Wednesday, October 1, 2014

OECD on Public Enforcement of Corporate Governance in Asia

The principles and norms of corporate governance tend to operate through layers. On the one hand, there is the basic legislation, i.e. the Companies Act, SEBI Act and the like. Then there are specific norms in the form of clause 49 of the listing agreement that are mandatory for listed companies. Finally, there could be voluntary guidelines that exhort companies towards higher standards. That leads to the obvious question of how one can ensure compliance with these rules and norms.

There are essentially two forms of enforcement, viz. public and private. Public enforcement is pursued by the state or the regulator against errant parties. Such action may either be initiated suo moto or based on a complaint or request received by it. Public enforcement is usually targeted at the errant party, and to ensure deterrence. Private enforcement, on the other hand, is initiated by an affected party before a civil court or other appropriate forum. Such an action is also pursued by such private party at its own cost. Private enforcement focuses on the affected party, and largely operates to restitute or recompense the victim. While public and private enforcement are both necessary, they perform somewhat different roles. In that sense, an appropriate mix of the two methods may be necessary in an ideal securities market.

Despite the need for both methods, private enforcement is popular in certain jurisdictions such as the US where class action suits have performed a significant role in investor protection. In other jurisdictions, public enforcement tends to play a larger role. In this context, a recent OECD report titled “Public Enforcement and Corporate Governance in Asia: Guidance and Good Practices” is useful in as much as it surveys the role of public enforcement in various Asian countries in the context of compliance with corporate governance.

As far as India is concerned, it is clear that public enforcement has played a more significant role in the development of capital markets than private enforcement, as I have observed in a recent paper as well. SEBI’s emergence as a strong securities regulator over the last two decades coupled with the difficulties in bringing (and taking to fruition) securities actions before Indian courts seem to be the reason behind this phenomenon. Nevertheless, given the added remedies provided to investors in the form of the class action mechanism under the Companies Act, 2013 (section 245), some change may be visible. However, it is unlikely to alter the balance given the pendency before the Indian courts, inordinate delays and exorbitant costs of bringing private securities claims. At the same time, the focus on public enforcement is set to continue as SEBI’s hands have been further strengthened through the Securities Laws (Amendment) Act, 2014.

Monday, September 29, 2014

The Indian Supreme Court on Lifting the Corporate Veil

In its recent judgment in Balwant Rai Saluja, a three-judge Bench of the Supreme Court has considered a number of important questions relating to when, if ever, it is appropriate to lift the corporate veil. Readers may recall that we had previously discussed Lord Sumption’s magisterial judgment on this point in Petrodel v Prest: Although the Supreme Court has not endorsed precisely the same criteria as did Lord Sumption, its recognition that the corporate veil should rarely be lifted is welcome.

In Balwant Rai Saluja, the question was whether workers in a statutory canteen maintained at Air India’s premises were to be treated as employees of Air India or as employees of the contractor running the canteen. The contractor, HCL, was a wholly owned subsidiary of Air India. The workers made two arguments. First, that the fact that Air India was required by statute (the Factories Act 1948) to run a canteen meant that those working in it were ‘deemed employees’; and secondly, on the assumption that they were in fact employees of HCL, it was appropriate to lift the corporate veil because HCL was a ‘sham’ company entirely controlled by Air India. The Supreme Court, it is submitted correctly, rejected both of these contentions. This post deals largely only with the second, but it may be helpful to briefly describe the Court’s findings on the first point.

The question whether X is an employee of Y can arise in a number of contexts: taxation (is X’s income salary or income from business), labour law (is X entitled to raise an industrial dispute), vicarious liability (is Y liable for X’s wrongful acts) and so on. The key point—and Dattu J, giving the judgment of the Court, accepts this—is that there need not be a uniform answer to these questions. That is, the fact that X is an ‘employee’ for tax purposes does not (of itself) mean that Y is vicariously liable for a tort committed by X. Dattu J recognises this in holding that the fact that workers at a facility which the employer is obliged to maintain are treated as employees under that Act does not mean they are employees generally. Where, however, there is no special statutory context of this kind, the courts normally ask whether the contract that the worker has entered into is a contract of service or a contract for services. But this does no more than restate the problem: how does one distinguish between a contract of service and a contract for services? In English law, the consensus appears to be that the ‘control’ test, which was previously thought to be decisive, is only one element in the analysis: in the context of vicarious liability, the courts have even recognised the possibility of two employers being liable for the same wrongful act (see Viasystems v Thermal Transfer). In Balwant Rai Saluja, the Supreme Court holds that the appropriate test ‘complete administrative control’ which, with respect, is questionable. The point must ultimately turn—in the absence of any special statutory test—on the intention of the parties, and control (although important) is not decisive. As Lord Wright famously pointed out, the master of a chartered vessel is an employee of the shipowner, not the charterer, even though the charterer is entitled to give him orders.

The second point—about the corporate veil—is more significant for our purposes. The Supreme Court, correctly, holds that the law on the point has in recent times crystallised around the six requirements set out by Munby J in Ben Hashem (approved by Lord Sumption in Prest). This is to be welcomed because it means that the Supreme Court is implicitly questioning the far wider grounds on which it had previously lifted the veil. The Court notes the narrow test accepted by Lord Sumption at [35] of his judgment in Prest (the ‘evasion principle’) but, crucially, its own formulation of the test is wider:

Thus,  on  relying  upon  the  aforesaid  decisions, the  doctrine  of  piercing  the  veil  allows  the  Court  to disregard the separate legal personality of a company and impose liability upon the persons exercising real control over the said company. However, this principle has been and should be applied in a restrictive manner, that is, only in scenarios wherein it is evident that the company was a mere camouflage or sham deliberately created by the persons exercising control over the said company for the purpose of avoiding liability.

This formulation is wider than Lord Sumption’s in two respects: first, it suggests that ‘mere camouflage or sham’ is a separate ground for piercing the veil which, with respect, is questionable because it invites the obvious question ‘what is a sham’ to which the only conceivable answer is either ‘economic reality’ (which the Supreme Court correctly rejects) or impropriety (which is the second limb of its test and therefore unnecessary). The second limb is also wider than the Prest test because ‘avoiding liability’ is not confined to avoiding liability that exists independently of the interposition of the company. If that condition is omitted, it becomes relatively easy to lift the veil because one is only asking whether some conceivable benefit that could have been lost without a company has now been obtained because of its interposition. This is perhaps why the Supreme Court, in applying the principle to the facts, examined the content of the Memorandum and Articles of Association of HCL, and relied on the fact (see [77]) that its objects were different to those of Air India. On the ‘evasion principle’ set out in Prest, this probably does not matter: one is not asking whether the parent ‘controls’ the subsidiary or whether the subsidiary is the ‘alter ego’ (as one would have done before Prest) but simply whether the claimant’s right against the controller, which existed independently of any company, is now being defeated or frustrated because of the interposition. But the Supreme Court’s ultimate conclusion in Balwant Rai Saluja—that it is not appropriate to lift the veil on these facts—is, it is submitted, clearly correct. Its observations at [80], in particular, are important:

The present facts would not be a fit case to pierce the veil, which as enumerated above, must be exercised sparingly by the Courts. Further, for piercing the veil of incorporation, mere ownership and control is not a sufficient ground. It should be established that the control and impropriety by the Air India resulted in depriving the Appellants-workmen herein of their legal rights.

It is submitted that this is correct and should be followed in preference to older authority suggesting a far wider jurisdiction to lift the veil. Those cases have not been formally overruled or even questioned because it was unnecessary to do so in Saluja but the underlying principle the Supreme Court has accepted is an open invitation to counsel to challenge those cases in the future.

Wednesday, September 24, 2014

“Dual-class” Share Structures

The recent NYSE listing of Alibaba has once again brought to the fore the issue of dual-class share structures, as discussed in this column in the Economist. Alibaba’s founder and a group of insider shareholders have control rights that are disproportionate to their economic rights. The wave of dual-class structures in tech-IPOs was triggered by Google’s IPO in 2004, which was followed by another large listing of Facebook in 2012 and now Alibaba (in what has been dubbed the largest IPO ever). The Economist indicates that dual-class structures are quite common in US public companies, with “55% of the 524 such companies in the global database of MSCI” giving disproportionate rights to shareholders.

The advantage of dual-class structures is that it allows companies to raise capital and at the same time preserve the control held by founders and insiders. At the same time, it also carries certain concerns. From a corporate governance perspective, the deviation from the customary “one-share-one-vote” rule places control in too few hands thereby rendering limited protection of the interests of the remaining shareholders. The ability of persons with limited economic interests to exercise greater control over the company may exacerbate agency costs that operate in the corporate governance sphere. Moreover, and related to governance as well, dual-class structures operate as takeover defences and allow incumbents to enjoy protection from hostile takeovers that may act as a curb on inefficient management. Using dual-class structures, the incumbents may enjoy favourable protection against such corporate raids.

Despite these concerns, why are jurisdictions permitting the use of dual-class structures that are increasingly becoming more common? It seems the answer is to attract listings on their stock exchanges. As the Economist notes, it is not surprising that Alibaba decided to list on the NYSE rather than the Hong Kong Exchange given that the latter does not recognise dual-class structures. Hong Kong itself seems to now be succumbing to the pressure to attract listings and is reviewing its own position through a concept paper that is a precursor to a public discussion on the issue. Similarly, while Singapore does not currently permit dual-class structures, it is considering legislative amendments to its company law to introduce the concept. After substantially dilly-dallying on the issue, the Companies Act, 2013 in India now recognizes the concept of shares with differential rights (sections 43(a)(ii)), although SEBI has imposed further curbs in the ability of public listed companies to issue shares with superior rights.

All of these beg the question whether the urge to attract listings and provide more flexibility to issuers and investors may result in eclipsing the concerns pertaining to structures both from the perspectives of corporate governance and takeovers, so as to result in the phenomenon of a “race to the bottom”.

Restrictions on Tax Inversions

A few months ago, we had discussed the use of “inversion” deals by U.S. companies to minimize the effect of U.S. taxes. Since then, inversions have been the subject matter of intense debate from a policy perspective. Two potential regulatory responses have been proffered. One is more short-term by which the U.S. government limits the ability of companies to carry out inversion deals by either prohibiting or restricting them. The other is more long-term and requires an overhaul of the U.S. corporate tax structure and system.

Earlier this week, the U.S. Treasury adopted the first response and introduced significant curbs on the ability of U.S. companies to carry out inversions. For an analysis of the impact of this announcement, please see here and here.

SEBI’s Final Order in GDR Manipulation Case

In a September 2011 post, we had discussed an ad-interim ex parte passed by SEBI in relation to a specific transaction structure that involved the use of global depository receipts (GDRs) to allegedly manipulate the stock price of several companies:

The modus operandi was as follows. The companies issued GDRs, which were acquired by various foreign institutional investors (FIIs) or their sub-accounts. The GDRs were all soon thereafter converted into underlying equity shares of the issuing company, which were then sold in large (synchronized) deals to several buyers, such as stock brokers. The stock brokers would in turn sell the shares to other investors. After investigation, SEBI found that the companies, the lead manager to the GDRs, the FIIs/sub-accounts and the stock-brokers were all acting in common as a group. They were able to maintain the stock price of the company through these transactions without symmetry of information to outside investors who may have paid a high price given the issuance of GDRs by the companies and large holdings maintained in them by FIIs. SEBI found this to be an instance of market manipulation and passed an order restraining the relevant companies and investors from participating in the capital markets.

In a final order passed last week, SEBI prohibited several entities from accessing the capital markets and dealing in securities for a five-year period. The order gives rise to a few legal issues.

SEBI’s Jurisdiction Over GDR Offerings

The entities affected by SEBI’s investigation argued that SEBI did not have jurisdiction over GDR issuances as they related to securities that are traded outside India. However, SEBI refused to accept this argument on the ground that GDRs related to underlying Indian securities which in turn affected the Indian securities markets. It observed:

5.1       i.          The issuance of GDRs is from the authorised share capital of a company listed in Indian stock exchanges. Any structuring or manipulation related to GDRs has a direct impact on securities of companies trading in Indian market. Further, the underlying security of GDRs are shares of Indian companies with two-way fungibility, which allows for conversion of GDRs in Indian market and vice versa. Hence, the impact of such issuance, cancellation/conversion and sale/transfer of shares so converted has direct bearing on the securities market in India. Such issuance, etc. of GDRs by Indian companies also greatly influences decision-making by investors in the securities market. In view of the same, it is seen that the issuance of GDRs, which are ‘marketable securities’ under Section 2(h) of the SCRA Act, cannot be regarded as an exclusive activity totally insulated from and not impacting the securities market in India.

The argument raised here seems somewhat analogous to the one raised in the Sahara case as to SEBI’s jurisdiction over hybrid instruments such as optionally fully convertible debentures (OFCDs), which the Supreme Court rejected, holding that those instruments were within the purview of the SCRA and hence under SEBI’s jurisdiction.

The matter relating to GDRs is, however, not beyond doubt. On an appeal by one of the affected parties in this GDR manipulation case, the Securities Appellate Tribunal (SAT) ruled that SEBI did not have jurisdiction to investigate matters relating to GDRs. SEBI filed an appeal against that ruling to the Supreme Court, which stayed SAT’s ruling. The Supreme Court is seized of the matter on the question of law. Hence, SEBI’s order on this issue will be subject to the outcome of Supreme Court’s opinion on the same.


On the issue of manipulation, SEBI’s investigations revealed that the GDR issues were devised and structured by Arun Panchariya and Pan Asia Advisors Limited (owned 100% by Panchariya). SEBI has sought to establish connections between them and the other entities involved to demonstrate the existence of an orchestrated scheme. It notes:

8.3       In the factual context of the instant proceedings, it is important to view the connection between the Noticees amongst themselves and with Panchariya not in isolation but rather as a factor in the totality of the circumstances. This is so because while each fact standing alone may be insufficient, the combination of all the facts can be a substantial basis for determining ‘manipulation’ or ‘fraud’ on the part of each Noticee. The investigations in the instant proceedings reveal that the GDR Issues were devised and structured by Panchariya and Pan Asia in connivance with the Issuer Companies through a fraudulent arrangement. The existing shareholders and prospective investors were aware of the ‘positive’ news that the Issuer Companies had raised foreign capital through GDRs but were completely unaware of the activities of Panchariya along with the connected entities, in such GDR Issues. The Sub-Accounts, viz. IFCF and KII who were allegedly connected to Panchariya, converted the GDRs held by them into shares and sold the same in the Indian securities market where the counter parties to a major portion of such sales were entities connected to Panchariya, i.e. Noticees 1-13. The objective of such trading between the Sub-Accounts and Noticees 1013 inter alia was to create an impression of there being liquidity in the market. As a result, the investors in India were lulled into thinking that stocks of the Issuing Companies had been highly valued by foreign investors, which in turn acted as an inducement for other persons to buy shares of the Issuer Companies in the Indian securities market. The Indian investors were therefore adversely affected by the misleading signals of Panchariya alongwith the connected entities, i.e. Noticees 1-13, through trading done amongst Noticees 1-13 and Sub-Accounts, creating liquidity in the market and their subsequent offloading of the shares. In these circumstances, I am of the considered view that the role played by each Noticee should not be seen in isolation and that the case needs to be seen in its entirety in the light of the large scale market abuse explained earlier.

In a nutshell, and as explained in the previous post referred to above, the parties are alleged to have indulged in regulatory arbitrage by taking advantage of a more lax regime pertaining to GDRs over a more stringent regime for issuance of underlying shares in the domestic markets.

Finally, the scope and sufficiency of SEBI’s order raises some questions. As Mobis Philipose argues, some entities have not been referred to in the final order. Moreover, the direction to debar the concerned entities from the stock markets may be insufficient as SEBI did not find it fit to impose penalties or order disgorgement of profits arising from the transaction.

Tuesday, September 23, 2014

Share buybacks - cause for concern?

Several recent articles (in The Economist, the Financial Times and the Wall Street Journal) highlight the spate of buybacks by blue chip companies over the last year, and raise some concerns arising out of this seemingly shareholder-friendly trend.

The companies in the S&P 500 index bought US$500 billion of their own shares in 2013, close to the high reached in the bubble year of 2007. This comprises 33 cents of every dollar of cashflow generated by these companies. Even in Europe and Asia (Japan, in particular), buybacks by companies have seen an upward trend. Given the cash reserves which have developed at many blue-chip companies since the 2008 crisis, the current low interest rate environment and limited investment opportunities, returning some of this surplus cash to shareholders may be viewed as a positive development – indeed the buybacks at some companies like Apple are in response to aggressive campaigns by activist shareholders.

However, there are a few major concerns with this recent trend – relating both to the underlying reasons for some of these buybacks and also their potential impact.

Lack of long term investment

One direct consequence of returning capital to shareholders is that the capital is no longer available for investing in the company, whether in improved facilities, distribution networks, or R&D. This has led some commentators to suggest that the long term prospects of these companies are being adversely affected by utilising surplus cash in buying back shares.

However, although this concern is valid (especially when combined with the second concern discussed below), many of the blue-chip companies returning capital are digital or internet companies (such as Apple, Intel, Cisco or Microsoft) which do not need the sort of heavy capital investment required by their counterparts in the manufacturing industry. Therefore, the fact that greater capital is being returned to shareholders does not necessarily translate into under-investment in the future of the business.

Self-serving motives

A more significant concern over the spate of buybacks is that they may be prompted by short-termism and the self-interest of those occupying management positions, rather than the long term interest of shareholders.

Share buybacks both increase the share price and reduce the number of shares in issue; the latter directly increasing the earnings-per-share (EPS) ratio of the company. Since the remuneration of management may comprise a stock-option plan and is also often linked to the EPS ratio, there is thus a self-serving motive for implementing buyback programmes. This leads to the concern that the management of some of these entities are moving away from ‘value creation’ to ‘value stripping’, benefiting short term shareholders at the expense of those investing in the companies for the long term.

Introducing instability 

Finally, the trend of buybacks poses a serious risk of introducing instability to the companies and the market as a whole.

According to The Economist, figures reveal that over the last year for non-financial firms in the S&P 500 index, buy-backs, dividends and capital investment added up to 101% of operating cashflow – suggesting that their books were balanced. However, this figure is misleading due the inclusion of a handful of giant pharmaceutical and technology firms. If these cash-rich entities are excluded, two-fifths of the S&P 500 companies spent more than their entire cashflow on dividends, buybacks and capital investment, thereby adding to their net debt. Further, even for cash-rich companies like Apple, the complex US tax structure means that most of the surplus cash is located offshore and is not utilised for funding buybacks. As a result, Apple borrowed $12 billion in the US last year to help fund buy-backs despite having $132 billion of cash sitting abroad. This trend is not limited to the last year either – an article in the September 2014 edition of the Harvard Business Review indicates that between 2003 and 2012, the top 449 companies in the S&P 500 spent 91 per cent of net income on buybacks and dividend payouts.

Not only do these excessive buybacks and dividend payouts impact future prospects of the companies concerned, but may also introduce instability to the market through inflated share prices and increasing corporate debt. Further, it is ironical that one of the major reasons for low interest rates is to prompt greater investment by companies into the economy – something that is hardly being achieved if companies utilise the low rates to borrow cash in order to fund share buyback schemes.

Looking forward

Most jurisdictions already impose broad limits on capital reduction schemes – either in the form of shareholder approvals or by capping the extent of buybacks in terms of trading volumes. However, given the events over the last year, these limits do not appear to be sufficient. Recommendations for further legislative change include improved corporate governance and shareholder influence over remuneration (to address the concern over self-serving motives). Even changes like simplifying the US tax system could have the effect of bringing back more surplus cash to the US, thereby limiting the building up of corporate credit.

Further, The Economist suggests that the buyback boom may now be peaking, with companies such as Exxon, Tesla and Amazon proposing injections of capital into their businesses. This is perhaps prompted by the realisation of institutional shareholders that high short term returns at the cost of investing targeting long term growth are not necessarily in their best interest.  

Monday, September 22, 2014

RBI Allows FDI against “Legitimate Dues”

Hitherto, an Indian company could issue shares to a non-resident against payment obligations only in certain circumstances. These related to “lump-sum technical know-how fee, royalty, External Commercial Borrowings (ECB) (other than import dues deemed as ECB or Trade Credit as per RBI guidelines) and import payables of capital goods by units in Special Economic Zones” subject to applicable conditions.

By way of a notification issued on September 17, 2014, the Reserve Bank of India (RBI) has now allowed companies to issue shares to non-resident investors under the foreign direct investment policy (FDI) “against any other funds payable by the investee company, remittance of which does not require prior permission of the Government of India or Reserve Bank of India under FEMA, 1999 or any rules/regulations framed or directions issued thereunder”. However, this is subject to compliance with the terms and conditions of the FDI policy, including sectoral caps, pricing guidelines, etc., and also applicable tax laws.

By expanding the scope of the types of obligations which can be met by issuance of shares, the RBI has conferred more flexibility to Indian companies to be able to meet their obligations through issue of equity. However, since it is limited to obligations the discharge of which is under the automatic route, the scope is quite clear and confined. If the payments require Government approvals, then the concomitant issue of shares cannot be effected under the automatic route.

For a more detailed analysis, see this column in The Firm – Corporate Law in India.

Report on Gender Diversity in Corporate Boards

The issue of board diversity has acquired considerable prominence in recent times. Although there can be various hues to the concept of diversity, one manifestation relates to gender diversity and the requirement for women directors on corporate boards. What began as a useful management strategy has acquired regulatory overtones. Several countries have incorporated gender diversity into their corporate governance regimes. Some, Norway being at the forefront, have sought gender diversity as a mandatory requirement under the corporate governance norms. Others have either required disclosures and transparency measures or even extended to “comply-or-explain” mechanisms to usher in gender diversity in corporate boards in their respective jurisdictions.

Under the Companies Act, 2013, India has adopted the mandatory approach to gender diversity. Section 149(1) provides that certain classes of companies must have at least one woman director. According to the Companies (Appointment and Qualification of Directors) Rules, 2014, this requirement applies to listed companies as well as to other companies having a paid-up share capital of at least Rs. 100 crores or turnover of at least Rs. 300 crores. The implementation is expected to occur in a phased manner. Although this requirement was also incorporated into the revamped clause 49 of the listing agreement prescribed by SEBI, the implementation of the gender diversity provision has been postponed until April 1, 2015.

In this background, a recent study entitled “Women on Boards: A Policy, Process and Implementation Roadmap” conducted by Biz Divas and Khaitan & Co. provides useful discussion, analysis as well as some empirical findings about gender diversity in Indian corporate boards as compared with developments on the global scene. The report may be accessed here (registration required, which is free) and some discussions/ analyses are contained here and here.

While the introduction of gender diversity in India is welcome, providing a legislative mandate is on part of the solution, and much lies in its actual implementation. Matters such as diversity extend beyond regulation and must percolate into the culture and DNA on the business organizations. A few thoughts come to mind (and they are by no means exhaustive).

First, gender diversity must be accepted in spirit and not just as a matter of law (that usually evolves into a mechanical “check-the-box” requirement). There is a need to guard against tokenism. It is not sufficient to merely appoint a woman director for the sake of compliance. What is required is a careful scrutiny and analysis of the strengths and contributions an individual woman director brings to the board. The nominating committees must take note of these aspects in a transparent manner and induct the most appropriate individuals to the job. One might go to the extent of adding that (although not strictly the legal requirement) the woman director ought to be an outside director with minimal association with the company or its promoters so as to bring to bear an independent perspective that will aid a more sustainable business outlook for the company so as to benefit its shareholders (in the long term) as well as its stakeholders.

Second, once the appropriate individual is appointed, the woman director’s contribution must be valued and duly harnessed by the company. Again, it would depend upon the board dynamics in individual companies and also the approach adopted by the chairman and the management. Here too, tokenism must be guarded against.

Third, a question remains whether a single woman director on a large board is likely to have any impact. Other countries (prominently Norway) have adopted the approach of requiring a larger number of women directors. This is with a view to ensure that gender diversity has the required impact on the boards. Empirical evidence discussed in the abovementioned report suggests a robust build-up of board diversity in Norway with nearly 40% directors comprising women. Hence, while the requirement of one woman director can be considered to be the beginning of the progress towards gender diversity, the issue may have to be revisited over a period of time to explore if changes are required so as to provide for a greater number of women directors. Of course, in such a case the availability of the requisite number of women directors would also have to be considered.

In all, the move towards gender diversity on Indian corporate boards is an important one. At the same time, other forms of diversity would also have to be taken into account. Although it is not possible to legislate for all forms of diversity, boards of companies and their nominating committee must work towards gaining an appropriate mix that maximizes the strategic and monitoring roles that modern corporate boards play.

Saturday, September 20, 2014

Supreme Court on Non-Compete Fee Under the Takeover Regulations

[The following post is contributed by Yogesh Chande, Associate Partner, Economic Laws Practice. Views are personal]

The Supreme Court passed an order setting aside the Securities Appellate Tribunal (SAT) decision [and order of SEBI] on payment of “non-compete” fee under the erstwhile SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 (SEBI Takeover Regulations)

Background and Facts

1.         On 29 March 2011, the appellants (IP Holding Asia Singapore and others) entered into a share purchase agreement with Bangur Group [20 entities] to acquire 53.46% of the share capital of the target company viz: Andhra Pradesh Paper Mills Limited[1] for a price of INR 523 per share aggregating INR 1,111.9 Crore.

2.         Additionally, the parties also entered into an exclusivity agreement to maintain exclusive negotiations with one another during stipulated period. Exclusivity fee for such an agreement was INR 21.20 per share.

3.         The parties also enter into a “non-compete and business waiver” agreement, in terms of which the appellants agreed to pay an amount of about INR 277.95 Crore to Bangur Group for refraining from competing with the business of the target company either on their own behalf or through their affiliates for a period of three years.

4.         The appellants accordingly made an open offer to the public shareholders of the target company representing 21.54%[2] of the voting capital at a price of INR 544.20 [INR 523 + INR 21.20] in accordance with the provisions of the SEBI Takeover Regulations[3].

5.         Upon filing the draft letter of offer (DLOF) with SEBI and after various correspondence between them, SEBI while issuing its comments/observations on the DLOF directed that, the offer price be increased to INR 674.93 per share,[4] inclusive of the non-compete fee being paid to Bangur Group.

SEBI’s reasoning for adding the non-compete fee to the offer price was as follows

6.         According to SEBI, the non-compete fee was in fact a part of the negotiated price per share payable by the appellants to Bangur Group and hence should be added to the offer price to the public shareholders.

7.         Of the twenty promoter entities comprising Bangur Group, only five were eligible to receive the non-compete fee.

8.         Of the remaining fifteen, two individuals were not eligible to receive the non-compete fee, since they did not have any experience or expertise in the area of operation of the target company and hence not capable of offering any competition to the appellants. According to SEBI, the payment was made merely because they were shareholders.

9.         The remaining thirteen entities were also not eligible to receive non-compete fee because they did not even have in their object clause, the business of pulp and paper manufacturing.

10.       Since the exclusivity fee was being paid to Bangur Group and also to the public shareholders, even the non-compete fee should be paid to the public shareholders.

11.       Above all, the merchant banker was unable to give sufficient justification for payment of non-compete fee.

Appeal to SAT and decision of SAT

12.       After reviewing the submissions made in the appeal, SAT while dismissing the appeal held that, the non-compete fee was directly linked to the shareholding of the promoter entities and had nothing to do with the possibility of the being in competition with the target company. In this regard, SAT also made reference to three promoter entities of Bangur Group, one of which was a religious & charitable trust, another being in the business of printing and publishing books and the other in the business of textile mill.

13.       SAT held that non-compete fee was a sham and resulted in depriving the public shareholders of their rightful claim to get a just price of their shares.

Appeal to Supreme Court and decision of Supreme Court

While allowing the appeal and setting aside the directions and orders passed by SEBI and SAT, Supreme Court considered the facts and held as follows:

14.       If the non-compete fee is less than 25% of the offer price, the jurisdiction of SEBI would be exercisable only in an extremely rare case and only if SEBI was in a position to ex facie conclude that the transaction involving the takeover was not bona fide. Ordinarily, when there is a gap of 25% between the consideration paid to the selling promoters and non-compete fee, SEBI ought not to conduct an inquiry.

15.       The reconvened Bhagwati Committee, while being fully aware of the possibility of a misuse of the non-compete fees, nevertheless recommended an elbow room of 25% of the consideration which would not be included for the purpose of arriving at the offer price.

16.       SEBI can certainly delve further into the matter, if it appears that the difference between the offer price and non-compete fee is less than 25% but is nevertheless a disguise or a camouflage to reducing the cost of acquisition. According to the Supreme Court, no such conclusion is apparent, nor was it canvassed or pointed out from the share purchase agreement and the non-compete agreement.

17.       It is the perception of the appellants that is more important, while deciding to pay non-compete fee to the selling promoters.


Non-compete fee is paid to the selling promoters so that they do not re-enter the business and pose threat to the target company under the control of new promoter.

Under the erstwhile SEBI Takeover Regulations, payment by an acquirer to the selling shareholders towards non-compete was always a vexed one. The tolerance limit of 25% on non-compete fee was brought in as a measure of curbing the practice where the acquirer passes on a significantly large portion of the consideration to the outgoing promoter in the form of non-compete fee and only a token amount is shown as negotiated price for acquisition of shares under the agreement. Under the present SEBI Takeover Regulations, 2011,[5] after much debate and discussion by Achuthan Committee, any form inclusive of all ancillary and collateral agreements forms part of the negotiated price and the same is now considered as one of the parameters for fixing the offer price, if such price is higher than other prescribed parameters.

Although SEBI is mandated to protect the interest of all investors and can question the payment of a non-compete fee or for that matter, even has the ability to intervene and question the merits of the decision taken by the parties involved in a transaction, following are some of the key takeaways from the Supreme Court ruling:

(a)        commercial decisions of the parties should be respected, unless there are good reasons not to do so;

(b)       it is imperative to give sufficient elbow room to commercial entities for entering into a business transaction and host of considerations go into business relations; and

(c)        threat perception cannot be decided on the basis of hindsight, but must be left to the commercial wisdom of the players on the field.

- Yogesh Chande

[1] In the business of manufacturing, sale and trading of pulp and paper
[2] 75% minus 53.46%
[3] Regulation 20(8) - Any payment made towards non-compete agreement in excess of 25% of the offer price was required to be added to the offer price and not otherwise.
[4] INR 277.95 Crore works out to INR 130.73 per share
[5] Regulation 8(7)