Negative Control, Positive Surprise!
At the heart of any M&A regulation, lies the definition of control. In the UK, control is 'an interest, or interests, in shares carrying in aggregate 30% or more of the voting rights of a company'. It's the same in Germany.
In the United States, the meaning of control is less linked to the acquisition of a certain amount of voting rights and is more subjective. But in all these jurisdictions the emphasis is more on positive control than negative control.
In India, though, Securities and Exchange Board of India (SEBI) defines control as 'the right to appoint majority directors on board or control the management or policy decisions...directly or indirectly, including by virtue of their shareholding or management rights or shareholders agreements or voting agreements or in any other manner'.
That definition opens the door to the concept of negative control— negative control that is often exercised by veto rights, veto rights that are common in most investor agreements, agreements that in SEBI's eyes are often judged to have crossed takeover thresholds and triggered an open offer. But last week, the Securities Appellate Tribunal (SAT) put a twist in the negative control tale. Isha Dalal brings good news for venture capital and private equity investors.
That’s right, good news it is. After all the concept of control is a heavily debated one. And the debate over negative control often provokes contrasting opinions.
Cyril Shroff, Managing Partner, Amarchand Mangaldas says,”Not anything and everything on which we have a veto right should be treated as negative control. There needs to be perhaps one more level of granularity in terms of important things and not so important things.”
Amit Chandra, MD, Bain Capital Advisors (India) says,”It may happen that you have vetoes which actually land up helping the minority investors in the company because you are adding an institutional element to a company where there is none.”
Anil Singhvi, Vice Chairman, RNRL says,”Private equity guy is also saying that I don’t want to interfere in the management but that does not mean that he is saying that I am not going to interfere in the control.”
Bharat Vasani, Group General Counsel, Tata Sons says”They are not wanting to run the company but they would certainly will not want the existing management to take certain decisions which they are not comfortable with.”
So are veto rights = control? Experts may disagree, but SAT has made up its mind.
In a ruling last week in favor of private equity firm Subhkam Ventures, the Securities Appellate Tribunal held that: “Power by which an acquirer can only prevent a company from doing what the latter wants to do is by itself not control. In that event, the acquirer is only reacting rather than taking the initiative. It is a positive power and not a negative power.”
A ruling that reverses SEBI’s longstanding position that any rights in the hands of an acquirer would constitute control over a target company
Siddharth Shah, Principal, NDA says, “That has been a bone of contention for most players, especially private equity players, when they are looking at PIPE transactions. As substantial investors, they would obviously be looking at protecting their interest in the company and would seek certain customary rights. To that extent, whether these are affirmative rights or veto rights, whether this would tantamount to control, has always been an issue on which there has not been any clarity given by SEBI. In practice, we have seen PIPEs which happen sub 15%, with certain rights but there was always a hanging sword whether that would be viewed by a regulator as change in control or not.”
But last week’s judgment may change all that. Here’s what happened:
In 2007, private equity firm Subhkam Ventures acquired a 17.9% equity stake in listed company MSK Projects. Since it crossed the 15% trigger it made a public announcement for a 20% open offer as required by India’s takeover regulations
Subhkam made the open offer under Regulation 10 of the Takeover Code, which deals with substantial acquisition. SEBI objected and said the open offer should also be made under Regulation 12 - which deals with control.
This, on the basis that the shareholders agreement between Subhkam and MSK gives Subhkam’s nominee affirmative rights over matters such as:
• Amalgamation or reorganization
• Appointment of key officials
• Altering composition or strength of board
• Transactions with affiliates
• Any strategic alliance/ JV proposal
In its written submissions before the Tribunal, SEBI asserted that:
“The entire object and intention of the acquirer is the control, management and policy decision of the target company. The offer letter merely creates a smoke screen by asserting that the rights afforded to the acquirer are merely available as an investor in the target company.”
But Subhkam’s lawyer Somasekhar Sundaresan argues that the acquisition does not give the investor control. The agreement between Subkham and MSK gives Subhkam only veto rights-veto rights which can only influence and not control the company’s decisions
Somasekhar Sundaresan, Partner, JSA says, “The ability to say no is the ability to veto. But that does not mean it’s the ability to positively drive the company in a particular direction. For example, if the company wanted to set up a new line of business-you’ve invested in a steel company and it wants to get into paper-you as an investor will not be able to dictate terms with one man out of ten people on the board, or with minority voting powers over the company. But if the steel company you’ve invested in for its steel projects is going to use that money and start a paper business, you’d want to have the ability to say no. because the object of your investment was to further the steel business and not to diversify into paper.”
The Securities Appellate Tribunal upheld this view.
In SAT’s views, these conditions do not constitute control. They are only 'protective provisions' to: “…protect the interests of the shareholders, including that of the appellant from the whims and fancies of the promoters of the target company.”
A view endorsed by most of the M&A community.
Abizer Diwanji, ED, KPMG says, “Negative control just says, I have a right to appoint somebody on the board- one member out of ten. So I’m just saying that I need to be in the know of all the decisions. Those are negative controls. Actual controls are where you say that you cannot take a decision without asking me—that’s the clear distinction. One, you can monitor the shareholding and the other you are running the company.”
Siddharth Shah, Principal, NDA says,” Drawing a corollary with lenders… and many lenders would also negotiate certain rights to protect their capital which they are investing in the company, whether that itself will be viewed as a change in control? Maybe not. Because there was a specific carve out for financial institutions and others. So when they negotiate their lending agreements and put covenants including appointment of directors and other affirmative rights, that was never viewed as a change in control. So now that same principle has been extended to mean that as long as these are rights which don’t give you positive control, they will not be viewed as a change in control to that extent.”
This SAT’s judgment may come as good news not just for Subhkam but for all venture capital and private equity players in the country.PM Devaiah, General Counsel of the Future Group's private equity arm Everstone Capital explains SEBI's negative view of negative control has jeopardized many private equity investments in public listed companies. But now –
PM Devaiah, General Counsel, Everstone Investment Advisors says,”Now I am thinking that pursuant to this SAT order, there could be a possibility of having more rights than what was there earlier. For example, nominee directors, that’s one right I really appreciate. Because that’s one right which gives investors tremendous comfort because they act as ombudsmen for the investor’s investment.”
But the control debate hasn’t been put to rest yet.
The judgment simply says that none of the clauses in the agreement between Subhkam and MSK constitute control in the hands of the investor-it does not, however, exempt all veto rights from the definition of “control”
Abizer Diwanji, ED, KPMG says “Control can be exercised in many forms. I think the qualitative aspect of whether that control is protective in nature or positive in nature has to be decided by appropriate judgment and no definition can cure that. So it is more of a judgment issue. And over a period of time... initially it will be more litigious but over a period of time they will establish principles based on past case laws.”
This SAT judgment has brought cheer to the world of venture capital and private equity investing. Already in the past week since SAT spoke, lawyers are working more affirmative rights into term sheets. SAT may have changed the investing landscape...but will it change SEBI’s view on veto rights and negative control? Will SEBI choose to appeal this SAT decision in the Supreme Court, or will it leave it to the Takeover Regulations Advisory Committee that is reviewing the Code?