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Regulatory | 20 August 2013

A New Regulatory Angle For PE Investors - Companies Bill 2012

by Tilak Devadiga
 
@Tilak

Companies Bill which is set to replace the Companies Act of 1956, had been approved by the lower house of the parliament last year. However with the passing of the bill by the upper house last week, the bill is awaiting the approval stamp of the President to become a law. The new law apart from stressing the norms for CSR has also many things in store for a PE Investor.
Provisions likely to affect the PE investors;

Definition of;

  • Private subsidiary - The ambiguity regarding a subsidiary of a public company is addressed by the new law which says that a subsidiary of a public company will be treated as a public company and all the provisions applicable to the public company will be applied to it.
  • Listed company – As per the new Act, a listed company refers to a company which has any of its securities listed on any recognised stock exchange.

Thus investors need to be cautious regarding the investee company’s status.

Restriction on Multilayer structures - The Bill limits the ability of a company to make investments through not more than two layers of investment companies, unless otherwise prescribed and subject to two specific exceptions: (i) allowing Indian companies to acquire offshore companies, which, in turn, has subsidiaries beyond two levels; and (ii) in cases where a company needs to have more than two layers of investment companies in order to comply with law.

Usually, private equity investors have preferred to take exposure at the level of the holding company so as to derive economic value from the entire group as a whole, as against any particular arm/investment vehicle within the group. Thus investors may not be able to derive the same amount of economic value from a single investment at the holding company level as they would have, under the Act.

The buy backs – Earlier regulations provided for a buy-back of up to 10% of the paid up equity capital and free reserves of the company by way of a board resolution, immediately followed by another buy-back of up to 25% of the total paid up equity capital and free reserves by way of shareholders' resolution.

The current act in focus brings in a cooling off period of a year between two successive buybacks., irrespective of who authorized such buyback (i.e. board or shareholders or as per the case) i.e no buy-back shall be allowed for a period one year from the date of a preceding buyback. This regulation would have an impact on the buy back route taken by many PE’s to exit, as the ability of the company to provide timely exit to its PE investor would be diminished.

Entrenchment clause - The Bill grants statutory recognition to contracts or arrangement between two or more persons in respect of transfer of securities of a public company, putting to rest contradicting judicial precedents on this aspect. Thus PE investors can use clause such as ‘tag along’, ‘drag along’, Right of first offer (ROFO), Right of first refusal (ROFL) against other contracting shareholders, providing much needed relief to private equity investors who rely on such contractual protections.

A 'tag along' clause helps protect a minority shareholder as he can sell his stake along with the majority shareholder, while a 'drag along' clause gives right to a majority shareholder to force a minority shareholder to sell stake.

ROFL refers to a contractual right of an entity to be given the opportunity to enter into a business transaction with a person or company before anyone else can. Whereas ROFO refers to a contractual obligation by the owner of an asset to a rights holder to negotiate the sale of an asset with the rights holder before offering the asset for sale to third parties.

This will allow private equity investors to negotiate certain protective clauses under their investment agreements to be entrenched in the articles such that these may be amended only with their prior approval, notwithstanding the promoters of their respective portfolio companies having majority voting power.

Liability of a director - . Under the current definition, if a managing director is absent, other directors are treated as 'officer in default'. However, the proposed definition in the Companies Bill seeks to widen the definition to include directors aware of the default, by way of participation in board meetings or receiving the minutes of the meeting without objecting to those. The Companies Bill will put higher onus on directors appointed by PE funds. Apart from widening the definition of 'officer in default', the Companies Bill could also lead to class action suits (collective lawsuits), which could increase potential legal liabilities for PE investors.

The Bill has also sought to grant greater protection to non-executive directors by making them liable only in respect of such acts of omission/commission by the company which had occurred with their knowledge, attributable through board processes, and with their consent or connivance. thus it easier for private equity investors to nominate directors on boards of their portfolio companies.

Treasury stock – The new act can cease the practice of creating treasury stock and remedy the current situation where such stock has voting rights that effectively end up increasing the control of promoters.

Treasury shares are those that a company holds in itself and could be created as a result of buy-backs from the open market or mergers. Since companies cannot hold their own stock, they hold it through a trust ostensibly for the benefit of shareholders.

In case of a merger, the new Act says a transferee company shall not, as a result of the compromise or arrangement, hold any shares in its own name or in the name of any trust whether on its behalf or on behalf of any of its subsidiary or associate companies...any such shares shall be cancelled or extinguished.

Generally the practice of holding treasury stock is to prevent hostile take overs and also for making profit by selling the stock at a higher price by buying back initially at a lower price.

Voting on party related transaction – a member of a company will not be permitted to vote in resolution if such member if such party is related party with respect to an arrangement put to vote. If a PE is party to a agreement, in such case thPE investor would not have the ight to vote for passing the resolution.

Thus the bill presents a host of new developments which would compel PE investors to scrutinize their investments keeping the new act in the backdrop prior to making any investments and its effects on its current investments.

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