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Has SEBI Eased Its Stance On Control?

What amounts to control: Has SEBI had a change of heart?

(Source: BloombergQuint)
(Source: BloombergQuint)

Investor rights such as board representation, veto against amendments to memorandum and articles of association and alteration to the capital structure of the company are ubiquitous in most shareholder agreements. The law doesn’t frown upon such rights as long as they are protective in nature and do not amount to exercise of control. But the subjectivity in the definition of control has led to much confusion and litigation between market regulator Securities and Exchange Board of India (SEBI), companies and their investors.

SEBI’s recent decision in the case of Clearwater Capital and Kamat Hotels India Ltd. sheds some light on the regulator’s current thinking on investor rights that may not amount to control.

Clearwater-Kamat Hotels Backstory

In 2010, Clearwater converted the foreign currency convertible bonds of Kamat Hotels into equity. As a result, its shareholding in Kamat Hotels increased to 32.23 percent from 24.50 percent.

SEBI’s Takeover Regulations mandate an open offer to public shareholders upon acquisition of 25 percent or more of shares or voting rights in a company. Clearwater made its open offer in 2012 and the parties submitted a draft offer letter to SEBI. The market regulator responded with its directions that were:

  • Clearwater had already acquired control in Kamat Hotels as result of certain clauses in the 2010 agreement.
  • Clearwater was in breach of Regulation 12 of Takeover Regulations as it failed to make an open offer in 2010 as a result of acquisition of control via the agreement. Regulation 12 mandates an open offer not only in cases where shares are acquired beyond prescribed limits but also in cases where a person acquires control over a company.
  • Clearwater must disclose that the open offer is pursuant to Regulation 12 and the possibility of penal action by SEBI in its offer document.
  • The open offer price should be higher of the two – price calculated on account of the trigger in 2010 or the price calculated basis 2012 trigger.

Clearwater complied with all these directions, except the disclosure that required it to state that the open offer was pursuant to Regulation 12 as well. And that led to a notice from the market regulator.

The Troublesome Rights

SEBI, in its show-cause notice, said the 2010 agreement gave Clearwater certain rights that amount to control. The contentious rights were:

  • Clearwater’s ability to restrict promoters from entering into agreements which would conflict with or restrict its rights.
  • Prior approval from Clearwater for altering Kamat Hotels’ share capital, creating new subsidiaries, entering into any joint ventures, merger or demerger, disposing of or acquiring any material assets, lending or borrowing money beyond certain limits, winding up or dissolving the company.
  • Clearwater’s right to nominate one director on the board of Kamat Hotels.

The Final Verdict

After considering Clearwater’s response, SEBI concluded that the disclosures in the offer document were adequate to enable investors to take an informed decision. And that the rights in the 2010 agreement were protective in nature.

Scope of the covenants in general is to enable the noticees (Clearwater) to exercise certain checks and controls on the existing management for the purpose of protecting their interest as investors rather than formulating policies to run the Target Company (Kamat Hotels).

It added that since the agreement had expired and Clearwater had offered the best price to public shareholders, the question of control is not material anymore.

Interestingly, SEBI also took note of the Subhkam Ventures precedent where the Securities Appellate Tribunal (SAT) had concluded that the investor rights didn’t amount to control.

SAT had held that an investor’s right of affirmative vote in certain matters including appointment of nominee directors or key managerial personnel and alteration of the basic structure of the company, does not amount to control, Iqbal Khan, a partner at law firm Shardul Amarchand Mangaldas, elaborates.

On SEBI’s appeal, the Supreme Court dismissed the case but stated that SAT’s order should not be treated as precedent.

Despite the decision of the apex court, most investors have been proceeding on the basis of SAT order’s in the Subkham case, Khan adds.

Investors have continued to incorporate affirmative rights in various transaction documents for protecting their interests and to exercise certain checks and controls on the existing management. This position of the investors has been supported by certain other SEBI decisions such as the 2014 order in Jet Airways-Etihad case, where SEBI has held that investor rights such as the right to appoint two out of 12 directors on the board, right to nominate the vice-chairman of the board who will chair meetings in the absence of the chairman and permanent membership of the audit committee, will not amount to acquiring of ‘control’ in Jet by Etihad.  
Iqbal Khan, Partner, Shardul Amarchand Mangaldas

Control: Change Of Heart At SEBI?

Abhijit Joshi, founding partner of law firm Veritas Legal, considers SEBI’s view in Clearwater’s case encouraging at best and says he’d still advise a calibrated approach.

I will continue to tell my clients that there is an element of risk in negative control in listed companies because in SEBI’s mind, it’s still control. If you want to be absolutely clear then don’t have it but if you must, then have only minimal rights required from a commercial perspective – rights which ensure checks on the management but are not controlling in nature. 
Abhijit Joshi, Founding Partner, Veritas Legal

Darshika Kothari, a partner at law firm AZB, agrees. This order will not end up providing clarity around the vexed issue of which veto rights will be acceptable to SEBI, she says.

While I think that there is language in there which suggests SEBI’s acceptance of protective veto rights, the order has not gone into the issue of what constitutes ‘control’. So I can’t tell a client, after this order, that it is fine to have sweeping veto rights and that SEBI has blessed it. 
Darshika Kothari, Partner, AZB & Partners

Since Clearwater had made all the other disclosures and since the price was favourable to public shareholders, it is really the facts of the case that ended up giving a positive outcome, she adds.

Khan, however, is relatively optimistic regarding the precedent value of this order. Clearwater is a good case to reiterate the position taken by SAT in the Subkham case, he says.

SEBI, in this order, categorically states that the nature of investor rights in question are ‘almost similar’ to those rights which were considered in the Subkham case. This decision accords validity to SAT’s order in Subhkam Ventures on investor protection rights. 
Iqbal Khan, Partner, Shardul Amarchand Mangaldas

But given SEBI’s protectionist approach towards minority shareholders, it is difficult to predict its view had the open offer price not been favourable towards the public shareholders, he adds.

Clearwater precedent aside, experts say that fruition of SEBI’s discussion paper on Brightline Tests for Acquisition of Control will be most useful to help clear the air on control.