When a Rights Offering Becomes a Public Offering

In August last
year, the Supreme Court unequivocally ruled in the Sahara case on the issue of when an offer of shares
by an unlisted company would become a public offering thereby invoking SEBI’s
jurisdiction.
One of our
readers, Sumit Agrawal, has brought to our attention a decision of the Kerala
High Court in Securities and Exchange Board of India v.
Kunnamkulam Paper Mills Ltd
,
where it was held that in certain circumstances a rights offering by an unlisted
company may amount to a public offering where SEBI would obtain jurisdiction.
Facts
An unlisted company
made a rights offering in which it allotted shares in 2001 to 163 persons,
which included persons who were not existing shareholders of the company. This
was because existing shareholders had a right to renounce their rights shares
offered to them in favour of others. After issuing a show cause notice and
following the necessary procedures, SEBI passed an order finding that this
amounted to a public offering and that the company had not complied with the
requisite disclosure obligations that apply to a public offering.
The company
filed a writ petition against SEBI’s order before the Kerala High Court. The
single judge quashed SEBI’s order on a finding that by virtue of section 55A of
the Companies Act, 1956, it is only the Central Government that has powers of
oversight over unlisted companies and that SEBI has no jurisdiction in the
matter. SEBI appealed to a division bench, which delivered the present
decision.
Decision
The court
considered two broad questions. First, it considered whether a rights offering
with renunciation rights amounts to a public offering or not. Second, it
considered whether SEBI has jurisdiction over such an offering if it was held
to be a public offering.
On the first
question, the court considered the ambit of section 67 of the Companies Act,
which determines when an offering becomes a public offering. Under the proviso
to section 67(3), any offering to more than 50 persons is treated as one made
to the public. This general principle was then applied to a rights offering
that carries renunciation rights. A rights offering under section 81(1)(c) of
the Companies Act includes a “right exercisable by a person concerned to
renounce the shares offered to him or any of them in favour of any other
person”. Reading these aspects together, the court observed:
That
being the situation when a company exercises its power under S. 81(1)(c) which
gives right to a shareholder to renounce the shares in favour of persons who
are not shareholders and when such a right is given to 50 or more persons that
also will be deemed to be an offer made to any section of the public as
provided under S. 67(1) and (2).
On the second
question regarding jurisdiction, the court interpreted section 55A of the
Companies Act and also the provisions of the SEBI (Disclosure and Investor
Protection) Guidelines, 2000 and found that SEBI has jurisdiction over any
public offering by an unlisted company. Since the present offering was treated
as one to the public, it did not seem to leave any doubt in the court’s mind
regarding the existence of SEBI’s jurisdiction.
Analysis
The Kerala High
Court’s ruling hinges on the renunciation right given to 50 persons or more.
That would make a rights offering a public offering. From a structuring
standpoint, where unlisted companies are proposing a rights offering, it would
help to insert some conditions or restrictions regarding the exercise of
renunciation rights. There may have to be a mechanism whereby renunciation
rights would be restricted to less than 50 persons. This may be difficult to
implement in a company that has more than 50 shareholders, because that would
then mean that the renunciation rights of certain shareholders might have to be
taken away altogether, the possibility of which may itself be debatable.
Providing renunciation rights to some but not all shareholders may raise
questions of fairness inter se among
shareholders of a same class.
A strict reading
of the proviso to section 67(3) could lead to a situation where a rights
offering per se (with or without
renunciation rights) in an unlisted company that has more than 50 shareholders
would itself amount to a public offering because an offer is being made to 50
shareholders or more. That would be an extreme situation. Fortunately however,
the Kerala High Court has not gone that far. Its decision is based on
renunciation rights to non-shareholders. Therefore, what seems to matter
(although the court has not expressly ruled on this) is that where the rights
offering and renunciation result in offers being made to more than 50 outsiders
who are not yet shareholders of the company, that would become a public
offering.
In the case of
listed companies, matters may take on a different turn altogether. Even if
there are renunciation rights that may be available to more than 50 persons, it
is doubtful whether that would make it a public offering. In such a scenario,
the issues may be somewhat moot because SEBI does have jurisdiction over listed
companies, and moreover the current regime on share offerings by listed
companies contained in the SEBI ICDR Regulations provides for a separate regime
(including disclosures) for rights offerings.
Sahara Case: It is interesting to note that the
Kerala High Court did not refer to the Sahara case at all in its interpretation
of the provisions of the Companies Act and the SEBI Act. This might be because
the Kerala High Court had heard the final arguments even before the Supreme
Court delivered the Sahara judgment. Nevertheless, the extensive debate that
took place on the Sahara case prior to that before SEBI and the Securities
Appellate Tribunal (SAT) on issues that have substantial bearing do not find
any mention at all in Kerala High Court’s observations. In any event, the two
rulings appears to be in tandem and do not give rise to any substantive
inconsistency.

Finally, on the Sahara case
itself, the episode is still ongoing. SEBI has now issued two orders of
attachment (
here
and
here)
relating to the two Sahara companies for failing to comply with the directions
of the Supreme Court. It remains to be seen as to when, where and how these
orders would be challenged. Primary issues may be whether SEBI has the
jurisdiction to pass these orders. The touchstone against which these issues
must be examined would not only be SEBI’s powers under the SEBI Act but also
the power it derives through the order of the Supreme Court which lays down the
consequences of Sahara’s non-compliance. We will need to watch this space. 

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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