A Tale of Two Amendments
- Recent controversial amendments by Securities and Exchange Board of India – lock in period for Shares arising out of Share Warrants and Fairness Opinion in mergers
1) Two recent amendments in August-September 2008 by SEBI are important and, in my view, at least one creates a sense of puzzlement – if not a little offense - at least for valuers such as Chartered Accountants. They are briefly recounted here before further discussion.
2) The first amendment is to the SEBI DIP Guidelines ("the Guidelines") and essentially provides that the lock-in period undergone by Share Warrants would no more be counted and adjusted against lock-in period for shares allotted against their exercise. Thus the shares would also have to undergo the full lock-in period prescribed.
3) The second amendment is to the Listing Agreement. It essentially provides that in case certain specified types of restructuring involving a listed company, the company would be required to obtain a "fairness opinion" on the valuation of the shares/assets in the restructuring. Such opinion is to be obtained from an "independent merchant banker" and should be circulated to the shareholders along with the explanatory statement required to be sent under law.
4) These amendments are just a couple of several other amendments made very recently. However, these two amendments are only discussed here.
5) Lock-in period on Share Warrants and shares allotted on exercise of such Share Warrants
a) Readers may recollect that, under Chapter XIII of the Guidelines, certain provisions are made with regard to allotment of shares and other instruments on a preferential basis to a selected few under section 81 of the Companies Act, 1956. Since, as the term itself signifies, some people can be given preferential treatment in allotment of shares in a company, SEBI has provided for guidelines to regulate such allotment which, over the years, have been amended several times and have become quite elaborate and complex.
b) One of the provisions in these Guidelines relates to lock-in period. This term lock-in is familiar to most of us though, as usually happens, with provisos and expansions, it moves far from the common understanding of the term. However, essentially, lock-in means non-transferability. You thus cannot transfer the shares during the lock-in period. Further, you cannot put them as security for a loan, etc though there are exceptions. Similarly certain types of transfers are permitted.
c) Presently, securities allotted on a preferential basis are locked in for a period of one or three years (let's skip when and why and for whom this period varies since it is not relevant for the present discussion). Securities could be classified for this purpose into convertible instruments fully paid for such as debentures, partly paid for Share Warrants and fully paid for shares.
d) Now let's understand what the law was before it was amended.
e) All the aforesaid securities were locked in for the specified period. However, if, during such period, the convertible instruments changed form and became shares, the shares were not subject to a fresh and full lock-in period. The period for which the convertible securities or Share Warrants were locked in would be deducted from the full lock-in period and the shares would suffer lock-in only for the balance period. Needless to say, if the convertible instruments/ Share Warrants had already suffered the full lock-in period, the shares would be free for sale from the first day of allotment.
f) Now an exception has been made by an amendment. It is provided, in essence, that the lock-in period suffered by Share Warrants would not be adjusted against the shares allotted on their exercise. Thus, such shares would suffer full lock-in period again. In theory, therefore, it is possible that an allottee could suffer a lock-in period of as long as 4 1/2 years (1 1/2 years for Share Warrants and 3 years for the shares).
g) The implications are obvious. The allottees cannot sell the shares for a further full lock-in period. In other words, shares allotted on exercise from Share Warrants cannot be sold the very next day. This, however, does not apply to shares allotted on conversion of, say, Convertible Debentures that have already undergone the full lock-in period. Perhaps the logic of this amendment is that the Share Warrants have not been fully paid for and hence the allottees have not blocked their money for the full period.
h) Before closing discussion on this amendment, note that there has already been a heated debate on the interpretation of this amendment – thanks to online instant publishing of articles and blogs. One interpretation, elaborately argued, is that the amendment is confused in intent, has harsh consequences and in any case the drafting fails to make any amendment, In short, that view says that, effectively, because of poor drafting, there is no change! With due respect, I think that would be an extreme view and is not warranted by the drafting.
6) "Fairness Opinion" on valuation in restructuring
a) Under the Indian Companies Act, there is an elaborate scheme of provisions to permit restructuring undertaken by companies in the form of mergers, demergers, etc. under the often benign but watchful eye of the High Court which is almost a single-umbrella forum for most aspects of the restructuring. However, the well settled law seems to be that the High Court considers the scheme of such restructuring from certain angles and gives considerable weight to the factors such as approval by shareholders with the special majority provided for and other compliances and disclosures being duly made. If these factors are taken care of, the restructuring is usually sanctioned unless there is a glaring injustice or anomaly or the like. It was felt by SEBI that there may be certain angles, say of interests of minority shareholders or perhaps broader interests of capital markets generally, that may require special attention.
b) Thus, there is a clause in the Listing Agreement that provides that schemes of specified types of restructuring should be submitted to the stock exchanges for approval at least one month prior to the date of submission to the Court for sanction. It is also provided that alongwith the special explanatory statement required to be circulated under section 393 of the Companies Act, 1956, the pre and post capital structure and shareholding pattern should also be circulated.
c) This requirement is now amended to provide the following shall also be circulated with such explanatory statement:-
"and the "fairness opinion' obtained from an independent merchant bankers on valuation of assets / shares done by the valuer for the company and unlisted company"
d) Note that this is a bland addition made with many defects in drafting and even lack of clarity of intention. It assumes a lot and leaves out a lot. However, let us first try to gather the broad intention and consequence.
e) It appears that the company should circulate a "fairness" opinion ("the "Fairness Opinion") obtained from an "independent merchant banker" on the valuation of assets/shares done by the valuer. Thus, the merchant banker would be required to examine whether the valuation of assets/shares done by the valuer is "fair" and give his opinion accordingly and this opinion should be circulated.
f) Internationally, a Fairness Opinion M&A transactions from an independent merchant banker is a common feature and even mandated by law. A study in 2005 in US pointed out that 95% of M&A deals had a Fairness Opinion from the acquirer side. The point though is one cannot import into India foreign practices out of context. In India, for example, we already have a practice of obtaining a "fair valuation" report required from a valuer in mergers, etc. which incidentally not a specific requirement of law. The mergers are already also subject to review specifically by stock exchanges, the Official Liquidator and, above all, the Court. This new SEBI requirement is over and above all such practices and legal requirements and in fact, requires that this valuation itself be reviewed.
i) At the cost of repetition, note that, unlike the concept in Western countries, the scope does not extend to the transaction as a whole but only to the valuation. Also, abroad, the emphasis of the Fairness Opinion is on the fairness of the merger itself, particular to public shareholders and in effect serves as a check on the management. SEBI's proposal requires a Fairness Opinion on the valuation done typically done by Chartered Accountants.
g) Several questions arise for which there are no clear answers. Consider though what the covering circular to the amendments had to say:-
"In order to safeguard the interest of shareholders, the listed company as well as the unlisted company which are getting merged shall each be required to appoint an independent merchant banker for giving a fairness opinion on the valuation done by valuers. Further, the "Fairness opinion" of the merchant bankers shall be made available to the shareholders at the time of approving the resolution under Clause 24."
h) Is the Fairness Opinion required only when there is a merger of a listed and unlisted company, as the circular suggests but the clause does not? The clause though refers to an unlisted company but grammatically or otherwise, one cannot understand the intent clearly. Of course, if the intention is to cover only mergers of listed and unlisted companies only, the scope of this clause (and therefore the discussion made and concerns expressed later herein) would be quite limited.
i) What is the scope of "fairness"? The circular talks of safeguarding of the interests of shareholders though in reality the term "fairness' is not restricted by only the interests of shareholders. In fact, the very objective of fairness is not to focus on any special interests including even shareholders. However, perhaps the intention is that the fairness should be considered from the limited point of view of the interests of shareholders. No such limitation is however made in the actual clause itself. Internationally, the Fairness Opinion has a wide scope.
j) The intention is also that such Fairness Opinion should be laid before the meeting so convened though the amended clause does not expressly require it.
k) The clause covers all types of restructuring such as mergers, demergers, reduction of capital. In fact, the provisions of section 391/394/100/101 allow for a wide variety of restructuring. Thus, if one looks at the wording of the amendment, the Fairness Opinion would be required for all such restructuring. However, the circular states that the Fairness Opinion should be obtained when there is a merger. Of course, arguably, valuation may not be required normally in cases of, say, reduction of capital. However, greater clarity would have been appreciated.
l) Where is the requirement first of all for obtaining a Fairness Opinion? In fact, the clause talks of enclosing the Fairness Opinion obtained should be circulated. What if the company has not obtained such an opinion? Perhaps this is nitpicking but considering the substantive requirement, one would again have appreciated an express requirement.
m) Coming to something closer home to Chartered Accountants, the obvious requirement is that the Fairness Opinion is required on the valuation of the shares/assets as made by the valuer. The valuation of shares/assets is almost always done by Chartered Accountants. Such Chartered Accountants are, as a rule, independent and often the Statutory Auditors who again are independent Chartered Accountants. The schemes of restructuring are again by definition to be sanctioned by the High Court and more often than not, the Court has to consider the aspect of valuation. The issue on considering the valuation and exchange ratio in case of mergers has been considered so many times by the Supreme Court and High Courts and many issues are well settled now. One well settled issue is that, unless there is something glaringly wrong in the method or some very apparent anomaly, the Courts refuse to interfere with the opinion of the valuers. This is so even when parties offer alternative valuation reports.
n) The requirement of obtaining a Fairness Opinion on the valuation is, to my mind, puzzling and in any case against settled law.
o) Coming to the core of it, is it because SEBI thinks that Chartered Accountants, who are regulated by the ICAI and who are also otherwise independent, do not provide for a fair valuation of assets/shares? If yes, how is one assured that merchant bankers would be fair in giving their opinion? Is the only fact that merchant bankers are registered with SEBI and therefore subject to its control the deciding factor? Ironically, senior staff members of merchant bankers are often Chartered Accountants and in practice, when valuation issues are involved, Chartered Accountants are almost without fail required to be involved or even in charge of the assignment at the merchant banker.
p) Interestingly, merchant bankers are not required by law to be qualified or to have recognized expertise in valuation which Chartered Accountants do have. However, this amendment provides for a review of the opinion by the qualified, expert and independent Chartered Accountant by a merchant banker.
q) Also, is it not against the very principle of a valuation, which is a subjective opinion, that it be made subject to another opinion? As stated earlier, courts have rejected other valuation reports provided by parties which give a different valuation recognizing that it should not interfere with the opinion of a Chartered Accountant even if the other valuation report gives a differing opinion and value.
r) Coming closer to reality though there may have been cases where the valuation report of Chartered Accountants may not have been upto the mark, at least of SEBI. However, can one be assured of 100% perfection by merchant bankers?
i) In the West, where Fairness Opinions are almost the norm, discrepancies are frequently found and have been criticized in some cases.
s) It is also amusing to note that by definition and practice, the valuer works out the "fair" value of the assets and shares and it is on this "fair" value that the merchant bankers gives a "fairness" opinion! That reminds me that auditors also give a report on the truth and "fairness" of the accounts. Will this report be the next target of a Fairness Opinion?!
t) In practical terms, though, note that merely because the merchant banker has given even a differing opinion or some adverse comments would not mean that the valuation of the valuer has to be rejected. The requirement is of circulation and disclosure and thus the company, the Court, the shareholders, etc. would have the benefit of this opinion. Again, though, in real terms, no company would like to circulate a valuation by a valuer where the merchant banker gives an adverse opinion.
u) The conclusion is that, though in quite ambiguous terms of scope and substance, the requirement now is that such a Fairness Opinion should be obtained. It is upto SEBI to clear the ambiguities. And it would be upto the profession of Chartered Accountants - who are usually the valuers in mergers - to decide how to respond against this senseless requirement.
v) For companies, who are caught in the middle, this only adds to the costs, efforts and time in carrying out restructuring.
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