Holding protective rights can’t be construed as ‘control’ of firm: Sebi

The Sebi order on Clearwater Partners and its investment in Kamat Hotel India provides clarity on shareholder agreements during M&A deals in listed firms


Sebi held that ‘negative control’, or protective rights cannot be construed as ‘control’ under the SAST Regulations, 2011—popularly known as the Takeover Code. Photo:  Aniruddha Chowdhury/Mint
Sebi held that ‘negative control’, or protective rights cannot be construed as ‘control’ under the SAST Regulations, 2011—popularly known as the Takeover Code. Photo:  Aniruddha Chowdhury/Mint

Mumbai: The Securities and Exchange Board of India’s (Sebi’s) recent order in the matter of private equity investor Clearwater Partners and its investment in Kamat Hotel India Ltd has cleared the air on a six-year-long debate on the definition of “control”.

In the order, Sebi held that “negative control”, or protective rights cannot be construed as “control” under the Substantial Acquisition of Shares and Takeovers (SAST) Regulations, 2011—popularly known as the Takeover Code. 

This order, according to legal experts, provided clarity on shareholder agreements during mergers and acquisition of shares in listed firms. 

In a shareholder agreement, investors are typically afforded certain rights to protect and safeguard investments. These rights can include a veto power in investment decisions and a board seat in a listed firm. 

“The order implies Sebi is now considering such protective provisions as the ones to have checks and control to protect the investments. This order is good enough to say that the learned member has clarified what does not amount to control,” said Ravichandra Hedge, partner, J Sagar Associates, the law firm that handled the matter.

While conducting quasi-judicial proceedings, Sebi had issued a showcause notice to Clearwater for not disclosing they were in “control” pursuant to the increase in their shareholding and protective rights in Kamat Hotels.

Though the investors made an open offer in lieu of their increased shareholding at 32.23%, they did not disclose they were in control. Under the takeover code, entities are required to make an open offer to investors if their shareholding goes above 26%. 

“They were under bona fide belief that they have not acquired control and accepting that they have acquired control would have resulted in classification of the noticees as promoters, which would have subjected them to various promoter-related obligations and adversely impacted their working and functioning as financial investors,” independent counsel Somasekhar Sundaresan said, arguing for Clearwater.

While the order passed by Sebi whole-time member G. Mahalingam did not consider all specifics of control, he made observations on protective rights. “The scope of the covenants (protective rights in shareholder agreements) in general is to enable the noticees to exercise certain checks and controls on the existing management for the purpose of protecting their interest as investors rather than formulating policies to run the target company,” said Mahalingam in the order. 

Tejesh Chitlangi, partner, IC Legal, said while the order did not completely tackle control as the shareholder agreement in the case is terminated, the remarks are equally relevant.

“It is relevant to note that Sebi has made a remark that rights providing certain checks and balances to an investor over management are not in nature of having policymaking rights with respect to target company but more in nature of investor protection mechanism,” said Chitlangi.

“This may provide certain positive cues for investors who may not want to be seen as exercising control over the target company merely by virtue of having some affirmative rights,” he added.

Hegde said investor protection rights are normally present in any investment pact to enable the investor ensure that the investments are not rendered infructuous.

“From the limited interpretation contained in the order, it is reasonable to assume that the bright line tests being proposed and considered by Sebi on the issue of “control” are on track,” said Hegde.

Sebi in March 2016 had issued a discussion paper proposing 'bright-line tests' to define control. Sebi had proposed a framework for protective rights with an exhaustive list of rights that do not lead to acquisition of control.

Sebi is yet to finalise the regulations, considering the varied feedback it has received on the said regulations. 

This issue around negative rights that first came up in the matter of Subhkam Ventures 17.9% stake in MSK Projects, where Sebi in 2008 held that protective rights lead to control. However, in appeal to the Securities Appellate Tribunal (SAT), SAT held that protective rights only lead to negative control and not positive control.

Sebi appealed the order in Supreme Court. The apex court dismissed the appeal and said SAT’s order would not be a precedent.

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