Tuesday, January 31, 2017

Issue of Convertible Notes by Startups Permitted

[The following guest post is contributed by Bhushan Shah & Neha Lakshman from Mansukhlal Hiralal & Company. The views expressed in the post are personal]

A convertible note is an instrument issued as debt and convertible into equity of a startup at the option of the holder, upon a future contingency taking place, usually when the startup obtains an additional round of investments. Therefore, convertible notes allow investors to invest in startups without concerns about their valuations, which are difficult to determine at the inception, as convertible notes are merely an instrument advanced as a loan and converted to equity at a later stage when the startup’s business model is more evolved.

In July 2016, the Ministry of Corporate Affairs (MCA) amended the Companies (Acceptance of Deposits) Rules, 2014 (Rules) exempting convertible notes from the ambit of deposits, and thereby allowing companies to issue convertible notes in tranches exceeding Rs 25 lakhs to prospective investors, without having to comply with the slew of requirements mandated by the Rules.

Now, the Reserve Bank of India (RBI) has  by way of a notification dated 10 January 2017 (Notification), amended the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 (FEMA 20/2000), implementing a key change in the foreign exchange policy by allowing startup companies to issue convertible notes to foreign investors. This is a marked change from the existing foreign exchange policy, where optionally convertible debentures are considered External Commercial Borrowings (ECBs) and are required to comply with the more stringent ECB Guidelines.

Following are the salient features of the Notification:

- Definition of convertible note: The notification defines a convertible note as follows:

- An instrument issued by a startup company evidencing receipt of money;

- This instrument is initially treated as debt;

- It is convertible into such number of equity shares of such startup company within a period 5 years from the date of issue, upon occurrence of specified events, as per the other terms and conditions agreed to and indicated in the instrument.

- Startup: This Notification is only applicable only to entities defined as startups. Startup companies includes the following:

- A company wherein 5 years have not elapsed from the date of its incorporation;

- Its turnover for any of those years does not exceed Rs. 25 crores; and

- The company is working towards innovation, development, deployment or commercialization of new products, processes or services driven by technology or intellectual property.

Therefore, entities that fall outside this definition would be unable to avail of the benefits of the Notification of being able to issue convertible notes.

- Persons eligible to purchase convertible notes

- Individuals / Entities resident outside India may purchase convertible notes issued by an Indian startup, for an amount of Rs 25 lakhs or more in a single tranche. However, a startup company engaged in a sector where foreign investment requires Government approval can issue convertible notes to a non-resident only with approval of the Government.

- Holders of the convertible notes are allowed to transfer the same to third parties, provided, such transfer complies with the pricing guidelines issued by the RBI.

- Non-Resident Indians may acquire convertible notes on non-repatriation basis in accordance with the applicable regulations under the Foreign Exchange Management Act, 1999.

- Persons barred from purchasing convertible notes: Citizens of Pakistan or Bangladesh, or entities registered in/incorporated in these countries cannot purchase convertible notes in Indian entities. 

- Other formalities: A startup company issuing convertible notes to a person resident outside India shall receive the amount of consideration by inward remittance through banking channels or by debit to NRE / FCNR (B) / Escrow account maintained by the person concerned in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016, as amended from time to time. The startup company issuing convertible notes shall be required to furnish reports as prescribed by Reserve Bank.

Comment: As mentioned earlier, convertible debt has been traditionally treated as ECBs and was required to comply with applicable ECB Guidelines, which permit only specific companies to access this route of financing from sources approved by the RBI as eligible non-resident entities, and that too for specific permitted end uses. With the issue of convertible notes being allowed, such convertible debt issued by startups shall now be considered foreign direct investment, thereby allowing the emerging companies to access to funds from foreign sources at a better valuation. However, this Notification is likely to have limited impact in increasing overall foreign investments as it is applicable only to specific types of entities.

- Bhushan Shah & Neha Lakshman

Sunday, January 29, 2017

Listing of Stock Exchanges and Addressing Conflicts of Interests

A few years ago, we had discussed possible issues that arise out of the commercial operations of a stock exchange. While an exchange is a profit-making institution and is required to act in the interests of its shareholders, it also carries out a regulatory role in selecting companies that are to be listed on it and thereafter in overseeing their compliance with the listing requirements. These issues have been addressed in various jurisdictions through different mechanisms as previously discussed. These questions (and more) have recently come to the fore in India with the listing processes of two leading stock exchanges, BSE and NSE, underway.

For instance, the red herring prospectus of BSE expressly recognises this as a risk factor as follows (at page 23):

8. Our duties as a stock exchange may conflict with our Shareholders' interests.

In discharging our obligations to ensure an orderly and fair market and/or to ensure that risks are managed prudently, we are required to act in the interests of the public, having particular regard to the interests of the investing public, and to ensure that where such interests conflict with any other interests, the former will prevail. There is no assurance, therefore, that our results will not be materially adversely affected through placing public interest ahead of our own interests, including the interests of our shareholders.

Similarly, the draft offer document of NSE too contains language to a similar effect (on page 27.

Apart from these usual conflicts duties and obligations of stock exchanges, there arises another question, which pertains to where stock exchanges can be listed. This is a common question as several leading stock exchanges around the world are listed, as this Economist report suggests. Interestingly, a few of those leading exchanges (examples being the Hong Kong and Singapore exchanges) have listed their securities on themselves, thereby imposing considerable onus on their regulatory mechanisms to be robust enough to address significant conflict issues that arise in the process.

When it comes to the venue for listing, the Indian legal position is somewhat stricter. For instance, regulation 45 of the Securities Contracts (Regulation) (Stock Exchanges and Clearing Corporations) Regulations, 2012 provides that “a recognised stock exchange may apply for listing of its securities on any recognised stock exchange, other than itself and its associated stock exchange”. Hence, a stock exchange in India is prohibited from listing on itself or an associated stock exchange, while partially seeks to address the conflict problems that arise when an exchange lists on itself. Hence, interestingly enough, in the current context, the BSE is listing on the NSE and vice versa.

However, such a listing of one exchange on another is itself likely to give rise to issues pertaining to conflicts of interest. Hence, the Securities and Exchange Board of India (SEBI) has sought to establish a mechanism to deal with potential issues that may arise from this dispensation. In a circular issued on 27 January 2017, SEBI has set out a three-part process for dealing with conflicts:

1.      The Listing Department of the listing stock exchange (i.e. a stock exchange on which the listing is done) shall be responsible for monitoring the compliance of the listed stock exchange (i.e. a stock exchange which is getting listed) as in the case of listed companies. This is similar to the usual duties carried out by the listing stock exchange in respect of any company.

2.      The Independent Oversight Committee of the listing stock exchange shall exercise oversight at the second level to deal with any conflicts. This also provides for a redressal mechanism whereby the listed stock exchange may appeal to the Independent Oversight Committee of the listing stock exchange, if aggrieved, with a decision of the listing stock exchange as specified under the previous paragraph.

3.      While the above two mechanisms are dealt with at the stock exchange level, SEBI has sought to add another layer whereby an independent Conflict Resolution Committee (CRC) constituted by SEBI, with an objective for independent oversight and review, shall monitor potential conflicts between listed and listing stock exchange on a regular basis. The listed stock exchange aggrieved by the decision of the Independent Oversight Committee of the listing exchange may appeal to the CRC. The CRC would effectively act as an arbiter of any conflicts between the two exchanges.

With the impending listing of both BSE and NSE, these issues are likely to become a reality in the near future. Hence, SEBI’s actions in attempting to forestall any problems are welcome. However, the circular contains only the barebones of the mechanism and lacks the precise details on how any conflicts will be resolved. Much will be left to be determined by the actions of these various committees which, unless supplied with the requisite guidance, might not be able to function effectively.

Friday, January 27, 2017

Supreme Court on Board Appointments During a Takeover Offer


In Securities and Exchange Board of India v. Burren Energy India Limited (decided on 2 December 2016), the Supreme Court of India was concerned with a couple of issues relating to the technical interpretation of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 (the “1997 Regulations”). This case involved an indirect acquisition of shares by an English company (Burren) of the Indian target company (Hindustan Oil Exploration Company Limited) through a Mauritius holding company. The acquirer entered into an agreement on 14 February 2005 to acquire the entire shares of the Mauritius holding company that in turn held 26% shares in the Indian target company. The acquisition of shares was completed on the same day. On that very day, the acquirer appointed two of its nominees as directors on the board of the target company. Since this amounted to an indirect acquisition of shares by the acquirer in the target company, which exceeded the 15% threshold prescribed for a mandatory offer, the acquirer made such an offer on the very next day, i.e., 15 February 2005.

Based on the above facts, the Securities and Exchange Board of India (“SEBI”) found a violation of regulation 22(7) of the 1997 Regulations and imposed a fine of Rs. 25 lakhs on the acquirer. On appeal, the Securities Appellate Tribunal (“SAT”) reversed SEBI’s decision, against which SEBI preferred an appeal to the Supreme Court. In its ruling, the Supreme Court set aside the order of SAT and concurred with the findings of SEBI, thereby reinstating the penalty on the acquirer.

Issues and Ruling

Regulation 22 (7) of the 1997 Regulations essentially provided that during the “offer period”, the “acquirer or persons acting in concert with him" are not to be entitled to be appointed onto the board of directors of the target company. In other words, there should be no change whatsoever in the composition of the board by which the acquirer obtains representation on it without its offer having been completed. Regulation 2(1)(f) provided that an “offer period” is to mean the period between the date of entering into a “memorandum of understanding or the public announcement, as the case may be” and the date of completion of the offer under the Regulations.

Given this legal framework, two questions came up for consideration before the Supreme Court. The first was whether the offer period had commenced on 14 February 2005 when the acquirer obtained the appointment of its nominees on the board of the target company so as to constitute a violation of regulation 22(7). This essentially revolved around the interpretation of the definition of “offer period” under regulation 2(1)(f). The second was whether the obligation under regulation 22(7) was applicable only to individual acquirers who appointed themselves onto the boards of the target companies or whether it was applicable also to corporate acquirers who nominated their representatives to the boards of the target companies. Here, I deal with each of the issues as addressed by the Supreme Court.

As regards the first issue pertaining to the offer period, regulation 22(7) makes references to two events as the starting point for commencement of the offer period. The first is a memorandum of understanding, and the second is a public announcement. In the present case, counsel for the acquirer adopted the argument that there was no memorandum of understanding executed by the acquirer for acquiring shares in the target indirectly, but rather that the parties had straight away entered into a binding agreement.  Hence, in the absence of a memorandum of understanding, the offer period should commence on the date of the public announcement, i.e., 15 February 2005. Since, the directors were already appointed on the previous day, their appointment does not relate to the offer period and hence there is no violation of the relevant regulations. This was also the reasoning adopted by the SAT. However, the Supreme Court did not accept the aforesaid argument made by the acquirer's counsel (that was accepted by SAT). The Court held as follows:

12. ... it is correct that in the definition of 'offer period' contained in Regulation 2(1)(f) of the Regulations, relevant for the present case, a concluded agreement is not contemplated to be the starting point of the offer period. But such a consequence must naturally follow once the offer period commences from the date of entering into a Memorandum of Understanding which, in most cases would reflect an agreement in principle falling short of a binding contract. If the offer period can be triggered of by an understanding that is yet to fructify into an agreement, we do not see how the same can be said not to have commenced/started from the date of a concluded agreement i.e. share purchase agreement as in the present case."

Here, the Supreme Court adopted a purposive interpretation of the definition of “offer period” under the 1997 Regulations, and eschewed a literal and hyper-technical stance taken by the SAT. Hence, it was found that the acquirer was in violation of regulation 22(7) by virtue of appointing its nominees on the date of the acquisition agreement.

As regards the second issue, the counsel for the acquirer argued that regulation 22(7) applies only to individuals and not to corporate entities, as the regulatory provision referred to the appointment of the acquirer on to the board of the target. However, this argument too was not accepted by the Supreme Court, which held:

The embargo under Section 22(7) is both on the acquirer and a person acting in concert. The expression 'person acting in concert' includes a corporate entity [Regulation 2(1)(e)(2)(i) of the Regulations] and also its directors and associates [Regulation 2(1)(e)(2)(iii) of the Regulations]. If this is what is contemplated under the Regulations we do not see how the first argument advanced ... on behalf of the respondents can have our acceptance.

Here, the Court adopted a slightly different approach to interpreting the provisions of the 1997 Regulations to arrive at its conclusion, i.e., by invoking the concept of “persons acting in concert”. The Court was not required to delve into the detailed aspects of persons acting in concert, as the letter of offer circulated to the shareholders clearly showed that the Mauritius company (which nominated the directors on the board of the target company) was acting in concert with the acquirer.

Implications under the 2011 Regulations

While these matters pertaining to a technical interpretation of the 1997 Regulations had to go all the way up to the Supreme Court in view of the varying findings arrived at by SEBI and SAT, there may be some cause to cheer. Both the issues that consumed the attention of these various forums have been addressed in the reforms to takeover law resulting in the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (the “2011 Regulations”). First, regulation 2(p) of the 2011 Regulations defines “offer period” as commencing on “the date of entering into an agreement, formal or informal, to acquire shares, voting rights in, or control over a target company requiring a public announcement, or the date of the public announcement, as the case may be”. Hence, it covers both memoranda of understanding as well as firm agreements, or other formal or informal documents, thereby signifying the earliest time when the acquirer enters into any sort of arrangement to acquire shares in the target that may trigger a mandatory offer. In the absence of any such arrangement (e.g. in a stock market acquisition), the date of the public announcement will signify the commencement of the offer period. Second, regulation 24(1) of the 2011 Regulations provides that during the offer period, “no person representing the acquirer or any person acting in concert with him shall be appointed as director on the board of directors of the target company, whether as an additional director or in a casual vacancy”. By using the concept of a representative, it skirts the issue of whether only individual acquirers are covered or whether corporate entities are as well. The nature of the acquiring entity does not matter, so long as the person is appointed on the board to represent the interests of the acquirer during the offer period. Given this scenario, one may hope that the 2011 Regulation may foreclose the present type of litigation that arises due to lack of clarity in regulation, at least as regards the issues that exercised the mind of the Supreme Court in the present case.

Thursday, January 26, 2017

SEBI Order in the United Spirits Case

Over the last year or so, there has been considerable discussion in the press about the allegations of diversion of funds by the erstwhile management of United Spirits Limited (USL) to other companies within the United Breweries (UB) group, including Kingfisher Airlines Limited (KFA). This was also a result of investigations conducted by USL through certain audit firms. Subsequently, this became a subject matter of SEBI investigation, which yesterday resulted in an ad interim ex-parte order passed by a whole-time member of SEBI.

The transactions that led to SEBI’s investigations and the present order are too detailed to be discussed in this post, and are available in SEBI’s order. However, SEBI’s key ground is that by these transactions value was diverted from USL, which is a listed company, to other companies within the UB group, thereby adversely affecting the minority shareholders of USL. This was done so not only in contravention of various regulations prescribed by SEBI, but at the instance or with the knowledge and involvement of the key managerial personnel (KMP) of USL at the time, including Mr. Vijay Mallya.

After discussing the various transactions and the possible justifications provided by USL, SEBI concluded its findings as follows:

2.2       Considering the aforementioned facts and circumstances, it appears that Mallya in his capacity as Chairman of USL during the relevant period was instrumental in the diversion of funds from USL. In his endeavor to supply funds from USL to various companies/entities of the UB Group including KFA, he had exerted pressure on the aforementioned KMPs to comply with his instructions and the same were complied with …. Similarly, in his capacity as the Managing Director of USL during the period when funds were diverted, Mr. Ashok Capoor was in charge of and was responsible to USL, for the conduct of its business. It is therefore prima facie clear that Mallya, Mr. Ashok Capoor alongwith the other KMPs were active in facilitating and/or had knowledge of the diversion of funds from USL to the companies of the UB Group. The individuals holding key managerial positions in such listed companies have to follow high standards of integrity and ensure good governance. By diverting substantial funds from USL to companies of the UB Group, Mallya and other KMPs have engaged in an act or practice which prima facie operated as a fraud or deceit on the public shareholder/investors of USL.

2.3       Mallya and the other KMPs i.e. Mr. Ashok Capoor, Mr. P.A. Murali, Mr. Sowmiyanarayanan, Mr. S.N. Prasad, Mr. Paramjit Singh Gill and Mr. Ainapur S.R. are therefore prima facie alleged to have committed fraudulent and unfair activities prohibited under Section 12A(c) of the SEBI Act , 1992 (“SEBI Act”) and Regulations 3(d); 4(1) alongwith 4(2)(e), (f) and (k) of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices) Regulations, 2003 (“PFUTP Regulations, 2003”).

2.4       The alleged prima facie violations observed in this case are serious and have larger implications on the safety and integrity of the securities market. Investors might have based their investment decisions on the manipulated books of accounts prepared and presented by these persons. It would therefore not be in the interest of the securities market and the interest of investors to allow persons of such doubtful demeanor to continue to act as KMPs in the company or in other listed companies or allow them to deal in the securities market. Therefore, pending investigations in the matter, effective preventive and remedial actions needs to be taken against the persons in order to safeguard the integrity of the securities market. Accordingly, the facts and circumstances of the case necessitates the issuance of this Ad Interim Ex-Parte Order. …

Accordingly, SEBI ordered that several persons mentioned above are prohibited from buying, selling or otherwise dealing in any securities, with two of them (Mr. Mallya and Mr. Capoor) being restrained from holding position as directors or key managerial personnel of any listed company. Finally, SEBI ordered that USL shall take steps to recover the amounts which have been diverted (being Rs. 655.55 crores as mentioned in a report by PWC-UK and Rs. 1225.24 crores mentioned in a report by E&Y).

Since this is an interim order, we may be yet to hear the last word on this. Nevertheless, this order is an important step not only in relation to the USL case, but also in relation to curbing related party transactions (RPTs) in India generally. RPTs, if not carried out properly, amount to transfer of value from listed companies to other entities that may enrich the controlling shareholders at the cost of the minority shareholders. There is evidence of such diversion, known in academic literature as “tunneling”, even in the Indian context, as discussed in a paper by Bertrand, et al. Hence, the regulation relating to RPTs has been considerably enhanced in regulatory reforms culminating in the Companies Act, 2013 and the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015. In this context, the USL case will be an important test to determine the robustness of the regulatory framework governing RPTs in India and, more importantly, the effectiveness of the enforcement of RPT regulation.

Wednesday, January 25, 2017

SEBI Order under the Investment Advisers Regulations

A whole-time member of the Securities and Exchange Board of India passed an order involving CapitalVia Global Research Limited under the SEBI (Investment Advisers) Regulations 2013 (the “IA Regulations”). The case arose out of an inspection carried out by SEBI on CapitalVia, which resulted in an interim order being passed by SEBI on November 11, 2016. Since then, SEBI has held hearings and received representations from CapitalVia, based on which it passed the present order on January 20, 2017.

The case involved several alleged violations by CapitalVia of provisions of the IA Regulations. Before considering the individual allegations, the SEBI order does a helpful job of laying out the scope and object of the IA Regulations as follows:

6. It is relevant to appreciate the role of an Investment Adviser as contemplated under the IA Regulations in order to actually ascertain and assess the scope of breaches and its impact on the securities market on a holistic basis. The object of the IA Regulations, inter alia, was to lay down a framework for independent financial advisers which was absent till 2013 and to address the conflict of interest arising due to the dual role (advisory and sale) played by the distributors of financial products. Investment Advisors perform a pivotal role in the securities market of securing investor confidence in the integrity of the markets. This stems directly from the quality of advice provided to the investors which has to be honest and unbiased without being, in any way, swayed by short term profit motives. In addition to the statutory mandate under section 12 of the SEBI Act, 1992 to get registered, the regulation of investment advisory activity is necessary to avoid unscrupulous advisory business wherein investors could be misguided towards making investments in the securities market without providing them with an honest assessment of risks involved. There is thus a need to ensure discipline and transparency in this field of intermediation business in the securities market to protect the interest of the investors.

7. Investment advisers are understood to be persons who, for consideration, render advice relating to investment in securities or a portfolio of securities. Advice given as incidental to other primary activity are exempt from the purview of registered investment advisers. By definition therefore, the primary role of an investment adviser is to render, in good faith, advice that is suitable for investors. Consequently, the role of an investment adviser revolves around how accurately the risk assessment/profiling of a client is done , and how suitable is the advice rendered to the clients' risk profile and more importantly, the continuous channel of communication that an IA establishes with the clients to strengthen investor confidence. Prospective clients who approach investment advisers do so because their ability to evaluate the complexities of the securities market may be inadequate, or because confidence in the investment will be enhanced by the advice of an informed professional. In any case, the high level of trust that the client/investor reposes in the adviser is the fulcrum on which the entire edifice of IA profession is predicated upon. The framework of the SEBI (Investment Advisers) Regulations, 2013 (hereinafter referred to as "IA Regulations") is structured towards protecting this trust, in addition to ensuring integrity of the securities market. The scheme of the IA Regulations makes it clear that besides laying down the registration requirements, and capital adequacy requirement, it elaborates on the general obligations and responsibilities in detail and step-wise risk profiling processes and how the advice should be methodically arrived at with respect to each client taking into consideration the clients' financials and investment objectives etc. The assessment of suitability of a product to a particular client, the necessity for all disclosures to be in place about the investment adviser itself and the pecuniary connections with the products as well as its affiliations to other entities associated with the securities market are all aimed at ruling out a potential conflict of interest. The success of the regulatory framework lies in the implementation of the same by the registered Investment advisers imbibing the spirit of the Regulations coupled with timely inspections conducted by the regulator.

Based on these objectives, SEBI considered the individual violations alleged in the case of CapitalVia. It found several violations of the IA Regulations (which are detailed in the order), including the following:

- The products of CapitalVia were not simple enough for the investors to understand their inherent risks; that products with short term horizon, which were more appropriate and suitable for only high risk investors, were sold to low/moderate risk investors, thereby diluting the norm of suitability;
- The responsibilities of an investment adviser highlight the fiduciary relationship it has with its client, and that it is expected to function in the best interests of the client and not shrug off the responsibility for its advice;
- There were false and inadequate disclosures regarding SEBI’s interim order, due to which CapitalVia continued to solicit new business rather than to dissuade fresh advisory business;
- CapitalVia failed to maintain records, including KYC details;
- It charged exorbitant fees to the clients, which violated the principle that investment advisers are to act with due care due to its fiduciary relationship with their clients.

Finally, before passing orders against CapitalVia, including requiring it not to undertake fresh advisory business for another period of four months, and not to accept funds from clients for such period, SEBI again highlighted the importance of the role of investment advisers on the broader markets:

10. Registration of investment advisers is a statutory mandate flowing from section 12 (1) of the SEBI Act, 1992. Regulation of Investment advisory activity was considered necessary to avoid unscrupulous advisory business wherein investors could be misguided towards making investments in the securities market. There was a need to ensure discipline in this field of intermediation business in the securities market. Quality of advice rendered to investors has an impact on investors confidence in the integrity of the markets. Consequently, it is statutorily and ethically important to view seriously any infraction on the part of investment advisers. This is all the more so in the case of a large organization like CapitalVia which by its own statement is considered to be a pioneer in the field of investment advisory business. The more significant an organization, the bigger the ripple effect its actions or omissions have on the confidence in the system. …

In relation to oversight on the capital markets, the IA Regulations are relatively new, and SEBI’s orders such as the present one will pave the way for a deeper understanding of the regulatory regime.