Sandeep Parekh
Founder, Finsec Law Advisors
If a law made by Parliament disallows non-compete payments, a regulation by Sebi cannot allow it and be the basis of discriminating between shareholders
The Securities and Exchange Board of India’s takeover regulations permit an acquirer to pay non-compete fees to the seller. In other words, the regulations allow for the differential payment to the private or negotiated seller from the public shareholders to whom a tender offer is made. Clearly, this has not gone down well with retail or institutional shareholders who feel short-changed.
Although investors are angry, it is relevant to test whether such payments can be made legally. Most developed markets, including in the US, do not permit such differential prices in a tender offer under what they call as the “all holders rule,” which states that all shareholders must be placed in the same position.
On the one hand, there is the Sebi-enacted takeover regulation that allows up to 25 per cent non-compete fees to be paid to the seller and, on the other hand, there is a restriction on non-compete agreements under the Indian Contract Act. Although Sebi has tried to restrict payments in specific cases, the Securities Appellate Tribunal (SAT) has held in two cases that such a payment is permissible given that the Sebi regulations permit it. Though the SAT rulings do not say that it would uphold non-compete fees in all facts and circumstances, it has allowed such fees to be paid even when the sellers had run the company so badly that it had turn sick. In other words, if the fee is permitted even when the sellers have shown a complete inability to run the business, it is difficult to think of a situation in which the fee would be held as illegitimate.
In another ruling, Sebi’s attempt to disallow a non-compete fee was overturned by the Securities Appellate Tribunal. In that case, the seller could indeed compete with the buyer and, therefore, the facts were much better than the previous case. However, here the case was based on an interpretation of section 27 of the Indian Contract Act which states that “every agreement by which any one is restrained from exercising a lawful profession, trade or business of any kind, is to that extent void”. The Indian law against restraint of trade and profession is peculiar in that it is deliberately absolute unlike many other jurisdictions like the UK which allows a reasonable restraint of trade and profession. The SAT overruled Sebi, quoting section 27 of the Act, but instead of relying on the Indian commentary, it relied on the UK commentary.
The difference in the law meant that section 27 was not interpreted properly. In other words, on a correct interpretation of the Indian Contract Act, the Sebi regulation allowing non-compete payments itself stands on weak legs. If the law made by Parliament disallows non-compete payments, it is clear that a regulation by Sebi cannot possibly allow it and be the basis of discriminating between shareholders. This fine legal issue will no doubt be resolved by the Supreme Court in due course.
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In parallel, an advisory committee of Sebi has recommended that non-compete fees be disallowed in their proposed set of regulations. However, these regulations are proposals by a committee. Converting them into actual regulation, assuming they will be accepted, would take several months at the least.
There is, of course, the possibility that Sebi considers this issue in isolation and removes the enabling regulations before it considers the bigger-picture recommendations of the committee. Also, if the Supreme Court were to rule in Sebi’s favour, there is a possibility that these transactions would be disallowed in the future.
Thus, it can be said that as on date such a fee can be paid by the buyer to the seller of shares to the exclusion of the public shareholders — including to public institutional shareholders like mutual funds. But doing so would entail adverse consequences for public and investor relations and on the corporate governance norms of the buyer. Upsetting a large number of shareholders and analysts also has consequences for a company’s future capital-raising plans, with an invisible cost attached to such action.
Chairman, Edelweiss Group
Non-compete fees are a recognition of the extra value that the promoters hold for the acquirer. Any knee-jerk reaction will result in a loss of opportunity for all shareholders
The recent Cairn Energy deal that included a non-compete premium of Rs 50 per share for the promoters has raised a few questions. This, together with the new draft takeover guidelines, has made us ask: should some shareholders get extra consideration in an M&A? Or to paraphrase George Orwell: “All shareholders are equal. But are some more equal than others?”
A company’s shareholding is a highly democratic structure. Generally, all voting shares are of equal value. However, the large — mostly majority — block of shares together does give some extra controlling rights, hence the concept of a control premium. Therefore, the controlling block of shareholders does come across as being more equal than others.
So, is there any justification for the extra premium for promoters who have a controlling share block? The fact is that the buyer, by buying this block in toto, can control the company and is, therefore, willing to pay a premium for this block which he does not want to pay for other smaller share blocks.
People with a considerable stake in a company hold some extra value for the acquirer — the person could be a technology innovator, a progressive leader or a manager with an in-depth understanding of the business and the environment and so on. The control premium/non-compete fees is often a recognition of this reality.
Currently, the Securities and Exchange Board of India (Sebi) rules do allow for the payment of non-compete fees. The draft takeover code proposes to change this rule and do away with the payment of any extra consideration to the controlling/majority shareholder.
In other countries, such as the US, the rules stipulate that “the consideration paid to any security-holder for securities tendered in the tender offer is the highest consideration paid to any other security holder for securities tendered in the tender offer”. But the important distinction is that this is for the same class of securities. It also allows an exemption from the rule for compensation for past services performed, future services to be performed, or future services to be refrained from performing, by the security-holder if s/he is an employee.
Many companies in the US offer different classes of equity shares. Google, for example, has two classes of shareholders. Class A is publicly-traded and has one vote per share and Class B common stock has 10 votes per share. While Class A is widely held, the more powerful Class B is held by just about 100-odd executive officers, directors, management and employees. This ensures that these key people control over 67 per cent of the voting power. This kind of “control premium” on a different share class is common in the US. In India, however, different share class structures are not popular because the market and investors are not sophisticated enough to understand the valuation differences in these different classes of shares.
On the other hand, this premium is open to abuse, and we have seen this in quite a few cases. In a takeover situation, the open offer rules protect the minority shareholders as the company is undergoing a significant change. There are rules to ensure that the small and minority shareholders do not get a raw deal and get the same benefit of their shareholdings. No one is in favour of a free-for-all that shortchanges minority shareholders.
Overall, we need a more pragmatic approach to the rules. One suggestion is that the non-compete fees paid to individuals and corporations have different limits; individuals are giving up some economic benefit in the future while the non-compete value for a corporate body is harder to gauge. Second, there could be an absolute cap on the non-compete amount; it should not be linked to price per share. Third, wherever non-compete fees are involved, the minority shareholders should be given a right to vote on the deal and the majority seller — being an interested party — cannot vote on the motion.
These issues are extremely nuanced and any knee-jerk reaction will ultimately result in a loss of opportunity for all shareholders. We need to understand the ground realities and acknowledge that the guidelines have to be in place to ensure fair play and prevent abuse. A wider debate is, therefore, necessary.