1) SEBI has amended the SEBI Prohibition of Insider Trading Regulations 1992 vide a notification dated 19th November 2008 which I briefly highlighted here. There are some far reaching amendments.
2) An important amendment is to the definition of “insider”. As I mentioned earlier, no word has been added or deleted but by dropping a comma and breaking the definition into two parts, a significant change has been made.
a) Before the amendment, an Insider had to, firstly, be a person connected or deemed to be connected to the Company. Such connected person should then either reasonably expected to have access to unpublished price sensitive information (“UPSI”) or should have received it or had access to it.
b) This definition was ambiguous. A person merely receiving UPSI or merely having access to it could also be said to be an Insider, as per one interpretation. It is probably this ambiguity that the amendment tackles though by changing the definition upside down!
c) Now, the amendment says that an Insider:-
i) a person connected or deemed to be connected to the Company and who can be reasonably expected to have access to UPSI. OR
ii) A person who receives or has access to UPSI.
d) Thus, a new category of, what one could call, deemed insiders has been created.
e) Readers may recollect the classic case of the printer of company documents who used the price sensitive information in such documents to deal in their shares and make profit (United States v. Chiarella 445 US 222). Of course, the Supreme Court acquitted this printer since, from, what little I recollect, the allegation was that he violated fiduciary duty to shareholders of the target Company and the Court held that he did not. A version of this case was also fictionalized by the best selling novelist Lawrence Sanders in his novel “Timothy’s Game”. Such a printer would though be an Insider in India as per this amended definition. So would any other person who receive or have access to UPSI.
f) In practice, such a broad definition may cause problems. Taken to its extreme – and I seek readers’ views on this - would even a hard working analyst who takes a lot of effort and puts 2 and 2 and 2 and 2 together and counts 8 also become an Insider since he now has access to UPSI? I feel that the answer is no for various reasons but the law could have said that a link with the Company is specifically required. This may even have also been intended since the words used are that such person should have “received” or “had access to” UPSI.
3) Going further, listed companies and certain other persons are required to frame a code of internal procedures intended to prevent Insider Trading (“the Code”). The Code should be framed “as near thereto the Model Code” provided. It is now provided that the framing of the Code as near to such model should be “without diluting it in any manner”. Further, the Company should “ensure compliance of the same”.
4) Disclosures of holding and changes therein are now required in respect of even dependents (as defined by the Company) of the directors or officers of the listed company. Disclosure of such changes is now also required to be made to the stock exchanges. Disclosure of holdings in derivatives is also to be made when a person becomes a director or officer.
5) The Model Code itself has been amended. There are two major changes.
a) Clause 4.2 of the Model Code has been amended. As per this amended clause, directors/officers/designated employees, who buy or sell shares, cannot now carry out a reverse transaction for six months. Thus, if such person buys even 1 share, he cannot sell any shares for six months and if he sells even 1 share, he cannot buy any shares for six months. Further, such persons cannot deal, at all, in derivatives of the Company. This bar is over and above the general prohibition on insider dealing.
b) The devil in me tells me that the ban is only on such directors, etc. and the dependents of such persons are not affected by such ban!. Of course, such dependent may have to answer to the charge of Insider Dealing generally.
c) This bar also does not apply to Promoters!!! This is absurd. Of course those Promoters who are directors, officers or designated employees would face the bar). So also, the prohibition on Insider Trading generally would continue to apply.
i) The bar also does not apply to other Insiders.
d) This bar on such transactions is total. There are no circumstances – whether of urgent need or otherwise – under which the bar can be lifted. There is also no provision under which even SEBI could grant exemption.
e) An interesting question arises. Does the bar apply also to shares acquired through exercise of employees’ stock options or under a Share Purchase Scheme? This can be seen in two ways. If such a person has sold shares, can he acquire shares under an ESOPs scheme in the next six months? Alternatively, if he has acquired shares under an ESOPs scheme, can he sell shares in the next six months?
i) The crucial word to examine is “buy”. I think there is a good case to argue that the word “buy” would include shares acquired under an ESOPs scheme. However, I still think that shares acquired under ESOPs schemes are not intended to be covered. Consider a related bar on shares acquired through an IPO. The existing clause, continued without any change, requires shares acquired by such persons through IPO should be held for at least 30 days. Obviously, if the intention was to cover shares bought in any manner, then such a separate bar was not required at all. I know the provisions are not happily worded. I also know it could be argued that the 30 day lock in for IPO acquired shares is meant to be a special case. However, taking all things into account, perhaps the intention is not to cover shares acquired under ESOPs Schemes.
ii) A poser for readers. Would such bar apply to sale of shares under a buyback offer by the Company or under an open offer under the Takeover Regulations?
6) There are a few other amendments and issues.
7) A final poser for readers. What are the consequences if a director, etc. violates the ban on reverse transactions or on taking positions in derivatives? More specifically, what if a director buys 10000 shares today and sells them after 15 days (lets focus only on the six month ban for now)? The devil in me gives a strange possible answer which I will share here after one or two days - J.
Recently, as briefly referred to an earlier post here, the Reserve Bank of India has notified the NBFCs Auditors’ Report (Reserve Bank) Directions 2008 (“2008 Directions”) (full text available here). These replace similar directions issued exactly a decade back, i.e., in 1998. Both these Directions require auditors of non-banking financial companies (“NBFCs”) to give specific comments regarding the compliance or otherwise of certain provisions applicable to NBFCs. These are to be given in a separate report to the Board of the NBFC. However, if there are any adverse remarks or there is any contravention of the laws applicable to them, as specified, then they have to report also directly to the Reserve Bank of India in what is called an exception report.
The 2008 Directions, however, are much more comprehensive than the 1998 Directions and particularly take into account many of the developments in law notified by Reserve Bank of India itself. It may be recollected that since the issue of the Directions relating to Public Deposits and relating to Prudential Norms in 1998, these provisions have undergone major changes. The objective of these 2008 Directions thus appear to update the reporting requirements of the Auditors in tune with these changes and also create certain fresh requirements apart from making some changes in light of experience.
The experience under the 1998 Directions has not been wholly satisfactory maybe due also to ambiguity in the Directions themselves or the provisions they covered.
The coverage of the 1998 Directions was very extensive – they were to examine each and every of the provision relating to NBFCs under the RBI Act and the Directions issued thereunder and check whether these are complied with or not. This scheme continues even under the 2008 Directions. The provisions of law relating to NBFCs have many areas of ambiguity and controversies and the amendments over the years have not improved the situation. The Directions to Auditors nevertheless require the Auditors to take a call on each such requirement and consider whether these are complied with or not. If they are not complied with, they have to report to the Reserve Bank of India and that too directly. Obviously, though, as a good and fair practice, they would give an opportunity to the NBFC first to give their view.
The 2008 Directions, replacing the 1998 Directions, say that they come into immediate effect. However, clause 2 clarifies that the report required to be given under the Directions is only in respect of financial years ending on or after the commencement date. In other words, it will apply to the accounts for the year ended 31st March 2009 and NOT to the year ended 31st March 2008. For the year ended 31st March 2008, therefore, the 1998 Directions will continue to apply.
There are many strange aspects to the requirements in the Directions. Consider some of them.
The NBFC itself is not required to report to the Reserve Bank of India of the contraventions. It is the Auditors who have to report. Of course, the NBFC would be liable for the defaults but it makes sense on creating a requirement to report by the NBFC itself as an early indicator as also an opportunity to the NBFC to present the situation.
The negative report by the Auditors has to be given not to the shareholders, who would be affected by such contraventions, and not even to the depositors who would have serious concerns since non-compliance may be indicative of possible default or at least poor management. The report has to be given only and directly to the Reserve Bank of India. While on this, note also that the report to the Board is a separate report. There does not seem to be any legal requirement of enclosing this report alongwith the regular Auditors’ report to the shareholders. Of course, there is a possibility that some of the contraventions would be needed to be also reported in the regular report of the Auditors.
The adverse report of the Auditors is quite likely to reach even the Reserve Bank of India after a fairly long time after the contravention. Typically, the company has about 5 months after the yearend to finalise the accounts and audit. Further, even after this period, strangely, no time limit has been given to the Auditors to submit its exception report to the Reserve Bank of India.
(To be continued - second and concluding part in one or two days)
Reserve Bank of India issued on 24th September 2008 (seehere) certain reporting requirements for certain non-deposit accepting non-banking financial companies (NBFCs). What is important though is that now these will be applicable to such NBFCs of asset size Rs. 50 crores but less than Rs. 100 crores. Though such entities are not given the status of “Systemically Important” NBFCs, effectively, it is seen that the benchmark or asset size is lowered to Rs. 50 crores though this new category would be exposed to lesser requirements, at least for now.
Let us consider some background.
Normally, Reserve Bank of India governs only deposit-accepting non-banking financial companies (NBFCs). Non-depositing NBFCs have generally been left alone for most purposes after initial registration. However, it was realized over a period of time that such non-deposit accepting entities had become relatively large in terms of asset size and their acts, omissions and defaults could have wider repercussions on the financial markets generally. Thus the concept of “Systemically Important” non-deposit accepting NBFCs was introduced (also called ND-SI). They were mainly required to give some reports though some substantive requirements were also placed. What is important is that initially the minimum size of an NBFC to reach the “Systemically Important” status was Rs. 500 crores. Over a period of time this limit was gradually lowered and today it stands at Rs. 100 crores.
The latest circular cited above now creates yet another category – no term has apparently yet been given to it – where the asset size is between Rs. 50 crores and Rs. 100 crores. Thus, this requirement is to catch them early. Once the NBFC reaches the asset size of Rs. 100 crores, it achieves the status of “Systemically Important” and would be subject to more comprehensive requirements.
This new reporting requirement is quarterly and is with immediate effect, i.e., the first report is to be given for the quarter ended 30th September 2008 though for this first period, the report may be given by the first week of December 2008 and thereafter within one month of the end of each quarter. These reports are to be filed electronically but the mechanics of this would be circulated by the Reserve Bank of India later on.
The sub-prime crisis is too fresh in the mind to be even discussed here and the supervision of the Reserve Bank of India of non-deposit taking NBFCs can be only viewed in this context as good conservative measures. The problem though is that complex regulatory requirements are created at times of crisis but continue indefinitely even after the crisis passes by.
TheReserve Bank of India has issued comprehensive and updateddirections to auditors ofnon-banking financial companies (NBFCs) requiring them to specifically answer many questions relating toNBFCs. TheDirections replace the decade old 1998Directions to auditors.
TheDirectionsare in a way unique since they require that any negative or qualified answer should be specifically and directly be reported to theReserve Bank of India. Normally, the Auditors report to theNBFC.
While there are many specific questionsrelating to many aspects ofNBFCs and compliance of various provisions under theReserve Bank of India Act andDirections issued thereunder by theReserve Bank of India, for most practical purposes, the Auditors have toreport evenif there is a single violation of any of these legal provisions.
WhileI will update this blog with a more detailed analysis of specific requirement of theseDirections, it can easily be seen that theReserve Bank of India has placed much of the burden of interpreting many controversial and ambiguous requirements. The Auditors will be damned if he interprets in one way and damned too if he interprets the other. For example, whether acompany is anNBFC or not itself is ambiguous withReserve Bank of Indiahaving not issued any clear cut official guidelines. However, the Auditor will have to interpretwhether acompany is anNBFC or not.
The violations of provisions relating toNBFCs can attract very serious consequences includingminimum imprisonment of one year.
Note though that these directions will NOT apply to the audit for the year ended on 31st March 2008. They apply only to audit in respect of years ending on or after 18th September 2008. However, to view the matter in another sense, they would have immediate and even retrospective effect since they would apply to the current financial year also and though there do not appear to be any fresh requirement on the company itself, they may need to prepare appropriate records for the auditors for the period from 1st April 2008 to satisfy the auditor that there is due compliance.
A review of these more comprehensive Directions should be made by the NBFCs and their Auditors.
-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.
Watch this space for critical analysis of two recent amendments by SEBI which have far reaching consequences and at least one of them is puzzling, maybe even outrageous. To state briefly, one amendments makes effectively the lock-in period in case of preferential allotment longer and the other requires a Fairness Opinion on fair valuation in case of mergers.
