Negating Negative Covenants: A Deterrence to Private Equity Investment in India?

[Shuchita Goel is a V year B.A., LL.B. (Hons.) student at National Law University Delhi]

The Indian corporate landscape is dominated by firms with concentrated ownership, where the controlling shareholders (also known as promoters) play an all-pervasive role in corporate governance.[1] Parties in control of a corporation are in a position to extract private benefits of control that do not accrue to dispersed shareholders. This may, at times, become an impediment to the fundamental role of takeover regulations in India which is stated to be the promotion and maintenance of a thriving market for corporate control.[2] Such a policy is aimed at reducing agency costs by enabling competition in the market, wherein the threat of takeovers and replacement of management incentivises current managerial personnel to reduce inefficiencies and promote better management practices.

Private equity investment is one such method of encouraging the creation of a market for corporate control, especially in the West where private equity firms conduct leveraged buyouts of inefficiently-run target companies, introduce talented managers whom they incentivise by giving them a stake in the company through equity shares, create value within a three to five year investment period, and exit the company by either selling it to a strategic buyer or conducting an initial public offering.[3]

However, due to the restrictions placed by the Reserve Bank of India on using assets of a company as collateral to finance its acquisition,[4] in India private equity firms usually undertake ‘growth’ deals, where they acquire a minority stake in the company, act as financial sponsors for the target firm, and negotiate certain rights through the use of shareholders agreements.[5]

These rights, also known as protective covenants, allow the private equity investor to veto key decisions, including amendments in the articles of association, changing the nature of the business, issuing securities, change in control transactions, incurring debt, replacing key managerial personnel and approving budgets.[6] Under most shareholders agreements, the investor may negotiate the ability to exercise an effective veto right by requiring shareholder approval for taking certain courses of action, and then further requiring that they be approved by special resolution.[7] If their negotiations are successful, they may also include others restrictions on transferability such as tag-along rights, drag-along rights and lock-in provisions.

Such contractual arrangements entered into by private equity investors may, however, trigger issues of ‘control’ under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (the ‘Takeover Regulations’) which require them, even as minority shareholders, to make mandatory open offers.[8] Further, minority shareholders face other issues under the Takeover Regulations that make their position worse off as compared to incumbent promoter-shareholders, due to the very same provisions that were added to benefit the minorities.

Regulation 2(1)(e) of the Takeover Regulations has defined control as inclusive of 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.” This definition delineates the broad framework of what constitutes control, and provides for both numerical and subjective aspects. It is the latter that requires further scrutiny.

While most jurisdictions follow only a requirement to exceed a particular numerical threshold for the open offer requirement to apply, merely following a quantitative threshold poses the problems of an acquirer gaining de facto control over a target company without substantial acquisition, which may provide an opportunity of inequality to minority shareholders.[9]

To remedy this, India’s Takeover Regulations have introduced the subjective element, which constitutes control over both the board of directors and the management of the company. With respect to the former, the acquirer may be granted a right to control the composition of the board (through a shareholders agreements), obtain the ability control board composition (through an increase in shareholding), or if it de facto appoints or removes directors. The latter requirement, i.e., that of management or operational control, focuses upon situations where the acquirer may not have obtained full control over the board, but may still exercise control over the policy decisions of the company by controlling its management.

However, this creates complications because of its inherent subjectivity in conferring excessive discretion upon the regulator to determine on a case-by-case basis what control means, and whether a change of control has occurred or not. Finally, it may also create a dissonance between the commercial intention of parties and the regulatory treatment afforded to certain investments, as has been the case with private equity investments in India.

The Indian regulatory approach towards protective covenants too, has historically been unfavourable or unclear. In one of its first orders on the question, in Rhodia SA v. Securities and Exchange Board of India,[10] the Securities Appellate Tribunal (“SAT”) stated that Rhodia SA controlled the affairs of the parent company of the target through the use of protective covenants, and hence controlled the target itself. In this case, Rhodia SA had funded Danube USA (the parent company), and controlled the bid placed by its wholly owned subsidiary for acquiring the target, through use of contractual veto rights vested with Rhodia SA on important matters such as payment of dividend, acquisition or disposal of the company’s assets, and issuing securities.

Subsequently, the SAT, through a separate ruling, relaxed its position, and in Sandip Save and others v Securities and Exchange Board of India,[11] held that a financial investor with affirmative rights could not be held to have had control of the target, since the company also had promoters who were in charge of the company’s affairs, and rights granted to the investor were mainly defensive and protective in nature.

Since the position of law was conflicting in nature, in 2011, the SAT delivered a judgement in Securities and Exchange Board of India v Subhkam Ventures (I) Private Limited[12] on this particular question, which was later appealed to the Supreme Court. In this case, the target company (MSK Projects India Limited) had made a preferential allotment of equity shares, constituting 17.9% of its shareholding, which triggered the requirement for open offers. The investor also entered into shareholders agreements with the promoters of the target and the target itself, wherein it was granted the following rights – the right to appoint a nominee on the board of directors of the target company, the requirement of the presence of the director nominated by the investor to constitute a quorum for board meetings of the target company, and affirmative voting rights.

While the investor fulfilled its obligations with respect to the open offer requirement, the Securities and Exchange Board of India (“SEBI”) required the draft letter of offer submitted by it to reflect that it was being submitted under regulation 12 of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997, which stated that “irrespective of whether or not there has been any acquisition of shares or voting rights in a company, no acquirer  shall acquire “control” over the target company, unless such person makes a public announcement to acquire shares  and acquires such shares”.[13]

In imposing this requirement, SEBI was of the view that the rights the investor gained under its shareholders agreement, all put together, were hit by the definition of ‘control’ under the Code, thereby triggering regulation 12. The question of law that came up for dispute in this case was thus, whether these negative control rights constituted “control” for the purposes of the Takeover Regulations.

Upon appeal, the SAT overturned SEBI’s decision, stating that ‘control’ under the Code is a proactive, and not a reactive power, wherein the acquirer must have the power to command the target to do as per its wishes. Control meant creation or control of a situation by the acquirer through an initiative taken by it, by which it may prevent the target from doing what the target itself wants to do by itself. Therefore, for the first time, ‘control’ under the Code was defined restrictively to not include protective rights under its ambit.[14]

Subsequent to this, the SAT order was appealed by SEBI. However, both parties settled the matter, and the Supreme Court did not rule on the matter. An interesting point that the apex court brought out, however, was that the SAT order would not be treated as precedent, effectively keeping the question of law open.

The determination of the question of control by an entity over a corporate is a simple process when the concerned rights are a consequence of the entity’s voting rights or shareholding in such company. Complications arise in those situations where the entity instead holds entitlements under contract; this is observed in most private equity transactions and requires a careful consideration of the factual circumstances surrounding the agreement.

The general international practice for investors – or at least, those whose investment is substantial – is to seek certain protective rights under their contractual agreements with companies.[15] In such a scenario, investors acquire a stake in the target which is below the requirement that usually triggers the numerical threshold for the open offer requirement. The investment is typically structured as an issue of new shares by the company, as opposed to through an offer for sale by existing shareholders, whose purpose is to fund business expansion or diversification of the company.[16]

Due to large investments, investors seek additional affirmative rights through protective covenants and, at most, acquire joint control over the target with the promoters. However, it is a premature conclusion to state that private equity investors insert these clauses to control the day-to-day activities of the company; in fact, most investors remain dormant throughout the life of their investment in India, unlike their foreign counterparts. This is even more so in cases where they insert specific clauses in their shareholders agreements disclaiming the acquisition of control over the target, and put in place processes to follow in case they are legally determined to be promoters for the purposes of an initial public offering.[17] In any event, the investor with a minority stake can never exercise any significant influence over the promoter, much less exercise control unilaterally over the board of directors or the key managerial personnel, without the aid of the promoter. The rights it seeks, therefore, are almost always to protect its investment and economic interests, rather than assert positive control or influence the policy creation activities of the company.

Thus, a holding by any court of law that imposes the idea across the board that all negative covenants are an assertion of control may be counterproductive to private equity investment, which works on the strength of short tenures and no restriction of exit opportunities for the investor. Such a move by the Indian regulatory and judicial establishments would deter investor confidence and further build on a legal environment that creates unnecessary fears on part of entities that would otherwise be keen on infusing capital in domestic industries.

Shuchita Goel

[1] Rajesh Chakrabarti, William Megginson & Pradeep K. Yadav, Corporate Governance in India, 20 Journal of Applied Corporate Finance 59 (2008); Lee Kha Loon & Angela Pica, Independent Non-Executive Directors: A Search for True Independence in Asia, CFA Institute Centre 10 (2010), available at:

[2] F.H. Easterbrook and D.R. Fischel, The Proper Role of a Target’s Management in Responding to a Tender Offer, 94 Harvard Law Review 1161-1204 (1981).

[3] Jeffrey Blomberg, Private Equity Transactions: Understanding Some Fundamental Principles, 17(3) Business Law Today 50-54 (2008).

[4] Narendra Chokshi, Challenges Faced in Executing Leveraged Buyouts in India: The Evolution of the Growth Buyout (Apr. 2, 2007).

[5] Afra Afsharipour, Corporate Governance and the Indian Private Equity Model, 27 National Law School of India Review 17-48 (2015).

[6] Siddharth Raja & Neela Badami, Private Equity: India in Getting the Deal Through: Private Equity 128-145 (2012).

[7] Afsharipour, note 5 above at 21.

[8] Regulation 3, Takeover Regulations.

[9] Marco Ventoruzzo, ‘Takeover Regulation as a Wolf in Sheep’s Clothing: Taking UK Rules to Continental Europe’ 11 University of Pennsylvania Journal of Business Law 136 (2008).

[10] Rhodia SA v Securities and Exchange Board of India (Securities Appellate Tribunal, 7 November 2001), available at

[11] Sandip Save v Securities and Exchange Board of India [2003] 41 SCL 47 (SAT).

[12] Securities and Exchange Board of India v Subhkam Ventures (I) Private Limited, Civil Appeal No. 3371 of 2010.

[13] Ibid.

[14] Ibid.

[15] Umakanth Varottil, Comparative Takeover Regulation and the Concept of Control, 208 Singapore Journal of Legal Studies 34 (2015).

[16] Ibid.

[17] Ibid., at 35.

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