Obligation to give an exit to dissenting shareholders

[The
following guest post is authored by by Bhargavi
Zaveri
, Prateek Misra, Sumant Prashant, Shefali Malhotra, who are
researchers at the National Institute for Public Finance and Policy.
An
earlier version of this post was published on Ajay
Shah’s Blog
.]

The Companies Act, 2013 (Act) obligates the promoters and majority
shareholders of a listed company to buy-out dissenting shareholders, where the
company has passed a special resolution:
1.   amending the main
objects for which the money was raised from the public;[1]
and
2.   amending the terms of a contract referred to
in the prospectus.[2]

The Act requires SEBI to frame regulations for the exercise of the exit right
by the dissenting shareholders.[3]

On December 1, 2015, SEBI issued a discussion
paper
 on this subject suggesting, amongst other things, the following:

1.         There must be certain thresholds which
trigger the buy-out obligation imposed on promoters and majority shareholders.
For instance, the buy-out obligation must be triggered only where the contract
proposed to be amended affects the main line of business or revenue generation
of the company, or where atleast a certain percentage of shareholders have
specifically voted against the amendment.
2.         Companies which have already utilised a
certain threshold percentage of the public funds and companies with no
identifiable promoters or majority shareholders, must be exempt from the
provisions.

At NIPFP, we have written a
response to this discussion paper
. We recommend that SEBI should, as part
of the ongoing
process
 for the review of the Act, instead recommend the deletion of
the provisions, which impose a buy-out obligation on promoters and majority
shareholders in the circumstances described above. Alternatively, the response
recommends certain other thresholds for triggering this obligation, to give
better effect to the legislative intent underlying these provisions.

This post summarises the reasons for recommending the deletion of these
provisions from the Act and explains why there is no case for minority
shareholder protection in the circumstances under which the Act imposes the
buy-out obligation.

No market
failure

The general rule in public economics is that markets work well in the absence
of state intervention. State intervention should, therefore, be limited to circumstances
in which the market does not work well. These circumstances are referred to as
market failures. Market failures which necessitate state intervention are:
1.         Information asymmetries between market
participants;
2.         Concentrated market power;
3.         Externalities resulting from market
practices;
4.         Public goods.
 
State
intervention in the form of obligating promoters and majority shareholders to
buy shares of dissenting shareholders, cannot be traced to any market failure:
1.         There is no information
asymmetry
 amongst the shareholders who vote for and against a
resolution that proposes to amend the main objects for which the money was
raised from the public or the terms of a contract referred to in the
prospectus. The company provides all shareholders with the same information
when it supplements the special resolution with a notice explaining the reasons
for the resolution.
2.         The issue of market power is
irrelevant where shareholders are voting on decisions of a company.
3.         Shareholders approving or dissenting to
certain resolutions of the company does not result in externalities.
4.         There are no public goods involved
when making decisions in relation to the affairs of a company.
Contradicts
the concept of equity capital

A right to be given an exit in a listed company contradicts the risk-bearing
nature of equity. Where a person acquires the shares of a company, he is
entitled to:
1.         the residual profits of the company,
once the creditors have been paid;
2.         participate in the decisions of the
company, by exercising voting rights attached to his shares; and
3.         sell his shares in the capital market.

The risk that the company may change the terms of its functioning, is factored
in the price at which the investor acquired the shares. Guaranteeing an exit to
equity holders on the ground of changes to the functioning of the company, is
antithetic to the concept of equity.
Equity is a
contract

The relationship between a company, its owners and management is essentially a
contract. The terms of the contract are codified in the Act. When an investor
subscribes to equity shares, he subscribes to the term that the company will be
bound by decisions taken by a certain majority.
Other
difficulties with the provisions
1.         An obligation to buy out shareholders
dissenting to a certain resolution imposes unforseeable costs on the promoters
and the majority shareholders. Every resolution will have some shareholders who
vote for it, some who specifically vote against it and others who do not vote
at all. It is not possible to identify in advance the number of shareholders
who will vote against the resolution and the value of shares at that time. The
provisions, thus, impose an un-ascertainable financial burden on promoters and
majority shareholders.
2.         The provision may incentivise opportunistic
behavior on the part of shareholders, at the expense of the company. Therefore,
even if the resolution is beneficial to the company, shareholders may choose to
vote against it, in the hope that the resolution will go through even without
their vote, and they will, as dissenting shareholders, be entitled to put their
shares on promoters or majority shareholders.
3.         The requirement of a special resolution
to approve the amendment of a contract referred to in the prospectus followed
by an obligation to buy-out dissenting shareholders, makes contracts expensive
for the company as a whole.[4]
Is there a
case for minority shareholder protection?

Notwithstanding the arguments set out above, several jurisdictions confer
statutory protection on minority shareholders against certain corporate actions
or actions by the majority. Generally speaking, the state intervenes (in the
form of a statute) to protect the rights of minority shareholders in two sets
of circumstances:
1.         Oppression and mismanagement by the
majority – Minority shareholders may seek judicial intervention to protect
themselves and the company against oppression and mismanagement. Here, the
minority shareholder must establish that the impugned action amounts to
oppressing or unfairly prejudicing their interests. The intervention is not
automatic under law.
2.         Change in control – The U.K. and most
EU members states have regulatory frameworks, which obligate the acquiror to
make an open offer to purchase the shares of the minority shareholders at
different thresholds, restrict the management from taking defensive measures in
certain situations, etc. The U.S. has a limited regulatory framework governing
takeovers, and most of the rules governing takeovers have evolved through
jurisprudence.

These circumstances involve the principal-agent problem where the management or
majority shareholders are uniquely positioned to adversely affect minority
shareholders. For example, in cases of a potential tender offer, the management
may fend off an offer not suitable to them but which otherwise enhances
shareholder value.

Under the Act, the changes which trigger the buy-out obligation do not involve
the principal-agent problem so as to warrant an automatic buy-out. First, a
change in the main object of the company requires a super majority approval.
Second, a change in the main objects or a contract referred to in the
prospectus, does not necessarily involve situations which can be exploited by the
management or majority shareholders to the detriment of the minority. If either
of these situations result in oppression or mismanagement, the Act contains a
statutory remedy which can be invoked by the shareholders of the company.[5]

Similar
provisions in other jurisdictions

A review of the laws governing corporations in some common law jurisdictions
reveals that while minority shareholders have appraisal rights across
jurisdictions, the events which trigger these rights are largely in the nature
of change in control, mergers and consolidations involving the company.
Exceptions can, however, be found in the corporation statute of New Zealand,
where the law provides for appraisal to minority shareholders who do not to
vote for a special resolution.[6]

Moreover, appraisal statutes impose the buy-out obligation on the company (and
not majority shareholders or promoters) to purchase the shares of the minority
shareholders.

Conclusion

For these reasons, our response to the discussion paper on this subject
recommends that the provisions of the Act mandating the majority shareholders
and promoters to buy-out dissenting shareholders in the circumstances
enumerated above, should be deleted. Alternatively, it recommends certain
thresholds for triggering the buy-out obligation, which give better effect to
the legislative intent.
Acknowledgements

The authors thank Somasekhar Sundaresan and Shubho Roy for useful discussions
on the response to the Discussion Paper.
– Bhargavi
Zaveri, Prateek Misra, Sumant
Prashant, Shefali Malhotra



[1] Section 13 of the Act provides that a
company, which has raised money from the public shall not change its objects
for which it raised the money unless (a) a special resolution is passed by the
company; and (b) the dissenting shareholders have been given an opportunity to
exit by the promoters and shareholders in control, in accordance with
regulations to be specified by SEBI.
[2] Section 27(1) of the Act says that a
company shall not, at any time, vary the terms of a contract referred to in the
prospectus or objects for which the prospectus was issued, except by way of a
special resolution. Section 27(2) states that the dissenting shareholders who
have not agreed to the proposal to vary the terms of contracts or objects,
shall be given an exit offer by promoters or controlling shareholders at such
exit price, and in such manner and conditions as may be specified by SEBI.
[3] Under the Companies Act, 1956, the
central government had the power to direct the purchase of shares of dissenting
shareholders who do not agree to a change in the memorandum of association of a
company, if the central government so deemed fit.
[4] The prospectus of a company generally
refers to material agreements entered into by it, including joint venture
agreements, agreements with key management personnel, key suppliers, etc.
[5] Chapter XVI of the Act.
[6] Companies Act, 1993.

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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