INDIAN CORPORATE LAW: SEBI’s Capital Market Reforms
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Tuesday, August 21, 2012
Thursday, August 19, 2010
A DISCUSSION ON SEBI TAKEOVER ADVISORY COMMITTEE (TRAC) REPORT
This discussion paper on the proposed Takeover Regulation by the Takeover Regulation Advisory Committee (TRAC) is an analysis of the TRAC Report mainly from the perspective of practicability of the proposals and unintended gaps or anomalies which needs to be either filled up or removed.
Equity Linked Instruments
The proposal to make an offer for acquiring all the shares held by other shareholders, in other words, 100% public offer, will bring about certain unintended situations in the takeover process. These aspects need to be addressed appropriately in order to make takeover provisions equitable for all stakeholders. The areas which need attention pertain to Employee Stock Option Scheme and Depository Receipts issued by the Indian companies to raise funds abroad. Both are convertible instruments.
For the holders of convertible instruments, the second proviso to the proposed Regulation 7(4) requires the company and the acquirer to take necessary steps to facilitate the conversion of these instruments into equity shares within 12 months from the fifteenth business day from the date on which the shares are delisted from the stock exchanges. This provision, providing for the conversion during the exit window, appears to be restrictive for the employees holding options under the employee stock option scheme (ESOS) of their employers. These options are normally long term instruments extending beyond one year.
The intent behind offering options under ESOS is to get the long term commitment of employees towards the company. The benefits of options granted under ESOS that occur to the employees as well as to the company are likely to be defeated since there will either be a forced conversion on an accelerated basis or the options become worthless. Further, if employees are forced to exercise the options prior to the vesting period, they may not realize the valuation benefits which they would have otherwise had, had the options granted vested in them according to the vesting period under the ESOS.
In addition, acceptance of the proposed recommendation would certainly require harmonization of the existing SEBI (ESOS and ESPS) Guidelines, 1999 since these Guidelines does not have the provision for accelerated exercise. Further, accelerated conversion is not an equitable solution to either the ESOS holders or the company. However, using the option pricing mechanism it may be possible to price such instruments in a manner of keeping some inherent valuation in case the company goes for delisting on account of open offer in case of equity shares of those companies on which derivative instruments are available.
Further, the Committee has viewed that the holders of the equity-linked instruments convertible into equity shares can tender the same prior to the expected closure date of the tendering period. However, practically it may be difficult to tender them due to various listing formalities to be completed for these equity shares to become tradable on the exchange platform and fit for acquisition in an open offer.
Depository Receipts
The impact of the proviso to the proposed Regulation 7(1) pertaining to depository receipts (DR) requires a thorough analysis. There are two main aspects which need consideration. The first point is the right of the DR holders to exercise their voting rights. The second issue relates to the impact of new proposal on the attractiveness of Indian companies’ depository receipts.
The intention behind the proviso to the proposed Regulation 7(1) is not clear since all equity shares underlying DR have voting rights. The only difference is that in majority of the cases the foreign custodian issuing the DRs retains the voting rights on the underlying shares which they normally exercise as per the directive of the management of the company. In very few cases, the DR holders are directly entitled to vote on the basis of the underlying shares. However, irrespective of the case, the equity shares underlying DRs are not counted towards the public shareholding. (SEBI has brought out some change in this respect subsequent to the publication of the Report). The proviso as drafted appears to imply that a big group of shareholders holding the equity shares through DR mechanism will be left out of the open offer mechanism because the voting rights may be retained with the management of the company. As per the proposal, DRs which do not entitle the holder to exercise voting rights will be excluded from the open offer. What happens if after the public announcement, DRs get converted into equity shares as this will increase the available number of equity shares while the open offer will be for a lesser quantity?
Further, DR holders will be left with illiquid instruments if the target company de-lists its equity shares. And, of course, this may not be the intention behind the proposed proviso. The only option available to such DR holders is to convert the DRs into underlying shares and exit the company immediately after the public announcement if the acquirer indicates intention to de-list its equity shares. Such an exit will have an adverse impact on the market price of the equity shares of the company during such a critical phase.
This whole scenario will prevent any prospective buyer of the DR of a company to plan their investment horizon as they may be forced to unwind their positions due to open offer. The adverse impact of the proposed regulation on the overall attractiveness of the DR of Indian companies will have a cascading adverse impact on the capital markets in particular and Indian economy in general. This is likely to impede the ability of Indian companies to raise funds from foreign markets.
In addition, the proposed Regulation 3 excludes acquisition or ownership of DRs towards calculating the acquisition threshold of twenty five percent can lead to a situation where an acquirer and Persons Acting in Concert (PAC) may acquire more than twenty five percent voting rights in a company without being forced to bring an open offer. This may happen where an acquirer acquires less than twenty five percent of the voting rights in India and PAC acquires the outstanding DRs. The two acquisitions put together may increase their total holding much beyond the threshold trigger for open offer. However, they will not be forced to bring out an open offer immediately. They may wait for an opportune time for converting DRs into underlying equity shares and bring the open offer.
Delisting
On the practical side, the delisting related provision is unlikely to get triggered unless the acquirer has the intention to delist. An acquirer who does not want to delist will prefer not to state upfront the intention to delist. In such a scenario, even if the response to the open offer is good and delisting threshold is breached, it will never happen that all the shareholders tender their shares. Thus, taking advantage of the proposed provision of Regulation 7(5), the acquirer will either reduce proportionately the number of shares to be acquired or bring-down the non-public shareholding as per listing agreement. The objection is what is the point in having a provision which is likely to only act as a show piece provision? Any acquirer who wants to delist will be in a better position to use the SEBI (Delisting of Equity Shares) Regulations, 2009 for the purpose.
Pricing
Regulation 8(8) proposes to allow the acquirer a decide on a lower price than the price arrived at as per the provisions of Regulation 8 in case the acceptance level is below the earlier indicated minimum level of acceptance. One, the methodology for calculating the new lower price has not been provided. Second, changing the open offer price subsequently does not appear to be equitable. Shareholders will suddenly come to know at the end of the tendering period that they will get a price lower than the price arrived at on the basis of the accepted method of pricing. In other words, would shareholders not suffer a double-whammy – once when they are kept in the dark about differential pricing and next when they bear the impact of getting the price lower than their expectation and what had been declared earlier by the company while making the open offer?
Further, if the open offer is subject to a minimum level of acceptance and in the open offer the acceptance level is below the identified minimum level then the question of accepting the lower quantity does not arise as the whole purpose and intent behind bringing out the open offer gets defeated.
Funding estimate
The proposal has multiple provisions which constrain the acquirer in making an estimate of the funds needed to support the open offer.
One such situation relates to Voluntary offers. Voluntary offers allow for competing offers to be made and in such a situation the offer size can be increased to normal full-sized offer. If the existing promoters want to continue to retain their control of the company they shall be ready to increase their offer size to the full. This means in the beginning itself all such voluntary offers have to evaluate the possibility of arranging, and be ready with, the finance in case they need to enhance the offer size. This will have some unintended consequences like increase in the cost of acquisition and a limited use of this provision to consolidate the shareholding.
Another such provision is the first proviso to Regulation 9(1) giving an option to each shareholder to decide the way it wants to be compensated. This will bring in unintended procedural complications in the whole takeover process.
Further, proposed Regulation 9(3) and 9(5) will further create uncertainty on the funding requirements for an acquirer. In case of one type of security, the valuation is fixed and, on the other hand, Regulation 9(3) allows for differential pricing thereby providing opportunity to influence the market price of such security.
Exemptions
Exemptions available from the applicability of the regulations are of two types. One, automatic exemptions which do not require approval or confirmation from SEBI. Second set of exemptions are those which require prior approval of SEBI. Currently, SEBI seeks the opinion of the Takeover Panel for all exemptions falling under category two. It is proposed to give discretion to SEBI to decide which of the requests falling with category two shall be forwarded to Takeover Panel for their approval. In order to maintain uniformity in the decision making process and to make it independent of individual’s interpretation, it would have been appropriate to continue to maintain the existing procedure for referring all such cases to the Takeover Panel.
Other Provisions
Certain proposals like removal of the upper holding limit in case of creeping acquisition and reduction in the minimum offer size for voluntary open offers appear to lean towards the existing management of the company. While the provision providing for exception from the compliance requirement on the board constitution as per the listing agreement (Proviso to Regulation 9(2) (d)) needs further analysis. Provision like proposed Regulation 3(3) will prevent the promoters to change the PAC composition to suite their changing needs. The proposal to make an open offer for acquiring all the shares of the target company held by other shareholders will definitely create financing constraints on the acquirers and is either likely to dampen the M&A activity or enhance the involvement of foreign entities.
Further, acceptance of the proposed regulation will require harmonizing various other SEBI regulations in particular those pertaining to SEBI (Delisting of Equity Shares) Regulations 2009, and SEBI (ESOS and ESPS) Guidelines, 1999.
Further, the current phenomenon of diluting either 10% or 25% of the post listing equity of a company will also ensure that the proposal of the TRAC to raise the trigger for open offer requirement to 25% from 15% will be beneficial for the existing management since companies listing with 10% or 25% public holding requirement will not have to worry about hostile takeover.
Overall, maintenance of continuity in the regulatory framework is of paramount importance in any jurisdiction. Implementing a totally new set of code will leave behind the jurisprudence developed on this aspect during the last ten years. If the new code is accepted it will have to go through its refinement and amendments to meet the practicalities of the situation. This will create substantial uncertainties for the market participants. Another approach which could have been developed was to list the main areas of concern in the existing regulations. Each area of concern could have been deliberated and incorporated in the existing regulations. This would have maintained continuity both for the participants as well as for the jurisprudence.
Equity Linked Instruments
The proposal to make an offer for acquiring all the shares held by other shareholders, in other words, 100% public offer, will bring about certain unintended situations in the takeover process. These aspects need to be addressed appropriately in order to make takeover provisions equitable for all stakeholders. The areas which need attention pertain to Employee Stock Option Scheme and Depository Receipts issued by the Indian companies to raise funds abroad. Both are convertible instruments.
For the holders of convertible instruments, the second proviso to the proposed Regulation 7(4) requires the company and the acquirer to take necessary steps to facilitate the conversion of these instruments into equity shares within 12 months from the fifteenth business day from the date on which the shares are delisted from the stock exchanges. This provision, providing for the conversion during the exit window, appears to be restrictive for the employees holding options under the employee stock option scheme (ESOS) of their employers. These options are normally long term instruments extending beyond one year.
The intent behind offering options under ESOS is to get the long term commitment of employees towards the company. The benefits of options granted under ESOS that occur to the employees as well as to the company are likely to be defeated since there will either be a forced conversion on an accelerated basis or the options become worthless. Further, if employees are forced to exercise the options prior to the vesting period, they may not realize the valuation benefits which they would have otherwise had, had the options granted vested in them according to the vesting period under the ESOS.
In addition, acceptance of the proposed recommendation would certainly require harmonization of the existing SEBI (ESOS and ESPS) Guidelines, 1999 since these Guidelines does not have the provision for accelerated exercise. Further, accelerated conversion is not an equitable solution to either the ESOS holders or the company. However, using the option pricing mechanism it may be possible to price such instruments in a manner of keeping some inherent valuation in case the company goes for delisting on account of open offer in case of equity shares of those companies on which derivative instruments are available.
Further, the Committee has viewed that the holders of the equity-linked instruments convertible into equity shares can tender the same prior to the expected closure date of the tendering period. However, practically it may be difficult to tender them due to various listing formalities to be completed for these equity shares to become tradable on the exchange platform and fit for acquisition in an open offer.
Depository Receipts
The impact of the proviso to the proposed Regulation 7(1) pertaining to depository receipts (DR) requires a thorough analysis. There are two main aspects which need consideration. The first point is the right of the DR holders to exercise their voting rights. The second issue relates to the impact of new proposal on the attractiveness of Indian companies’ depository receipts.
The intention behind the proviso to the proposed Regulation 7(1) is not clear since all equity shares underlying DR have voting rights. The only difference is that in majority of the cases the foreign custodian issuing the DRs retains the voting rights on the underlying shares which they normally exercise as per the directive of the management of the company. In very few cases, the DR holders are directly entitled to vote on the basis of the underlying shares. However, irrespective of the case, the equity shares underlying DRs are not counted towards the public shareholding. (SEBI has brought out some change in this respect subsequent to the publication of the Report). The proviso as drafted appears to imply that a big group of shareholders holding the equity shares through DR mechanism will be left out of the open offer mechanism because the voting rights may be retained with the management of the company. As per the proposal, DRs which do not entitle the holder to exercise voting rights will be excluded from the open offer. What happens if after the public announcement, DRs get converted into equity shares as this will increase the available number of equity shares while the open offer will be for a lesser quantity?
Further, DR holders will be left with illiquid instruments if the target company de-lists its equity shares. And, of course, this may not be the intention behind the proposed proviso. The only option available to such DR holders is to convert the DRs into underlying shares and exit the company immediately after the public announcement if the acquirer indicates intention to de-list its equity shares. Such an exit will have an adverse impact on the market price of the equity shares of the company during such a critical phase.
This whole scenario will prevent any prospective buyer of the DR of a company to plan their investment horizon as they may be forced to unwind their positions due to open offer. The adverse impact of the proposed regulation on the overall attractiveness of the DR of Indian companies will have a cascading adverse impact on the capital markets in particular and Indian economy in general. This is likely to impede the ability of Indian companies to raise funds from foreign markets.
In addition, the proposed Regulation 3 excludes acquisition or ownership of DRs towards calculating the acquisition threshold of twenty five percent can lead to a situation where an acquirer and Persons Acting in Concert (PAC) may acquire more than twenty five percent voting rights in a company without being forced to bring an open offer. This may happen where an acquirer acquires less than twenty five percent of the voting rights in India and PAC acquires the outstanding DRs. The two acquisitions put together may increase their total holding much beyond the threshold trigger for open offer. However, they will not be forced to bring out an open offer immediately. They may wait for an opportune time for converting DRs into underlying equity shares and bring the open offer.
Delisting
On the practical side, the delisting related provision is unlikely to get triggered unless the acquirer has the intention to delist. An acquirer who does not want to delist will prefer not to state upfront the intention to delist. In such a scenario, even if the response to the open offer is good and delisting threshold is breached, it will never happen that all the shareholders tender their shares. Thus, taking advantage of the proposed provision of Regulation 7(5), the acquirer will either reduce proportionately the number of shares to be acquired or bring-down the non-public shareholding as per listing agreement. The objection is what is the point in having a provision which is likely to only act as a show piece provision? Any acquirer who wants to delist will be in a better position to use the SEBI (Delisting of Equity Shares) Regulations, 2009 for the purpose.
Pricing
Regulation 8(8) proposes to allow the acquirer a decide on a lower price than the price arrived at as per the provisions of Regulation 8 in case the acceptance level is below the earlier indicated minimum level of acceptance. One, the methodology for calculating the new lower price has not been provided. Second, changing the open offer price subsequently does not appear to be equitable. Shareholders will suddenly come to know at the end of the tendering period that they will get a price lower than the price arrived at on the basis of the accepted method of pricing. In other words, would shareholders not suffer a double-whammy – once when they are kept in the dark about differential pricing and next when they bear the impact of getting the price lower than their expectation and what had been declared earlier by the company while making the open offer?
Further, if the open offer is subject to a minimum level of acceptance and in the open offer the acceptance level is below the identified minimum level then the question of accepting the lower quantity does not arise as the whole purpose and intent behind bringing out the open offer gets defeated.
Funding estimate
The proposal has multiple provisions which constrain the acquirer in making an estimate of the funds needed to support the open offer.
One such situation relates to Voluntary offers. Voluntary offers allow for competing offers to be made and in such a situation the offer size can be increased to normal full-sized offer. If the existing promoters want to continue to retain their control of the company they shall be ready to increase their offer size to the full. This means in the beginning itself all such voluntary offers have to evaluate the possibility of arranging, and be ready with, the finance in case they need to enhance the offer size. This will have some unintended consequences like increase in the cost of acquisition and a limited use of this provision to consolidate the shareholding.
Another such provision is the first proviso to Regulation 9(1) giving an option to each shareholder to decide the way it wants to be compensated. This will bring in unintended procedural complications in the whole takeover process.
Further, proposed Regulation 9(3) and 9(5) will further create uncertainty on the funding requirements for an acquirer. In case of one type of security, the valuation is fixed and, on the other hand, Regulation 9(3) allows for differential pricing thereby providing opportunity to influence the market price of such security.
Exemptions
Exemptions available from the applicability of the regulations are of two types. One, automatic exemptions which do not require approval or confirmation from SEBI. Second set of exemptions are those which require prior approval of SEBI. Currently, SEBI seeks the opinion of the Takeover Panel for all exemptions falling under category two. It is proposed to give discretion to SEBI to decide which of the requests falling with category two shall be forwarded to Takeover Panel for their approval. In order to maintain uniformity in the decision making process and to make it independent of individual’s interpretation, it would have been appropriate to continue to maintain the existing procedure for referring all such cases to the Takeover Panel.
Other Provisions
Certain proposals like removal of the upper holding limit in case of creeping acquisition and reduction in the minimum offer size for voluntary open offers appear to lean towards the existing management of the company. While the provision providing for exception from the compliance requirement on the board constitution as per the listing agreement (Proviso to Regulation 9(2) (d)) needs further analysis. Provision like proposed Regulation 3(3) will prevent the promoters to change the PAC composition to suite their changing needs. The proposal to make an open offer for acquiring all the shares of the target company held by other shareholders will definitely create financing constraints on the acquirers and is either likely to dampen the M&A activity or enhance the involvement of foreign entities.
Further, acceptance of the proposed regulation will require harmonizing various other SEBI regulations in particular those pertaining to SEBI (Delisting of Equity Shares) Regulations 2009, and SEBI (ESOS and ESPS) Guidelines, 1999.
Further, the current phenomenon of diluting either 10% or 25% of the post listing equity of a company will also ensure that the proposal of the TRAC to raise the trigger for open offer requirement to 25% from 15% will be beneficial for the existing management since companies listing with 10% or 25% public holding requirement will not have to worry about hostile takeover.
Overall, maintenance of continuity in the regulatory framework is of paramount importance in any jurisdiction. Implementing a totally new set of code will leave behind the jurisprudence developed on this aspect during the last ten years. If the new code is accepted it will have to go through its refinement and amendments to meet the practicalities of the situation. This will create substantial uncertainties for the market participants. Another approach which could have been developed was to list the main areas of concern in the existing regulations. Each area of concern could have been deliberated and incorporated in the existing regulations. This would have maintained continuity both for the participants as well as for the jurisprudence.
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