PNB Housing Finance vs Sebi: Mystery of the Articles of Association

The rigmarole over the valuation of a preferential share allotment has raised a confusing question on the status of a company's Articles of Association

It was a seemingly innocuous provision in the Articles of Association (AoA) of PNB Housing Finance (PNB HF) that has posed several larger questions around the need for amendments in preferential offer regulations. In the first place, that provision was not supposed to be part of the listed company’s AoA. But the fact remains that it was bypassed — whether conveniently ignored, or a case of just plain oversight, the jury is out on that one — when the company was arriving at the price for its proposed preferential issue.

The controversy concerns PNB HF’s challenge before the Securities Appellate Tribunal (SAT) to a Securities and Exchange Board of India (Sebi) order that directed it to go through a preferential share sale transaction only after the board takes into consideration an independent valuation report from a registered valuator. PNB HF is in the process of raising Rs 4,000 crore through a share sale at Rs 390 apiece to a clutch of investors, led by the Carlyle group.

PNB HF’s AoA makes it mandatory for the company to appoint a registered valuer for a valuation report for pricing any preferential share sale. That provision has been sitting in its AoA from its pre-listing days. This provision was in line with company law provisions for unlisted companies. However, Compa­nies Act, 2013, exempts listed companies from this requirement. To fill in the gap, the capital market regulator through its ICDR (Issue of Capital and Dis­closure Requirements) Regula­tions lays out the pricing formula for preferential allotments by listed entities. Technically, PNB HF should have amended its AoA after it was listed in 2016 and removed the provision for a valuation report from a registered valuator.

So, when PNB HF went ahead and used the Sebi-mandated ICDR guidelines, which focuses on market discovery of price, the regulator did not take kindly to the act. Some market watchers believe that the current deal is undervalued and that PNB HF management could potentially have extracted up to Rs 2,000 crore more had it negotiated a premium for giving up management control to the new clutch of investors. Sebi’s argument has been that price discovery through the independent valuator’s report would have given shareholders an additional option to choose from.

Accordingly, the regulator flagged off the price discovery process as being non-complaint with the company’s AoA. The regulator also hauled up the board of directors for failing to ensure that the company was in compliance with its AoA.

Amid the larger debate of whether the price discovery process for preferential allotments of shares needs a relook, the PNB HF-regulator spat raises questions around the sanctity of a company’s AoA, it’s inter-play with provisions of securities law, the Companies Act, and the governance implications for board of directors.

As the dispute reached SAT, what caught the attention of many legal and company law experts is the reported contention by PNB HF’s legal counsel that the market regulator cannot compel it to follow the company’s AoA because it is “just a contract”. PNB HF argued that the AoA cannot override ICDR regulations, which listed firms follow for issuing preferential allotments.

Most legal experts say an AoA should not be seen as “just a contract”. The AoA defines the internal working of a company. It is binding on the company and its members, unless contrary to law. “So, an AoA casts a wider responsibility on the board of directors to ensure compliance,” says Pune-based company secretary Gaurav Pingle.

Citing Section 166 of the Companies Act, which spells out the duties of directors, Pingle says, clearly states that a director of a company shall act in accordance with the AoA of the company.

So, when can the AoA be superseded by the ICDR regulations, or any other law? For the AoA to remain valid and applicable, first it should not pres­cribe something that is not permissible in law. “If there is a conflict between the provisions of the AoA and the Companies Act, the provisions of the Com­panies Act will prevail. However, the AoA can prescribe additional requirements beyond those set out under the Companies Act,” says Rajat Sethi, partner, S&R Associates.

If the provisions of AoA are more stringent than the provisions of any other law, the AoA’s provisions will have to be followed, experts added. In case of conflict, the stricter rule will prevail. The same logic applies when certain provisions of the Companies Act conflict with securities laws, they pointed out. More importantly, if there is no conflict between the provisions of AoA and any law, both provisions will be applicable.

In the present case, the PNB HF AoA requires the price for a preferential allotment to be determined by a report of a registered valuer. Under the Share Capital and Debentures rules, the requirement for a report of a registered valuer is not applicable to PNB HF.

So, the question before regulators and SAT is whether the PNB HF AoA imposes an additional requirement beyond those set out under company law, or whether they are in conflict with the company law provisions.

“It could be argued that the PNB HF AoA merely imposes an additional requirement for a registered valuer report even though that is not required in terms of the Companies Act. However, there is also an argument to the contrary that the PNB HF AoA should not be read in such a manner as to conflict with the clear legislative scheme,” says Sethi.

On the issue of breach of corporate governance principles by directors for not adhering to the provisions of AoA, experts are divided. There are many who agree with Sebi’s stance that the PNB HF directors failed in their fiduciary duties by not complying with the AoA. However, some are willing to take a liberal view of things at PNB HF boardroom.

“In PNB Housing’s case specifically, the issue is more of a technicality,” says Hetal Dalal, chief operating officer at proxy advisory firm Institutional Investor Advisory Services (IiAS).

Experts say the debate that the PNB HF issue raises is seminal and is likely to have material implications for several other companies, and in several other contexts.

Some of the issues raised by the regulator essentially question whether the market mechanism is efficient enough for true price discovery, say experts. “It is unconscionable to think that a Sebi-approved valuer’s report can trump market judgement — it inherently questions whether the Indian capital markets are adept at price discovery,” says Dalal.