Wednesday, June 28, 2017

Minimizing the Liability of Directors: SEBI’s Order in the Zylog Case

[Guest post by Amitabh Robin Singh, who is a corporate lawyer practising in Mumbai]

Liability of directors is a sensitive topic in India, particularly for foreign investors who propose to nominate directors to the boards of their Indian investee companies. That is why clauses are inserted in shareholders’ agreements to the effect that the investor’s nominee director will not be identified (to the extent permitted by applicable law) as an “officer who is in default” or “employer” or “occupier” for the purposes of various laws. Also, shareholders’ agreements often record that the promoter/founder of the company will be in charge of the day-to-day affairs of the investee company.

Further, directors are often advised to record their objections or reservations to any action by the company which they are against, for the purpose of insulating themselves from any punitive action that may be initiated by regulatory authorities for alleged non-compliances. This thought may stem inter alia from the definition of “officer who is in default” in the Companies Act, 2013, which has a clause as follows: “every director, in respect of a contravention of any of the provisions of this Act, who is aware of such contravention by virtue of the receipt by him of any proceedings of the Board or participation in such proceedings without objecting to the same, or where such contravention had taken place with his consent or connivance”.

An apt case broaching this particular point was recently decided by a whole time member of the Securities and Exchange Board of India ("SEBI") in the matter relating to Zylog Systems Limited ("Zylog").

Zylog had declared dividend on its shares, which was approved at its annual general meeting held on September 25, 2012. In relation to this declaration, Zylog failed to deposit the amount of the dividend in a separate account within five days of its declaration, as mandated by section 205(1A) of the Companies Act, 1956 (with section 123(4) of the Companies Act, 2013 prescribing a similar requirement). Further, Zylog did not disburse the dividend within 30 days of declaration in contravention of section 207 of the Companies Act (that corresponds with section 127 of the Companies Act, 2013).

A violation of section 205 of the Companies Act, 1956 will result in the company and every officer of the company who is in default being punished with a fine for every day during which the failure continues. Separately, contravening section 207 of the Companies Act, 1956 attracts a punishment of imprisonment of up to three years and fine for every director of the company who is knowingly a party to the default, and the company will be liable to pay interest on the amount.

SEBI had issued show cause notices to all the individuals who were directors of the Zylog on the date of declaration of dividend. Two independent directors of Zylog, Mr. S. Rajagopal and Mr. V.K. Ramani responded to the show cause notices stating that they were not associated with the day to day operations of Zylog, and that the default occurred without their knowledge and consent. Mr. Rajagopal stated that he was unaware of the default until it was brought to his notice by a certificate furnished by the company secretary and managing director. Mr. Rajagopal, who was also the chairperson of Zylog's audit committee, submitted minutes of the audit committee dated November 14, 2012 in his defence, which recorded that the audit committee looks seriously upon such defaults and the matter needs to be brought up before Zylog's board with a direction to make all statutory payments.

Mr. Ramani contended that he came to know of the default at the board meeting dated November 14, 2012.  Both Mr. Rajagopal and Mr. Ramani placed reliance on the minutes of this board meeting, where it was recorded that defaults had been committed and Mr. Rajagopal desired that steps be taken to remedy such defaults. Also, observations were made regarding the non-payment of certain dues (apart from the unpaid dividend) such as provident fund contribution.

Based on the above minutes, both Mr. Rajagopal and Mr. Ramani contended that they acted promptly and diligently. Also, both resigned from the board of directors within two months of the abovementioned board meeting.

SEBI’s whole-time member noted that independent directors have a very important role to play in both protecting the minority shareholders and guiding the management of companies. Further, it was observed that independent directors also should ensure that the company operates in compliance with applicable laws. With respect to the matter of Zylog, he went on to say that Mr. Rajagopal and Mr. Ramani took strong stands to convince the board to comply with its statutory obligations and, with Zylog failing to do so, they resigned from the board of the directors.

Seeing that Mr. Rajagopal and Mr. Ramani were not in charge of the day to day operations of Zylog, and discharged their duties as independent directors by using their best efforts, it was held that there was no need for action against them.

From this case, it may be noted that for directors to protect themselves from punitive action for acts of the company, they should inter alia always ensure that the objections raised by them are duly recorded in the minutes. To accomplish this, the directors should exercise their right to comment on the draft minutes which have been circulated to them. Further, caution should be exercised to ensure that the directors provide their comments on the draft minutes within the stipulated period of within seven days of circulation. This is because if the comments are given subsequent to such period, their consideration will be at the discretion of the chairman of the board. If the directors fail to provide any comments on the draft minutes, then they are deemed to be approved by such directors. Hence, directors, whether nominees, independent, or otherwise, should be very vigilant in order to limit their individual exposure to regulatory action.

- Amitabh Robin Singh

Consolidation of Promoter Holdings: Exemptions from Takeover Offer

The SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (the “Takeover Regulations”) provide for a series of exemptions involving consolidation of promoter shareholdings whereby acquirers of shares in such consolidation efforts need not make a mandatory takeover offer to acquire the shares of the remaining shareholders. Apart from specific promoter-oriented exemptions, promoters can also avail of other general exemptions that are seemingly broader in nature. One such involves restructuring of shareholdings of a target company through a scheme of restructuring, which is exempt from mandatory offer requirements under regulation 10(1)(d)(iii) of the Takeover Regulations.

The above exemption applies when there is a transfer of shares in a target company that is occasioned by a scheme of arrangement or reconstruction (including amalgamation, demerger) not involving the target company pursuant to the order of a court or other competent authority pursuant to applicable law, so long as two conditions are satisfied: (i) the cash component of the transaction is no more than 25% of the consideration paid under the scheme, and (ii) following the transaction, those who held the entire voting rights prior to the scheme continue to hold at least 33% of the voting rights in the combined entity.

This exemption, while quite specific, is understandable. At the outset, it is available only when the transaction is undertaken through a scheme of arrangement that seeks the imprimatur of a court or other competent authority, which indicates an element of oversight. Moreover, the two conditions stipulated above would ensure that the transactions represent genuine consolidation or restructuring efforts within a group rather than those that seek to effect changes in control of the target company.

An interpretation of regulation 10(1)(d)(iii) was sought from the Securities and Exchange Board of India (“SEBI”) in the form of an informal guidance request from Rajdhani Investments & Agencies Private Limited, a shareholder holding 0.01% shares of DLF Limited, the target company. A total of 11 entities (including Rajdhani) hold 54.08% shares of DLF. It is proposed that 10 entities merge into Rajdhani by way of a scheme of arrangement, such that Rajdhani’s shareholding will increase from 0.01% to 54.08%. This is because the shares in DLF held by the 10 entities will be transferred by way of the scheme to Rajdhani. The 10 entities will cease to exist after the amalgamation, and as part of the transaction Rajdhani will issue shares to the shareholders of those entitles. All the 11 entities are controlled (either directly or indirectly) by the Singh Family Trust through its trustees, Mr. Rajiv Singh and Ms. Kavita Singh, who have been classified as promoters or promoter group of DLF since its initial public offering in 2007.

It is on these grounds that Rajdhani sought a clarification from SEBI on the applicability of regulation 10(1)(d)(iii), which SEBI responded to positively in its informal guidance letter, stating that the transaction will be exempt under the provision so long as the scheme is approved by the court or other appropriate authority. Moreover, Rajdhani has clearly asserted that the two conditions stipulated in regulation 10(1)(d)(iii) (as discussed earlier) stand satisfied on the facts of the present case.

In all, this case seems to be a straightforward one that encompassed the exemption requirements of regulation 10(1)(d)(iii) in their entirely, especially because both conditions stipulated therein have been satisfied. This seems to be a classic case that the exemption is intended for, i.e., consolidation of shareholdings (especially by promoters) through use of the scheme of arrangement mechanism. At one level, it is surprising why Rajdhani even needed to approach SEBI to seek a clarification given that the transaction complied on the face of it with all the requirements of the exemption, but the parties may have decided to mitigate any risk and avoid any potential disputes by seeking SEBI’s informal guidance.

Tuesday, June 27, 2017

The amended Arbitration Act: The Power to Nominate and the Choice of the Nominee

The Bombay High Court in DBM Geotechnics v. Bharat Petroleum Corporation Ltd. recently decided a short but important point arising out of the recent Amendments to the Arbitration & Conciliation Act, 1996. In particular, the Court had to consider how the bar on a party’s employees serving as arbitrators had to be construed.

The relevant arbitration clause between the parties before the Bombay High Court was that disputes will be referred:

[t]o the sole arbitration of the Director (Marketing Division) of the Corporation or some officer of the Corporation who may be nominated by the Director (Marketing Division)… In the event of the arbitrator to whom the matter is originally referred being transferred or vacating his office or being unable to act for any reason, the Director (Marketing Division) as aforesaid at the time of such transfer, vacation of office or inability to act may in the discretion of the Director (Marketing Division) designate another person to act as an Arbitrator… It is also the term of this contract that no person other than the Director (Marketing Division) or a person nominated by such Director (Marketing Division) of the Corporation aforesaid shall act as Arbitrator…

Thus, the clause provided: (a) the Director Marketing, or another officer of the corporation nominated by the Director will be sole arbitrator, (b) if the arbitrator to whom the matter is originally referred in unable to act, then another person may be designated, and (c) in any event, the sole arbitrator must be either the Director or a person nominated by the Director.

The question was whether the power to nominate would survive, given that part (a) no longer can be fulfilled due to the bar introduced by the 2016 Amendment on employees serving as arbitrators.  

DBM argued that the power of nomination was unworkable, because part (b) above could come into the picture only if there was indeed a nomination in terms of part (a), and that nominee was unable to act. In circumstances where part (a) was incapable of being complied with (and indeed, BPCL did not at all nominate any employee first), the entire nomination procedure must fall. In other words, the Court could conceivably have held as a matter of interpretation, part (b) of the arbitration clause above remained in place. Textually, that would have been problematic because the application of part (b) contemplates in the first place that there is a nomination under part (a): if that nomination is itself impossible, there can be no question of part (b) applying.

The Court’s answer to this argument is instructive, because the Court does not simply decide the question on an interpretation of this particular (somewhat intricate) clause: rather, the Court draws a conceptual distinction between the power to nominate and the choice of the nominee. It holds:

The parties before me had, as I have pointed out earlier, clearly agreed that the power to nominate would vest in BPCL’s DM alone. It is true too that the clause also said that the DM, in exercising that power, was to draw from a specified class of persons (himself or a BPCL employee). It just so happens that because of the operation of the amended statute combined with a want of consent from DBM, the eligibility of both those sets of persons was rendered impossible. In fact, as Mr Joshi says, the DM’s ‘power to nominate’ cannot be dependent on the DBM’s granting or not granting consent, and this is what the Applicant’s argument amounts to: had DBM consented, there would have been no question of the BPCL’s DM being divested of his power to nominate. I believe Mr Joshi is correct in saying that by withholding consent and then relying on the statutory bar, DBM cannot argue that the power to nominate itself has completely gone. The DM does not, for want of DBM’s consent, stand stripped of all his nominating power. He must exercise that power in the manner that the law requires, i.e., by appointing an independent and neutral Arbitrator. It is perhaps true that as a result of this, the latter portion of clause 19(a) may require to be severed, but there is no difficulty in doing this, nor is this impermissible…

This may well be important in construing other clauses which prescribe a arbitration before an employee of a company/corporation – if the clause provides for nomination by the company/corporation and further prescribes that the choice of a nominee is to be an employee, that clause cannot be considered as ineffective even in light of the amendment, and it cannot be contended that the appointment must now only be by the Court under section 11. The power to nominate itself would survive, notwithstanding the limitations on the choice of the nominee.

[Interestingly, DBM did not argue that the clause itself would be ineffective. It only argued that BPCL’s power to nominate is ineffective; and the nomination must therefore be made by the Court under section 11. This strategic choice may well have saved it from an order as to costs. On costs, the Court indicated, “The amendments to the Code of Civil Procedure, 1908 introduced by the Commercial Courts, Commercial Division and Commercial Appellate Division of High Courts Act, 2015 require that, as a general rules, costs must follow the event, and that reasons must be given if costs are not awarded against the party that fails. I decline to award costs in this case having regard to the fact that the issue raised was limited, and since Mr Doctor very fairly did not suggest that the entire arbitration clause was ousted. No costs.” This, and certain other orders of the Commercial Court, appear to indicate that orders as to costs need not be made if the case set up is reasonable and not frivolous (even if not ultimately successful). With respect, this approach to costs may need further consideration. The new costs provisions do mirror some of the rules in the English CPR. The fact that a case set up is not frivolous or unarguable may be a factor going to the quantum of the costs, rather than to the question of whether to levy costs of not itself.] 

Monday, June 26, 2017

Promoter Exits in India: Reined by the Market Watchdog?

[Guest post by Malek Shipchandler, who practices law with a firm in Mumbai. Views are personal and do not necessarily represent those of the firm.]

It was reported last week that the Securities and Exchange Board of India (SEBI) is likely to relax rules pertaining to promoter reclassification in listed companies. An article co-authored by Gaurav Malhotra and I for the Oxford Business Law Blog in December 2016 on this theme had endeavoured to argue that the requirement of obtaining shareholders’ approval for reclassifying promoters into the public category (pursuant to an open offer or ‘in any other manner’) is counter-intuitive and therefore otiose. The article also touched upon the apparent lacuna in the rules which do not explicitly provide a route for promoters holding minimal (or even nil) shareholding to convert themselves into the public category – except by way of seeking SEBI approval through the informal guidance mechanism or approaching the stock exchanges. It is hoped that SEBI irons out these wrinkles while reviewing the promoter classification rules. For the benefit of readers, we set out below the text of our previous article.


Most Indian listed companies are run by promoters who are a set of persons and/ or families having effective control over a listed company. The Securities and Exchange Board of India (SEBI), the securities market regulator, has historically been wary of investor protection issues that may arise between promoters of listed companies and public shareholders. This is evident by the fact that SEBI, in the past year itself, has restricted promoters from changing the objects of an issue as stated in the issue prospectus (unless shareholder approval is obtained) and barred promoters of companies undergoing compulsory delisting from receiving shareholder benefits and being appointed as directors of other listed companies.

The term ‘promoter’ has been defined under Section 2(69) of the Companies Act, 2013 and Regulation 2(1)(za) of the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2009 to broadly mean persons having ‘control’ over a company. The shareholding pattern of listed companies is primarily classified into two categories viz. promoter and public. Entry into the promoter club has never been barred (as anyone who gains control over a listed company, irrespective of shareholding, is categorized as a ‘promoter’) and formal guidelines for exiting the promoter club did not exist until September 2015.

SEBI introduced provisions relating to promoter reclassification into public shareholders under the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (Listing Norms). Regulation 31A of the Listing Norms deals with disclosures and conditions for reclassification. Regulation 31(A)(5) of the Listing Norms requires a listed company to obtain shareholders’ approval for the reclassification of its exiting/ selling promoter into a public shareholder occurring due to control being established over the listed company by an incoming promoter/ acquirer via (i) an open offer in accordance with the Indian takeover code or (ii) in any other manner. In addition, the exiting/ selling promoter is required to, inter alia, have no more than ten percent shareholding in the listed company, and abandon any special rights vis-à-vis the listed company, established through formal or informal arrangements.

For those who may be less familiar with the concept of an ‘open offer’, it is a procedure required to be undertaken to acquire control over a company by triggering thresholds prescribed under the Indian takeover code. The open offer procedure requires the incoming promoter/ acquirer to provide an exit option to the existing public shareholders of the listed company by offering to buy their shares – after giving numerous disclosures and assurances in the open offer documents under the regulatory scrutiny of SEBI. The expression ‘in any other manner’ would appear to refer to methods such as court-blessed schemes of arrangements and Reserve Bank of India regulated strategic debt restructuring schemes that can facilitate the establishment (and replacement) of control over a listed company. These schemes are exempt from open offer obligations under the Indian takeover code as they already involve regulatory/ judicial oversight and/ or approval of shareholders.

Interestingly, SEBI through its recent informal guidance letters, has allowed existing promoters holding nil or minimal shares to exit without obtaining shareholders’ approval – this appears to be in sync with the Listing Norms (Regulation 31A(5) requires approval of shareholders only when the promoter is being ‘replaced’).

Despite SEBI’s efforts to streamline promoter reclassifications, there appear to be certain lacunae. It appears odd and to an extent, even counter-intuitive, for the law to (a) require shareholders’ approval in relation to reclassification of exiting/ selling promoters into public shareholders pursuant to an open offer, when in fact the law already provides the shareholders with full information/ disclosures about the transaction (triggering such change in control) coupled with a fair option to exit the listed company (in case of ‘open offer’) and an opportunity to approve/ decline such replacement when put to vote (in case of ‘any other manner’) and (b) allow an existing promoter with nil or minimal shareholding to exit the listed company without shareholder blessing.

Delving into this apparent lacuna, a scenario may be envisaged wherein shareholders show reluctance to give their approval for reclassification after the exiting/ selling promoter has transferred the entire stake to the incoming promoter/ acquirer (the earliest this transfer may take effect under law based on the open offer procedure is twenty-five working days after the signing of the acquisition agreement). This would essentially translate into a situation wherein the exiting/ selling promoter may continue having legal obligations as a ‘promoter’ along with the incoming promoter/ acquirer despite not holding any shares.

From a M&A transaction perspective where ‘conditions precedents’ are at the heart of any acquisition agreement, the shareholders’ approval for reclassification being made a condition precedent for the share transfer to occur may not be feasible, as a shareholding of less than ten percent by the exiting/ selling promoter is a prerequisite for seeking reclassification.

An escape from the aforesaid situation can perhaps be found, oddly, through a literal interpretation of Regulation 31A(2)–(3) of the Listing Norms coupled with a reading of the recent SEBI informal guidance letters. Through this route existing promoters can seek reclassification by approaching the stock exchanges – without shareholders’ approval. As such, to obviate the need for obtaining shareholders’ approval under Regulation 31A(5) of the Listing Norms or on being refused such shareholders’ approval, the literal law seemingly allows the exiting/ selling promoter to approach the stock exchanges under Regulation 31A(2)–(3) of the Listing Norms to seek reclassification – without obtaining shareholders’ approval. It should be acknowledged however that this approach ostensibly defeats the spirit of Regulation 31A(5) of the Listing Norms, which requires the exiting/ selling promoter to obtain shareholders’ approval.

On a related note, Regulation 31A(5) of the Listing Norms provides for “re”classification i.e. changing the status of a shareholder from ‘promoter’ to ‘public’ and not “de”classification i.e. a situation where the exiting/ selling promoter sells the entire shareholding to the incoming promoter/ acquirer. However, on perusal of certain recent transactions triggering an open offer, it can be seen that exiting/ selling promoters are adopting the approach of obtaining shareholders’ approval despite having transferred or agreed to transfer their entire shareholding to the incoming promoter/ acquirer. This approach seemingly blessed by SEBI (considering, open offers are overseen by SEBI) and reflecting its “once a promoter, always a promoter” psyche is, respectfully, preposterous and needs correction before a precedent is etched.

Having been established with the task of protecting the interests of public investors and the development of the Indian securities market – has SEBI, in its sincere effort, baked half-hearted guidelines on promoter exits?

- Malek Shipchandler