Policing is not management control

WITHOUT CONTEMPT

Venture capital funds and private equity funds investing in India are in a state of discomfort.

Recent media reports suggest that the Securities and Exchange Board of India (SEBI) is interpreting investor protection provisions in agreement with venture capital and private equity investors, as amounting to acquisition of control over the investee companies, or evidence of concert between promoters and such investors.

At the outset, it is important to look at what such investment agreements normally contain and what they seek to achieve.

A venture capitalist or a private equity investor primarily makes a financial investment, and his interest is to protect the investee company from value-destroying decisions and bad corporate governance. Companies in India are notorious for being promoter-controlled and therefore, such investors seek protection against bad decisions by promoters.

Therefore, the investment agreements between such financial investors and the promoters normally provide for the ability to veto certain crucial decisions that could destroy the very foundation of the investments.

For instance, if a steel company wants to diversify into rubber, the investor would want the ability to veto the proposal. If the company wishes to dilute its equity at a low price to persons introduced by the promoter, or to change its accounting policies, or to wind itself up, the investor would have legitimate concerns. Sophisticated investors would definitely want to have the ability to veto such proposals, and would therefore write contracts to let them do that.

There is an entire class of investors that essentially bothers itself with only such crucial and fundamental decisions that cut at the root of their investment decisions.

On other hand, there are some investors who simply like to enjoy the stated ability to control every move of the investee company, regardless of whether they actually use the powers.

This approach would often manifest itself in the form of contractual provisions that lead to the investee company not being able to move a muscle without their consent.

For instance, any supply or sales contract, purchase or sale of any asset, or a decision to set up a new sales outlet, that involves an outlay of beyond a small value, would require an affirmative consent of the investor.

Lower the materiality threshold in such controls, greater the sense of being comfortably in control. Such controls tend to be more operational in nature and are akin to what a strategic joint venture partner would want, rather than what a financial investor would desire.

Both these approaches essentially work as checks and balances against the promoters and the management of the investee company. While the latter may be ill-advised and come perilously close to the definition of "control" under the SEBI Takeover Code (defined as including the ability to control the management or policy decisions exercisable by virtue of shareholder agreements or voting agreements), the former approach is compliant with the law.

First, the primary mantra of SEBI is to further investor protection against deviant conduct by corporate managements. In fact, right since its own inception, successive SEBI Chairmen have been exhorting financial institutions and mutual funds to police corporate boards and to ensure adherence to best governance standards.

When sophisticated investors actually write contracts to ensure the same object, the very existence of such contracts ought not to be construed as acquisition of "control". Of course, no two contracts may be alike, and one would have to retain flexibility to determine whether an investor has taken over complete operational control, or if it is only policing good corporate governance.

Second, by their very nature, such clauses provide for protection of investors against the promoters i.e. the fundamental interests of the promoters and the investors are acknowledged as being contrary. Therefore, such clauses protect the investors against potentially value-destroying decisions that are contrary to well-established norms of good governance.

Consequently, the investors cannot be construed as having a common intention or concerted objective with the promoters. The veto clauses regulate the conduct of the promoters in the exercise of control, but do not lead to a common objective of exercising control.

Why is this issue important? Without agreement on good governance, the quality of capital formation in the country will suffer. Investors will never want to take a punt on the quality of governance. The small public investor only benefits because a sophisticated institutional investor is policing the company management, and that leads to value appreciation.

Finally, if the holdings of such institutional investors are clubbed with those of promoters, it would draw curtains for venture capital and private equity investments in most companies that have a reasonable promoter holding.

SEBI has now announced that public shareholding has to be 25% in all companies, and public shareholding is defined as holdings of persons other than promoters and persons in concert with them.

Holding any institutional veto power as evidence of "control" is fraught with the danger of militating against a fundamental object of the SEBI Act "" orderly development of the capital market.

The author is a partner of JSA, Advocates & Solicitors. The views expressed herein are his own.

somasekhar@jsalaw.com