10 December 2015

Exit option to shareholders on change of objects of fund raising in IPO

I have a piece on the Firm website where I discuss the consultation paper on exit being provided to dissenting shareholders where public offer proceeds have not been applied towards the disclosed object. I argue that the Companies Act provision which provide an exit option to shareholders where objects are modified is unwholesome in its application and is wholly wealth destructive for genuine shareholders. Some punters may make some money in the short term in some cases, but broadly everyone loses. Below if the full piece and here is the link to the original article:

"Punters versus The Real Economy
SEBI has come out with a consultation paper on exit being provided to dissenting shareholders where public offer proceeds have not been applied towards the disclosed object.

To provide a brief context, sections 13 and 27 of the Companies Act, 2013 provide that where a company has raised money from the public, and wishes to use part of the funds towards an object not originally stated in the prospectus, then such change of object must be permitted by shareholders by way of a special resolution. In addition, dissenting shareholders are to be provided an exit by the promoters of the company in terms of regulations of SEBI.

The basic premise of the Companies Act in the two sections is that a change of objects for use of funds raised is by itself a dubious activity. It also seems to protect shareholders from such a change by guaranteeing them money back. On the face of it, this does not sound wrong at all. If a company has raised money for a purpose, it must use it for that purpose. But the reality is quite different from the optics.

The world of economics and the competitive landscape for almost every company is a slippery slope. Oil at $100 a barrel versus oil at $37 in a matter of just over a year can make entire industries highly uncompetitive, where they were previously profitable. And of course conversely, many companies would find the dip in oil prices a big bonanza, so that they would like to enter into a business which was previously unattractive. For a company, the price of oil is merely one of the hundreds of variables which make their business viable or unviable. The reality is that these variables, much as we like predictability, vary on a daily basis. Whether it is input costs, change of regulations, number of competitors or many other unforeseen factors.

Now imagine a company which had raised funds for a particular project, say deep sea oil discovery in 2013 or a beer factory in Kerala in 2014. Now imagine what such a company would be looking at in 2015. Funds were raised for a project which has now become unviable because of change in competitive features or regulatory changes. If the oil drilling is done the cost of extraction (say) would exceed the sale price by 30% and in the second case sale of beer locally would be banned and transport costs would ensure that sale outside the state would be unviable.

Now imagine what the promoters of the company would do with the funds raised, assuming that only a small part of the funds raised had actually been invested in the two projects. They can do one of the two things a) continue with the projects and watch the shareholder money go down a certain black hole, but with no liability on the promoters/managers. b) discontinue the project and attempt to invest in a viable sector, but seek shareholder approval and give them an exit option out of the personal funds of the promoters. Clearly, the incentive will be to take the first option given the new Companies Act. Equally clearly, this is a bad outcome for the company, the shareholders and for economy.

While the SEBI discussion paper seems to understand some of the issues, it only subtly talks about them and recommends statutory change. SEBI as a creation of the statute of course rightly does not challenge the statute itself. But, someone ought to- in the national interest. This law is unwholesome in its application and is wholly wealth destructive for genuine shareholders. Some punters may make some money in the short term in some cases, but broadly everyone loses. We really need a discussion paper on the existence of the statutory provisions more than a discussion paper on the logistics of the SEBI norms for providing the exit option to dissenting shareholders."

(Attached is SEBI’s Discussion Paper on “Exit Offer to Dissenting Shareholders)

14 September 2015

We need independence with accountability in financial regulators

I have a face-off opinion piece in today's Business Standard on improving accountability of financial regulators. Independence without accountability is dangerous. Below is the full piece and here is the link to the piece:

Under the new Companies Act, a director is independent, if she is a person of integrity, possesses relevant expertise, and one who is not a promoter besides other requirements
It would be interesting to view the independence of financial regulators by trying to view it through the prism of how directors are considered independent. Under the new Companies Act, a director is independent, if she is a person of integrity, possesses relevant expertise, and one who is not a promoter besides other requirements. There is also a term limit for each independent director. Most importantly, there are also several accountability standards applicable to independent directors.

A more blunt definition of independence for financial regulators would be that it is independent of the government and independent of the politics and politicians who might seek to influence its behaviour. From the perspective of the second definition, the financial regulators are highly independent.

Based on the first definition, the answer is more nuanced. Broadly, all financial regulators possess high integrity, relevant expertise and experience and are relatively uninfluenced by the government. The Reserve Bank of India (RBI)'s hawkish stance on the monetary policy, for instance, is evidence of that. Top leadership of the regulator has terms, usually three to five years and that keeps limits on their power.

However, the integrity of the regulators has a missing twin. And that is accountability. Not only is accountability weak with some financial regulators but this lack of accountability often flows from the over-confidence of its integrity and expertise. The classic example of this weak accountability is the way payment bank licences were handed out as if alms were distributed.
In a rule of law country, if eligibility of standards is set, it cannot be open to give a licence only to some people who meet the standards. It must be given to all who qualify. The only reason RBI can get away with it is because hardly anyone suspects foul play. The award is wrong but it is also objective and uninfluenced by politics or money.
Similarly, Sebi's investigations are carried out with a gun on the head of witnesses asked to furnish information in a day or even half a day. These excesses are tolerated, but we do need independence coupled with accountability for true independence of regulators.

21 August 2015

Related Parties - Listing agreement versus Companies Act, 2013

My colleague and I have a piece on The Firm website on the inconsistencies of listing agreement with Companies Act with respect to Related Parties  and reforms which are required to be done by SEBI.
The full piece is copied below.

The Companies Act, 1956 (“Companies Act”) and the Listing Agreement both set out different requirements for related party transactions (“RPT”). While the former applies to all companies, the latter applies only to listed companies. 

The Definition of Related Party
The Companies Act provides a definition for the term “related party” whereby a list of nine parameters have been prescribed to determine whether a particular entity is a related party. However, under the Listing Agreement, SEBI has prescribed additional parameters, apart from those specified in the Companies Act. Under Clause 49 (VII) (B) of the Listing Agreement, listed companies must also consider the parameters set out under the applicable accounting standards to determine whether a particular entity is a related party.  

The Indian Accounting Standard 24 (“IndAS 24”) deals with related party disclosures. Transactions with such entities will have to meet the higher standards and obligations set out in the Listing Agreement. The table below contains a comparison of the definitions of related party under the Companies Act and IndAS 24:

Section 2(76) of the Companies ActIndAS 24
(i)    a director or his relative;
(ii)    a key managerial personnel or his relative; 
(iii)    a firm, in which a director, manager or his relative is a partner; 
(iv)    a private company in which a director or manager is a member or director; 
(v)    a public company in which a director or manager is a director or holds along with his relatives, more than 2% of its paid-up share capital;
(vi)    any body corporate whose Board of Directors, managing director or manager is accustomed to act in accordance with the advice, directions or instructions of a director or manager;
(vii)    any person on whose advice, directions or instructions a director or manager is accustomed to act:
(viii)    any company which is
a. holding, subsidiary or an associate company of such company; or 
b. subsidiary of a holding company to which it is also a subsidiary;
(ix)    such other person as may be prescribed;
a)    A person or a close member of that person’s family is related to a reporting entity if that person:
i.    has control or joint control over the reporting entity.
ii.    has significant influence over the reporting entity.
b)    An entity is related to a reporting entity if any of the following conditions apply: 
i.    The entity and the reporting entity are members of the same group (which means that each parent, subsidiary and fellow subsidiary is related to the others).
ii.    One entity is an associate or joint venture of the other entity (or an associate or joint venture of a member of a group of which the other entity is a member).
iii.    Both entities are joint ventures of the same third party.
iv.    One entity is a joint venture of a third entity and the other entity is an associate of the third entity.
v.    The entity is a post-employment benefit plan for the benefit of employees of either the reporting entity or an entity related to the reporting entity. If the reporting entity is itself such a plan, the sponsoring employers are also related to the reporting entity.
vi.    The entity is controlled or jointly controlled by a person identified in (a).
vii.    A person identified in (a)(i) has significant influence over the entity or is a member of the key management personnel of the entity (or of a parent of the entity).

The threshold prescribed under IndAS is essentially for determining disclosures and auditing. For the purpose of disclosure, the standards are of course very broad, as they ought to be.  Adding this standard to the Clause 49 standard is adding to the length of the definition and making it more burdensome, overlapping and confusing for listed entities. The definition within the Companies Act is easier to understand and adequate for the task at hand. SEBI should consider excluding the accounting standards from its definition of ‘related party’.

Voting rights of Related Parties
Under the Companies Act, the prior approval of the board of directors of a company is required for a RPT relating to any of the seven subject matters listed therein. It must be noted that rules made under the Companies Act state that directors who are interested in the RPT shall not participate in the meeting considering its approval. 

Further, the Companies Act requires prior approval of the company’s shareholders, by way of ordinary resolution, if abovementioned transactions are beyond the prescribed monetary thresholds. The Companies Act itself states that no member of the company who is a related party shall vote on such a resolution to approve any RPT, if such member is a related party. The Ministry of Corporate Affairs, vide Clarifications dated July 17, 2014, clarified that this restriction only applies to such related parties which may be related in the context of the RPT for which the resolution is being passed. As a result, other entities that fall within the parameters of related party but are not directly involved or interested in the transaction can vote on the resolution.

Under the Listing Agreement, material RPTs require the prior approval of the company’s shareholders by way of a special resolution. However, unlike under the Companies Act, it is expressly states that all entities falling under the definition of related parties shall abstain from voting irrespective of whether the entity is a party to the particular transaction or not. 

This inconsistency leads to some peculiar scenarios. We may consider a few hypothetical fact situation to highlight the issues here. Company X is attempting to enter into a transaction with Company Y, a related party. One of the directors and shareholders of Company X, Mr. A is also a related party of Company X but is unrelated to Company Y. He is opposed to the proposed transaction with Company Y as he believes it is not in the company’s interest. As per the Companies Act, Mr. X may vote during the board meeting and the shareholder resolution as he is unrelated to Company Y and is not interested in this transaction. However, under the Listing Agreement, as he falls under the category of related party, he may not participate in the meeting. As he is not directly or indirectly interested in the transaction, we are of the view that there is no reason to restrict him from exercising his vote. 

To take another example. If an independent director of Company X is also an independent director of a Mutual Fund AMC, the Mutual fund would be disbarred from voting even though the director has no interest in the issue at hand. SEBI may consider amending the provision accordingly in order to align it with the position under the Companies Act. Keeping it so broad would only restrict non interested parties (in a particular transaction) from voting and thus harm the interest of the shareholders which SEBI seeks to protect. In some cases, the harm may extend to non-interested parties opposing the vote being barred from voting. This again could not be the intention of SEBI. Restrictions should apply only where a person or its related entities are interested in that transaction.

03 July 2015

Finsec Law Advisors turns 5 years old

We complete 5 years of Finsec Law Advisors this weekend. It's been an exhilarating journey. Starting with having myself as sole employee and a rent free office to growing into a professional firm with a solid team which clients can trust with the largest and most complex of challenges. It's been great. We fought against the notion that you need to be large to be able to gain the client's confidence. We don't do everything for everybody, but what we do, we do damn well. This focus on quality has resulted in our present (presumably good) reputation. We have kept up with policy making and devote a large part of our time to it. We have a large volume of newsletters, articles and of course two books to our collective credit. 

This would not have been possible without the excellence of our team, which is aligned in its goal of being thought leaders not just professionals who do their jobs. Thanks are due to all the benefactors and clients who have had confidence in our quality. Lastly, many thanks to the media which has always been kind in respecting and airing our views on many things.

25 June 2015

I have a piece hosted on "The Firm" on the "For New Age Companies - From SEBI, With Love" on the new segment of institutional trading platform allowing 'new age' companies and the like to list in India rather than look for listing abroad. I think it is a good development though it should over time move from a separate segment into the main trading board of the exchanges (with a larger trade size of Rs. 10 lac (Rs. 1 million)). Copied below is the full piece.

The SEBI board decided to enable a 'Simplified Framework for Capital Raising by technological start ups and other companies on Institutional Trading Platform' is a big step forward for all Indian companies seeking domestic listing.

To set the context, we already have a main board where companies list. We have a relatively recent SME board for small and medium sized companies and we also have another relatively recent Institutional Trading Platform (or ITP). 

The Still Born ITP
The proposed simplified framework is essentially a reform of the rather unworkable ITP segment. If one were to summary the new ITP (NITP) it allows companies, particularly technology oriented companies to raise capital for general corporate purpose from sophisticated investors. To be sure, this platform is for capital raising and it is for rather large companies (minimum investment of Rs. 10 lacs with minimum 200 investors mean a total capital raise of Rs. 20 crores) of capitalisation of approximately Rs. 100 crores or upwards. The NITP is also a big change from the nitpicking ITP requirements which included the maximum age of the company, the maximum revenue of the company, the maximum size of the company, the latest time when the CEO wakes up (kind of).

NITP Is Now Born
The NITP is a big step forward, not just from the ITP in existence but also from the draft proposal for the NITP which was full of silly requirements. It is a tribute to SEBI's openness that all the silliness has gone away (Finsec among many had commented on the draft paper). 

NITP Not An Alternate Market
It should be noted that except for the purpose of raising funds and some relaxations in reaching the valuations, there is no relaxations from either disclosure standards (with a minor exception relating to immaterial issues which can now be disclosed on the website of the company) or corporate governance standards. In other words this is not forum like the AIM market or other alternate segments. This is a big boys market where both the issuer and the investors are big boys (minimum issue size and trading lots are both Rs. 10 lacs). The main purpose of NITP is to bring a market which was travelling abroad - onshore. This is likely to be effective in achieving that purpose.

Over the medium term I would like to see the NITP being transformed from a separate trading segment into the primary board itself, where the trading size remains Rs. 10 lacs or multiples. This should achieve the purpose of segmenting sophisticated investors from unsophisticated without fragmenting the market.

01 June 2015

Finsec Law Advisors ranked top ten law firm in India in two categories

India's first domestic law firm rankings are out - Magic Lawyers. We are delighted to report our ranking in India's top ten law firms in both the categories where we exist - Capital Markets and Investment funds. In both categories we are the smallest by size (in capital markets the next largest player is 5X our size). Thanks to team Finsec for their merciless attention to quality and responsiveness. Thanks to our clients for reposing their faith in us - and believing in us when we said quality is key, not size. @magiclawyers

20 April 2015

The new new Insider Trading regulations of SEBI

I have a piece in the current issue of Outlook business on the new insider trading regulations. Broadly they look good, but of course like any new legislation, many questions will remain unanswered for the time being. This is of course also a great time to peddle my book on fraud and insider trading - Fraud Manipulation and Insider Trading in the Indian Securities Markets available from Amazon India.  

After a much discussed report on the subject, SEBI has finally published a new rule book for prohibiting insider trading. The change was overdue as there was a need to not only improve the language of the prohibition, but also protect a large number of legitimate transactions which could potentially be seen as illegal if a very pedantic view of the law was taken. The purpose of the law was to outlaw dishonest conduct, not be so broad as to catch legitimate trades. What is interesting in the 2015 regulations is not just the prohibition part, but more so what is explicitly permitted.

The no-no of insider trading
First, of course, the actual prohibition. The prohibition comes in two parts. The first relates to communication of unpublished price sensitive information. The prohibition outlaws not just communication of unpublished price sensitive information, but also one who allows access or one who procures or causes the communication by an insider. This is much broader than the 1992 regulations, because it restricts the flow of information even without any trading occurring. It does however, provide for flow of information for legitimate purposes, performance of duties or discharge of legal obligations. To give an example, two friends gossiping about one friend’s company on whose board he sits, would be illegal even if the other does not trade based on such information. This is not a great development, as it will chill communication even where no one has been hurt and there has been no intent or action to hurt investors. While not clear, it is hoped that this would be seen more as a violation of best practices of corporate governance rather than a substantive violation. Ideally such innocuous talk should not be outlawed as there is neither intent to cause nor any actual damage to anyone.

All unfairness should not be made illegal
The other part related to the prohibition is the classic prohibition on insider trading. The regulations prohibit an insider from trading in securities when in possession of unpublished price sensitive information.  While this looks narrow and seems to apply to insiders, the definition of insider includes anyone who is in possession of inside information. To give an example if a few pages from a company blew away in the wind, landed on someone’s front yard and that person who chanced across the information were to trade, such possessor would be guilty of insider trading. This is the broadest form of definition, by global standards, which relies on ‘parity of information’. It is hard to dispute with the argument that all information should be equally shared, and no one person should have an advantage over another. But equally hard to argue is the fact that not everyone gets three square meals to eat everyday. It is unfair. But all unfairness is not illegal. To use an analogy, comparing a person who finds a hundred rupee note flying around on a deserted road and keeps it with another case of a person picking a pocket in a crowded train and giving both of these persons the same punishment is just wrong. One is unfair, the other is unfair and illegal. To summarise the history of insider trading in a single sentence, the prohibition arose out of the fiduciary duty of insiders, particularly senior persons of a company, who owe their company and their shareholders the duty to place their interest ahead of their own, and by trading in information which they have in fiduciary capacity to their own benefit breach that high trust. To place a random person who did not even steal or misappropriate that information from the inside of a company is what the possession standard imposes. Many jurisdictions do, like India, impose the possession standard, but I must assert my unequivocal opposition to it.

Benefits of doubt - exemptions
Having said that the new law provides a fair set of benefits and exemptions which were not present previously. This is of course a much needed change from the previous regulation, which at times could be seen to outlaw not just unfairness but also totally honest conduct. The prime example was the ambiguity surrounding due diligence amounting to access to inside information. Specifically, private equity or institutional shareholders would often like to do a due diligence on the investee company so as to verify facts represented to them by the company and its promoters. By definitions such investors would be given access to unpublished price sensitive information not available to all shareholders. Based on the due diligence, investment into the company would squarely fall within the prohibition of the old regulations. This ambiguity was of course perverse, because the interest of the private equity player aligned very well with the interest of the minority shareholder. The due diligence could potentially uncover mis-representation in the financial books of the company. To virtually outlaw due diligence by insider trading law was in fact hurting shareholders rather than helping them.

The new regulations provide several protections for honest conduct and also provide several safe ways by which insiders could trade by minimising the possibility of mis-use of privileged unpublished price sensitive information.

The first protection comes from communication in furtherance of legitimate purposes, performance of duties or discharge of legal obligations. While the prohibition is intended to restrict the free flow of information to only need to know basis, the protection offers protection when the information is given in good faith but is mis-used. The giver of information in that case would be protected, though the one who mis-uses it would not be. Similarly, any person in the chain of persons who is passing on information for a good reason would stand protected.

The second protection is provided where a friendly takeover with an open offer is on horizon. In such cases the company can give access to price sensitive information but only if the board of the company believes the transaction to be in the best interests of the company. While this comes with some interpretational complications, it is a useful addition to the available exemptions for honest conduct.

The third protection is in similar cases of due diligence where the board of the company believes the access to be in the best interest of the company, but where there is no open offer on the horizon. In such cases, the price sensitive information needs to be disseminated to the public two trading days before the transaction. This exemption will causes some problems in its implementation as people do not ordinarily wish to announce the deal before its signing or execution.

The fourth exemption is provided where two persons, both persons being promoters, choose to transact between each other when both are in possession of unequal information which is not widely available - so long as the transaction is off market, so as to not pollute the market with a differing price. This is a useful and logical exemption which permits trades between two people who have access to privileged information as they are not hurting the market with their trade.

The fifth exemption is where individuals in possession of unpublished price sensitive information were not the ones who took the decision to trade.  In other words where the causal link can demonstrably be broken between a person or group of persons having superior information and other person or group of persons who trade in the securities, the unfairness does not arise out of uneven ownership of information and its misuse. This is a sensible exemption and rooted in logic.

The sixth exemption arises out of a trading plan. A trading plan would be a plan to sell (or buy) a fixed number of securities (say) every week or month for at least a year after the plan begins. The plan provides a defence to those insiders who are perpetually in possession of unpublished price sensitive information, particularly non promoter senior management, who depend on ESOPs or sweat equity for their compensation. The exemption would allow such employees and senior management to encash their shareholding without being wrongly accused of insider trading. Of course to get the protection of law, several safeguards are provided including the period after which the plan would start (after six months), how long it must stay in place (at least a year), public disclosure of the plan, its irrevocability and certain freezeout dates and a requirement that it be the exclusive form of trading (no contra trades or other plans being used simultaneously). Again the purpose is to break the causal link between having privileged information and its actual mis-use based on that information. The plan, though unlikely to be popular with promoters because of the stringency of its exercise, may just turn out to be popular with senior professional management with large ESOP and sweat equity grants. 

Finally, and most importantly, the new regulations provide for an exemption for innocent behaviour. The exact text is “Provided that the insider may prove his innocence by demonstrating the circumstances including the following: -”. Lawyers of course get very exciting every time they see the word including in a legislation. It is actually a secret word used by legislators to say that whatever follow is only an indication and not an exhaustive list. The use of the words ‘innocence’ and the use of the word ‘including’ seems to suggest that some level of fraud or intention (or mens rea as we lawyers pretending to speak latin must say) to defraud must be present. This aligns the definition more closely to the American definition of insider trading which is a derivative of the anti-fraud rule, there being no specific law defining insider trading. This is a welcome addition and it is hoped that judicial precedent will create a definition closer to the classical definition of insider trading (which is based on fraud and breach of fiduciary duty) rather than the over-broad possession theory that we seem to have adopted.

Principle based code of conduct
The simplification of the law to make it more principle based in many aspects is a positive development and would allow companies to craft internal policies in the context of the risks inherent in their organisation. An auditor would need very different internal procedures compared to a merchant bankers working for a listed company.
The disclosure norms have been simplified and a high (from a previously very low) threshold provided (sale or purchase of ten lac rupees over a quarter) though the disclosure norms have been expanded to all employees rather than select ones.

Breathing space for corporates to implement new law
Finally, it is a good development that SEBI has provided a period of 120 days for the regulations to become effective. This would save the industry the pain of sudden change in the law before understanding its implications.

Use of explanatory notes – not particularly useful
One of the few cons of the regulations is the addition of explanatory notes below every regulation. These have added no clarity in interpreting, as was intended, but range from a very poor rephrasing of the same to at its worst contradicting the actual provision contained in the regulation. Perhaps it is time to either junk the concept or at least develop it more so that it is useful rather be the origin of confusion. An example where the note contradicts the regulation is the definition of trading. While the regulation defines it as includes subscribing, buying, selling, dealing or agreeing to subscribe, buy, sell deal in any securities, the note includes pledging of securities while in possession of unpublished price sensitive information. Including pledging of shares in the term trading does violence not only to the concept of trading and dealing, but also does not make a meaningful impact on the object sought to be achieved. It will also cause pain in genuine pledge transactions and provide no benefit to investors.

In conclusion, the new regulations are a big reform from the past set of regulations. But new cases interpreting the new regulations and also logistical problems in implementing the exemptions would guide us with the way forward in both interpreting the provisions and also in guiding us where further reform is needed in the regulations.