SEBI’s Bright Line Tests for ‘Control’ - An Analysis

Background

The idea of corporate control has been subject to a longstanding debate in India and elsewhere. A fluid concept such as ‘control’ is a term of wide connotation and, by its very nature, is not amenable to any precise standard definition of general application. What constitutes control is most often a subjective test and is best determined on case to case basis. The crucial obligation under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (hereinafter referred to as the ‘Takeover Regulations’) is the requirement to make an ‘open offer’ to the public shareholders of the target company upon a substantial acquisition of shares or voting rights or acquisition of control of the target company, directly or indirectly. Thus, the quest for the appropriate definition of control for Takeover Regulations is driven by the underlying rationale of providing the minority shareholder an exit opportunity.

In India, over time, the definition of ‘control’ has been subject to different assessments and has turned to be, quite manifestly, a grey area under the Takeover Regulations. The Supreme Court in case of SEBI v. Subhkam Ventures Private Limited [see end note 1] had left the question of control unattended and undecided. SEBI has finally decided to address this issue and has recently issued a Discussion Paper [see end note 2] seeking public opinion over certain proposals related to bright line tests for defining ‘control’ for the purpose of the Takeover Regulations.

According to SEBI, there is a need for a bright line test for control as the existing definition of control in the Takeover Regulations [see end note 3] has broad contours resulting in multitude of opinions and a number of litigations. Further, the Discussion Paper refers to the definition of control provided in several other statutes/regulations [see end note 4] and emphasizes that, in the present scenario, there are multiple sectoral regulators like the Department of Industrial Policy and Promotion (DIPP), Insurance Regulatory and Development Authority of India (IRDAI), Civil Aviation Regulators and Competition Commission of India (CCI). In the light of several definitions available under different statutes/regulations and the presence of several regulators, there could be a situation where a regulator may or may not rely on the interpretation given by other regulator to ascertain control. This may result in confusion in the market as different regulators may adopt different perspectives. The Discussion Paper also examines the definition of ‘control’ as applicable in several other jurisdictions such as Hong Kong, Germany and Singapore, Canada and USA and highlights that quite a few jurisdictions have adopted objective tests to ascertain control.

Therefore, SEBI has proposed the following two options:

Option 1- Framework for Protective Rights

SEBI has listed down several illustrative situations where negative control or, affirmative voting rights or protective clauses in the shareholders’ agreement shall not be regarded as ‘control’. The proposal is actually illustrative in nature and seeks to protect strategic and financial investors who may seek protective rights in targets through shareholders’ agreements and corporate constitutional documents.

Under this option, the Discussion Paper has laid down the following instances which will not amount to acquisition of control in any manner:

1. Appointment of chairman/vice chairman: A chairman or vice chairman may be a nominee of an investor, provided the person does not hold any executive position and does not have a casting vote.
2. Appointment of observer: An observer appointed by an investor without having any voting or participation rights.
3. Customary lender covenants: Banks/non-banking finance companies (NBFCs) may have customary covenants specified by lenders provided the lender has granted the loan strictly on commercial basis.
4. Commercial Agreements: Rights conferred on the parties to a commercial agreement would not amount to control, provided it is for mutual commercial benefit and the board of the target company shall have approved, has the right to terminate and have the right to enter into similar arrangement with any other party.
5. Veto/Affirmative Rights: SEBI has provided an illustrative list of veto/affirmative rights in matters that are not part of the ordinary course of business or involve governance issues, which include, inter alia, amendments to memorandum and articles of association of the target company which adversely impact the investor’s rights, any alteration to the capital structure of the company and material divestment. Such affirmative rights shall be considered as protective in nature and would not amount to exercise of control over the target company.
6. Quorum rights: For meetings involving the illustrative list of veto/affirmative rights, if two meetings are not quorate, the next meeting would be deemed to have quorum despite the absence of the investor nominees. 

The above-mentioned protective rights shall be subject to several conditions, such as:

1. Minimum 10% investment: The respective investors must invest at least 10% in the target company;
2. Public shareholders approval: The grant of such rights will be mandated to require public shareholders’ approval;
3. Incorporation in articles of association: The aforesaid protective rights shall also be incorporated in articles of association of the company;
4. Initial Public Offer (IPO): In case of an IPO, the existing agreement needs to be modified or cancelled until the approval of public shareholder (majority of minority) is taken after the listing.

Also, it has been suggested that every company should formulate a policy to ascertain which transactions are ‘material’ for the purpose of affirmative votes on ‘material divestment’ and ‘material acquisition’. Further, the Discussion Paper has recommended that a policy should be formulated to define ‘outside the ordinary course of business’ for the purpose of the illustrative list of rights.

This option does attempt to restrict the definition of control, however, the element of subjectivity cannot be ruled out. This is because SEBI can only prescribe an indicative list of affirmative votes that will be protective rather than participative in nature. In this regard, it is noteworthy that SEBI has included appointment of observer in the illustrative list, however, it has failed to clarify the status regarding appointment of one or more directors. It is impossible to provide an exhaustive list that will encompass every single voting matter due to the fact that new rights may be drafted and negotiated in different ways which could be read subjectively and falling outside the scope of protective rights.

Also, it is quite likely that the list of protective rights that SEBI proposes to lay down, though illustrative, might be read literally by the regulators as well as practitioners. By applying the interpretation rule of expressio unius est exclusio alterius (i.e. to express one thing is to exclude another), the regulators/practitioners may tend to think that all that is not covered by the illustrative list may be construed as ‘control’.  Further, the conditions imposed on these protective rights need some clarification, for example, it is not clear if the condition pertaining to minimum 10% investment in the target company is applicable to secondary acquisition. Also, by introducing the condition regarding incorporation of protective rights in the articles of association, the proposal has tried to introduce the aggressive principle of many years that was sought to be corrected by the Companies Act, 2013.

Therefore, this option may result in more cases ending up before the regulator and may not deliver the intended results, with investments still getting stalled in disputes as to whether control has been acquired or not.

Option 2- Numerical Threshold

The Discussion Paper recommends, as one of the other options, to amend the definition in the Takeover Regulations as follows:

“(a) the right or entitlement to exercise at least 25% of voting rights of a company irrespective of whether such holdings gives de facto control and/or

(b) the right to appoint majority of the non-independent directors of a company”

It is pertinent to note here that SEBI has included the right to appoint the majority of ‘non-independent’ directors in the above definition as by virtue of the requirements prescribed under the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, appointing the majority of the directors may be a highly remote possibility.

By adoption of the proposed definition of control under ‘Option 2’, a number of scenarios could potentially emerge. The proposed amended definition would create a statutory presumption of control on holding of 25% voting rights and it is not prudent to lose the sight of the fact that there may be repercussion on several other laws which may tag themselves with the definition of control as provided in the Takeover Regulations such as the Companies Act, 2013, the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009.

Application of the numerical threshold, decoupled with de facto control, may also induce an element of arbitrariness. One can visualize a situation where to escape the mandatory open offer, an acquirer may acquire up to 24.9% of the target company. In such circumstances, the acquirer’s ability to exercise de facto control over the target company would depend, among other things, on the shareholding pattern of the target company. If there is no other shareholder with similar voting rights, then the acquirer may be able to effectively exercise control over the target company and influence its management and policy decisions without making a mandatory offer.

The rationale behind introducing the threshold of 25% of the voting rights is also based on the fact that as per the Companies Act, a special resolution requires a three fourth majority and an investor holding more than 25% of the voting rights shall be in a position to block special resolutions. However, it is noteworthy that sometimes an investor requires more than 25% voting rights merely to be able to block special resolutions, and the effective control, even in that situation, may lie with the other shareholders holding the remaining voting rights depending on how thinly those voting rights are split amongst other shareholders as there are several decisions such as appointment or removal of directors which require only a simple majority vote. Therefore, introduction of 25% threshold may result in the regulatory treatment of an investment transaction contrary to the commercial intention of the parties.

Conclusion

As elucidated above, it is evident that each of the options suffer from certain deficiencies both conceptually and operationally. However, certainly, from an investor’s perspective, the present Indian scenario is riddled with uncertainties that may have chilling effect over investments in listed targets.  Therefore, SEBI’s proposal to adopt a bright line test to ascertain control for the purpose of Takeover Regulations is, undoubtedly, a substantial step towards improving the ease of doing business in India.

 [The author is an Associate, Corporate Practice, Lakshmikumaran & Sridharan, Mumbai]