INDIA’S SECURITIES REGULATOR ON SHELL COMPANIES, EXEMPTIONS FROM OPEN OFFER
Recently, the Securities and Exchange Board of India (the “ SEBI”) has approved and notified several important changes to Indian securities regulations, including, extending relaxations from open offer and preferential issue requirements to new investors acquiring shares of distressed companies, extending relaxations from open offer requirements to acquisitions made pursuant to resolution plans approved by the National Company Law Tribunal (the “NCLT”) and exemptions from lock-in requirements at the time of initial public offer (“IPO”) to Category II Alternative Investment Funds (“ AIFs”) such as private equity funds and debt funds.
The SEBI has also initiated the public consultation process to ease access norms for foreign portfolio investors (“FPIs”).
Moreover, last week, the SEBI, through stock exchanges, issued a trading ban on 331 listed companies which it regarded as “shell companies,” used to facilitate money laundering transactions.
This update discusses the implications of the foregoing developments.
Acquisition of distressed companies
The SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (the “Takeover Regulations”) prescribe open offer requirements in certain instances of direct or indirect acquisition of shares, voting rights or control of an Indian listed company, which require the acquirer to purchase shares from the public shareholders. Currently, the acquisition of equity shares of a distressed company by secured lenders (including banks and financial institutions) upon conversion of debt pursuant to the Strategic Debt Restructuring scheme of the Reserve Bank of India (the “RBI”) is exempt from open offer requirements. Now, the SEBI has extended this exemption in case of divestment by secured lenders of the equity stake acquired by them in distressed companies to new investors. Given that most secured lenders would eventually want to offload the equity stake to an investor in order to set off the company’s outstanding dues with the share sale proceeds, this change will make it easier for lenders to approach investors as investors will not face the additional financial and procedural burden of making an open offer.
Chapter VII of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 (the “ICDR Regulations”) prescribes requirements for the preferential issue of equity shares by an Indian listed company, including terms and conditions for issuance, pricing of equity shares and lock-in requirements. Currently, conversion of debt into equity pursuant to the Strategic Debt Restructuring scheme of the RBI is exempt from the requirements applicable to preferential issuances under the ICDR Regulations subject to compliance with the following conditions: (i) the conversion price has to be in accordance with the guidelines prescribed by the RBI which should not be lesser than the face value of the equity shares and has to be certified by two (2) independent valuers; (ii) the applicable provisions of the Companies Act, 2013 should be complied with; and (iii) the equity shares should be locked-in for a period of one (1) year from the date of trading approval, although the secured lenders can transfer their shareholding to another entity during the lock-in period so long as the entity complies with the remaining lock-in period. Now, the SEBI has extended the exemption from applicability of chapter VII of the ICDR Regulations to the restructuring of listed companies undertaken by secured lenders pursuant to guidelines prescribed by the RBI, including the Strategic Debt Restructuring scheme. This exemption will ensure that investors do not have to comply with the procedural rigmarole for preferential issuances.
Acquisitions pursuant to NCLT-approved resolution plans
The Insolvency and Bankruptcy Code, 2016, made effective in December 2016, has established a new regime for liquidation of companies in India. Now, the SEBI has exempted from complying with open offer requirements under the Takeover Regulations in case of an acquisition made pursuant to a resolution plan approved by the NCLT. In our view, the foregoing exemption will enable timely and effective restructuring of listed companies under insolvency or bankruptcy proceedings, and ensure that a resolution plan approved by the NCLT does not impose the additional burden of making an open offer on investors.
Easing access norms for FPIs
On June 28, 2017, the SEBI issued a consultation paper on easing access norms for investments by FPIs. The consultation paper proposes the following key changes:
- Applicants from countries having diplomatic tie-ups with India and are compliant with foreign exchange regulations, a list of which will be notified by the SEBI, will be considered eligible for registration as FPIs. Currently, only applicants whose securities market regulators are signatories to the International Organization of Securities Commission’s Multilateral Memorandum of Understanding or a signatory to bilateral Memorandum of Understanding with the SEBI are eligible to be registered as FPIs.
- A lien or set off on FPI investments required for regulatory and statutory reasons, such as payment of clearing and settlement obligations, custody fees, etc., will not be considered as encumbrance on equity shares held by the FPI;
- Currently, broad-based funds, i.e., funds established outside India having at least twenty (20) investors with no investor holding more than 49% of the shares or units of the fund are eligible for registration as Category II FPIs. It is proposed that in case a fund has a bank, sovereign wealth fund, reinsurance company, pension fund or an exchange trade fund as its underlying investor, and such investor jointly or singly holds a majority stake in the fund, then such a fund shall be considered a broad-based fund (regardless of whether it has at least twenty (20) investors).
The foregoing changes are intended to simplify the registration and eligibility requirements for FPIs and boost FPI investments in the Indian securities market. We will have to wait for the final amendments to the regulations governing FPI investments to assess any further implications.
Revised norms for consolidation and re-issuance of debt securities
In line with the decision approved by the SEBI at its board meeting on April 26, 2017, the SEBI amended the SEBI (Issue and Listing of Debt Securities) Regulations, 2008 to provide that: (i) the articles of association of the issuer company do not have to mandatorily authorize consolidation and re-issuance of debt securities; however, there should not be a provision prohibiting the issuer company from doing so; and (ii) any issuer company issuing debt securities on a private placement basis must comply with the issuance of International Securities Identification Number (“ ISIN”) as prescribed by the SEBI from time-to-time.
On June 30, 2017, the SEBI prescribed that in respect of ISINs related to private placement of debt securities, a maximum of twelve (12) ISINs maturing per financial year would be allowed for secured and unsecured non-convertible debentures and bonds, and five (5) additional ISINs may be provided per financial year for structured debt instruments such as bonds with call options. These changes will simplify the process for consolidation and re-issuance of debt securities, and increase the liquidity in the secondary market for debt issuers.
Category II AIFs exempt from lock-in requirements pursuant to IPOs
Under the ICDR Regulations, the pre-IPO capital held by Category I AIFs such as venture capital funds, SME funds, social venture funds and infrastructure funds is not subject to the lock-in requirement of one (1) year post-issue; provided, that, the pre-IPO stake has been held by the Category I AIF for one (1) year from the date of purchase. Now, the SEBI has amended the ICDR Regulations to extend this exemption to Category II AIFs such as debt funds and private equity funds also. This change provides a level playing field to Category I and Category II AIFs and provides simpler lock-in requirements to Category II AIFs, which commonly invest in pre-IPO companies.
SEBI issues a trading ban on 331 “shell” companies
In the past one (1) year, the Indian government has adopted stringent norms to curb black money, tax evasion and money laundering. Further, the Special Investigation team on black money (constituted by India’s Supreme Court) had recommended that the SEBI must identify shell companies and take appropriate action. In line with this recommendation, earlier this year, the Ministry of Corporate Affairs issued show cause notices to companies which had not commenced business operations within one (1) year of incorporation or had not undertaken business for the preceding two (2) financial years, with an intent to strike off or de-register such companies.
Based on this information, on August 7, 2017, the SEBI directed the stock exchanges to place the trading of 331 “shell” companies in stage VI of the Graded Surveillance Measure with immediate effect. Under stage VI of the Graded Surveillance Measure, trading in securities of the company is permitted once every month, and no upward movement in the price of these companies’ securities is permitted beyond the last traded price. Further, an additional surveillance deposit of 200% of the traded value is collected by the stock exchange from the purchaser of such securities and retained for five (5) months. The stock exchanges have commenced verification of the credentials of these companies through independent auditors, including conducting a forensic audit, if required. Until such time that the verification process is over, the promoters and directors cannot purchase securities of these companies or transfer their existing shareholding in the company. If appropriate credentials in respect of the existence of these companies are not found, the exchanges will initiate compulsory delisting of these companies.
Following this ban, it has been reported that many of the companies are in fact not shell companies. This ban has been criticized on the basis that no show cause or advance notices have been issued to these companies before placing the ban. In fact, over the past few days, companies like J Kumar Infraprojects Limited, Parsvnath Developers Limited, Prakash Industries Limited and Kavit Industries Limited have obtained stay orders from the Securities Appellate Tribunal on the basis that the SEBI’s order was arbitrary and contrary to the principles of natural justice, and that the SEBI should have investigated the “shell” companies before arbitrarily passing an order imposing a ban on trading, which affects the investors as well as the company.
In our view, while the SEBI’s order was well motivated, it should have been preceded by preliminary investigations on these companies or the companies should have been given a show cause notice similar to the ones issued by the Ministry of Corporate Affairs. For instance, J Kumar Infraprojects Limited and Prakash Industries Limited were allowed to trade again, but witnessed a steep decline in their share price, thereby reducing investor wealth.