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Clause 36 Review!

Published on Tue, Sep 02,2014 | 22:26, Updated at Wed, Sep 03 at 13:15Source : 

By Somasekhar Sundaresan, Partner, JSA

SEBI has proposed to overhaul the regulatory regime governing continuous event-based disclosure requirements for listed companies – a body of law that is distributed across the listing agreement and the regulations governing insider trading.  Despite India’s long legacy of stock markets, this area of regulation is still mired in ambiguity and controversy.

SEBI’s Discussion Paper titled “Review of Clause 36 and related clauses of the Equity Listing Agreement” (“Discussion Paper”), seeking to review and bring out a well co-ordinated change in this area is laudable. That disclosure obligations in the primary market (for issuance of securities) are detailed and even onerous while the disclosure regime for the secondary market (where most investors participate by buying and selling shares on stock exchanges) is sparse, is an anomaly.  The Discussion Paper seeks to provide guidance to bring clarity on adequacy of information provided to the secondary market, as also the timing of provision of information.  

The determination of “materiality” of a development and the timeliness of its disclosure lies at the very core of market integrity. Any information that is material to a listed company’s operations would constitute price-sensitive information, thereby warranting timely disclosure to the stock exchanges.  Without such disclosures, market participants would not be able to take informed decisions when dealing in securities issued by such listed companies. Therefore, a clear, predictable and unambiguous framework for disclosure of ongoing developments and events in the life of a listed company is essential for any market that cares for its integrity.

While the intention to review is laudable, one should not expect the moon from SEBI in this department.  SEBI has rightly pointed out that listed companies and their advisors have been rather liberal in interpreting what is required to be disclosed.  By definition, what is “material” and what is “timely” are subjective elements and SEBI can only provide guidance and lay down principles, acknowledging that discretion can never be ruled out.  The regulatory framework should only deal with abuse of discretion – which would arise by ignoring relevant factors and dealing with irrelevant factors.  It would be impossible to prescribe a formulaic approach since it could lead to counter-productive outcomes. Yet, SEBI has attempted to present some formulaic thresholds for determination of materiality, and it likely that public comments would push for moving more in that direction – SEBI should avoid agreeing with such demands.

The existing regime governing continuous disclosure requirements are contained in Clause of 36 of the equity listing agreement between the issuer of securities and the stock exchange (“Listing Agreement”). Clause 36 of the standard form Listing Agreement, incorporated in 1998, requires a listed company to disclose to the stock exchanges “all events that have a bearing on its operations/performance as well as price sensitive information both at the time of occurrence of the event and subsequently after the cessation of the event in order to enable the security holders and the public to appraise the position of the Issuer and to avoid the establishment of a false market in its securities.

Clause 36 adopts a “light-touch” approach, which lays down the principle as was considered clear in 1998 but entirely leaves it to the listed companies to interpret what constitutes a “material event” or “has a bearing on operations/performance” or what constitutes “price sensitive information”. SEBI has not hitherto provided any guidance note. Different companies have adopted varying standards, if at all.  The lack of clarity in expectations has led to minimal regulatory punishments and therefore, litigation has been sparse and case law too does not provide much clarity.

Listed companies are often confronted with the vexed question of when exactly an event has become sufficiently crystallized for a public disclosure to be made. This is easy to determine where the development is a force majeure event such as an earthquake or cyclone – the reporting can be done when it occurs.  However, a transaction that involves the buy-in of multiple parties can never move from the stage of germination to fruition overnight.  Typically, long and hard negotiations ensue.  The longer the deal negotiation, the greater is the risk of leakage and reporting in the media.  An expectation that once there is a media report of any nature, there has to be a disclosure of the transaction exposes the market to the risk of inchoate and non-concrete and speculative information being disseminated. On the other hand, issuers have also been facing charges of making unnecessary disclosures, thereby allegedly seeking to “talk up” the stock price.

Therefore, there is indeed a crying need for issuing clear guiding principles to ensure compliance with continuous disclosure obligations.  Once clarity and predictability on the expectations are in place, the regulator should make an example out of companies that adopt unreasonable positions in exercise of discretion. Case law from such proceedings would then provide further clarity to the rest of the market.  The Discussion Paper is divided into three parts.  The first part sets out the new law that would replace Clause 36 of the Listing Agreement or constitute a part of new regulations to be called the “SEBI (Listing Obligations and Disclosure Requirements) Regulations” (“Draft Listing Regulations”).  The second part contains guidelines to determine “materiality”, “price sensitive information” and timing of reporting of occurrence of events.  The last part contains an indicative list of events, information of which should be considered on the touchstone of materiality and price sensitivity for disclosure upon their occurrence.

The Discussion Paper sets out fairly detailed guidelines and tests for determining: (i) “materiality”, (ii) “price sensitive information” and (iii) when an event can be said to have “occurred” i.e. the event has become sufficiently crystalized for it to be disclosed to the stock exchanges. In short, the Discussion Paper is the first of its kind – a clear “guidance note” for ongoing disclosure of material developments in the life of a listed company.

The Discussion Paper adopts the standard of the Board of Directors of the listed company forming an opinion on materiality of any transaction or arrangement for it to be disclosed.  All occurrences and events have to be informed within a day of their occurrence if no other timeline is specifically mandated.  A delayed intimation would need to be accompanied by explanation of the delay.  

As regards agreements, the Discussion Paper requires disclosure of material agreements that are binding in character and all revisions, amendments and termination of such agreements. This is a positive development giving specific clarity on a highly controversial aspect of ongoing disclosures. Stock exchanges routinely follow up with listed companies and seek confirmations of news breaks of purported transactions.  Without anything binding being contracted, it would not be possible to confirm or deny the news reports.  That some listed companies outright deny news reports instead of stating that no obligation to report has arisen, and then later go on to announce the very deals as reported in the news breaks, makes matters worse. The clarity from SEBI puts this issue beyond doubt.  SEBI has done well to differentiate between events that involve discussion, negotiations and approvals, from events such as natural calamities and disruptions where the company would become aware of concrete information.  Clearly, according to SEBI, the former would be linked to the approval while in the latter, there would be clear notice of the event.

To determine “materiality”, the Discussion Paper rightly requires the listed entity to evaluate events that occur, from both a quantitative and a qualitative perspective. However, in the quantitative criteria, it is stated that if the potential value or impact of an event exceeds either 5% of the gross turnover or exceeds 20% of the net-worth of the company, it would be considered to be material. This can be problematic because assessing the “value involved” or the “impact” particularly when the “event” is a potential event rather than an event that has occurred, is easier said than done.  The attempt to bring in a quantitative methodology is also resorted to for determination of timing, which is even more problematic. The Discussion Paper proposes that the company would be “construed to have become aware of the event or the information when the probable impact of the event becomes known or assessable to the extent of 75% of the materiality threshold” and not when full and certain assessment of the impact is made.  This is an impossible prospect – that one would become aware when the value of the impact crosses a threshold.  

The Discussion Paper has also reduced to writing the standard legal principle that subjective tests should be determined as how a reasonable person would determine it.  The guidance to listed companies is to decide whether or not a certain piece of information would be relevant for an investor in arriving at an investment decision.  Towards this end, the listed company is required to consider whether a reasonable investor is likely to use the information as part of the basis of his investment decision.

While the approach can be regarded as unexceptionable, it should be acknowledged by SEBI that merely because a piece of information is “likely to be used by a reasonable investor as part of the basis of his investment decisions” such information would not become price-sensitive i.e. information that is likely to have a significant effect on the price of shares of the listed entity.” Multiple factors can impact price and therefore it would be difficult to link the determination of price-sensitivity of a piece of information with whether it is also a part of what could impact the decision, would be circular in nature.

The problem of determining whether a fact is material is not unique to India. The United States Supreme Court dealt with this in TSC INDUSTRIES, INC., ET AL. V. NORTHWAY, INC. 426 U.S. 438where a shareholder sued for non-disclosure of material information in a joint proxy statement issued by the Petitioner and the Respondent. The Court explicitly rejected the test adopted by the Court of Appeal which had held as material “all facts which a reasonable shareholder might consider important”. The Court adopted a more nuanced and a higher standard positing that “there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information made available,”, cautioning that “if the standard of materiality is unnecessarily low, not only may the corporation and its management be subjected to liability for insignificant omissions or misstatements, but also management's fear of exposing itself to substantial liability, may cause it simply to bury the shareholders in an avalanche of trivial information a result that is hardly conducive to informed decision making.

Therefore, while the Discussion Paper makes a substantial contribution in providing guidance on operating the principles-based regulation that this area requires, much will depend on how SEBI implements this regime and how it reacts to public comments. Some may criticize the paper and force SEBI to get prescriptive.  SEBI would do well to avoid such pressures.  Over time, there will develop conflicts between the regulator’s view of how the principles should be worked out with its guidance, and listed companies believe it should.  A sensitive and objective approach to enforcement would result in courts too taking a view on the subject and enhancing the clarity on the subject. Any attempt to hard-wire concepts like “materiality” and “price-sensitivity” would remind one of the US Supreme Court’s Justice Potter Stewart’s ruling on whether a certain film was pornographic in nature:

“I shall not today attempt further to define the kinds of material I understand to be embraced within that shorthand description, and perhaps I could never succeed in intelligibly doing so. But I know it when I see it, and the motion picture involved in this case is not that.”

(Abishek Venkataraman, JSA also contributed to this article
The views expressed by the author are personal.)


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