Conflicts and Gaps in Regulatory Aspects of Schemes of Arrangement

[Guest post by Purvi Khanna, a 4^th year student at NALSAR University of Law, Hyderabad.]

The Ministry of Corporate Affairs’ recent notifications formalise an overhaul in the procedure for Schemes of Arrangements (“SoA”). .

This post attempts to shed light on certain commercial aspects, and the inconsistencies and overlaps in the provisions of the Companies Act 2013 (the “Act”), the operationalising regulations and the ancillary rules, especially the SEBI Circular for Schemes of Arrangement by Listed Entities (“the SEBI Circular”) issued in March 2017, which obfuscate certain procedural requirements. A previous post on SEBI’s Board Meeting on January 14, 2017 discussing proposals inserted in the Circular can be viewed as an effective summary of the same.

Approvals from Sectoral Regulators

Regulatory approvals which were earlier undertaken in a haphazard and interventionist manner during approval petitions, or after schemes had been approved, were sought to be streamlined under the Act. Section 230(5) provides a window of 30 days to sectoral regulators relating to the transacting entities involved in the proposed SoA to submit comments, if any, failing which a presumption operates indicating that there are no representations from such regulators. Since the Act imposes its own timeline upon regulators, the obvious implication of the stipulation is whether a non-representation within the stipulated time period encumbers the regulator from raising objections before the National Company Law Tribunal (“NCLT”) at a later date in light of conflicts with regulators’ statutes.

The Competition Commission is allowed an extended period of 210 days under the Competition Act to send out replies; otherwise a deemed approval is assumed. The propensity of tax authorities to object to SoAs before courts on the ground of avoidance of tax subsequent to necessary approvals and procedures having been completed has also been condoned by High Courts under the previous regime.

With the operation of the General Anti-Avoidance Rules (“GAAR”), authorities are allowed to treat a transaction as if it had not been carried out (for the purpose of tax computation), if found to be an impermissible avoidance agreement on a subsequent assessment. The 2017 GAAR Circular indicates that GAAR can be invoked on an arrangement sanctioned by the NCLT if tax implications have not been adequately considered. This could adversely impact the clarity on rules and conclusiveness of representations by taxing authorities for permissible SoAs, and discourage companies from pursuing efficiency-promoting restructuring mechanisms in fear of unpredictable tax implications. The NCLT would do well to the read the provision of the Companies Act restrictively to allow entities to avail the benefit of the new provision’s stipulated time period keeping these considerations in mind.

Delisting Mergers

Under Section 232(3)(h) of the Act, a listed company and unlisted company can merge to form a resulting company which, until it goes for listing, remains unlisted. This is a previously uncharted entry since the Companies Act, 1956 did not explicitly envisage resulting unlisted companies formed through SoAs. Mergers involving listed entities were generally undertaken to avoid the strict compliances of listing but, under the new scenario, a listed company can attempt to de-list itself by availing the procedure under the section.  It remains unclear whether such mergers operate in tandem with the conditions imposed on entities under the SEBI (Delisting of Equity Shares) Regulations, 2009 (the “Delisting Regulations”), such that the eligibility conditions prescribed therein have to be complied with to undertake a delisting merger under the Act, or, in alternative, providing a legislative loophole to companies to de-list without following the regulatory compliances of the Regulations. On a literal interpretation, the Section does not subject itself to the Delisting Regulations and it may appear that the latter case may be true.

Moreover, the SEBI Circular, in sub-clause I.A.3 regarding “Conditions for schemes of arrangement involving unlisted entities” limits the understanding of such mergers to those resulting in listed entities, as per the pre-Act understanding of mergers involving listed and unlisted entities. Conditions imposed involve 25% public shareholding post-SoA (applicable to all listed companies under Rule 19A of the Securities Contracts (Regulation) Rules, 1957) and disclosures as per Schedule VII of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 (the “ICDR Regulations”). In the days leading up to the Circular, it was reported by Mint and reiterated at the SEBI Board Meeting on January 14, 2017 that the Circular was framed with the perspective of preventing companies from undertaking backdoor listing through merger routes (i.e. merging of unlisted and listed entities to form resulting listed companies without complying with listing regulations). SEBI presumably overlooked the possibilities offered by section 232(3)(h) on the reverse scenario, i.e., backdoor delistings,  in its attention to regulate this aspect and directed its focus primarily on formulating conditions that would prevent entities from evading listing requirements through SoAs.  The omission now raises doubts upon the legality of section 232(3)(h)’s delisting mergers itself. It is uncertain whether companies can undertake delisting mergers at all in the light of the nomenclature of the SEBI Circular expansively regulating “Schemes of Arrangements involving Listed Entities”.  The other possibility may be that these mergers are unregulated and therefore permissible for practical purposes, notwithstanding the nomenclature of the Circular (since it does not intend to regulate these scenarios).

The requirement on listed companies to attain no-objection letters from SEBI before approaching NCLT may make this a largely academic argument, since companies would be directed to comply with the essence of the Delisting Regulations if SEBI deems appropriate, but section 233 of the Companies Act provides a small window of debate. The section provides for fast track mergers between a holding company and its wholly-owned subsidiary, and SEBI has not been listed as a mandatory regulator from whom approval has to be attained. Moreover, the SEBI Circular does not regulate SoAs between holding companies and their wholly-owned subsidiaries, which means that its conditions would not apply in these SoAs (please refer to point 7 of the introductory note of the SEBI Circular). A combined reading of these provisions makes a theoretical possibility for a merger between a listed parent company and its unlisted wholly-owned subsidiary without undertaking the SEBI route.

Redressal Committee for Objections by Shareholders

A redressal committee has been constituted under the Circular to perform the function of receiving complaints on the SoA from all stakeholders, to be considered by stock exchanges and SEBI in granting no objection letters to the scheme. The objections would be forwarded to the listed company under sub-clause I.C.3 of the Circular for necessary action and resolution. The Act presupposes a threshold of 10% shareholders (in value) or 5% creditors (in value) for an objection to be raised that can prevent a SoA from being approved. It remains to be seen whether this provision acts as a work-around to the thresholds, as an additional layer of caution that SEBI would want to impose in case of listed entities. The threshold limits may lose meaning if the SEBI withholds approval to such objections which are raised by a decidedly smaller percentage of shareholders who can stall procedures that may be beneficial to the entity itself. An argument could lie against the perceived conflict between the Act and the SEBI Circular on the issue of thresholds for the limited subset of shareholders and creditors, in which case the statute should prevail. Exit options can be explored to deal with this decidedly smaller shareholder groups’ concerns.

Pricing Exit Options

The proviso to section 232(3)(h) states that pricing of shares in an exit pursuant to such a SoA should be not less than the prices mandated by SEBI under its regulations. Neither the Delisting Regulations nor the ICDR Regulations contemplates a delisting pursuant to a SoA of a listed and unlisted company. Currently, no other SEBI Regulation has been introduced or amended to provide pricing regulations for exit options in such a scenario. Thus, the proviso arguably leaves a legislative gap on pricing of exit options until a commensurate change is inserted to provide for the same.

Importantly, the ICDR Regulations’ pricing guidelines have been made applicable to stock swaps (i.e., consideration paid in shares to existing shareholders for continuing in the scheme), whereas consideration paid in cash is omitted from the point (refer to point 8 of the introductory note of the SEBI Circular). This means two things: first, consideration paid to exiting shareholders from SoAs is not price-protected, and second, non-compete fees are free to be determined by private arrangement on attaining shareholder assent, unlike the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (the “Takeover Regulations”) which prohibits such pay-outs. After the recent HDFC-Max merger, where shareholder approval was taken for the payment of non-compete fee to a promoter in the event of an amalgamation and not an acquisition, the Circular has given space to listed entities to take shareholder approval through e-voting in terms of a favouring vote for such agreements under sub-clause I.A.9. Arguments exist in favour of extending the prohibition under the Takeover Regulations in case of acquisitions to SoAs.)

Point 8 of the SEBI Circular mentioned above, additionally, makes pricing norms applicable “in case of allotment of shares only to…shareholders of unlisted companies”. Assuming the presumptive focus of the SEBI in bringing out these guidelines, shareholders of unlisted entities availing exit options in the form of cash and shareholders of listed entities availing a proposed scheme or the exit are left unregulated by the pricing norms. The Act itself does not impose any requirement for companies in providing equitable exit options to investors except in section 232(3)(h). The NCLT is empowered to provide for exit options without undergoing the procedure for reduction of capital under the Act through orders; however, this has not been provided in case of SoAs between two companies (in section 232). It remains to be seen whether practical realities play out in a manner that shareholder protection is threatened by companies not providing suitable exit modes, prompting amendments to be brought in by SEBI to govern these and other categories of mergers.

Regulatory concerns vis-à-vis taxing authorities and sectoral regulators, especially with respect to the GAAR, can serve as major roadblocks for entities pursuing restructuring methods if clarity is not provided before NCLT benches adopt differing approaches. Despite the binding nature of Advance Rulings as per the GAAR Circular, they may not serve as a respite for entities due to interventions made subsequent to favourable rulings being admitted in courts. Clarity on the aspect of delisting mergers is awaited since no known delisting merger has been proposed as of date. A commensurate change in the ICDR Regulations or the Delisting Regulations (if they are applicable to such mergers) on pricing norms by way of amendment should be expected.

– Purvi Khanna