The SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 (the takeover code), was notified by SEBI in order to prevent actions that are detrimental to the interests of minority shareholders of companies. The takeover code requires that a fair chance be given to shareholders to exit a company in case of management changes. Ideally, the shareholders (especially the minority shareholders) should have a say in determining whether any corporate action (including a takeover) is in the best interest of the company.
Kraft Food’s offer to acquire Cadbury shows differences between the US and UK systems with regard to shareholder rights in the case of a takeover offer. While the UK is principle-based, the US is rule-based in its approach, allowing companies to adopt anti-takeover strategies including “poison pills” and “crown jewel sales”. By contrast, such “frustrating action” is prohibited in the UK by the principle that a company cannot take any action which results in a bonafide possible offer being thwarted, without gaining shareholders’ approval.
The first, limited attempt at regulating takeovers in India was made in 1984 with the incorporation of clause 40 in the listing agreement. Clause 40 contained a rule stating that a public offer must be made to the shareholders if any person acquired 25% or more of voting rights of the company. But the clause was easily circumvented and its purpose frustrated by acquirers using the simple strategy of acquiring direct voting rights to a maximum a little below the threshold limit. In addition, there was no restriction on the level of indirect participation.
This example shows the typical shortcoming of a rule-based system: market participants often find and exploit loopholes that meet the literal wording of the provision but violate its intent. This leads to the need for frequent amendment and updating of the system to deal with such abuse. In fact, the takeover code has been amended 15 times, with 30 substantial amendments enforced. While many of these have involved the revision of various thresholds or limits, and others dealt with specific developments such as privatization, many amendments were triggered when the spirit of the takeover code was contravened by market participants.
Principle-based regulation lays relatively less emphasis on the means of compliance and more on end results. It asks market participants to use the means they judge are most appropriate to comply with the principles laid out. Adopting a principle-based approach would remove the need for frequent amendments to regulations. However, principle-based regulation does advocate the provision of guidance or consultation to those who seek to comply, rather than mandating policies without regard to circumstances.
An example of how a principle-based system works is provided by the 1992 Cadbury Committee report in the UK, which said that the chairman and chief executive of a company should not be the same person. This is a principle, not a rule. Were it a rule, boards could simply give two members different titles even though power remains with one (which is the case in India). By contrast, a principle – that there be a clearly accepted division of responsibilities which is identifiable and proved to the satisfaction of shareholders – is harder to evade.
By comparison, clause 49 of the listing agreement in India provides rules for the constitution of the board of directors. It is possible and common for companies to comply with the letter of these rules while evading their spirit. For example, the legal adviser to the promoters of a company is often described as an “independent director” on the company board.
SEBI already uses a principle-based approach to a limited extent, as in relation to the acquisition of American depository receipts (ADRs) or global depository receipts (GDRs), which does not require an open offer to be made under the takeover code on the (unstated) basis that ADRs/GDRs do not carry voting rights until conversion into underlying shares. A recent informal guidance by SEBI proceeded on the basis of this spirit of the takeover code, though guidance on any change in control was not sought. However, SEBI also announced that amendments would be made to the takeover code to deal with holders of ADRs/GDRs who exercise voting rights even before conversion.
While checks and balances can be established to counter the risks of manipulation of any system, they may be ineffective if the market is not mature.
While the rule-based approach of the takeover code may have been suitable for a nascent market such as India in 1984, the evolution of the Indian capital markets means it is now time to evaluate the adoption of a more objective-oriented takeover code with fewer checklist-style details and “bright line tests”, in the words of a report by the committee headed by Justice Bhagwati. SEBI has now constituted the Takeover Regulations Advisory Committee (TRAC) to review the takeover code and consider further refinements. The question which TRAC must address is whether the Indian capital markets are mature enough to enable to adoption of a predominantly (if not a purely) principle-based approach.
H Jayesh is the founder partner and Prachi Loona is an associate at Juris Corp. The firm is a full-service law firm based in Mumbai and specializes in financial transactions including capital markets and securities, banking, corporate restructuring and derivatives.
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