Pre-agreed buyback of shares through put/call option in not valid under SCRA

Securities and Exchange Board of India (SEBI) in its recent informal guidance to Vulcan Engineers Limited (VEL) (dated 23 May, 2011) has communicated to VEL that, the pre-agreed buyback of VEL shares from SIMEST through put/call option is not valid under SCRA.

Background

VEL had gone to SEBI to understand SEBI’s view about the relationship between one of its major shareholder, TERUZZI, an Italian company having a stake of 66.91% in VEL and SIMEST SpA, an Italian financial institution controlled by Italian government, which intend to acquire 14% share capital of VEL.  Under the proposed agreement (which was based on business model of investment by SIMEST), SIMEST can exercise its option to sell to TERRUZZI all VEL shares owned by SIMEST by a put/call option starting from 30 June, 2015 and TERRUZZI is obliged to purchase the shares offered by SIMEST after complying with all applicable laws in India.  There were a few more legal clauses determining the relationship between TERUZZI and SIMEST, however those are not important for our analysis here.  In short- the question raised by VEL to SEBI was that, whether TERRUZZI and SIMEST are ‘persons acting in concert’ (PAC) under the regulation 2(e) of the SEBI Takeover code, 1997.

SEBI’s view

SEBI, before even looking at the possible PAC relationship between SIMEST and TERRUZZI commented on the nature of proposed agreement between TERRUZZI and SIMEST.  I am not sure, whether SEBI should have commented on the ‘proposed agreement’ (put/call option) or not, as this was not asked in the queries submitted to SEBI, it should have in ordinary course, returned the application and let the court decide about the nature of put/call option.

SEBI, after the opinion in open offer by Vedanta to the shareholders of Cairn India Limited is asserting the view that all kinds of put/call options are in the nature of forward contract and are therefore not valid under the securities laws in India.

I quote from the SEBI informal guidance- “As this option would be exercised in a future date (June 30, 2015 onwards), the transaction under this arrangement would not qualify as spot delivery contract as defined under section 2(i) of SCRA.  Further, the aforesaid put/call option would not qualify as a legal and derivative contract in terms of section 18A of SCRA as it is exclusively entered between two parties and is not a contract traded on stock-exchange and settled on the clearing house of the recognized stock-exchange.  Therefore, it light of the aforesaid provisions of SCRA read with SEBI Notification No. S.O. 184(E) dated 1^st March 2000, the pre-agreed buyback of VEL shares from SIMEST through put/call option is not valid under SCRA…”

Takeaways from the SEBI Informal Guidance

• Legal practitioners in India are habitually and regularly inserting put/call option clauses in the SPA/SSA, they should relook at this practice, especially for the listed companies in India. 
• SEBI, while deciding the validity of put/call agreement should also ponder on the fact that such type of contracts are ‘contingent contract’, which depend upon happening on some event and this event can be- exercise of option by the option holder- so when the option holder exercises his option, then only, this contract needs to be performed as per the provisions of section 2(i) (spot-delivery contract) of the SCRA.

Stay as promoter and get non-compete fee too in a Takeover transaction

In a recent verdict, the Securities Appellate Tribunal (SAT) [E-Land Fashion China Holdings Limited v. SEBI, 24 May, 2011], ruled that the non-compete fee can be paid to the promoters (without including the non-compete fee in the open offer price) by the acquirer even if (a) the promoters are still continuing as promoters of the acquired company; (b) the promoters are in joint control of the acquired company; (c) the promoters have the right to appoint the board of director, managing director of the acquired company; (d) the promoter shave the ROFR; (e) the promoters have a full tag along right in case of sale of the acquirers; (f) the promoters have mandatory put-option to sell its shares to the acquirer.

To me the judgment of SAT is erroneous and bad in law and SEBI must appeal before the honorable Supreme Court to get the correct the interpretation of non-compete fee paid under regulation 20(8) of the SEBI Takeover regulations, 1997 (SEBI Takeover code).

In the intent and domain of regulation 20(8) of SEBI Takeover code, is to stop and discourage the erstwhile promoters/ selling shareholders of the acquired company to directly/indirectly compete with the new promoters (and or acquirers).  If the selling shareholders are still the part of the acquired entity and exercising rights such as appointing the board of directors, managing director, having ROFR, put option etc., then paying non-compete fee to the selling holders is just like- paying non-compete fee to a non-competitor, which is not the intention (literal or implied) of the SEBI Takeover code.  These erstwhile promoters/ selling shareholders are no where competing with the acquirers-although it may be conceded that these erstwhile promoters/ selling shareholders have potential to compete with the acquirers, however, this remains a possibility only.  And, if we were to look the SPA/SSA signed by these erstwhile promoters/ selling shareholders and the acquirers, it can easily be inferred that the erstwhile promoters/ selling shareholders are still in the game and playing in the same team although under different captain.

The verdict of Tata Tea case, Cementrum IB.V case cannot be mindlessly applied in such cases (as above), as the facts of both the cases are entirely different.

Takeaways for Transactional Lawyers

Well, till the time this SAT order is challenged and reversed by the Supreme Court, a non-compete agreement may be entered into the selling shareholders and the acquirers under which the selling shareholders may still be a categorized as promoter and take major decisions of the acquired entity (for e.g., appointing of managing director, board of directors etc.).

Dissecting offering circular of a debt offering (Part-II)

Global Certificates representing the Notes

As a market practice, in international offerings such as Tata Power Backed Deal, the Global Certificates (GC) are issued to the investors, which more or less have the same Ts & Cs of the Notes. Notes in registered form will be represented by a registered GC. One GC is issued in respect of each Noteholder’s entire holdings of registered Notes. The GC contain information about the accountholders. Cancellation, payments, notices, registration of title, transfers, record date etc. Additionally, for as long as bonds/notes are represented by the GC, payments of principal and interest in respect of the bonds/notes will be made without presentation or if no further payment falls to be made in respect of the bonds/notes against presentation and surrender of the GC to or to the other principal agents for such purpose.

Clearance and Settlement of Notes

To issue and transfer of bonds/ notes, the issuer generally enters into an agreement with the clearing and settling agency. In the Tata Power Backed Deal, custodial and depositary links were established with Euroclear and Clearstream, Luxembourg to facilitate the initial issue of the Notes and transfers of the Notes associated with secondary market trading. In international debt offerings, Euroclear and Clearstream are preferred because they provide services for safekeeping, administration, clearance and settlement of internationally traded securities and securities lending and borrowing.

Global clearance and settlement procedures

Initial settlement
Interests in the Notes will be in uncertificated book-entry form. Purchasers electing to hold book-entry interests in the Notes through Euroclear and Clearstream, Luxembourg accounts will follow the settlement procedures applicable to conventional eurobonds. Book-entry interests in the Notes will be credited to Euroclear and Clearstream, Luxembourg participants’ securities clearance accounts on the business day following the Issue Date against payment (for value on the Issue Date).

Secondary market trading
Secondary market sales of book-entry interests in the Notes held through Euroclear or Clearstream, Luxembourg to purchasers of book-entry interests in the Notes through Euroclear or Clearstream, Luxembourg will be conducted in accordance with the normal rules and operating procedures of Euroclear and Clearstream, Luxembourg and will be settled using the procedures applicable to conventional participants.

Use of proceeds

It depends and the practice varies. In Tata Power Backed Deal the use of proceeds was:

“The proceeds of the issue of the Notes will be applied by Issuer to fund its corporate and acquisitive activities and to repay the outstanding amount of U.S.$247 million owed by Bhivpuri Investments Limited under a U.S.$590 million non-recourse facility. No amount of the use of proceeds will be used in India by the Guarantor.”


Description of Issuer

Generally in global offerings which are backed by big corporate, there is very less to mention under this heading, as most of the issuers are paper companies incorporated under Mauritius, BVI, Cyprus laws. It covers the information about the business, board of directors and general information about the issuer company.

Description of Guarantor

Where the debt offering is backed by the guarantor, this section is of major importance. This section covers detailed information about the guarantor-the information may range from incorporation to board of directors to shareholding pattern to financial statements to business segment to industry overview etc. (it’s more or less like information provided under the prospectus for the equity offerings, about the issuer).

Enforcement of Guarantee

This section was drafted in the Tata Power Backed Deal, where, Tata Power guaranteed the return on investments to the investors. Tata Power, an Indian listed company can do so only because of certain enabling provisions under the India laws.

A guarantee issued by an Indian company on behalf of its non-Indian direct or indirect wholly owned subsidiaries or joint ventures is subject to certain regulations under Foreign Exchange Management Act, 1999 (FEMA), such as the Foreign Exchange Management (Guarantees) Regulations, 2000 (the FEMA Guarantees Regulations) and the Foreign Exchange Management (Transfer or Issue of Foreign Security) Regulations, 2004 (as amended, the FEMA ODI Regulations) as well as the provisions of the RBI’s Master Circulars on Direct Investment by Residents in Joint Venture / Wholly Owned Subsidiary Abroad that are periodically updated by the RBI, with the latest master circular dated 1 July 2010 (Master Circular).

Under the FEMA Guarantees Regulations, an Indian company can provide a guarantee on behalf of its non-Indian wholly owned subsidiaries or joint ventures if it is in connection with its business and provided that it is in compliance with the FEMA ODI Regulations. Pursuant to the FEMA ODI Regulations and the Master Circular, an Indian company is permitted to provide a guarantee on behalf of its non-Indian wholly owned subsidiaries or joint ventures without the prior approval of the RBI, subject to certain conditions including, without limitation:

(i) such Indian company’s total financial commitment does not exceed 400 per cent of its net worth set forth in its last audited balance sheet at the time of issuance of any such guarantee. For purposes of the FEMA ODI Regulations, “total financial commitment” includes the aggregate direct equity contributions, loans provided and amount of guarantees given by the Indian company on behalf of all non-Indian wholly owned subsidiaries and joint ventures;
(ii) the Indian company (which is providing the guarantee outside India) is not on the RBI’s exporters’ caution list or list of defaulters to the system circulated by specified entities or is under investigation by any investigation or enforcement agency or regulatory body; and
(iii) the guarantees must specify a maximum amount and duration of the guarantee upfront i.e. no guarantee can be open-ended or unlimited.

The Indian company is required to disclose certain terms of the guarantee to the RBI, in Form ODI, through an authorised dealer (bank) in India. The non-Indian wholly owned subsidiaries or joint ventures must be engaged in bona fide business activities.

Generally, following language is used in the OC, if the above mentioned legal requirements are met:

“The Company has complied with all such requirements as prescribed under the FEMA ODI Regulations and the Master Circular with respect to the issuance of the Guarantee and therefore, no RBI approval is required for the granting of the Guarantee as set out in the Trust Deed.”

Generally, under Section 372A of the Companies Act, 1956 (the Companies Act), an Indian company is required to obtain by special resolution the approval of 75 per cent of its shareholders entitled and voting on the matter prior to issuing a guarantee which, together with existing loans, investments and guarantees, exceeds the greater of (i) 60 per cent of the aggregate paid up share capital and free reserves; or (ii) all of its free reserves. Section 372A does not apply, namely, to any guarantee given by a “holding company” (as defined in the Companies Act) in respect of a loan made to its wholly owned subsidiary.

Financial Statements

This section is one of the most important section of an OC. Generally, this portion is drafted by the auditors and after several rounds of ‘circle-ups’ and review by lawyers finally inserted in an OC. Financial statements covers (a) auditors report, (b) consolidated balance sheet, (c) consolidated profit-loss account and (d) consolidated cash flow statement.

Other general legal requirements

Before floating a debt offering, certain background work needs to be done by the issuer, which includes:

• The constitutional documents (Memorandum and Articles) of the issuer provides for issue of debt securities/Notes.
• The issue of notes was duly authorized by a resolution of board of director of issuer
• Application has been made and approval-in-principle has been received for the listing of the Notes on the Stock Exchange(s).
• Depending on where the Notes are listed, the Issuer and the shall appoint and maintain a paying agent, where the Notes may be presented or surrendered for payment or redemption, in the event that the Global Certificate is exchanged for definitive Registered Notes.
• The Notes have been accepted for clearance through Euroclear and Clearstream, Luxembourg (this is not a universal requirement).
• Subscription Agreement is signed with the managers to the offer.
• Trust deed is executed between the issuer and the trustees and other relevant party(ies).
• Agency Agreement is executed between the issuer and the trustees and other relevant party(ies).

Dissecting offering circular of a debt offering (Part-I)

In the recent times, corporates in India are tapping one source of funding then anything else (especially, when funding through equity offerings are drying-up) - debt offerings- to general public or through private placements. There is a surge amongst the corporates and banks to issue medium term notes, perpetual bonds or simple bond. Here, I would be dissecting an ‘offering circular’ of a debt offering in two parts-this is the first part.

The soul of a debt offering’s offering circular (OC) is its ‘term-sheet’. I have written about ‘term-sheet’ earlier here. There is no hard and fast rule to draft an OC, however, jurisdictions such as India has provided for basic template under the Securities and Exchange Board of India (Issue and Listing of debt securities) Regulations, 2008. I have taken the OC of Bhira Investments Limited (backed by Tata Power Limited) (Tata Power Backed Deal) as a base model for writing about the OC and its contents in this piece.

In this note, I would be discussing about following aspects of an OC:

• Front Page
• Due-diligence requirements
• Risk Factors
• Terms and Conditions of the Notes
• Global Certificates representing the Notes
• Clearance and Settlement of Notes
• Use of proceeds
• Description of Issuer
• Description of Guarantor
• Enforcement of Guarantee
• Financial Statements
• Other general legal requirements

Front Page

Generally, an OC starts with front page containing:

• Date of offering of debt securities
• Logo of the company offering debt securities and amount involved
• Kind of debt securities offered
• If the offerings are guaranteed
• If the offering is a ‘Regulation S’ offering
• Where will the debt securities be listed
• Denomination of issue of debt securities
• Redemption of the Notes
• Issue opening and closing date
• Logo of investment bankers arranging/ managing the deal

In simple terms, the front page of OC would contain briefs of the ‘terms and conditions’ of the issue of Notes/ debt securities, so that the prospective investors can make out in brief ‘what the offering is about’ and who is the entity behind the offerings and whether a US investor can invest in this offering.

Due-diligence obligations

Well, regarding the due-diligence (DD) for a debt offering – practice varies. Generally, in a private placement there is no requirement for conducting DD. For example in the recent Tata Power Backed Deal, a general disclaimer was draft regarding the DD, which read as:

“Neither the Managers (as described under “Subscription and Sale”, below) nor the Trustee have independently verified the information contained herein. Accordingly, no representation, warranty or undertaking, express or implied, is made and no responsibility or liability is accepted by the Managers or the Trustee as to the accuracy or completeness of the information contained or incorporated in this Offering Circular or any other information provided by the Issuer or the Guarantor in connection with the offering of the Notes. None of the Managers, the Trustee, the Principal Paying Agent, the Transfer Agent or the Registrar accepts any liability in relation to the information contained in this Offering Circular or any other information provided by the Issuer or the Guarantor in connection with the offering of the Notes or their distribution. Advisors named in this Offering Circular have not caused the issue of, and take no responsibility for, this Offering Circular, have acted pursuant to the terms of their respective engagements and do not make, and should not be taken to have verified, any statement or information in this Offering Circular unless expressly stated otherwise.”


Risk Factors

In this section factors which may affect the ability of Issuer or the Guarantor to fulfill their obligations are mentioned. All of these factors are contingencies which may or may not occur and neither the Issuer nor the Guarantor is in a position to express a view on the likelihood of any such contingency occurring. In addition, factors that are material for the purpose of assessing the market risks associated with the Notes are also mentioned in this section.

Term and Conditions (Ts & Cs) of the Notes

The Ts & Cs of the notes issued depends upon cases to case and the terms of the trust deed and the agency agreement signed between the parties (parties are issuer, guarantors and the trustees). In the Tata Power Backed Deal, the Ts & Cs of the notes were categorized as:

• Form, denomination and title of the bond offerings
• Status and Subordination
The section covers the situation- whether the notes constitute direct, unconditional, unsecured and subordinated obligations of the Issuer and whether the notes at all times rank pari passu without any preference among themselves or not.
• Guarantee, if any [which was in the case of Tata Power Backed Deal]
This section covers the aspect of limitation of guarantees, status of guarantees, winding-up of guarantor.
• Interest
This totally depends on the business terms of the issue of notes. Interest payable could be for (a) fixed interest period, (b) floating interest period, (c) optional deferral of interest, (d) increase in rate of interest, (e) capitalization of interest
• Redemption and Purchase
This section covers the aspect of (a) maturity of the notes, (b) early redemption at the option of issuer, (c) early redemption due to various factors, (d) purchase of notes.
• Payments in respect of notes
• Taxation and Gross-ups
Generally, this section is the domain of tax-experts involved in the deal. However, generally in most of the debt offerings, all payments are made to the investors by the issuer without any withholding tax, unless there is contrary law to this effect.
• Prescription
• Further Issue
This section covers the possibility where the issuer intends to issue further notes. The notes may be in parity with the issued notes under the present offering or may be senior/ junior to it.
• Events of default
• Replacements of certificates
• Notices
• Meetings of the note holders, modifications, waiver, authorization and determination
The Trust Deed generally contains provisions for convening meetings of the Noteholders to consider any matter affecting their interests, including the modification or abrogation by Extraordinary Resolution of any of these Conditions or any of the provisions of the Trust Deed.
• Substitution
Generally, in cases, where the dummy companies are incorporated (in jurisdictions such as Mauritius or Cyprus or BVI etc) by the trusted corporate (such as Tata Power), a residual clause is inserted in the OC stating that the issuer may be substituted by another issuer.
• Indemnification and protection of Trustee and its contracting with the Issuer and the Guarantor
The Trust Deed may contain provisions pertaining to indemnification and protection of trustee.
• Governing laws and submission to Jurisdiction
In case of international offerings, generally ‘English law’ is recommended by the law firms as governing law and English courts are given the authority to decide if any dispute arises.
• Rights of Third Parties

FDI Investment transactions: New provisions for Escrow Accounts

Taking note of various share purchase agreements concerning FDI investments transaction taking in India, under which, generally, there is a time lag between payment of purchase consideration and the receipt of the shares; Reserve Bank of India (RBI) has come out with a circular (A. P. (DIR Series) Circular No. 58) dated 2 May, 2011 (May 2 Circular) to provide operational flexibility and ease the procedure for such transactions. 

Under the May 2 Circular:

·         AD Category – I banks are permitted to open and maintain, without prior approval of the RBI, non-interest bearing Escrow accounts in Indian Rupees in India on behalf of residents and/or non-residents, towards payment of share purchase consideration and / or provide Escrow facilities for keeping securities to facilitate FDI transactions.

·         SEBI authorised Depository Participants are permitted to open and maintain, without prior approval of the Reserve Bank, Escrow accounts for securities subject to the terms and conditions as prescribed.

Salient features of May 2 Circular

·         The Escrow account in INR would be maintained only with an AD Category – I bank in India.

·         The Escrow account may be opened jointly and severally.

·         Escrow account can be opened by the residents and the non-residents.

·         Securities kept / linked with such Escrow accounts may be linked with demat account maintained with SEBI authorised Depository Participants.

·         Escrow account needs to be non-interest bearing escrow.

·         Permitted credits

o   Receipt of foreign inward remittance as consideration towards issue or transfer of shares through normal banking channels; or

o   Receipt of rupee consideration through the normal banking channels from India by the resident acquirers of shares who proposes to acquire them from non-resident holders by way of transfer.

·         Permitted debits

o   Remittance of consideration for issue of shares or transfer of shares directly into the bank accounts of the beneficiary (issuer in India or transferor of shares in India or abroad); or

o   Remittance of consideration for refund to the initial remitter of funds in case of failure / non-materialization of the FDI transaction for which the Escrow account was opened.

·         The Escrow account shall remain operational for a maximum period of six months only.  For more than six months, RBI approval is required

·         Fund and non-fund based facilities shall not be permitted against the balances in such cash escrow accounts.

·         Balance in the Escrow account, if any, may be repatriated at the then prevailing exchange rate, after all the formalities in respect of the said acquisition are completed.

Takeaways for Transactional Lawyers

·         Prior to May 2 Circular, there was an uncertainty as to whether an RBI approval was required for opening of escrow accounts pertaining to FDI transactions; therefore, as a market practice escrows to facilitate such transactions were often maintained outside India to facilitate the commercials of the transaction (commercials includes the structuring of transactions, closing of transactions etc.). But the May 2 Circular, has now made it possible to set up and maintain such escrow accounts for FDI-related transactions in India without any delay.

·         Certainly, May 2 Circular is a welcome step towards removing the confusion which was prevalent in the bankers-lawyers community.  Often, AD-Banks would insist the banker-lawyer duo to seek approval from RBI to open securities escrow with them based on their faulty interpretation of word ‘deposit’ under the FEMA Deposit Regulations. This hassle of taken RBI approval for opening Escrow account in INR and securities escrow is no-more required; this would some-what ease the burden on Transactional lawyers as well as the AD-Banks.

·         As per the May 2 Circular, the terms of the Escrow account shall be laid down strictly in the Escrow agreement, Share purchase agreement, conditions of issue of shares etc.

·         For the purposes of FDI reporting (such as FC-TRS filings), date of transfer of funds into the bank account of the issuer or transferor of shares, shall be the relevant date of remittance.

Changes in fundamental attributes: Mutual Fund Regulations to be strictly followed

Securities Appellate Tribunal (SAT) on 3 May, 2011 delivered an important verdict concerning the protection of mutual fund investors in mutual fund schemes.  In the case of Subramanian R Venkat v. SEBI and others, SAT ordered, when there is any substantial and fundamental change in the attributes of a mutual fund scheme, then such change should be in accordance with regulation 18(5A) of the SEBI (Mutual Funds) Regulations, 1996 (Mutual Fund Regulations).

Background of the case

Respondents (Board of Trustees of HSBC Mutual Fund, HSBC Mutual Fund, HSBC Securities and Capital Markets (India) Private Limited, SPV (an AMC) floated of HSBC Mutual Funds and CEO of AMC floated by HSBC Mutual Fund) (HSBC Mutual Fund) in 2003 floated an open-ended gilt scheme (HSBC Gilt Fund- Short Term Plan-plan in which the appellants invested)(Scheme) by the name of HSBC Gilt Fund to generate income from investing in government securities (Govvies).

Thereafter, in 2009 certain attributes of the Scheme were altered unilaterally by HSBC Mutual Fund, under which (a) name of the scheme was changed from HSBC Gilt Fund- Short Term Plan to HSBC Gilt Fund, (b) benchmark index changed from ‘I-Sec Si-Bex’ to ‘I-Sec Composite Index’, and (c) change in duration of scheme.

Issues

• Whether the impugned changes made in the scheme amounted to changes in the fundamental attributes of the contravention of regulation 18(15A) of the Mutual Fund Regulations?
• Whether the Board of Trustees and the AMC have contravened regulations 18(9) and 18(22) and clause 2,6 and 9 of Fifth schedule of Mutual Funds Regulations?
• Whether the AMC have contravened regulations 18(9), 18(22), 25(1) and 25(16) and clause 2,6 and 9 of Fifth schedule of Mutual Funds Regulations?
• Whether the CEO of the AMC have contravened regulation 25(6A) of Mutual Funds Regulations?

SAT’s verdict

SAT was of the view that the above mentioned-changes are in the nature of change in fundamental attributes of the Scheme.  SAT further held – “In the context of an investment scheme, one of the important factors that an investor looks at is the duration for which the investments are going to be made in the Scheme….There could be other attributes other as well depending upon the nature of the scheme….The powers of the fund manager of bring about the changes in the scheme cannot be disputed but if such changes alter the fundamental attributes of a scheme or modify the scheme affecting the interest of the unit holders-the fund and the managers have to comply with the provisions of regulation of 18(15A) of the Mutual Funds Regulations.”

Takeaways for Transactional Lawyers

Transactional Lawyers in the Mutual Funds space, while involved in the transaction pertaining to the changes in the attributes of the Mutual Fund Scheme must insure that:

•  Requirements of Regulation 18(15A) are fully met.
• Clarifications issued by SEBI under circular (IIMARP/Cir/01/294/98) dated 4 February, 1998 are ‘not the whole and sole’ for determining the fundamental attributes of a Mutual Fund scheme.
• Fundamental attributes of a mutual fund scheme depend on case to case basis.