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The Cairn Test

Published on Fri, Jul 25,2014 | 22:01, Updated at Fri, Jul 25 at 22:01Source : Moneycontrol.com 

By: Menaka Doshi, Executive Editor, CNBC TV18

Cairn India may have, in a fit of bravado, decided to test the new company law – Companies Act, 2013. And in doing so may test the patience of its investors as well.

In an post earnings analyst conference call on Wednesday evening Cairn apparently revealed that it will be loaning $1.25 billion to a Vedanta Group company. Of this $800 million has already been disbursed during this quarter (April – June 2014). Cairn says

‘The loan has been extended for 2 years at floating rate of 3% plus LIBOR after requisite approvals, which is significantly higher than comparable rates being received on fixed deposits of same tenor’

This is what the company said to CNBC TV18
‘The Company’s 3 year Capex plan of USD 3 billion, which includes both development and exploration, is well supported with its current cash reserves of USD 3 billion and is further bolstered with its annualized operational inflows of over USD 1.5 billion. As such, considering the exploration oriented focus and its advancement plan over the next 2 years, the Company is adequately funded. The returns from the said facility is benchmarked with return of similar rated instrument and is significantly higher than returns the Company was earning from the deposits’  

The news did not go down well with investors - Cairn's stock lost some 6% on Thursday and another 4% on Friday. Many brokerage reports panned the move.

Credit Suisse
‘That surplus cash is not used for dividends/buybacks (recently concluded) may raise concerns’

CLSA
‘we believe that this related party loan will create doubts in minds of investors on reinvestment of cash and raise fears on leakage of cash out of the core oil & gas business’

Macquarie
‘Indeed, the real focus could lay firmly on corporate action within the Vedanta Group, always a shadow on Cairn’s strong operating performance, but brought into sharper relief now with the 2-year US$1.25bn loan to its parent Sesa-Sterlite’

Shadows aside…it is not unusual for a cash-rich company to fund a cash-hungry company in the same group. Many large corporate groups resort to such intra-group loans, guarantees and investments. And often many such loans have been at ‘special’ non-commercial terms, that disadvantage shareholders of the lending company and benefit those of the borrowing company. Often the borrowing company is even more closely connected to the group’s promoter, unlisted and opaque.

There are two legal checks on this practice. Company law prescribes limits for such  inter corporate funding, to safeguard companies from over-lending. But it does, or rather has done, little to tackle the governance issues arising from such transactions. On the other hand, tax law, while not purposed to be a pro-governance measure, might achieve more on that front than erstwhile company law. Because transfer pricing norms require arm’s length pricing to ensure that no income evades tax. Over the last few years, revenue officials have been cracking down on cross-border inter-company loans and guarantees to ensure that such transactions are done on fair commercial terms. The principle is simple – the transaction should be done at terms the borrowing company would be subject to in a similar commercial arrangement with an un-related party. To the best of my knowledge, the same principles are now being extended to Domestic Transfer Pricing as well.

What then will it take for the Cairn – Vedanta loan deal to pass the test?
It will first have to prove that the loan is priced at arm’s length ie: the interest rate of 3% + Libor is what the Vedanta Group company would pay if it borrowed the same amount of money from a commercial lender, say a bank. If the Cairn loan passes that test it will succeed in shaking off the tax guys. And may assuage some of the governance concerns as well. But only some.

On the company law front the Cairn loan will be subject to 2 provisions of the Companies Act, 2013 - Section 186  & Section 188.

Section 186 deals with Loans by a company and says (emphasis supplied by me)
(2) No company shall directly or indirectly —

(a) give any loan to any person or other body corporate
(b) give any guarantee or provide security in connection with a loan to any other body corporate or person; and
(c) acquire by way of subscription, purchase or otherwise, the securities of any other body corporate, exceeding sixty per cent. of its paid-up share capital, free reserves and securities premium account or one hundred per cent. of its free reserves and securities premium account, whichever is more.

(3) Where the giving of any loan or guarantee or providing any security or the acquisition under sub-section (2) exceeds the limits specified in that sub-section, prior approval by means of a special resolution passed at a general meeting shall be necessary.
(4) The company shall disclose to the members in the financial statement the full particulars of the loans given, investment made or guarantee given or security provided and the purpose for which the loan or guarantee or security is proposed to be utilised by the recipient of the loan or guarantee or security.
(7) No loan shall be given under this section at a rate of interest lower than the prevailing yield of one year, three year, five year or ten year Government Security closest to the tenor of the loan.

Cairn says its loan does not exceed the limits set out in Section 186  and hence does not need shareholder approval via a special resolution.

There's also sub section (7) to contend with - is Cairn's loan rate of 3% + Libor (approx  3.55%) below the 2 year yield of a government security? No, if the security in question is a US Govt bond - the 2 year yield is some 0.5%. No, if the security in question is a UK Govt bond - the 2 year yield is around 1%.

Had this been a rupee loan, Cairn would have had to charge an interest rate higher than the 2 year GOI bond. Well the overnight rate is 8%, so I imagine the 2 year rate is higher than that.

Most likely the battery of Cairn and Vedanta lawyers would have ensured compliance on this front...

The more important question then is on the impact of Section 188?

This dreaded new section on Related Party Transactions is giving most of India Inc. nightmares.

Section 188 says...(emphasis supplied by me)

(1) Except with the consent of the Board of Directors given by a resolution at a
meeting of the Board and subject to such conditions as may be prescribed, no company shall enter into any contract or arrangement with a related party with respect to -

(a) sale, purchase or supply of any goods or materials;
(b) selling or otherwise disposing of, or buying, property of any kind;
(c) leasing of property of any kind;
(d) availing or rendering of any services;
(e) appointment of any agent for purchase or sale of goods, materials, services or property;
(f) such related party's appointment to any office or place of profit in the company, its subsidiary company or associate company; and
(g) underwriting the subscription of any securities or derivatives thereof, of the company:

Provided that no contract or arrangement, in the case of a company having a paid-up share capital of not less than such amount, or transactions not exceeding such sums, as may be prescribed, shall be entered into except with the prior approval of the company by a special resolution:
Provided further that no member of the company shall vote on such special resolution, to approve any contract or arrangement which may be entered into by the company, if such member is a related party:
Provided also that nothing in this sub-section shall apply to any transactions entered into by the company in its ordinary course of business other than transactions which are not on an arm’s length basis.

In simple English this section says that any related party transaction that fits the description in (a) to (g) needs board approval if it is not in the company’s ordinary course of business and at arm’s length. The first proviso requires that prescribed transactions must also seek shareholder approval via special resolution. And the second proviso means, in such a special resolution, the ‘related party’ connected to the transaction cannot vote.

The first determination is if Cairn’s loan to a Vedanta group company matches any of the transactions listed under Section 188. One could argue that extending a loan is rendering a service and hence the Cairn transaction fits the description of Section 188 (1) (d). If that argument succeeds then the next test is whether such a loan is in Cairn’s ordinary course of business and at arm’s length – both criteria must be met if the RPT was to spared the provisions of this section. Cairn will not pass this test because even if it proves the loan was extended at arm’s length pricing, it cannot claim that giving loans is in its ordinary course of business. Striking oil, yes…giving loans, no!

That would imply that Section 188 applies to the Cairn loan and hence it must be approved by Cairn’s Board of Directors – let’s assume that’s an easy ask (and hopefully has already been done before the disbursement). But the next one is not. Because as per the Rules, any company with a paid up share capital of Rs 10 cr or more must take all related party transactions described in Section 188 to shareholders for approval. Since Cairn’s share capital exceeds Rs 10 crore, and since the loan matches the transactions described in the section, it must be approved by shareholders via a special resolution. Not just that – as per the second proviso, the connected related party cannot vote on such a resolution. Thus Cairn’s promoter, the Vedanta Group and its related parties will have to abstain from voting. And the special resolution will need the support of a majority of the minority to succeed!

If it’s so simple to determine the legal requirements why has Cairn not bothered to get shareholder approval yet? Because legal opinion is divided on whether Section 188 applies to a Section 186 loan. Some lawyers believe such a loan must meet the requirements of only Section 186, others believe if it is a related party loan then Section 188 must also apply. And then some argue that a loan does not match the transactions listed in Section 188 ie: it is not a service.

Last week, in order to clarify a similar confusion, the Ministry for Corporate Affairs said that Schemes would operate only under the provisions for Schemes and will not attract the provisions of Section 188. If the same were to apply to Section 186, Cairn is home safe. If not, it may have to get this loan facility approved by shareholders, especially a majority of the minority. And there’s no telling in this day of ‘jaago investor’ whether Cairn will pass that test!

Before I end - a quick note on how SEBI treats Related Party Transactions under the new Clause 49

All Related Party Transactions shall require prior approval of the Audit Committee
All 'material' Related Party Transactions shall require approval of the shareholders through special resolution and the related parties shall abstain from voting on such resolutions.
Definition of ‘Material’:  exceeds 5% of annual turnover or 20% of the net worth

It will be interesting to see how investors view the Cairn loan and decide to press for shareholder approval. Or not. After all selling the stock is easier!

PS: Will seek opinion from lawyers and Cairn on the arguments laid out above...maybe it will be interesting to cover on The Firm next week?

 
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