Monday, June 20, 2011

Rights Issue, Unsecured Loan Adjustment

In SRM Energy Limited v. SEBI, SAT has adjudicated upon the issue of adjustment of unsecured loans against the price to be paid for the shares allotted in the rights issue. The brief facts of the case are as follows. The appellant company borrowed a certain sum of money from the promoter group upon an oral understanding that if and when the appellant company came out with a rights issue, the unsecured loans would be adjusted against the share price. Subsequently, the appellant company came out with a rights issue and further sought to give effect to the aforementioned oral understanding entered into with the promoter group.

SEBI objected to such an adjustment on the ground that the unsecured loan advanced by the promoter group did not comply with the conditions prescribed u/s 81(3) of the Companies Act, 1956 [hereinafter “the Act”]. On the other hand the appellant company argued that shares were proposed to be allotted in accordance with the provisions of S. 81(1) of the Act and that the conditions incorporated in S. 81(3) were not applicable to the dispute in question. Before discussing the ruling of SAT, it is only appropriate to discuss the relevant provisions of the Act.

S. 81(1) of the Act empowers the Board to issue shares to the existing body of shareholders of the company in the same proportion in which they already hold shares of the company, without any special resolution or government approval. S. 81(1A) further empowers the Board to issue shares to non existing shareholders. However, as a condition precedent, such an issue has to approved by the shareholders vide a special resolution. S. 81(3) stipulates that S. 81 would not apply (a) to a private company (b) when the loans/debentures have a stipulation attached thereto that the lender will be entitled to exercise an option to convert the loans/debentures into shares at a future date. Such a conversion is however subject to two conditions (a) the terms of the loan has to be approved by the central government or is in conformity with the rules made in this behalf; and (b) a special resolution has to passed by the shareholders sanctioning the terms of the loan. 

SAT, while taking a pragmatic view allowed the adjustment. The reasoning adopted by SAT was that the entire transaction fell within the purview of S. 81(1) of the Act in that the additional shares were sought to be issued to the existing body of shareholders in the same proportion and that the transaction was not a mere conversion of debt into equity in the strict sense. Additionally, SAT noticed that as per the terms of the loan it was open for the promoter group to demand the immediate payment of the loans from the appellant company and hence, it was meaningless for the promoters to first demand the payment of the loan and then forward the very same amount towards the price of the shares allotted in the rights issue. 

Sunday, June 12, 2011

Non Compete Fee, Takeover Code: Part 2

In my previous post I had briefly discussed the concept of non-compete fees and the legal issues surrounding it. In this post I shall discuss the prevailing position of law with regard to non-compete fees. The present position of law is clearly articulated in E Land Fashion China Holdings Limited v. Securities Exchange Board of India wherein the SAT while reversing the order of SEBI allowed the acquirer to pay the additional non compete fees to the exiting promoters.


The appellant entered into a share subscription agreement and a share purchase agreement with the target company and its promoters whereby it was inter alia agreed that the appellant would acquire 51% of the equity capital of the target Company at a price of Rs. 75 per share inclusive of a non-compete fee of Rs. 15 per share. The appellant and the target company and its promoters also executed a shareholders agreement. Since, the equity shares acquired by the appellant pursuant to the aforesaid agreements were in excess of 15% of the voting rights in the target company, the provisions of Regulation 10 and 12 of the Securities and Exchange Board (Substantial Acquisition of Shares and Takeovers) Regulation 1997 [Hereinafter “takeover code”] got triggered. Accordingly, the appellant made an open offer to acquire 20% of the voting capital of the target company at a price of Rs. 60 per share. The offer price did not include the additional Rs. 15 which was offered to the promoter group. Thereafter, SEBI directed the appellant to add  the non-compete fee paid to the promoters to the offer price.                                         
SEBI's Contention

SEBI argued that the non compete fee should be added to the offer price as (i) the existing promoters were still continuing to hold substantial shares (post offer shareholding) in the company and that they were not exiting completely (ii) the promoters had the right to appoint two directors and jointly select two independent directors in the company (iii) the shares of the promoters had a lock in period of 3 years i.e. the promoters were not entitled to transfer their shares without the written approval of the acquirer. The crux of SEBI's argument was that the exiting promoters even post offer would continue to hold substantial shares in the company and also control the company. In such a scenario, SEBI argued, it was unlikely that the promoters would totally exit the target company and offer competition.

SAT's Ruling

The SAT allowed the payment of the non compete fee to the promoters of the target company on the ground that the promoters had the experience and expertise to compete with the target company at a future point in time. In arriving at this conclusion SAT heavily relied on its earlier ruling in Tata Tea Ltd. v. Securities Exchange Board of India. In tata tea the tribunal had held that if the payment of non compete is based on a strong business rationale and is not a mere tool to reduce the cost of acquisition to discriminate against the public shareholders, the Board or the tribunal is not entitled to intervene.


It is now fairly well settled that an acquirer is entitled to pay the promoter group of the target company an additional non-compete fee. However the non-compete fee can only to paid when there is a “lurking fear of competition”. The question as to what amounts to “lurking fear of competition” is a factual one and will have to be determined on a case to case basis. Additionally, the validity of a non-compete fee is not dependent on the extent of the threat of competition from the selling promoters i.e. even if the threat is remote it is not open for the Board or even the tribunal to intervene. The Board can intervene only when the non-compete fee is used as a design to reduce the cost of acquisition to discriminate against the public shareholders.

Although the controversy surrounding non-compete fee and the takeover code is clear (at least for the time being), several commentators (here and here) believe that non-compete agreements are in violation of S. 27 of the Indian Contract Act, 1872. The commentators argue that a SEBI Regulation cannot allow what the parliament expressly prohibits.      


Saturday, June 4, 2011

Preferential Allotment/Private Placement, New Rules

Recently the MCA released the Draft Unlisted Companies (Preferential Allotment) Rules, 2011. The draft rules seeks to substitute the Unlisted Companies (Preferential Allotment) Rules, 2003. The Draft rules inter alia requires more disclosures and also mandates the securities to be kept in a demat form. Here is a comparative table of both the rules:

Current 2003 Rules
Proposed 2011 Rules
Applies only to unlisted public companies in respect of preferential issue of equity shares, fully convertible debentures, partly convertible debentures or any other financial instrument which would be convertible into or exchanged with equity share at a later date.
Special Resolution
The issue of shares can be only made, if (i) the AoA of the company authorizes to do so and (ii) a special resolution is passed at the general meeting authorizing the allotment. The special resolution has to acted upon within a period of 12 months.
Additional Requirements

The company has to make disclosures in the offer document as prescribed.

The offer document has to be approved by way of a special resolution.

Both the copy of the special resolution and the offer document has to be filed with the RoC.

Condition for the issue of Private Placement
Does not prescribe any such condition.
The following conditions are prescribed:

Not more than 30 day gap between opening and closing of the issue.

Minimum 60 days gap between two issues.

Any financial instrument which is convertible into equity shares at a later date and resulting into a cumulative amount of Rs. 5 Crores or more will require the prior approval of the central government.

After the issue, the company has to file a return of allotment with the RoC within 30 days.
Dematerialization of Securities
No such requirement
All securities issued under preferential allotment or private placement has to be kept in a demat form.
Compliance Certificate
A Similar audit certificate was only required to be placed before the shareholders.
The compliance certificate has to be filed with the RoC.
Disclosures in the offer document
Not applicable. However disclosures are to be made in the explanatory statement to the notice for the general meeting.
The 2003 rules only prescribed that the object of the issue had to be disclosed. The 2011 rules requires disclosures with regard to the object of the issue, brief detail of the project and statutory clearances required and obtained for the project. Apart from this the two rules are more or less the same in this regard.

It is quite clear that the new rules, if they become operational, would increase the compliance burden on the companies. It will also increase the paper work and possibly the transaction cost. Moreover, fund raising through the issue of convertible financial instruments would be hit severely as now all such transactions resulting into a cumulative amount of Rs. 5 Crores or more will require Central Government approval.

The rationale for these new rules is unclear. However, initial reports suggest that the rules are a fallout of the Sahara-Sebi Controversy.

Wednesday, June 1, 2011

Non Compete Fee, Takeover Code: Part 1

Non Compete Fee is fees that is paid to the selling promoter(s) so that they do not re enter the same business and pose a threat to the acquired Company. This fee is not included in the offer price made to the public shareholders. For e.g., the acquirer pays Rs. 75 per share to the promoters and an additional Rs. 15 per share as non compete fee i.e. the promoters are paid a total of Rs. 90 per share whereas the offer price made to the public shareholders is only Rs. 75 per share.

In principle there is nothing in either the Takeover Code or any other related legislation that bars an acquirer from paying an additional non-compete fee to the promoter(s). On the contrary, in recent years SEBI has approved several transactions (here and here) where the promoter group was paid a higher price per share compared to the public shareholders. The higher price being justified as a non-compete fee.  The takeover code, however, imposes a restriction on the acquirer in that the non-compete fee cannot exceed 25% of the price offered to shareholders in the open offer.

Allowing the acquirer to pay an additional non-compete fee has several commercial justifications. However such additional payments have to be regulated inorder to ensure that the public shareholders are not discriminated against unfairly. In other words SEBI has to ensure (which it has in several instances) that the non-compete fee is paid by the acquirer only when there is an actual threat of the selling promoter re entering into the business. The non-compete fee is not justified when say, even after the acquisition the promoter continues to be a co promoter or the board of directors of the acquired company has equal representation from the selling promoter and the acquirer. Ultimately whether the payment of non-compete fee is justified or not depends on the facts and circumstances of a particular case.

Interestingly the TRAC Report recommends that the non-compete fee should be completely done away with.  The following observations of the TRAC are apposite:

“4.9.4 The Committee concluded that in keeping with the spirit of equal treatment  for all shareholders, and the scope for abuse of non-compete payments, the  Takeover Regulations ought to be explicit that consideration paid for the  shares in any form to the selling shareholder and his affiliates, concurrent with the purchase of shares, whether termed as ―control premium, or ―non-compete fees or otherwise must be added to the negotiated price per share for the purpose of determining open offer pricing.

4.9.5 The Committee concluded that once the extant exemption in respect of non-compete fee is deleted from the Takeover Regulations, and it is clearly articulated that apart from the share acquisition agreement, consideration in any form inclusive of all ancillary and collateral agreements shall form part of the negotiated price, it is in the selling shareholders‘ interests to ensure that the negotiated price truly reflects the value of the scrip fairly. Since this negotiated price in any case would be one of the parameters for fixing the offer price, if such price were higher than other proposed parameters, all shareholders will get the same negotiated price.”

In a subsequent post we will discuss the recent ruling of SAT in E-Land Fashion China holdings Limited and other related judgments inorder to ascertain the prevailing jurisprudence on non-compete fees.