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A Socialist Agenda For Indian Securities Law

Published on Tue, May 28,2013 | 12:44, Updated at Tue, May 28 at 16:16Source : 

By: Shishir Vayttaden, Partner, Luthra & Luthra

On 9th May 2013, the Supreme Court upheld SAT’s decision to prevent Nirma Industries Limited (Nirma) from withdrawing its open offer for Shree Rama Multi-Tech Limited (SRMTL).

SRMTL's facts were similar to Satyam’s with this difference that the fraud was uncovered after the open offer had been launched. Briefly, the facts were these. In 2002, the promoters of SRMTL had pledged its shares with Nirma. In July 2005, Nirma invoked the pledge and acquired 24.25% of SRMTL’s shares. Since this trigged an open offer under the 1997 takeover regulations, a public announcement was made to acquire SRMTL’s shares at Rs. 18.60 apiece (the then ruling market price).

While the processes of that open offer were underway, SRMTL’s auditors noted irregularities in their audit reports for the quarter that ended in September 2005. At the insistence of lenders, the promoters were replaced by independent directors on SRMTL’s board and a forensic audit was commissioned. The audit uncovered that SRMTL’s promoters had fraudulently siphoned out about Rs. 350 crores. Separately, it also emerged that SRMTL had understated its liabilities by about Rs. 250 crores. Adjusted for these facts, the share price fell drastically below the open offer price. 

Nirma applied to SEBI for permission either to adjust its open offer price or to withdraw the open offer. The predicament was unprecedented. A change of controlling stake had occurred and that egg could not be unscrambled. Nirma had attributed a value of Rs. 18.50 to the pledged shares for invoking the pledge; so the promoters had received that sum on a per-share basis for their shares. If Nirma was allowed to withdraw the open offer or to reduce the open offer price, it would mean that the promoters would have received an inflated value for their shares, that Nirma would get to keep the controlling stake and that the public shareholders would be stuck with their shares which were worth much less.

So the stage was set for some innovation using that fountainhead of SEBI’s creativity in recent years – section 11 of the SEBI Act. Perhaps SEBI could permit Nirma to reduce the offer price subject to a corresponding write-back of the amount credited to the promoters. It could have proceeded against the promoters. It could have debited the investor relief fund.

Instead, SEBI summarily rejected Nirma’s application. The decision was appealed before SAT. SAT, and the Supreme Court, held that the 1997 Takeover Regulations did not permit SEBI to allow a withdrawal in these circumstances. For a number of reasons, the decisions make for bad law and poor policy.

Firstly, the decisions applied a rule of interpretation called ejusdem generis somewhat routinely. Simply put, the rule says that when specific entries in a list constitute a class and are followed by a general word, the general word is also limited in scope to that class. So, for instance, the lawyer would argue that the word “eatables” in “oranges, lemons and other eatables” should only mean fruits (or even only citrus fruits).

The list, to which the Supreme Court and SAT applied this rule, appeared in regulation 27(1)(d) of the 1997 regulations which allowed an open offer to be withdrawn only in the following circumstances:

(a) the withdrawal is consequent upon any competitive bid;
(b) the statutory approval(s) required have been refused;
(c) the sole acquirer, being a natural person, has died;
(d) such circumstances as in the opinion of the Board merits withdrawal.

The italicized words (entry (a)) had been omitted by a prior amendment. The court applied the ejusdem generis rule to the remaining entries. It concluded that entries (b) and (c) constituted a class of cases where consummating an open offer has become impossible. On this basis, it held that even under (d), SEBI could permit a withdrawal of an open offer only if it had become impossible to continue with the offer.

The objection to this view of the regulations is that the prior amendment, which had deleted entry (a), had not touched entry (d) and it could, therefore, not have affected the meaning of (d). It was as if our list had originally read “meat, oranges, lemons and other eatables” before it was amended into its form above. Since “eatables” in this original list could not have been limited to fruits and since “eatables” itself was not amended, one would hardly expect it to be so limited after the amendment. But that is precisely what the courts did in Nirma.

Nuances of statutory interpretation apart, neither SAT nor the Supreme Court thought there was anything silly about seeking SEBI’s consent to withdraw an offer that had become impossible to consummate!

The decision in Nirma is also a rather blatant volte face on the part of SEBI and SAT. In Luxottica and BP Amoco, SEBI and SAT had held that share purchase agreements triggered open offers even if they were subject to conditions precedent. When confronted with the absurdity that would result if open offers were made but the triggering agreements were themselves rescinded, SAT had confidently retorted that SEBI could permit the withdrawals of these open offers under regulation 27(1)(d). Yet, there would have been no impossibility in consummating either the Luxottica or the BP Amoco open offer if the underlying agreements were rescinded. In other words, when an open offer could be justified only by holding that it could be withdrawn under regulation 27(1)(d) even though it was still possible to consummate it, that is exactly what SEBI and SAT said. In Nirma, when the open offer could be justified only by placing a diametrically opposite interpretation on regulation 27(1)(d), that too was done.

The darkest implications for Indian M&A, however, come from perfectly gratuitous portions of the judgment.

For example, even though they had held that the law would not permit Nirma’s open offer to be withdrawn, SAT and the Supreme Court nevertheless proceeded to explain why Nirma didn’t deserve a withdrawal anyway. SRMTL had been a financially weak company. Its net worth had been negative even before the pledge was invoked and recovery proceedings were pending against it in various courts. In a passage that essentially tells investors in high-yield securities to fend for themselves, the court and SAT conclude “The above facts would seem to be enough to provide [Nirma] a correct prognosis regarding the financial health and prospects of [SRMTL]. Clearly, [Nirma] decided on invoking the pledge on the shares of [SRMTL] with open eyes and sufficient knowledge about the affairs of [SRMTL]. It is not as if [Nirma] were innocent and were caught napping in an unexpected turn of events.” Basically, Nirma had it coming. The fact that no one (including Nirma) knew about the fraudulent siphoning of funds until the forensic audit revealed it was, of course, irrelevant.

Again, in a perfectly unnecessary exposition, both SAT and the Supreme Court found Nirma to have been deficient in exercising due diligence before invoking the pledge. Not only was this totally unnecessary in light of the court’s interpretation of regulation 27(1)(d), it also upsets settled jurisprudence on what constitutes due diligence. As a practical matter, even in a friendly acquisition, due diligence exercises are seldom able to uncover fraud. In hostile acquisitions, where the acquirer receives no cooperation from the controlling shareholders, it is simply ridiculous to expect this. Indeed, as Nirma’s counsel had pointed out, SEBI’s own insider trading regulations would hardly allow the acquisition to proceed if a due diligence exercise had uncovered the fraud. More to the point, SEBI’s insider trading regulations criminalize the selective sharing of unpublished price sensitive information (of which a hidden fraud is a textbook example). So the only due diligence exercises that are legally possible in listed companies are confirmatory exercises of the sort that can never uncover a fraud!

In Nirma, as in several instances before it, the takeover regulations have been used to redistribute wealth rather than providing public shareholders an exit at a fair price. When public shareholders are cheated by promoters, they should be compensated by those promoters or by the State. This is precisely the sort of contingency that investor relief funds should be used for. Passing that burden to an acquirer, which has itself suffered the same fraud, is a convenient but flawed policy. It is an unfair allocation of risk. It makes M&A more difficult in a jurisdiction that is already notorious for opacity. Most importantly, to reach these convenient conclusions, courts continue to wreak havoc on established legal principles, making the Indian legal regime unpredictable and unconducive to business.

(Vinay Subramanian & Bhargav Joshi, Associates, Luthra & Luthra contributed to this article. Views are personal. Comments are welcome at


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