Hostile Takeovers Regulations

ABSTRACT

The recent M&A boon in india has comprised exclusively of friendly deals, and since its economic [1] liberalization in 1991, India has experienced only a handful of hostile takeover attempts. Among the prevalent modes of corporate acquisitions, hostile takeovers is quite common. Although earlier such takeover attempts were seen mainly for small firms, it is now employed for large corporations as well, involving multi-billion dollar deals. Due to the fact that hostile bidders making tender offers seek to by-pass the friendly route of negotiations with the target company’s managers in order to seek control, it has the potential of upsetting the normal functioning of the target corporation at any time. This poses a threat not only to the shareholders of the target, but also the management, and thus the need to regulate market control in the field of takeover is quite high.

Conventional wisdom suggests that hostile takeovers by foreign enterprises will not occur in India because of (i) the prevalence of controlling shareholders in most Indian corporations and the significant shareholding of Indian financial institutions that generally side with controllers, (ii) the necessity of obtaining onerous government approvals for foreign acquisitions that would make hostile takeovers impossible, and (iii) provisions in the Indian Takeover Code favoring existing controlling shareholders. Thus the project proposes to deal with the brief introduction in which the concept of takeovers has been discussed. Further, the background of takeover regulation and various issues related to takeover regulations have been discussed in the paper. The paper concludes by propounding a hope for new laws and amendment of the existing laws.

INTRODUCTION

Mergers and takeovers are prevalent in India right from the post independence period. But Government policies of balanced economic development and to curb the concentration of economic power through introduction of Industrial Development and Regulation Act-1951, MRTP Act, FERA Act etc. made hostile takeover almost impossible and only a very few M&A and Takeovers took place in India prior to 90s. But policy of decontrol and liberalization coupled with globalization of the economy after 1980s, especially after liberalization in 1991 had exposed the corporate sector to severe domestic and global competition. This had been further accentuated by the recessionary trends, resulted in falling demand, which in turn resulted in overcapacity in several sectors of the economy. Companies started to consolidate themselves in areas of their core competence and divest those businesses where they do not have any competitive advantage. It led to an era of corporate restructuring through Mergers and Acquisitions in India. Mergers and acquisitions (M&A) activity in India is booming. The beginning of 2007 saw the signing of the largest inbound deal in india’s history, vodafone’s $11.1 billion acquisition of hutchisson essar, india’s fourth largest mobile phone company [2] , while Tata steels $13.2 billion dollar acquisition of the European steelmaker, corus, which closed in January, 2007, headlined a frenzy of acquisitions of foreign companies by Indian corporate enterprises in the past year. Any takeover in India needs to comply with the provisions of SEBI (Substantial Acquisition of Shares and Takeover) Regulations, 1997 (“Takeover Code”). Hostile Takeovers is a type of method used for Corporate Restructuring. There are other methods like Mergers & Acquisitions, Leveraged Buyout, Spin offs, etc. through which Corporate restructuring may be done. In India, hostile takeover is a dreaded word, may be since it is a method used which is not democratic in nature and somewhat unpleasant for the management of a target company.

MEANING OF ACQUISITION/TAKEOVER

Acquisition refers to the process in which a person or firm acquires controlling interest in another firm. Acquisition can be friendly or hostile. A friendly acquisition is one in which management of the target company or controlling group sells its controlling shares to another group at its accord. Acquisition can take market route also. If management of the target company is unwilling to negotiate a contact with prospective acquirer, it can approach directly to the shareholders of the target company by making an open offer. This is known as Hostile takeover.

Takeovers are governed by ‘SEBI Regulation for Substantial Acquisition of Shares and Takeover’ (most popularly known as Takeover code).

HISTORY OF HOSTILE TAKEOVER ACTIVITY IN INDIA

Swaraj Paul- Escorts/ DCM In 1980s London-based NRI Swaraj Paul sought to control the management of two Indian companies, Escorts Limited and DCM (Delhi Cloth Mills) Limited by picking up their shares from the stock market. [3] Though Swaraj Paul failed to fulfill his dream of controlling Escorts and DCM, but was successful in highlighting how particular families were able to exercise managerial control over large corporate entities despite holding a minuscule proportion of the concerned company’s shares. Paul finally retracted his bid. While he was ultimately unsuccessful, Paul’s hostile threat sent shockwaves through the otherwise complacent Indian business world.

Raasi Cements-India Cements-Sri Vishnu Cement Ltd. India Cements Limited (“ICL”) in its hostile bid for Raasi Cements Limited (“RCL”) made an open offer for RCL shares at Rs. 300 per share at the time when the share price on the Stock Exchange, Mumbai (“BSE”) was around Rs. 100. [4] The tendency of the Indian FIs has till recently always been to protect the existing promoters in case of a hostile takeover bid. However, in this case they felt cheated as the promoters themselves sold out their stake to the acquirer leaving little room for them to tender their stake to the acquirer during the open offer. However, ICL also bought out the FIs in the open offer and thereby increased their holding in RCL to 85%. There was another interesting twist to this deal, which made matters more complicated. Raju transferred 39.5% stake of Shri Vishnu Cement Limited (“SVCL”), which was an subsidiary of RCL, to nine investment companies owned by Raju and his family barely days after the purchase by ICL of Raju’s shares in RCL. This was in violation of Regulation 23(1) (g) of the Takeover Code, which prohibits a target company from transferring its significant assets after a public announcement has been made by the acquirer to make an open offer for purchase of shares from the public. Since SVCL was the crown jewel of RCL, and in fact the primary reason for ICL’s interest in RCL, the matter was taken to SEBI, which held that the transfer was not valid. The matter was ultimately sorted out through a negotiated deal by which Raju’s associates sold their shares of SVCL to ICL.

Gesco Corporation In October 2000 Abhishek Dalmia, made an open offer to acquire 45% of the share capital in Gesco Corporation.at Rs. 23 per share at a total. This transaction entered in to a drama of hostile takeover until the promoters of Gesco corporation and the Dalmia group announced to have reached an amicable settlement in the battle for Gesco, with the former buying out Dalmias’ 10.5% stake at Rs 54 per share for a total consideration of Rs 16 crore. [5] The Gesco Corporation takeover drama showed that a bidder with admittedly poor financial resources could talk up a share only to exit later with a huge profit via a negotiated deal.

NEED FOR TAKEOVER CODE

In India activities of the companies from the point of view of M&A and takeover can be seen in term of three waves. First Wave: The first wave of takeover witnessed in India during 80s and in the beginning of 90s. It was altogether different from current scenario. There were hardly any regulation and making a tender offer was not compulsory. Takeover was considered as a willing buyer-seller negotiation. During this period some cases were where acquirer was a strong person and loser were generally small investors e.g. Tata’s acquisition of Special Steel and HLL’s acquisition of Stepan Chemicals. During this period Swaraj Paul, RP Goenka, Manu Chabbria, Ambanis and Murrugappa group were the pioneers.

Second Wave: Second wave in the Indian context however started after 1994. This was the era of Expansion, Consolidation and restructuring and a marked shift from friendly to hostile takeover was witnessed during this period. In fact liberalization of Indian economy, dismantling of MRTP and Licensing regime, relaxation under FERA, availability of foreign funds etc had led to a rise in the number of mergers and takeovers during this period.

Third Wave: The wave gaining momentum now is the third wave. It is significantly different from earlier two because role of Banks and FIS becomes important now.

Because of the complexity of the nature of takeover, to protect the interest of small investors as well as the target company a need was felt to develop a code to regulate the whole process of acquisition and takeovers based on the principle of transparency, fairness and equal opportunity to all. The impact of the SEBI’s initiative on the takeover code in the interest of investors seems to be visible. According to a presentation made by SEBI in 2001, introduction of takeover code has resulted in a benefit of Rs. 4250 crores to the shareholders of various companies.

REGULATORY OBSTACLES TO HOSTILE TAKEOVERS

The Indian Companies Act, 1956 (hereinafter the “India Act”) has been substantially adopted from the English Act. The India Act governs the incorporation, operation and winding up of companies in India. Although, the term ‘takeover’ has not been defined, it is covered under the broader definitions of reconstruction and amalgamation in the India Act. [6] The specific regulation dealing with takeovers in India was first enacted in 1994, and then amended in its current form – Securities & Exchange Board of India (Substantial Acquisition of Shares and Takeovers) (SEBI) Regulations, 1997 (the “Regulations”). [7] Other regulations interrelated with corporate activities include the Code of Civil Procedure, 1908, The Indian Trusts Act, 1882, SEBI (Prohibition of Insider Trading) Regulations, 1992 and The Partnership Act, 1932, among others. The Regulations have the statutory force of law, and are also armed with penalty provisions for the violation of the Regulations and the SEBI Act. [8]

THE TAKEOVER CODE AND OTHER REGULATIONS

The takeover code presents no direct barrier to a hostile acquisition. Indeed the concept of open offers and creeping acquisition limits creates a mechanism by which hostile takeovers can be accomplished, while balancing the need for shareholders to be paid a control premium. The new regulations made in 2002 are a finer version of the earlier Code and largely aim at benefiting the investing community. It aimed at increasing the ambit of open offer. However, from the first hand analysis of the present takeover code it seems to be much biased against hostile acquirers.

According to some practitioners, under Section 22(6) certain disclosure requirements imposed by the code as interpreted by SEBI may require the acquirer to disclose and vouch for non-public information about the target board and hence would preclude a hostile takeover. [9] Ostensibly intended as a check on fraudulent promotion of the acquiring firm and the benefits of takeover, the provision seems fairly pedestrian as securities regulations go.

Hostile acquirers must also deal with general challenges imposed by the takeover code that all acquirers face. Section 25, dealing with competitive bids, requires that the subsequent bidder at least match the total number of shares held by the first bidder and offered to the public. This provision favours promoters in most cases in India because of the prevalence of controlling shareholders and makes bidding expensive for competitors. The code also allows shareholders to withdraw shares already been tendered in an open offer and sell them either in the open market or to another acquirer at a higher price. This move will benefit investors in hostile takeover bids where the counter-parties keep raising their offer prices and also will provide a liberty to them if takeover process is taking undue long time. [10] Indirect acquisition gives shareholders of a company indirectly acquired by another promoter an exit route especially through GLOBAL-LEVEL arrangements, which have increasingly started to impact the structure of their Indian affiliates. Generally an acquirer takes up a stake in another company for either of the two reasons – consolidation of business or to unlock shareholder value. But the fear of indirect acquisition and a resultant open offer in a third company may discourage acquisition. Instead of compulsorily disclosure at 5% level, SEBI introduced three stages disclosure at 5, 10 and 14% level. Rationale behind this move is to aware the management about the prospective takeover threat in future. The move favours existing promoters as it makes a hostile takeover exercise difficult and expensive. This will hurt the vibrant development of capital market for corporate control, because management can use this information in unfair way to corner the shares through the creeping limit prior to such threat. The Takeover Code, vide Regulation 23, also imposes a prohibition on the certain actions of a target company during the offer period, such as transferring of assets or entering into material contracts and even prohibits the issue of any authorized but unissued securities during the offer period. However, these actions may be taken with approval from the general body of shareholders.

The Takeover Code is required to be read with the SEBI (Disclosure & Investor Protection) Guidelines 2000 (“DIP Guidelines”), which are the nodal regulations for the methods and terms of issue of shares/warrants by a listed Indian company. They impose several restrictions on the preferential allotment of shares and/or the issuance of share warrants by a listed company. [11] Under the DIP guidelines, issuing shares at a discount and warrants which convert to shares at a discount is not possible as the minimum issue price is determined with reference to the market price of the shares on the date of issue or upon the date of exercise of the option against the warrants. This creates an impediment in the effectiveness of the shareholders’ rights plan which involves the preferential issue of shares at a discount to existing shareholders.

The DIP guidelines also provide that the right to buy warrants needs to be exercised within a period of eighteen months, after which they would automatically lapse. Thus, the target company would then have to revert to the shareholders after the period of eighteen months to renew the shareholders’ rights plan. [12]

Without the ability to allow its shareholders to purchase discounted shares/ options against warrants, an Indian company would not be able to dilute the stake of the hostile acquirer, thereby rendering the shareholders’ rights plan futile as a takeover deterrent.

Also, the FDI policy and the FEMA Regulations have provisions which restrict non-residents from acquiring listed shares of a company directly from the open market in any sector, including sectors falling under automatic route. There also exist certain restrictions with respect to private acquisition of shares by non-residents, under automatic route, is permitted only if Press Note 1 of 2005 read with Press Note 18 of 1998 is not applicable to the non-resident acquirer. [13] This has practically sealed any hostile takeover of any Indian company by any non-resident.

TAKEOVER DEFENCE STRATEGIES

The need for growth and expansion always leaves scope for takeover attempts, and this necessitates managers to remain alert for threats of a hostile takeover. Companies therefore employ several safeguards to counter this threat. No defensive measure can be said to be full proof, and some may be disadvantageous as well, depending on the particular situation of a corporation; however every tactic affords some negotiation leverage and time to formulate strategies for safeguard. [14] Takeover defensive strategies may be adopted both at a pre-bid stage, or a post-bid stage. Described below are some of the commonly employed tactics to counter hostile takeover bids. [15]

‘Poison Pills’ – Also referred to as a shareholder rights plan, poison pills are triggered when a hostile bidder acquires a certain percentage of the target’s voting stock, upon which the target shareholder becomes entitled to new shares of the target at a heavy discount, making the target company’s shares expensive and the deal becomes unattractive for the bidder. This does not require a shareholder vote to promulgate, since the board has the absolute discretion of issuing shares as dividends. [16] However, one of the disadvantages of poison pills is that it helps in entrenching the board by giving an opportunity to raise the offer price, thereby discouraging a genuine takeover bid, which could be beneficial for the shareholders. However, there are impediments on this poison pill in India imposed by the DIP guidelines and not the takeover code. Instead takeover code under section 23 prohibits the issue or allotment of authorized but unissued securities during the voting period without shareholder approval, it makes an explicit exception for the right of a target company to issue or allot shares upon exercise of warrants as per pre-determined terms of conversion. However, for the poison pill strategy to work best in the Indian corporate scenario certain amendments and changes to the prevalent legal and regulatory framework are required. Importantly, a mechanism must be permitted under the Takeover Code and the DIP Guidelines which permit the issue of shares/warrants at a discount to the prevailing market price. These amendments would need to balance the interests of the shareholders while allowing the target companies to fend off hostile acquirers.

‘Shark Repellents’ – A specific type of defence strategy which can be adopted simply by amending the corporate charter or by-laws. [17] These are put in place largely to reinforce the ability of a firm’s board of directors to remain in control. [18] Mechanisms such as Staggered or Classified Board structure may be adopted whereby only a specified number of directors are re-elected to the board while others have a fixed tenure, thereby forcing a hostile bidder to wait for the entire circle until he gets full control of the board. In India, section 256 of companies act actually requires companies to maintain staggered boards by default i.e only one-third of a company’s directors are re-elected per year. The disadvantages of shark repellents are that although they afford a strong protection, but they can be circumvented by altering the size of the board, or acquiring a super-majority shareholding in the company. Besides, it also provides enormous opportunity to provide safety-net for the management so that it is more comfortable if the bid fails, or even if it succeeds, he is let-off with a huge compensation.

‘Dual-class stock’ – Also known as ‘super-voting’ or ‘dispute-class’ stock, these shares are issued to existing shareholders as dividend or as a part of an exchange offer. [19] These stocks have disproportionately high voting rights, but low liquidity or dividend rights.

Sale of Assets – The target company may sell off the entire company or some of its ‘crown jewel’ assets which may be of particular interest to the acquirer, thus making the target less attractive to the acquirer. [20]

Friendly Hands – Where a hostile takeover seems imminent, the target may seek out other investor(s) which are perceived to be friendly to the target, and sell the company or substantial stocks of the company to the friendly investor. Such friendly investor is called a ‘white knight’. [21]

De Pamphilis argues that tactics such as poison pills, staggered board, sale of assets, Golden Parachutes support the ‘management entrenchment hypothesis’ whereas tactics such as improvement of profitability, share repurchase, auction to highest bidder and litigation, etc. Are more favourable to ‘shareholders interest hypothesis’. [22] A combination of poison pills and staggered board structure is considered to be the most powerful combination of defence tactics, because it provides enormous discretion to the management to manoeuvre a tender offer. [23]

LACUNAS IN EXISTING TAKEOVER CODE AND REGULATIONS

In my opinion SEBI takeover code is not full proof. It still has some lacunas and some sort of vagueness. It is improving gradually and learning from experiences. The 1994 document was just a two-three-page guideline and prepared hurriedly. 1994 code was a comprehensive and dynamic one. Although there were some loopholes in that code also, which corporates used for their benefits. But SEBI has done a great job to put a definite process in progress. To make our code a full proof one a proper co-operation from all the concerned parties like regulators, Corporates, Bidders, Target Company’s management, FIs etc. is required.

In India takeovers, especially hostile ones are still taken in negative sense. One should not forget the important role played by takeover. It helps to unlock the hidden value of the shares, also put pressure on the management to work efficiently and thus contribute in Corporate Governance.

Regulators are expected to protect the interest and right of the shareholders, curb malpractices and ensure a free, fair, transparent and equitable place for takeover. A study showed that in India 84% takeovers are taking place through the route of exemption. This is not only anti-investors but also against the very purpose of the takeover code. There are still some areas where code is not clear. One such debatable issue is what is meant for change in management control, especially when such changes are the result of some arrangements at global level. Provisions related to indirect acquisition are also not very clear.

In the code undue advantages are given to the promoter at the cost of small investors, so in due course SEBI should try to bring promoters also on the same level.

Provisions related to acquisition of shares by Govt. Company are also need a change. According to present code a govt. company can purchase shares of another govt. company from govt. without making open offer, but open offer will be necessarily in case of a private company. This does not provide a level playing field to private companies. It provides Govt. an easy exit route but not to small investors. In this process FIs also have an important role to play. They should have a long-term perspective, rather than short-term profit-booking motive, while deciding upon an open offer. Acquirers should ensure full information to the public & Make pricing decisions properly.

A NEW WINDOW FOR TAKEOVERS

In 1990, as the gigantic private equity fund KKR (Kohlberg Kravis Roberts & Co) stormed and procured the American biscuit company RJR Nabisco Corp in a $25 billion weighted buyaout (LBO), the scuffle between RJR and KKR was acknowledged in an suitably titled book ‘Barbarians At The Gate’ in print by financial journalist Bryan Burrough. Now in India we may soon come across cases where many corporate chiefs will beef about ‘Barbarians’ at their gates since India’s merger and acquisition (M&A) rules are set for a complete alteration from April 2011. [24]

The rules will become straightforward, more crystal clear and free from many barricades that now come in the way of M&A. [25] To overhaul the 15-year old takeover rules, last week SEBI appointed committee, Takeover Regulations Advisory Committee, headed by C Achuthan, proposed sweeping modifications in many considerable issues like open offer trigger, offer size, pricing norms, non-compete fees, etc. Changes proposed by the Achuthan committee are now open for public mooting and, if approved, will become the new Takeover Code from the next financial year.

THE REAL THREAT

In a major change, the Achuthan committee advised that the spark point for a mandatory open offer should be raised to 25 per cent of the equity capital. Earlier, an acquirer needed to make the open offer to buy shares the moment his stake reached 15 per cent. It also recommended that the mandatory open offer should be for the total 100 per cent of the equity capital as oppose 20 per cent under the present norm. [26] The twin changes, if included in the takeover code, will make it easier for a predator to plunge down on an Indian company in which a advertiser has less than 50 per cent stake. The 100 per cent obligatory open offer may now assist an acquirer to congregate more than 50 per cent share in a company and capture the management. If the acquirer’s stake goes up to 90 per cent, he can even get the company de-listed from the stock market. [27]

Some of the major companies ripe for aggressive takeover are Moser Baer — promoter holding is 16.29 per cent and the largest shareholder Warburg Pincus is holding 13.10 per cent; Apollo Hospitals — promoter 33.54 per cent and investor Apax partners 13.80 per cent; India Cements — promoter 25.18 per cent, investors LIC 13.44 per cent and HSBC 12.10 per cent; Polaris software — promoter 29.08 per cent and investor 26.98 per cent; Indiabulls Securities — promoter 29.88 per cent and investor HSBC Global 14.84 per cent. In all these cases if the investors with hefty assets decide to be hostile and craft a bid for 100 per cent of the company, it can be a grave threat to the active promoters.

CONCLUSION

In this paper we have clearly analysed the existing regulatory opportunities regarding hostile takeovers in India as provided under the takeover code. Hostile takeovers have not been prohibited anywhere in the code nor has it been discouraged. The whole intention of the Indian law makers has been to prevent the interests of shareholders and investors during such act. However, while doing this the policy makers adopted a very protective policy which in turn made hostile takeovers look like a dreaded ghost. This over protectionist was not favoured by major economy players in the world owing to the recent trends of globalization and opening up of domestic markets for international players. Thus to cater to the needs of changing society the policy makers have come up with a new Takeover Code which would be implemented by 2011 in all probabilities. Thus on a concluding note this paper tries to evaluate and analyse these new prospects and challenges posed by regulatory mechanism of takeovers in India. Thus there are many considerations with regard to promoter’s interests, investor’s protection and other interested parties including parties who want to acquire a company only for making huge profits and do not have any interest in the organisation as such. Thus the effects of the new takeover code on these aspects have been enumerated as follows:

Promoters’ protection

To guard themselves from a predator, frail promoters will have to toil harder in the future. First of all, many will switch on buying shares of their own companies to take the holding up to at least 51 per cent. Under the creeping attainment norm, if their attainment crosses 5 per cent of the equity in a year it will prompt an obligatory open offer. A promoter can also make a intentional open offer to check a hostile bid, but in such a case, one can procure only 75 per cent of the equity and not 100 per cent. The possibilities of bids and counter bids will undoubtedly make acquisitions more cut-throat and pricey after the new code comes into effect. [28] However, some experts say that pricey M&As will get only serious players into the space. [29] We may also observe many leveraged buyouts (LBOs) in near future as banks and investors will be keen to fund hostile takeovers. In the LBO game the possibility of takeover bids is higher from the foreign acquirers because they have well-built financial muscle and access to the several modes of funding options.

Good for investors

The proposed amendments in the Takeover Code, however, will be benefecial for large institutional investors and for private equity (PE) funds because they