Executive summary: The following article discusses recent developments around the definition and interpretation of the term ‘control’ under Indian Takeover Regulations and the impact it may have on investments in publicly listed entities in India, including the risk of classification of investment in a publicly listed entity as the acquisition of ‘control’ of such entity.

Main Article:

Controlling ‘Control’

On March 12, 2016, India’s securities markets regulator, the Securities and Exchange Board of India (“SEBI”) published a press release pursuant to its board meeting earlier that day (the “SEBI Press Release”). Amongst other matters, the SEBI Press Release indicated that SEBI would initiate a public consultation process regarding bright-line tests (“BLT”) for determination of the term ‘control’, as defined under the SEBI (SAST) Regulations, 2011 (“Indian Takeover Regulations”).

To those unfamiliar with this issue, there has been considerable debate in Indian corporate legal circles around the interpretation of the term ‘control’ and the risk of classification of investment in a publicly listed entity as the acquisition of ‘control’ of such entity on account of the definition of the term ‘control’ under Indian Takeover Regulations. Whether the genesis of such debate owes its origins to conflicting definitions of ‘control’ by Indian courts and legislators or interpretations of ‘control’ by Indian regulators is moot, but the absence of a clear and exhaustive definition of ‘control’ continues to exist. Recognising this and its impact on deal making and M&A in the public space in India, SEBI has sought to define ‘control’ and initiate a public consultation process.

Significance of ‘Control’

Under Indian Takeover Regulations, where (a) an acquirer seeks to acquire substantial shares or voting rights (including and upwards of 25%) in a public listed entity (“Target”) or where an acquirer acquires ‘control’ of a Target; and (b) such acquisition is not exempted under Indian Takeover Regulations (for instance, acquisition in the ordinary course of business by intermediaries or transfer between certain shareholders, etc), then such acquirer is required to make an open offer for the purchase of shares held by the public shareholders of the Target, in the manner set forth in the Takeover Regulations (“Open Offer”). The Open Offer process is detailed and broadly involves notices to be provided to shareholders, minimum number of shares to be acquired by an acquirer, the engagement of a merchant banker, allowing tendering of shares by the shareholders, payment there-for and filing of relevant documents with SEBI during and after the process.

Therefore, and in the context of the current discussion, if an investor’s terms of investment in a Target, including the obtaining of contractual rights that are not available to other shareholders (“Special Rights”), are deemed to be indicative of ‘control’, then the investor is required to undertake an Open Offer, irrespective of (a) the investment being within the said 25% threshold, or (b) the underlying commercial considerations of the transaction at hand, including the percentage of ownership that may be acceptable to the investor, or (c) the implications of being in ‘control’ of an enterprise as opposed to being invested in the said enterprise. This opens up larger questions of relevance and commercial acceptability of an Open Offer to the transaction at hand.

The First Approach: ‘Protective’ Special Rights 

As may be expected, the confusion around what constitutes ‘control’, especially in the context of Special Rights granted to an investor, has been impacting deal making and M&A in the public space in India. Based on various industry representations and feedback, SEBI has proposed two approaches to conveniently identifying or ‘bright-lining’, whether there exists ‘control’ in its discussion paper titled “Brightline Tests for Acquisition of ‘Control’ under SEBI Takeover Regulations.”

SEBI’s first proposal is to identify certain Special Rights as protective and exclude them from the purview of ‘control’. The principle enunciated is that where a Special Right is aimed at protecting the investment by an investor or preventing dilution of their stake in the Target or preventing the Target from undertaking a significant change in the current business by the Target, such Special Right would not be construed as ‘control’. An overarching rider to this principle is that the Special Right in question should not limit the Target from conducting its business on a day-to-day basis or from policy making, including by subjecting it to investor approval. Further, SEBI has suggested that these Special Rights not amounting to ‘control’ may be granted subject to: (a) the investment being 10% at the least, (b) the Target setting forth the concepts of materiality and what would be ‘outside the ordinary course of its business’ (see below) and disclosing the same to its shareholders; and (c) obtaining the public shareholders’ approval for grant of the Special Rights.

In this context, SEBI has described certain rights that it deems to be protective in nature and which do not amount to exercise of ‘control’, some of which are set out below:

1. The right to appoint an observer to the board of the Target (“Board”) by an investor. However, SEBI prescribes that such observer should not have any “participation rights”. Prima facie this would seem to limit an investor from ensuring that its observer is part of the quorum for a valid Board meeting.
2. If Special Rights are conferred pursuant to a commercial agreement between parties, the same would not amount to ‘control’ if (1) the said commercial agreement is fair and mutually beneficial to the Target and the other party, (2) the Board has approved the commercial agreement and has the right to terminate the said agreement, and (3) the commercial agreement is non-exclusive i.e. it does not restrain the Target from entering into a similar contract with any other party.
3. Veto rights enjoyed by an investor that would not amount to exercise of ‘control’ over a Target include those pertaining to restricting amendments to the bye-laws of the Target (in so far as such amendments impact the rights of the investors), alteration of the capital structure of the Target, material divestments of assets or subsidiaries, material acquisitions, write off or loans or investments outside the ordinary course of business, any change to the statutory auditors of the Target or indebtedness beyond what is statutorily permissible.

The Second Approach: A Quantitative Test

SEBI has suggested that ‘control’ be determined on the basis of the right to exercise at least 25% of the voting rights of the Target. It has also suggested that, additionally, if an investor is granted the right to appoint the majority of non-independent directors, then such right would be construed as ‘control’ for the purposes of the Indian Takeover Regulations.

Balance or Brightline: What Works in the Indian Context 

BLTs have been historically criticised for their inability to appreciate factual nuances and for addressing legal issues in a predictable, convenient and over-simplified manner. A related criticism of a BLT is that on account of its nature, it may not always result in an equitable outcome. Conversely, adopting fine-line tests or balancing tests (“FLTs”), whereby various factors surrounding the matter at hand are examined and then the legal principle applied, may result in the introduction of excess objectivity in ‘control’ determination process. A standalone BLT may be easier to administer but it may not be the best option in the Indian deal making context, given the Special Rights that are typically sought by investors. Similarly, a pure FLT may not be the most effective and efficient manner to determine the existence of ‘control’ on a case-by-case basis. As such, whilst the SEBI initiative to define ‘control’ is welcome and has been long due, it is interesting to see where the consultative process takes the definition of ‘control’.