[By Srishti Suresh]
The author is a third-year student at NALSAR University of Law, Hyderabad.
In light of the COVID-19 outbreak and its resultant economic lockdown, several companies are cash starved and are facing immense financial crunch. There exists an incumbent need to infuse funds into such stressed entities, to enable them to avoid insolvency and bankruptcy proceedings. Consequently, the securities market regulator SEBI, issued a Consultation Paper on April 22nd 2020, titled Pricing of Preferential Issues and Exemption from Open Offer for Acquisitions on Companies having Stressed Assets.[i] The same seeks to tweak certain provisions under the current SEBI Issue of Capital and Disclosure Requirements (“ICDR”) Regulations, 2018, and the SEBI Substantial Acquisition of Shares and Takeover (“SAST”) Regulations, 2011.
The Changes Proposed by SEBI in Consultation with the Primary Market Advisory Committee (PMAC) in Contrast to the Present ICDR and SAST Regulations
Three aspects of the original Preferential Allotment route are sought to be tweaked, in order to encourage more private investors to infuse funds into stressed companies.
First, an objective-criteria for what constitutes a ‘stressed company’ is to be made clear. This is to ensure that companies and investors alike, are made aware of those companies that are in urgent need of funding. At present, neither of the two Regulations enunciate on the criteria for determining what a stressed company is. As a consequence, if a company satisfies two out of the three criteria specified hereinunder, the same would be considered a ‘stressed company’. They are –
- A listed company which has previously disclosed its defaults in payments of interest and repayment of the principal amount on loans taken from any bank or financial institution, as well as listed/ unlisted debt securities for two consequent quarters, in consonance with the SEBI Circular.[ii]
- If there exists an inter-creditor agreement with the company, in terms of the RBI Circular[iii], and/or
- Downgrading of credit rating of the listed instruments of such stressed company to “D”.
Further, the securities regulator has acknowledged the burdensome nature of the existing norms of raising capital, which has proven itself to be more of an impediment, and has proposed the following changes to be introduced to the ICDR and SAST Regulations.
Exemption from Pricing Norms
Currently, Regulation 164 of the ICDR requires the pricing of equity shares of a listed company (allotted through the preferential route), to not be less than the
- average of the weekly high and low of the weighted average price of the said shares on the recognized stock exchange during the twenty-six weeks preceding the relevant date (for frequently trading entities), OR
- The average of weekly high and low of the volume weighted average prices of the quoted shares during the two weeks preceding the relevant date.[iv]
The exemption proposes to narrow down the price determination to Regulation 164(b), basing it on the weighted average price of the preceding two weeks, applicable even to frequently trading companies. Ordinarily, the twenty-six-week period is said to determine the demand surge for an entity’s shares, and the pricing is therefore based on the said period. But owing to crashing markets and deterioration of performance of industries, the latency period would create a wide gap in the pricing of such shares. The price at the beginning of the twenty-six-week period, before its decline in the forthcoming weeks, is significantly higher than what an investor would have to pay on the basis of the preceding two-week period. If the earlier requirements are imposed as a hard-handed rule, investors investing in frequently trading stressed entities would have to pay more to acquire shares and voting rights, and the financial burden imposed on an investor would increase manifold. Therefore, restricting the price determination to the two-week weighted average would allow companies and investors to factor in economic changes caused due to the unforeseen circumstances and the gap would be reasonably constricted. This is a reasonable measure to attract investments.
Exemption from Open Offer Requirements
Regulation 3 read with Regulation 7(1) of the SAST requires an investor, who has acquired 25% or more of such shares or voting rights in a company, to make a public announcement of an open offer. The open offer made to the existing shareholders should aggregate to a minimum of 26% of the total shares of the target company. The open offer is sought to be waived off in the new proposal.
It seeks to serve two purposes; First, the entity is restricted in allocating such shares to promoters and promoter groups. This is to ensure that newer more efficient management is roped into a cascading entity, without further entrenching the position of promoters. Resuscitation requires dynamism and innovation, and this is furthered by attracting investors motivated to hold substantial interest in a stressed entity. Second, imposing burdens of an open offer would prove counterproductive in attracting potential investors in saving the entity. This is primarily because the earlier requirement of open offer creates a substantial financial obligation on the investor, in addition to his fund infusion. This would discourage plenty of investors and defeat the purpose of saving stressed entities from the cusp of insolvency.
The Discounted Factor
The Consultation Paper is open to public comments, while being inclusive of present and potential investors. A point that SEBI and PMAC seem to have overlooked, is that a slew of companies that have begun to have Non-Performing Assets (“NPA”), are slowly treading into the trajectory of insolvency owing to the economic shutdown caused by COVID-19. Many do not fall under the ambit of ‘frequently trading’ entities. But the trend observed in the economy has indicated that several small/medium companies (listed) are heading towards severe capital starvation and a plausible bankruptcy. Therefore, it would be prudent in extending the proposed exemptions in the ICDR and SAST Regulations to companies that have not yet fallen under the banner of stressed entities. But this expansion across the board would prove to be a double-edged sword, and thereby requires precaution.
On one hand, the waiver of the open offer requirement can lead to abuse and result in hostile takeovers. Large corporations with substantial cash flow have the ability to acquire a substantial interest, in light of the decreased share prices due to the fall in share prices. Furthermore, the proposed approval of majority of minority shareholders with respect to offer price (considered to be an in-built check), would not be difficult to procure, given the decreased market prices of shares. A decent and an incrementally higher offer price can facilitate a shareholder approval. More importantly, the Takeover Code ultimately hands over the reins of decision making to the shareholders, in deciding whether to sell or hold on to the shares of the current shareholders. The Boards of such target companies have only a secondary role, in offering advice and recommendation to the shareholders, in reacting to the offers made by a raider without it causing a detriment to the entity’s interest. As per the Revlon Rule, the Board in a stressed entity selling a substantial interest in its stake, would have the obligation to act as a custodian until a sale is imminent (giving primacy to the overall interest of the stakeholders and the long term objectives of the company), and soon after the sale becomes imminent, the duty gets converted to that of an auctioneer (where the priority is to ensure that the shareholders receive the highest possible price for the shares that are sold)[v]. And it is at this juncture that the duties of the Board and Directors of financially struggling entities get conflicted. As a result, even if lucrative investors swoop in as knights to save stressed companies, by offering a sizeable price for such shares, it would in all likelihood result in shareholder approval and the Board would be focused on ensuring shareholder welfare and wealth maximization. The larger long-term interests of the entity might get compromised. The true impact of the proposals would be discernible only after they are put to test; but in uncertain times such as the present one, it is always better to be safe than sorry.
[i] SEBI, Consultation Paper: Pricing of Preferential Issues and Exemption from Open Offer for Acquisitions in Companies having Stresses Assets (Apr. 22, 2020), https://www.sebi.gov.in/reports-and-statistics/reports/apr-2020/consultation-paper-preferential-issue-in-companies-having-stressed-assets_46542.html.
[ii] SEBI Circular, (Nov. 21, 2019), (https://www.sebi.gov.in/legal/circulars/nov-2019/disclosures-by-listed-entities-of-defaults-on-payment-of-interest-repayment-of-principal-amount-on-loans-from-banks-financial-institutions-and-unlisted-debt-securities_45036.html).
[iii] RBI Notification on Prudential Framework for Resolution of Stressed Assets, (Jun. 7, 2019), (https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11580&Mode=0).
[iv] SEBI (Listing Obligations and Disclosure Requirement) (Amendment) Regulations, 2018, R. 164
[v] Revlon Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del 1986).