SEBI Board on proposed new Takeover Regulations based on recommendation of TRAC

Securities and Exchange Board of India (SEBI or Board) finally met on 28 July, 2011 and took major decisions on the takeover regulations, which may impact takeover activities in times to come in India.

In this post, I would deal briefly with the decisions of SEBI on Takeover regulations.  Most of the recommendations of the Takeover Regulations Advisory Committee (TRAC) are accepted by the Board.  As per the press release PR No. 119/2011 dated 28 July, 2011, the Board took note of and decided the following:

(a)   Initial trigger threshold increased to 25% from existing 15%.

Takeaways of transactional lawyer

This is a welcome move for the industry.  Listed Indian corporates may tap-in more funds from strategic investors like Private Equity firms, foreign institutional investor, foreign venture capital investors, and of course Indian investors etc. without there being any need for open offer to acquire further 20% (now 26%) shares of the company.  SEBI in its wisdom increased the triggering limit to 25%- this I believe has to do with the changing times in emerging markets coupled with the prevalent view that strategic investors having no potential or willingness to further acquire equity in the company as they are not interested in control or day to day affairs of the company.  In times to come, I view a lot of investment happening in the listed companies where new shares would be issued to the strategic investors (in form of qualified institutional placement, rights issues, preferential allotment of shares etc).

(b)   There shall be no separate provision for non-compete fees and all shareholders shall be given exit at the same price.

Takeaways of transactional lawyer

Indian promoters exiting the business would hate this.  This decision is in-effect would null the verdicts of the Securities Appellate Tribunal (SAT) in the cases of E-Lands Fashion China Holdings v. SEBI (SAT 2011) and Tata Tea Limited v. SEBI (SAT 2008).  Recently, SEBI was also very slow on giving approvals to the takeover offers in cases where a non-compete fee clause was existing in a share purchase agreement (SPA) which was triggering the open offer.  Transactional lawyers drafting the SPAs should take note of the above and delete the non-compete fee clause and if not, they may be prepared with their litigation counter-parts to challenge this policy move before the court of law, but I believe Indian courts do not give any opinion where Government’s policy is involved.

(c)    In cases of competitive offers, the successful bidder can acquire shares of other bidders after the offer period without attracting open offer obligations.

Takeaways of transactional lawyer

This would certainly ease the takeover process, however it is not clear how this policy move would apply as in is there any time period or is it left open ended after the offer period has passed.  Under the present takeover code, the successful bidder can buy the shares of other bidders-there is no limitation on this.  Under the TRAC recommendation, within twenty-one business days from expiry of the offer period, any competing acquirer would be free to negotiate and acquire the shares tendered to the other competing acquirer, at the same price that was offered by him to the public. I hope this would be clarified when SEBI comes out with draft new takeover regulations for public comments.

(d)   Voluntary offers have been introduce subject to certain conditions.

(e)    A recommendation on the offer by the Board of Target Company has been made mandatory.

Takeaways of transactional lawyer

This move shows the graduation of maturity level in the Indian capital markets.  This is in line with the practices followed in US and the EU.  We might see the emergence of white knights and other takeover market practices prevalent in the US or the EU.

(f)     Existing definition of control shall be retained as it is.

Takeaways of transactional lawyer

Verdict of SAT is very clear on this.  Transactional lawyers should read and apply the holding in cased of Subhkam Ventures (I) Pvt. Ltd v. SEBI (SAT, 2010).

(g)   The minimum offer size shall be increased from the exiting 20% of the total issued capital to 26% of the total issued capital.

Takeaways of transactional lawyer

This is in line with initial triggering event at 25%, so under the proposed takeover regulations, pursuant to successful open offer and assuming that the existing shareholders tenders the shares upto 26%, this will lead to acquisition of 51%, therefore making the target company a subsidiary of the acquirer fulfilling the requirements of section 4 of the Companies Act, 1956 (Companies Act).  Under the Companies Act, any equity holding greater than 25% gives a right to block a ‘special resolution’, however this is a type of indirect control or negative control, with 51% equity shareholdings the acquirer would exercise the majority stake in the target company.  This is also in line with the definition of ‘control’ under section 5 of the Competition Act, 2002.

(h)   The Board did not accept the recommendation of TRAC to provide for delisting pursuant to an offer and proportionate acceptance.

Certainly, in times to come there is going be a lot of in-bound acquisition deals and these changes in takeover regulations may in short run as well as long run propel the acquisition activities of listed companies in India.

Outbound acquisition by Indian firms: Case of acquisition of Peguform Group by Samvardhana Motherson Group

Indian corporates are on buying spree-more specifically outbound acquisitions.  Recently, on 13 July, 2011 board of directors of Motherson Sumi Systems Limited (MSSL) approved the acquisition of 80% shareholding in Pegasus group, Germany (Pegasus) from Cross Industries AG, Austria (Cross Industries). 

MSSL is a JV between Samvardhana Motherson Group (SMG) and Sumitomo Wiring Systems, Japan and is listed on the Bombay Stock Exchange (BSE) and National Stock Exchange (NSE).  MSSL specializes as manufacturer of automotive rearview mirrors, automotive wiring harness, plastic components and modules to the automotive sector, HVAC systems, automotive and industrial applications and other diverse support systems related to automotive accessories sector,

Pegasus Group, is owned by Cross Industries and specializes in manufacture, supply and distribution of high quality interior and exterior products for the automotive and related industries.

Transaction Structure

The outbound transaction (as proposed) was outlined in the press report submitted with the Bombay Stock Exchange.  The proposed transaction structure is as follows:

Under the present structure, MSSL, through a special purpose vehicle (SPV) along with Samvardhana Motherson Finance Limited (SMFL) would acquire 80% shareholding/ stake in Peguform Group, Germany from Cross Industries.  Cross Industries would continue to hold 20% in Peguform Group.  This would also include acquisition of 50% shareholding of Wethje Carbon Composite (Wethje) which is a part of Cross Industries.

SPV would be structured in a form of 51:49 JV between MSSL and SMFL.

Legal provisions concerning outbound acquisition in India

The relevant Indian law provisions pertaining to outbound acquisitions are:

• Foreign Exchange Management (Transfer or Issue of any Foreign Security) Regulations, 2004 (notification no. FEMA 120/RB-2004 dated July 7, 2004) (FEMA 120) seeks to regulate acquisition and transfer of a foreign security by a person resident in India i.e. investment by Indian entities in overseas joint ventures (OJV) and wholly owned subsidiaries (WOS) as also investment by a person resident in India in shares and securities issued outside India.  Overseas investments can be made under two routes (i) automatic route and (ii) approval route.
• The criteria for investment under automatic route are as under:
• The Indian Party can invest up to 400 per vent of its net worth (as per the last audited Balance Sheet) (50 % of net worth in case of listed Indian companies) in JV / WOS for any lawful activity permitted by the host country. The ceiling of 400% of net worth will not be applicable where the investment is made out of balances held in the EEFC account of the Indian party or out of funds raised through ADRs/GDRs.
• The Indian Party is not on the Reserve Bank of India’s (RBI) exporters' caution list / list of defaulters to the banking system published/ circulated by the Credit Information Bureau of India Ltd. (CIBIL)/RBI or  any other credit information company as approved by RBI or under investigation by the Directorate of Enforcement or any investigative agency or regulatory authority.
• The Indian Party routes all the transactions relating to the investment in a JV/WOS through only one branch of an authorised dealer to be designated by the Indian Party
• Investment in an overseas OJV / WOS may be funded out of one or more of the following sources:
• drawal of foreign exchange from an AD bank in India
• capitalisation of exports
• swap of shares
• proceeds of External Commercial Borrowings (ECBs) / Foreign Currency  Convertible Bonds (FCCBs)
• in exchange of ADRs/GDRs issued in accordance with the Scheme for issue of Foreign Currency Convertible Bonds and Ordinary Shares (through Depository Receipt Mechanism) Scheme, 1993, and the guidelines issued thereunder from time to time by the Government of India
• balances held in EEFC account of the Indian party
• proceeds of foreign currency funds raised through ADR / GDR issues.
• In case of partial / full acquisition of an existing foreign company, where the investment is more than USD 5 million, valuation of the shares of the company shall be made by a Category I Merchant Banker registered with SEBI/ other foreign regulatory authority.
• In case of acquisition by way of share swap-prior approval from Foreign Investment Promotion Board is required.
• Prescribed form under FEMA 120 should be filed with the Reserve Bank of India within prescribed time (30 days from date of transaction, presently) for the purpose of reporting and legal compliance.
• More information on direct foreign investments by Indian firms is available at http://rbi.org.in/Scripts/BS_FemaNotifications.aspx?Id=2126.
• In addition to above under section 6 of the Competition Act, 2002 (Competition Act), (if requirements under section 5 of the Competition Act are met) no person or enterprise shall enter into a combination which causes or is likely to cause an appreciable adverse effect on competition within the relevant market in India and such a combination shall be void.  Further, the parties to the combination would have to approach the Competition Commission of India (the Commission or the CCI) under section 6(2) of the Competition Act and take prior approval from the Commission before executing the transaction. If the approval is not given, the parties to the combination shall not enter the transaction or work upon it.
• For investing in target company, in excess of 60% of the net worth of the company or 100% of its free reserves, the company under the Companies Act, 1956 would require approval from the shareholders of the company.

Outbound acquisition in practice

• In practice the vast majority of the transactions have been structured as friendly, plain vanilla, all-cash acquisitions of the target company, with few using company shares as consideration.
• Indian firms have been able to use ADRs and GDRs to ease access to foreign capital markets and to facilitate M&A activities in foreign markets.
• Indian firms have been able to raise acquisition financing abroad, they have faced difficultly in raising acquisition financing in India as Indian regulations restrict the ability of Indian banks to provide acquisition financing.
• The typical structure for the Indian acquirer to set up an SPV by providing some equity financing, and then to raise large amounts in the SPV through senior debt and mezzanine financing for which the target company‘s assets will be provided as security.
• RBI approval for financing of outbound investment by way of pledging of shares is rarely given in practice.
• Combination provisions under Competition Act has just started operation (from 1 June, 2011), so it would be pretty early to comment on CCIs practice, but as per the Competition Act and Combination Regulations, it appears that CCI would not take more than 30 days (210 days in case a show cause communication is issued) to clear a transaction which have no appreciable adverse effect on the competition in India.

Present deal- acquisition of Peguform Group by SMG

• The present deal (Peguform Acquisition Deal) appears to be a plain deal where the outbound investment would be following a plain vanilla through Mauritius route under automatic route. 
• With debt to equity ration of 0.8 of MSSL, the promoters of SPV (MSSL and MSFL) would face less-problem in raising finances for the acquisition.
• If the thresholds are met under section 5 of the Competition Act, Peguform Acquisition Deal would require prior approval from the CCI and a notification under section 6 of the Competition Act and Combination Regulations is required in this deal.
• If the Peguform Acquisition Deal happens to be a ‘no-all cash’ deal, then perhaps, in all likelihood, MSSL and MSFL would enter into a receivable agreement/ guarantee/ financing  agreement with a lender-preferably an Indian bank having branches outside India or having some association with foreign bank- which would in turn provide loan to Mauritius/ Cyprus/ BVI based SPV.
• MSSL and MSFL (through SPV) may enter into share-pledge agreement (not involving any Indian asset), put-option agreement with Financial Institution/ Bank in order to get financing.

Irregular IPOs: Lessons from Vaswani Industries IPO

Market players in the Indian equity capital markets have been exposed by the Securities and Exchange Board of India (SEBI) of following a cartelized approach with respect to subscription and allotment of securities in an initial public offering (IPO) in a recent order dated 11 July, 2011 in the matter of issuance of shares by Vaswani Industries Limited (Vaswani Industries).

Various complaints were filed before the SEBI regarding deliberate huge withdrawals/ rejections after the closure of the Vaswani Industries IPO.  The issue was subscribed to the extent of 4.16 times and after the withdrawals/ rejections the issue subscription dropped to 1.28 times. During the investigation, SEBI found that there was collusion amongst the BRLM/ syndicate-sub syndicate members to the issue in artificially raising the demand of Vaswani Industries shares during the bidding period.

Contentions of Vaswani Industries and the BRLM/sole syndicate member

In brief, the contentions were (Vaswani Industries):

·         Company should not be penalized for unlawful acts of others;

·         In terms of section 71 of the Companies Act, 1956 (Companies Act), an allotment made by a company to an applicant could be voidable at the instance of the applicant only under two circumstances i.e. (i) an allotment made without ensuring the minimum subscription under section 69 of the Companies Act and (ii) an allotment is made without issue of prospectus under section 70 of the Companies Act.

In brief, the contentions were (BRLM/sole syndicate member (SSM)):

·         SSM is under no obligation to underwrite the Company’s IPO post-allotment;

·         If option of withdrawal of shares is ordered then requirements of regulation 26 (4) of SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 may not be satisfies;

·         SEBI has no power under section 73 of the Companies Act to declare the allotment null and void.

SEBI order

This order is not as impeccable as any other order passed by Dr. K.M. Abraham, Whole Time Member, SEBI.  The order appears to be a compromise between the SEBI and the Company under which, the Company would be allowed to list and trade and at the same time the Company give a withdrawal option to all the investors who have been allotted shares (in retail and non-institutional category) for such number of shares by which allotment ratio was impacted.

Takeaways for transactional lawyers

·         During the refund/withdrawals process, separate escrow demat account for crediting the shares that are offered to be put in place.

·         In case the is under-written, then the underwriters under the agreement may purchase or arrange purchases post-IPO of such number of shares so as to ensure that the subscription does not fall below the minimum level of subscription.

·         In case the issue is not under-written/ there is non-compliance of above the entire subscription money to be refunded to the investors and all shares so allotted shall be cancelled.

·         Section 71 of the Companies Act shall not be literally applied and the irregularly allotted shares shall be cancelled and the money refunded in the interest of the securities market.

Standardized Due-diligence norms for Merchant Bankers in a Public issue

Under regulation 64 of the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2009 (ICDR Regulations), the lead merchant bankers shall exercise due diligence and satisfy himself about all the aspects of the issue including the veracity and adequacy of disclosure in the offer documents.  Further under schedule VI of the ICDR Regulations, the merchant bankers to the public issue are required to submit a due-diligence certificate (DD Certificate) to the Board.  In the DD Certificate, among other things, the merchant bankers are required to certify that they have examined various documents (including those relating to litigation like commercial disputes, patent disputes, disputes with collaborators, etc. and other material) in connection with the finalisation of the draft red herring prospectus (DRHP) and the prospectus submitted with the registrar of companies.  There is no format prescribed by SEBI/ or guidance issued by SEBI on the issue of due-diligence.  In practice, the due diligence work is outsourced by the merchant bankers to legal counsels (for legal due diligence) and accountants (for financial due diligence), who further have their own due-diligence check lists to conduct due-diligence over the issuer.  Most of the due-diligence checklists of the legal counsels are similar and standard and caters very well to the requirements prescribed under schedule VIII of the ICDR Regulations.

However, if a reports published in Business Standard (8 July, 2011, http://www.business-standard.com/india/news/regulator-wants-due-diligence-norms-for-merchant-bankers/441957/) is to be believed, SEBI wants to put in place standard guidelines for the due diligence process carried out by the merchant bankers for public issues.  In my view this move of SEBI is guided by the fact that SEBI is receiving quite a few sub-standard drafts of the DRHPs being filed with it and is aimed to enhance the quality of information (both in terms of uniformity and greater clarity) available to the public before investing in the public issue.  In furtherance of this objective, Association of Merchant Bankers of India (AMBI), had been asked by SEBI to come up with the draft guidelines by September, 2011.

These due-diligence guidelines (if it becomes a reality) would certainly make the work of capital markets lawyers a lot more-easier.  Further, I believe, the AMBI should also come up with a concrete answer to the standard question on insider trading aspects of the public issue (as in, is the company really worth as is stated in the price-band of the red-herring prospectus?) amongst various other issues like eligibility of issuers, corporate records, promoters etc..