Background
Under the SEBI Takeover Regulations, there are two methods by which an acquirer could be obligated to make an open offer to the public shareholders of a listed target company. The first is when the acquirer acquires shares or voting rights beyond certain defined thresholds (as contained in Regulations 10 and 11, with the initial threshold being 15%). The second is when the acquirer acquires “control” over the company, whether or not it acquires shares or voting rights of the company (in terms of Regulation 12).
Financial investors such as private equity investors and sometimes venture capitalists tend to invest minority stakes in listed companies in transactions usually referred to as PIPEs. If the investment exceeds 15%, as it often does, the investors are required to make an open offer under the Takeover Regulations. Moreover, in terms of deal structure, such financial investors typically seek protection through specific rights under transaction documentation such as the ability to appoint a nominee director or an observer, quorum rights at board and general meetings and, most importantly, certain supermajority or veto rights whereby the target company cannot undertake certain actions without the prior approval of the investor.
For quite some time, such investors made open offers under Regulation 10 as they exceeded the 15% limit. However, about 5 years ago, SEBI began insisting that such offers should be made under Regulation 12 as well because such investors are deemed to have obtained “control” over the target company by virtue of obtaining several rights under the transaction documents. This came as a complete surprise to the investing community and the corporate lawyers who were advising them. This is because such investors are pure financial investors with no intention of obtaining any control over day-to-day management or other aspects of functioning of the company. Moreover, designating them as persons in “control” could give rise to other unintended consequences (such as designating them as promoters) that may expose them to greater obligations under law and consequent liability. Since then, investors and their advisors have repeatedly made submissions to SEBI arguing that the existence of such negative rights does not amount to control. But, in view of SEBI’s position remaining constant, there had not been much progress towards resolution.
Given this background, the Securities Appellate Tribunal (SAT) passed an order on Friday in the case of Subhkam Ventures that provides considerable succor to investors. SAT has held that protective rights conferred on financial investors, such as board representation, quorum rights and supermajority rights by themselves are inadequate to constitute “control” by the acquirer.
The Subhkam Case
The case involved Subhkam Ventures (I) Private Limited acquiring more than 15% shares in MSK Projects Limited, the target company. Subhkam made the public announcement of open offer under Regulation 10 and filed a draft letter of offer with SEBI, which then required the acquirer to state in the letter of offer that the offer is being made under Regulation 12 as well. This is because the subscription and shareholders agreement entered into among Subhkam, the promoters and target company contained protective provisions in favour of Subhkam. As the issue remained unresolved, the acquirer preferred an appeal to SAT.
At the outset, SAT laid down some general principles on what constitutes “control” in such a situation involving a financial investor. Noteworthy is the distinction being made between proactive power (positive control) and reactive power (negative control):
The term control has been defined in Regulation 2(1)(c) of the takeover code to “include the right to appoint majority of the directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert directly or indirectly, including by virtue of their shareholding or management rights or shareholders agreements or voting agreements or in any other manner.” …
…Control, according to the definition, is a proactive and not a reactive power. It is a power by which an acquirer can command the target company to do what he wants it to do. Control really means creating or controlling a situation by taking the initiative. Power by which an acquirer can only prevent a company from doing what the latter wants to do is by itself not control. In that event, the acquirer is only reacting rather than taking the initiative. It is a positive power and not a negative power. In a board managed company, it is the board of directors that is in control. If an acquirer were to have power to appoint majority of directors, it is obvious that he would be in control of the company but that is not the only way to be in control. If an acquirer were to control the management or policy decisions of a company, he would be in control. This could happen by virtue of his shareholding or management rights or by reason of shareholders agreements or voting agreements or in any other manner. The test really is whether the acquirer is in the driving seat. To extend the metaphor further, the question would be whether he controls the steering, accelerator, the gears and the brakes. If the answer to these questions is in the affirmative, then alone would he be in control of the company. In other words, the question to be asked in each case would be whether the acquirer is the driving force behind the company and whether he is the one providing motion to the organization. If yes, he is in control but not otherwise. In short control means effective control.
Thereafter, SAT examined the types of specific rights provided to Subhkam under its agreement. First is the right to nominate one director on the board of the target company. SAT held that a single nominee on a board of ten members constitutes a “microscopic minority”, and that the purpose of such nomination is only to provide certain informational rights to the investor rather than any veto rights as such. Second are the “standstill” provisions in the agreement which prohibit the company from carrying out certain actions between signing and closing of the agreement. SAT found that this was a transitional provision with a limited purpose and does not give any control. The third provision relates to quorum rights to the investor. Even here, SAT held that quorum rights by themselves do not confer any veto power on the investor and hence that does not amount to control.
The last, and perhaps most contentious, provision is the supermajority rights under which the affirmative vote of the investor’s nominee on the board is required for the company to carry out any matter among a list of 22 items. These include certain fundamental corporate matters such as amendment to the memorandum and articles, change in share capital, amalgamation, winding up, etc., and also certain matters pertaining to the business such as approval of the business plan, sale of property, appointment of key officials, capital expenditure, etc. Although at first blush this list appears to be quite extensive in nature covering a range of matters involving the company, SAT did not have any hesitation in ruling that these did not constitute control by the investor. Although SAT found that these matters do not cover the day-to-day operation of the company, its logic seems to be premised on the fact that a veto right is only a negative right and does not allow the investor to carry out these actions on its own. In other words, emphasis has been placed on the inability of the investor to carry out any positive acts rather than on the nature of the matters themselves that are on the list of veto items.
Relevance
The importance of this SAT ruling is that it sets to rest an issue that has caused a great amount of consternation amongst investors and their advisors. It now equips private equity funds, venture capitals and other similar venture capitalists from being able to obtain customary contractual rights while undertaking PIPE transactions without the fear of inviting unintended consequences of becoming controllers of the target company. In a sense, the ruling also emboldens the financial investors’ position by a long stretch as it has permitted a great number of supermajority rights that can be included without being in control. A review of the list of 22 veto items in the Subhkam agreement set out in SAT’s order will provide a feel for the magnitude.
It is hard to assume that the last word has been said on the issue. The possibility of an appeal by SEBI cannot be discounted. Considering the importance of this issue, it is also reasonable to anticipate recommendations from the Takeover Regulations Advisory Committee.