sale and purchase of shares. A contract for the purchase or sale of the shares would come into being only at a future point of time in the eventuality of the party which is granted an option exercising the option in future. Once such an option is exercised, the contract would be completed only by means of spot delivery or by a mode which is considered lawful. Hence, the basis and foundation of the order which is that there was a forward contract which is unlawful at its inception is lacking in substance.”

The next issue whether the agreements “would amount to an option in securities and, therefore, derivatives which were neither traded nor settled at any recognised stock exchange, nor with the permission of Securities and Exchange Board of India and therefore in violation of SCRA”. The Court noted that this allegation did not form part of the original notice and thus parties were not given an opportunity to reply to SEBI. Thus, SEBI was required to first give such an opportunity and then give its decision and then the question of appeal may arise.

The decision gives relief to parties who have entered into or propose to enter into such agreement at least from the concern that such agreement may amount to a futures agreement. Needless to emphasise, the decision was on facts. The other concern, though, remains open and that is whether such an agreement may amount to an option which is prohibited under law. It will have to be seen what course of action SEBI takes and whether the matter goes back to the Court.

However, it is time that the law-makers and even SEBI take the initiative and resolve the controversy. It does not seem that there can be any objection to such private agreements between two groups of shareholders where most of the elements of standardised over the counter futures/options contracts are absent. Such private agreements should be explicitly exempted and if desired, the specific areas where the law-makers have concern can be duly regulated.

Nirav Shah

US Decision Giving Relief to Satyam Directors – Implications for Independent Directors in India

The recent US Court decision to give relief to Satyam independent directors/audit committee members has raised both – concerns and hopes. Concerns on corporate governance are indeed ineffective in practice and impossible to enforce, as has long been the suspicion. Hopes are that SEBI’s actions against independent directors and others in several recent cases, are perhaps unwarranted or probably even without legislative sanction.

Recently, the independent directors/audit committee members of Satyam Computers Limited were given relief in a class action suit filed against them in USA, for their alleged recklessness (it may be recollected that, as widely reported, in 2009, in settlement of class action claims, Satyam had paid INR7,797 million and the Auditors had paid INR1,591 million). Would the latest decision change SEBI’s approach ? Will independent directors in India be also treated with the same standards by SEBI or will they continue to be punished, as they have been punished in several recent cases, for alleged negligence, connivance, etc.?

First of all, what does the US decision say? It will be beyond the competence of this author to comment on what the scheme of provisions is in the US in this regard nor is it relevant significantly here. But a summary of some aspects apparent on the face of the decision can be made.

The decision is related to many issues, apart from the role of independent directors, such as whether the US courts had jurisdiction if shares of an Indian company was acquired on Indian stock exchanges. However, the relevant issue for discussion here is whether the independent directors (including audit committee members) could be held liable for loss caused to the investors.

The allegations in Satyam may be recollected. The company falsified its records and showed fictitious revenues, profits and assets. Further, it showed fictitious expenditure through which monies were channeled out in group companies. Loans from related parties were shown to have been taken in Satyam to compensate for the cash shortage. Such funds diverted were used in a related party – Maytas – to acquire huge amounts of immovable properties. Such fictitious amounts rose over the years and in a last ditch effort to cure the fraud, it sought to merge the related party into Satyam and show that the fictitious assets were used to acquire immovable properties and that too at an inflated price. Though this alleged fraud was carried out over several years, neither the independent directors, the Audit Committee members, nor the auditors detected or reported it. The question in the US decision was whether independent directors (including audit committee members) could be held liable for the fraud?

It needs to be noted that the US decision was not given on merits – that is — where the facts of the case were examined in great detail and decision given. The decision was on whether the class action could be dismissed on preliminary grounds that the facts, as alleged, were insufficient to determine reasonable scienter or state of mind/knowledge. The standards for this decision were simple. Are the facts – as merely alleged and not even proved – sufficient to reach the standards of scienter or a guilty state of mind, in terms of recklessness, connivance, etc.?

Thus, the plaintiffs were required to have alleged a certain level of facts which, assumed to be wholly true, should show a level of scienter/recklessness on the part of the independent directors. Several facts were alleged. That the fraud was so huge that it could not have escaped scrutiny of such competent people. That the auditors raised certain red flags in the form of certain internal control systems not being followed. That the independent directors approved the Maytas purchase without sufficient scrutiny. That though the auditors were paid huge amount for “other services”, the independent directors did not question this properly and grasp why the auditors were engaged for ‘other services’. That the norms of corporate governance in India required several things to be done by the independent directors/audit committee members who failed in performing. And so on.

The Court found that these alleged facts were not sufficient to establish scienter/recklessness. Hence, the class action was dismissed. More specifically, it was even observed that the independent directors were more likely the victims of a sophisticated fraud themselves rather than its perpetrators. The Court observed, “The majority of the allegations in the FACC concern an intricate and well-concealed fraud perpetrated by a very small group of insiders and only reinforce the inference that the AC Defendants were themselves victims of the fraud. The strength of this competing inference outweighs the inference of scienter asserted by lead plaintiffs.”

The Court dismissed the case, stating as follows:-

“Having considered the FACC in its entirety, the Court finds that lead plaintiffs have failed to plead sufficient facts to raise a strong inference of recklessness on the part of the AC Defendants that is at least as compelling as the non-fraudulent inference reasonably drawn from the allegations.”

There are some important points to note here. Firstly, this was a private action for damages, and not an action by a regulator against persons having certain statutory obligations. Secondly, certain actions were already taken against the company and its auditors and settlement for compensation was made. Arguably, the provisions of law and standards of proof required for fraud/negligence/recklessness, etc. are different in the US as compared to India, even though some of the obligations of the independent directors in the Satyam case were traced to Indian laws. Further, what are the obligations of persons under US law and how are they deemed to be contravened are also different. The specific allegations made in the class action is also to be seen in this context.

Nevertheless, it makes a difference that the actions/ omissions of the independent directors were held as not to constitute recklessness/scienter and it has some relevance in general times in India too. This is because, unless it is alleged and found that the independent directors did not comply with specific obligations under law, the issue before the Indian regulator would be similar – and that is, did the independent directors do their duties correctly? Interestingly, to the best of the author’s knowledge, there are no findings made as of today for any of such independent directors in the Satyam case. And it would be interesting to see whether what finding SEBI makes against the same independent directors who are given relief by the US Court.

However, it is also noteworthy for comparable or even lesser levels of manipulations in several cases, SEBI has taken stringent actions against independent directors, members of audit committee, CFOs, etc. For example, in several cases (Bharatiya Global Infomedia Limited, Pyramid Saimira, Tijaria Polypipes Limited, etc. as also discussed earlier in this column), independent directors and audit committee members (and even CFOs/CSs) have been strongly acted against by SEBI. The question that will be relevant is whether such actions were correct in context of the US decision. Or whether, in India, even the Satyam independent directors would be held liable.

On balance, this author submits that the US decision should be taken in its context and will result in change in India’s approach

Having said that, there are some basic wrong things that exist in the Indian framework for corporate governance. Firstly, and perhaps most importantly, they are contained in Clause 49 of the listing agreement, which is not a law, but an agreement. Moreover, it is an agreement between the stock exchange and the company. Of course, recently, violation of the listing agreement has been made punishable. However, still, it is a legally bad place to be for a provision that is meant to have such significance.

Secondly, while a significant level of obligations are laid down on independent directors in Clause 49, their rights are fairly marginal and difficult to enforce, particularly when one compares the powers of auditors under the Companies Act, 1956. Often, the only recourse left for an independent directors is to resign or otherwise report what he has already found to be objectionable.

Thirdly, this weak basis of law making causes problems even for SEBI. It really does not have any specific powers – as it has for various other ills – for taking action against errant companies, independent directors, etc. Thus, it uses its generic powers – which are meant to be used in exceptional cases – and debars them. While it is true that SEBI as an expert body needs certain wide and discretionary powers to take action in the face of newer and innovative types of market manipulations, corporate governance is fairly old now for resorting to such actions.

Finally, the scheme of law leaves the investors uncompensated. Whether it is Satyam, Pyramid or other cases, it was the investors who were left stranded with their shares devalued, as they assumed that SEBI had put in an effective system of corporate governance, where there are responsible persons to carry out the safeguards. The weak basis of law which, at best, punishes the independent directors by debarring them, does not help the investors recover their losses.

There is another dimension too. The general principles and even the concept of corporate governance are borrowed from the West where the management is with executives whose total holdings is usually in single digits. In comparison, in India, companies are promoter controlled, usually families and who often hold 35-50% and even more of the company. The concept of independent directors, etc. are relevant where shareholders holding 90% can appoint such people to safeguard their interests. While in India, if such concepts are blindly introduced for similar purposes, they would be – and indeed they are often – defeated by promoters, having full power to appoint people who are favourably disposed to them and the inherent power to remove them.

In the end, it seems that a transparent, effective, and comprehensive scheme of law governing corporate governance relevant to Indian realities, is needed. In this context, then, it is sad that neither the concept paper on corporate governance recently issued by SEBI nor the Companies Bill 2011 addresses these fundamental issues. The result then is likely to be a false sense of security, which would often be taken away by scams and which would be acted against by SEBI using its discretionary and arbitrary powers.

Nirav Shah

Relief for Shareholders Agreements – SEBI Notifies Long-overdue Relaxations

SEBI finally resolves an age-old self-created problem SEBI has finally set at rest, substantially though not fully, a controversy that affected for decades some core issues in Shareholders Agreements and related agreements/structures. An age old provision in the form of a circular existed that was meant to prevent certain ills but ended up affecting innumerable agreements between two or more groups of shareholders and others. A brief introduction of the issue is first necessary to understand what the problem was and what SEBI has now provided.

What was the problem?

Take an example of a situation where such a provision created hurdles. When two or more groups get together in a company, to control and run it together, it is common and even inevitable that they will agree that one group will not exit without the other having a say. Thus, if Group A wants to sell its shares, Group B would want certain safeguards/rights. It would require Group A to give what is known was Right of First Refusal. This means that if Group A is getting an offer to acquire its shares at say, Rs. X per share, then Group B would have right to buy the shares at the same price. In other words, it has a right of pre-emption. Of course, Group B could choose not to buy and let the shares be sold to the offering party. At times, they may agree that on completion of certain conditions, one group (or a third party, say an executive) would have a right to acquire a certain number of shares. One could go on with more such examples but, in essence, rights are given over to one person to acquire another person’s shares in the future. Similar rights could be given to a person to sell its shares.

The law makers had a certain concern on an entirely unrelated issue. Considering the evils of unregulated trading in shares (including what is known as dabba trading in common parlance) it was decided that trading in securities otherwise than on regulated and recognized stock exchanges should not be permitted. Thus, trading – or even contracting to buy/sell – securities except on a recognised stock exchange was made null and void. Thus, such a contract was not enforceable. The only real exception (apart from certain territorial exceptions) to was “spot transactions”. This covered a contract of purchase and sale of securities where the delivery/payment was spot – which was effectively defined to be that the delivery of shares and payment was to be made within one day of the contract.

The law as so framed ensured that forward/futures/ options trading in securities could not be carried out without being regulated. However, a simple transaction of private sale and purchase of shares and other securities on ready payment/delivery basis was exempted.

The wording of this law, however, had a peculiar consequence. It meant that no contract of sale/ purchase of securities could be entered into unless it fell into the very narrow exempted category. For most practical purposes, one could not enter into a valid agreement to buy/sell shares in the future. Or enter into an agreement where involving postponement of the payment of consideration and/or delivery of the securities beyond one day. As joint ventures, private equity, co-promoted companies, etc. became increasingly common, this became a serious concern. Parties entering into such agreements could not bind each other with such basic commercial safeguards. This was despite the fact that almost all of such agreements could not even remotely affect public interest, being entered into by informed parties on a negotiated basis without any intention of trading.

In practice, this problem was dealt with parties by often being in denial or half-baked structuring or even sheer ignorance. Some legal counsels even opined that, structured in a particular way, the notification did not apply to private agreements. The reality, however, was that even in the most optimistic scenario, often, there was concern that, if put to test, many of such clauses in agreements may not be held valid. Thus, what was referred to euphemistically as a “calculated risk” was taken. The fact that Supreme Court, other courts and SEBI held many of such agreements to be unenforceable worsened matters (the various decisions and their legal basis can be subject for a separate detailed article).

The matter became more complicated when this issue spilled over to other laws including laws regulating foreign exchange.

SEBI’s recent circular gives relief – with some conditions

Finally, on 3rd October 2013, SEBI issued a circular withdrawing the earlier notification and allowing parties to enter into agreements for purchase/sale of shares, though with certain conditions which are fairly reasonable. Let us consider which of such contracts are exempted and under what conditions.

The first two exemptions are as expected and continuing ones. “Spot Delivery Contracts” are exempted. Purchase or sale of securities/derivatives on stock exchanges in accordance with law and bye-laws, etc. of such exchanges are also exempted.

Next exempted category is “contracts for preemption including right of first refusal, or tag-along or drag- along rights contained in shareholders agreements or articles of association of companies or other body corporate”. Thus, all contracts of pre-emption are exempted, including the specified ones such as right of first refusal, etc. These may be contained in the agreements between shareholders and/or incorporated in the articles of association of the company.

Then come certain “options” in agreements between shareholders (or contained in the articles of association). Such options provide a right to one person to buy or sell shares. On exercise of such options, the actual purchase/sale of shares is effected. Such agreements are also exempted, subject, however, to certain conditions. Firstly, the securities underlying such options should have been held continuously for at least one year by the selling party. This is effectively a lock-in period. Secondly, the price/consideration for such purchase/sale of shares should be in compliance with prevailing laws. Finally, the contract, i.e., the purchase/sale is settled by actual delivery of the underlying securities.

The circular makes it clear that the contracts will continue to have to adhere to FEMA and Regulations/Rules issued thereunder. FEMA has other policy considerations and hence such agreements particularly with parties across the border would require such compliance.

Will the relaxations apply to existing agreements?

An interesting provision is made for agreements for purchase/sale of shares existing on the date of this circular. It is clarified that this circular shall neither affect nor validate agreements existing immediately prior to the date of the circular. In other words, all such existing agreements shall continue to be subject to the earlier law. Only those contracts having such clauses and which are entered into on or after the date of this circular would benefit from the relaxations made in it, subject of course complying with the conditions stated therein.

There have been views expressed that parties could merely re-execute such contracts as of a date after the date of such circular. This sounds like a fairly simple solution to the thousands of agreements existing as on such date, though one wonders whether it is simplistic too. The practical hurdle is whether all the parties concerned would readily agree to re-execute such past agreements. In practice, often relations may have soured between the parties who may want to re-negotiate certain terms of the agreement if it has to be re-executed. Obviously, though the party entitled to the rights may be keen, the party who is subject to the obligations may not readily agree. Then there is a commercial reality that was often observed in practice. Many parties entered into some version of such agreements knowing quite well that they are likely to be unenforceable. Hence, they considered the likelihood of being required to act upon it fairly remote and considered that if at all such transactions were to be executed, the parties could consider the offered terms and generally the reality at that time. The party entitled to the rights too may not have really believed that it would actually get them. Clearly, these parties never intended such agreements to have unqualified binding force and they may not agree to re-execute them to give them such force. Thus, the parties would want to re-negotiate the contract instead of merely printing out a copy and re-executing the same today.

Applicability to other laws for certain contracts

The circular also clarifies that as far as government securities, gold related securities, money market securities, contracts in currency derivatives, interest rate derivatives and ready forward contracts in debt securities entered into on the stock exchange are concerned, they shall be in accordance with various specified laws such as securities laws, banking laws, FEMA, etc.

Anomalous provision in Companies Act, 2013

In this context, it is necessary to discuss a strange provision in the recently notified Companies Act, 2013. Section 194, which incidentally has been notified as to have come into effect, prohibits certain contracts by directors/key managerial persons of companies. The specified contracts are rights (or a right exercisable at option of such person) to call for delivery or make delivery of a specified quantity of shares/debentures, at a specified price and within a specified time. It appears that the intention is to prohibit contracts of futures/options. While this is consistent with the existing provisions under the SEBI Regulations relating to prohibition of insider trading, this provision is too widely worded. The SEBI Regulations are intended to prohibit directors/officers/designated employees from entering into derivatives transactions of their companies. However, the scope of section 194 is very broad. It is a blanket ban on all agreements giving any right or option to acquire/sell shares. Further, the section applies to all companies – listed, unlisted or even private. It does not even give exemption to employees’ stock options. Thus, despite the relaxation by the circular, this ill-advised provision in the Act can present problems. On the other hand, it applies only to directors/key managerial persons and not others including other promoters or promoter companies.

Curiously, the Explanation to this section seems to modify its scope. Firstly, it states that it would apply to those shares/debentures where the concerned person is a whole -time director and not merely a director. Secondly, the shares/debentures may be of the employer company or its holding company or its subsidiary. Even more curiously, the initial part of the section refers also to “associate” companies. Further, the ban in the section is on “buying” such rights and one thus wonders whether such rights granted to employees or otherwise forming part of contracts are also covered. The section is an example of bad drafting. To summarise, however, this provision will create hurdles in case of whole-time directors/key management persons in entering into agreements to buy/sell shares in the future or acquire options for such buy/sell of shares.

To conclude, SEBI has finally provided relaxation to genuine contracts between parties that faced the possibility of being treated as impermissible under SEBI regulations though they did not affect public interest.

Nirav Shah

Rewriting and Revising Securities Laws – Highlights of some recent amendments

This series of articles introducing securities laws for listed companies to the lay reader continues …

1) SEBI has been busy in recent times and several revisions/amendments have been made, some of which are highlighted here.

2) SEBI rewrites and replaces the DIP Guidelines 2000 with ICDR Regulations 2009

a. While not comparable to the Direct Taxes Code which seeks to rewrite the direct taxes laws into what is hoped to be an easy to understand law, SEBI too has undertaken a comparable exercise and has replaced the almost one-decade old DIP Guidelines with a re-written (though not overhauled) Regulations – the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 or ‘the Regulations’.

b. Readers may recollect that the DIP Guidelines mainly regulate issue of securities to the public, shareholders and others. They regulate initial pubic offers, rights issues, preferential issues, etc. They provide for very detailed provisions which border on micro-regulation of every aspect of the process of such issues. These Guidelines are very frequently amended. For listed companies, their promoters and merchant bankers, these guidelines are literally like a Bible which they need to keep handy for regular reference.

c. As can be expected, frequent changes have made the Guidelines unwieldy and complex. Further, when one writes a set of clauses, one may have a central theme in mind. However, as new clauses and provisos and explanations are inserted and amended, the new set of clauses represent neither the original harmo-nious theme nor a new one but represent a hotch potch of ideas.

d. Another aspect of these Guidelines was that they were not, in my opinion and also as held in decisions, law in the strictest sense of the word. These guidelines were obviously not Parliament-made law nor could they be compared to Regulations and Rules which the Act provides for and which are also laid before Parliament later. Rather, they represented the provisions made by SEBI from time to time. While there is nothing wrong in SEBI prescribing such Guidelines – indeed this manner is inevitable and required in dealing with the dynamics of the capital market, a question often arises as to what their legal status is and what could be the penal consequences of their violations.

e. Thus, the replacement of the Guidelines with Regulations at least removes this concern over their legal status. Incidentally, though, the SEBI Act will now need to be amended to provide for specific punishment for violation of these Regulations since otherwise, the violation of these newly notified Regulations will fall under the residuary provisions and this mayor may not achieve the object that SEBI may have in mind. In fact, it may make sense if different provisions of these new Regulations are treated differently and thus separate punishment is provided for violations having differing intensity or seriousness. However, that would require a Bill to amend the SEBI Act itself.

f. In any case, to reiterate, the Guidelines are now replaced by Regulations whose violations can be punished with significant penalty and/or prosecution.

g. While it would be a mammoth exercise to compare the old Guidelines and the new Regulations and even to highlight the changes, suffice it to say that the intention has not been to completely rehaul the provisions. Future articles here may highlight some interesting implications particularly arising out of change in wording.

h. Further, the Regulations represent the DIP Guidelines rewritten but in most cases without any intention of changing the law. However, how well this intention of keeping the substantive law intact will be successful will be shown by time and experience in varying situation since the wording would often show up differently when one tries to apply and interpret them.

i. On first appearances, the substantive provisions and clauses have been trimmed and made more compact. However, part of the reason for the substantive clauses appearing more compact is also because the Regulations are now divided into substantive clauses and drafts of various precedents, forms, agreements, etc.

j. Consequential changes have been made in the SEBI ESOPs Guidelines and the Listing Agreement.

3) Ban on issue of shares with superior voting rights:

a. SEBI has issued a circular dated July 21, 2009, to make amendments to prohibit issue of shares with superior voting rights by listed companies. Earlier to this, SEBI had a Press Release announcing the decision to make such changes. Incidentally, the actual amendment covers all superior rights as to voting as well as dividends. The original decision as per the Press Release read that “No listed company can issue shares with superior voting rights.”.

b. The amendment is by way of insertion of a new clause 28A to the Listing Agreement. The amendment is to come into immediate effect though because of the peculiar status of Listing Agreement, one will also have to wait for amendment of the Listing Agreement by the respective stock exchanges.

4) The new clause is brief and is reproduced for ready reference:

“28A. The company agrees that it shall not issue shares in any manner which may confer on any person, superior rights as to voting or dividend vis-a-vis the rights on equity shares that are already listed.”

5) The following are some quick comments and concerns :

a) The prohibition is on issue of shares with ‘superior’ rights and not on ‘inferior’ rights.

b) A corollary from the earlier point, if a company issues shares with ‘inferior’ rights, those shares will then become the new benchmark. If one takes this further logically, then, thereafter, even ‘normal’ equity shares cannot be issued since these normal shares would have ‘superior’ rights as compared to the existing shares with ‘inferior rights’ assuming such latter shares are also listed !

c) Can the amendment affect issue of preference shares which have priority of dividends and at times even rights of sharing further dividends? Or can one say that the intention is to cover issue of equity shares only since the comparison is made to existing equity shares?

d) To bring the change into effect, the Listing Agreement is amended. This is curious. One would have thought the SEBIDIP Guidelines/ ICDR Regulations could have been a better place.

e) Would special rights given to certain investors/ promoters under the Articles of Association such as veto rights, special rights, etc. be deemed to be ‘superior rights as to voting’ ? Can it be said that the ban applies only where the superior rights are given to the ‘shares’ and not to the ‘persons’ holding such shares?

6) SEBI issues circular to formalise clarifications on 5% additional creeping acquisition

a) It may be recollected that late last year, SEBI had amended the Takeover Regulations to provide for a creeping acquisition window between 55-75%. These amendments permitted acquisition of further shares upto 5% for persons who held shares between 55-75%. A circular has been issued recently to clarify on some of the concerns expressed.

b) The circular is fairly self explanatory. A few quick comments though.

i) The clarifying circular is issued under Regulation 5 which permits SEBI to, inter alia, issue directions to remove difficulties in interpretation. S. 11 of SEBI Act is also relied on.

ii) It is seen that some of the interpretations so given go clearly beyond the plain wording and meaning. It is possible that in the future, a legal issue may come up whether such ‘clarification’ can go beyond the express and unambiguous wording of the Regulations.

iii) It is clarified that the 5% acquisition may be made in one or more tranches and also without any time limit.

iv) For calculating the 5% acquisitions, sales cannot be netted off. Thus, only gross purchases would be counted. For example, the acquirer cannot purchase 4%, then sell 3% and then acquire another 4% and claim that the net purchases are within the 5% limit.

v) The cumulative holding of the acquirer cannot exceed 75%. Thus, a person holding, say, 73% can acquire only a further 2%.

vi) The cumulative holding limit of 75% is irrespective of the minimum public share-holding that is required to be maintained under the Listing Agreement. Thus, e.g., in respect of a company having a 10% minimum public shareholding, the upper limit for this Regulation will still be 75% and not 90%.

7) SEBI clarifies on Insider Trading Regulations amendments of November 2008.

a) SEBI had amended the Insider Trading Regulations 1992 vide a Notification dated November 19, 2008. SEBI has now released a set of ‘Clarifications’ on 24th July 2009 on certain issues arising out of the amendments made.

b) Curiously, the ‘clarifications’ have no formal standing or reference. It is neither a circular, nor a notification, nor even a press release. It is neither signed nor dated. But it seeks to ‘clarify’ and give meaning to the Regulations that have legal standing and where such ‘meaning’ is quite contrary – as we will see to the plain reading of the text. Having said that, the ‘clarifications’ mostly relax the requirements and hence, being gift horses, one should not examine them in the mouth too closely!

C) Let us consider the clarifications given.

i. lt may be recollected that specified persons were banned from carrying out opposite transactions’ (banned transactions’) for six months of original buy/sale (‘original transactions’). The question was whether acquisition of shares under ESOP scheme and sale of such shares would be considered as transactions that trigger off such ban and whether these themselves are banned. It is clarified that exercise of ESOPs will neither be deemed to be ‘original transaction’ nor ‘banned transaction’. Thus, by acquiring shares under ESOPs, you don’t trigger a ban and if you are banned for six months, you can still exercise ESOPs. The reasoning given is that the ban is only on transactions in secondary market.

ii. Sale of shares acquired through ESOPs is covered but it will only be deemed to be an ‘original transaction’ and not a ‘banned transaction’. In other words, even if you are under a ban, you can still sell shares acquired under ESOPs but once you sell such shares, you have triggered a ban of six months. On this aspect, I do not understand the basis of clarifying that the sale of shares acquired under ESOPs scheme will not be an ‘original transaction’ – the logic of covering secondary market transactions should apply here also.

iii. Then, it is clarified that every later transaction triggers a fresh six month ban. A purchase on 1st February results in ban till 1st August. However, if there is a fresh purchase on 15th March, there is a ban now till 15th September. Effectively, this means that the ban period is from 2nd February till 15th September.

iv. What about transactions before this amendment – will the amendment create ban in respect of them too – this is an academic issue now at least as the six month period is now complete. It is clarified though that the transactions before the amendment are not to be considered. On a similar note, unwinding of positions in derivatives held on the date of this amendment is possible.

v. A crucial clarification is that the ban on ‘sale’ of shares for personal emergencies is permissible by waiver by the Compliance Officer. This is not evident from a plain reading of the provision. But SEBI thinks it is so evident and hence let us accept this gift without creating legal niceties! Note that this clarification applies only to sales and there can be no purchases within these six month ban period – obviously there cannot be any personal emergency to purchase shares !

vi. It is also clarified that tile ban on derivatives does not apply to NIFTY/SENSEX futures.

Nirav Shah

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