PIPE transactions

This article has been written by Raunak Sood, pursuing the Diploma in Advanced Contract Drafting, Negotiation, and Dispute Resolution from LawSikho. This article has been edited by Prashant Baviskar (Associate, Lawsikho) and Smriti Katiyar (Associate, Lawsikho).

Introduction

When dealing in the securities market it is important to know and understand some basic concepts:

  1. Whether the security the investor is going to purchase, is that security a marketable security?
  2. Who is in control of the company that has floated its shares in the market?
  3. What is the corporate governance structure and whether any differential voting rights are present with the existing shareholders of the company?
  4. Is the company professionally managed? If yes, then what are the benefits for the investor?
  5. Who is a wilful defaulter?

With these questions being answered any investor can go and invest in the securities market. A basic answer to the above-mentioned questions will help any novice investor to understand and make a wise decision before buying any security in a careless manner. 

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6. Marketable security

Whether security is marketable or not has been discussed in various judgments which are summarised as follows:

Norman J. Hamilton v. Umedbhai S. Patel, LNIND 

The plaintiffs entered into a contract of purchase of redeemable preference shares with the defendants for the procurement of ordinary shares and redeemable cumulative preference shares of A. Macrae Company (private company), wherein the total sum of money paid for the contract was Rs. 2,77,500 and Rs. 10000 was paid by the defendants as the down payment and the rest of Rs. 26,750 was to be paid in ten annual installments. However, there was a default by the defendants during the fourth and fifth payment, hence the present matter reached the court. 

  1. Whether the contract for the purchase of shares is void ? (b)Whether the Securities Contract ( Regulation) Act, 1956 applies to the present matter and the contract?

The plaintiffs argued that the contract was for the sale of shares and transfer of the controlling power within the company, the defendants contended that the contract for the purchase of redeemable preference shares was illegal as per the law laid down in the Securities Contract Regulation Act, 1956, henceforth the court had to look into the aspect of the said Act to apply to the contract between the parties. 

Under Section 2(1) of the Securities Contracts (Regulation) Act, 1956 (hereinafter referred to as “SA”) only spot delivery contracts ( the contract provides for the actual delivery of security on the same day the parties entered into the contract or the next day) are allowed, but in the present case, the contract provides for the contract money to be paid in installments, hence it is not a spot delivery contract. According to the court, the shares of a private company are not marketable securities under Section 2(h) of SA because marketable securities are those securities that are of high liquidity and applying the noscitur a sociis rule of interpretation and reading the statute of SA as a whole the court noted that securities of a private company are not “securities” mentioned in Section 2(h) of SA as in the present case the redeemable preference shares are not governed by the SA as the legislative intent behind the SA was to prohibit the speculation of the share price on stock exchanges and no proposal was seen from the side of Gorwalla Committee to regulate the private companies securities whereas the securities which are traded on the Stock Exchange enjoy high liquidity whereas shares of the private company enjoy less liquidity as they cannot be freely bought and sold on the stock exchange, hence SA can only apply to shares of a public company. 

In lieu of the aforesaid discussion, it is hereby concluded that the contract between the plaintiff and defendant is binding and legal whereas SA will not apply to the present matter.

Mysore Fruit Products Ltd. and Others v. Custodian and Others, LNIND

The petitioner company received Rs. Four crore ten thousand,  from another company for buying the FSSL shares worth Rs. 500 each, but it was contracted between the parties that an outstanding amount of Rs ninety-nine lakhs ninety thousand would be paid by the respondent along with the return of one lakh fifty thousand shares to the petitioner. The whole transaction was to come into effect on a future date of 30th Sept 1993, but the respondent did not pay the contractual amount of Rs. 99,90,000.

  1. Is the transaction illegal? (b)Whether the transaction falls under the scope of Securities Contract (Regulation) Act, 1956 for an unlisted public company (hereinafter referred to as “SRA”)?

The petitioners argued that the shares of the company were transferable shares and the allegation of the respondent regarding the diversion of money cannot be made a separate ground whereas no fraud was committed on the petitioner’s behalf, it was also contended by the petitioner that forward sale of shares is not prohibited under SRA for a company which is unlisted in the stock exchange. The respondents argued that the contract was about a forward sale which is not allowed under the provisions of the SRA because the shares bought by the petitioner were not listed on the stock exchange.

Under Section 2(h) of the SRA, there is a word of “other marketable securities”, thus it means that the securities should be “marketable” i.e., marketability means buying and selling of shares, hence those securities which can be bought and sold are covered under the provisions of SRA. The sale of shares of a public unlisted company means that even though the public company is not on the stock exchange but still its shares can be converted into some degree of liquidity, hence shares of a public unlisted company are “marketable” in nature. It is also pertinent to note that the SRA promotes spot-on delivery of shares and not the forward sale. 

Therefore in lieu of the aforesaid discussion, it is hereby concluded that shares of public unlisted companies come under the scope of SRA and the transaction between the parties is completely illegal. 

Bhagwati Developers Private Limited v. Peerless General Finance And Investment Company And Another, LNIND 

Bhagwati Developers (hereinafter referred to as “BD”), whereas BD lent some amount of money to the respondent for buying equity shares later on a bonus issue was generated on the purchased shares, but respondent 2. did not give the shares to Bhagwati, a suit was filed in the civil court at Allahabad which was later on compromised and the decree was drawn by the court. Respondent 1( peerless), who was the company that issued the shares, did not allow access to those shares to BD because the shares were registered in the name of respondent 2. BD was aggrieved and hence the present matter. 

  1. Whether the contract between BD and respondent 2 is valid? And what is the nature and definition of “security”. (b) Whether the SCR will apply to shares of unlisted public companies?

BD argued in the court that the shares of peerless are not marketable hence Section 2(h)(i) of SCR (“Security Contract (Regulation) Act, 1956) is not applicable and respondents argued that the share to be marketable does not mean that the said share has to be sold off in the market. 

According to the court, the only requirement to be a share under SCR is the free transferability of shares, hence shares of public companies not listed on the stock exchange are securities for the purpose of SCR and SCR does not apply to the shares of private companies. In lieu of the aforesaid discussion, it concluded that the contract between the parties is not a valid contract and SCR applies to the shares of unlisted public companies. 

Control of a company

For the purpose of this part let’s suppose that there is an equity shareholder with the hereunder mentioned number of shares and the voting right exercised by him is proportional to the number of shares owned by him. The control (defined in Section 2(27) of the Companies Act, 2013) of the said equity shareholder over the company is as follows: 

  1. The shareholder has 10% equity shareholding – Such a shareholder is called a minority shareholder because they have very little control over the company whereas they can take part in the said appointment of director to the board from the side of minority shareholders wherein even listed companies have to comply with this provision (Section 151, Companies Act, 2013 hereinafter referred to as “CA, 2013”). 
  2. The shareholder has 20% equity shareholding – Such a shareholder acts like an associate company (refer to Section 2(6) of CA, 2013) wherein such company has significant influence on the decision making and they get a chance to appoint a director along with other minority shareholders.
  3. The shareholder has more than 25% equity shareholding – This kind of shareholder exercises a negative control over the company because he has to agree with other shareholders for the passing of a special resolution and is called a significant beneficial owner of the company. The term of “Significant beneficial owner” (see Section 90 of CA, 2013) is having separate rules in Companies (Significant Beneficial Owners) Rules, 2018 they have the right to receive entitlement from their own shares.
  4. The shareholder has more than 50% of equity shareholding – Such a shareholder is highly influential and can take almost all decisions of the company, he is called as having the controlling interest in a company. He can appoint majority of board of directors and can veto the decisions of the board of directors as it can be seeming under SEBI ( Substantial Acquisition of Shares and Takeovers) Regulations, 2011 that majority shareholder can even control shareholder agreements and voting agreements by passing of an ordinary resolution (Section 114(1) of CA, 2013). 
  5. The shareholder has more than 75% of equity shareholding – Such a shareholder can unanimously amend the Memorandum of Association and Articles of Association of the Company by a special resolution ( See S. 114 of the CA, 2013) without even consulting the other shareholders along with that he will be able to influence lot of decisions in  the company. 
  6. The shareholder has 90% of equity shareholding – Such a shareholder has the power to pass ordinary resolution and special resolution but under Section 236 of the Companies Act such a shareholder has to give a chance to the minority shareholders to leave the company and if this is read with section 27 of the Companies (Compromise, Arrangement and Amalgamation) Rules, 2016 then the minority shareholders can sell of their shares to this 90% holder at a reasonable price.
  7. The shareholder has 100% of the equity shareholding – Such a person has complete ownership of the company in other words it is a one-person company as defined in Section 2(62) of the Companies Act 2013.

Corporate governance and differential voting rights

Differential Voting Rights ( hereinafter referred to as “DVR”) wherein a person in the company has less share of the company, he has more voting rights and control, herein control is not equivalent to holding in share. Instruments with DVR assist companies to raise capital from the public without the weakening of control in the company so that any hostile party may not take over because the shares issued will have a fractional number of voting rights. 

At present (a) equity listed company, (b) unlisted company with an intention of listing, (c) unlisted company without an intention of listing( Section 43 of Companies Act 2013 r/w Rule 4 of Companies (share capital and debenture) Rules, 2014), and (d) private companies not coming under Section 43 of Companies Act 2013.

Perspective of corporate governance

Generally, in a company share is assigned one vote, it is one of the practices followed even on an international level because the main reason is that the Board of directors tends to work in the best interests of all the present shareholders. A company where the one share-one vote ( hereinafter referred to as “the policy”), the policy is not followed herein an event might happen where the board of directors is focused on the interests of those shareholders who despite having fewer shares in the company are having higher quantum of voting rights, this is a scenario where it becomes unfair towards the majority shareholders who have shares worth more compared to that of the minority shareholders, therefore there can be a divide between the cash flow rights ( the majority shareholders with less voting rights ) and voting rights ( minority shareholders with higher voting rights). 

Another reason from the corporate governance point of view is that the policy makes a fair playing field whenever there are events of taking over of the management of a company and it is the most effective solution from a social point of view and improves distribution of control to minority shareholders who can feel empowered to raise their concerns in the company.

Why are differential voting rights desirable ?

Since India is growing and the general trend is that the equity method of raising capital is better compared to raising capital by way of debt, hence DVR is the preferred method of raising capital because it does not dilute the control of an existing shareholder who might be the promoter of the company. This is beneficial to investors as the trust in the founders of the company has made the said company successful and there is no near chance of a takeover of the company and generally speaking, DVR shares have a higher amount of dividend associated with them compared to an ordinary equity share. 

Balancing rationale between corporate governance and differential voting rights

There is no doubt that DVR is theoretically against the principle of healthy corporate governance because it violates the one share-one vote rule but in a practical sense, DVR is necessary for the growing economy of India because founders and promoters of a company fear the loss of control may not ask assistance from the public for the purpose of raising capital whereas such companies might excessively resort to debt instruments in which they will have to pay the principal amount plus the interest on that principal amount, hence this is not a very good option for raising capital for financing the operations of a company. Therefore, for the growth and securing the future of the company DVR is a necessary evil that needs to stay even if principles of corporate governance are being violated. 

Professionally managed companies and investors

A company running without a promoter

A professionally managed company is a company wherein no promoter is capable of being identified because no such person exerts “control” (as defined under Section 2(27) of the Companies Act, 2013 read with Regulation 2(1)(e) of the Securities Exchange Board of India (Substantial Acquisition of Shares and takeover) Regulations, 2011 by virtue of their shareholding or participation in the management or SHA (special controlling rights) or rights granted under an executed agreement. 

In a professionally managed company, firstly, the Board of Directors (“BOD”) enjoys independent decision-making powers, secondly, the daily management functions are carried out by professionals, lastly, no shareholder/director or otherwise shall have the authority to make appointments to the important managerial designations in the company. Therefore, in such a company the AOA, BOD, and shareholders are the ones to define the guiding factors of such a company (professionally run company). 

Minimum promoters’ contribution and how this requirement is fulfilled

The requirement of 20% holding of the post-issue capital has been waived off vide Proviso of Regulation 14 sub-clause 1, wherein in the case of a professionally managed company (no identifiable promoter) there is no need for minimum promoter contribution. As per Regulation 31A sub-clause 3(c)(i) read with Regulation 38 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 points out that there has to be a minimum public shareholding as described in  Rule 19(2) and Rule 19A of the Securities Contract (Regulation) Rules, 1957 described hereunder :


Equity shares or debenture convertible into equity shares issued by the company. 		Minimum offer and allotment to the public. Quantum of post issue capital at an offer price
At least 25 percent Less than equal to Rs. 1600 Cr.
Percentage of each equity or convertible debenture equal to Rs. 400 Cr. More than Rs. 1600 Cr. less than Rs. 4000 Cr. 
At least 10%Above Rs. 4000 Cr. 

Therefore, in the case of a professionally managed company, there has to be minimum public shareholding which is to fulfil the requirement in post-issue capital, herein there exists no promoter holding more than 10% of the voting rights in the listed company. 

Regulatory rationale and investor protection with regards to a professionally managed company

It is a known principle of corporate governance that ownership and management should be separate, and shareholders should not interfere in the management of a company. This is the main rationale surrounding a professionally managed company wherein there is no promoter having control over the affairs of the company thereon the ownership and management is acting on an independent basis, hence as far as investor protection is concerned wherefore SEBI under Regulation 31A is protecting the investors herein it can be seen in sub-clause (3) that when a promoter is being reclassified as “public” then he or she shall disclose the rationale behind being reclassified as “public”,  under sub-clause 3(b) the mandatory conditions to be followed for being reclassified and sub-clause (8) and sub-clause (9) relating to disclosures of material events and need of a BOD resolution approved under S.31 of the Insolvency Code, thereby show that SEBI is not compromising on the aspects of investor protection as SEBI is acting as a check against abuse of power by any promoter to cheat or defraud an innocent investor. 

Wilful defaulters

The Reserve Bank of India (hereinafter referred to as “RBOI”) is responsible for the regulation of this issue of wilful default ( hereinafter referred to as “WD”) by issuing a master circular (“MC”) the RBOI makes the law on this topic. In chapter 12 under the heading of “Disclosures pertaining to WD” under the SEBI ( Listing of Obligations and Disclosure Requirements), 2015, lists the disclosures to be made for enlisting the said redeemable preference shares read with Regulation 102 of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 that an issuer company gets disqualified from making a  further public offer on the ground that the promoters or directors are declared WD by the RBOI. 

What is meant by a wilful defaulter ?

The RBOI issued an MC dated 1.07.2015 (“MCD”) wherein a combined reading of clause 2.1.3 read with clause 2.3 of the MCD states that a wilful defaulter (“Defaulter”) is a person who has not paid back to the bank the loan amount (“Loan Money”) taken by him even though he has the money to discharge the loan money, or has not used the loan money for the said objective for which he was given the money by the bank, or has neither used the loan money for the specific objective for which the loan was obtained nor the loan money is currently present with the WD in the arrangement of assets. 

Note that INR 25 lakh is the limit of loan money herein the said promoter/director shall be held to be a WD as per the bar set by the Central Vigilance Commission (“CVC”). 

How to identify the defaulter and which procedure is followed  ? 

Clause 3 read with clause 2.5 read with clause 4 ( including all the sub-clauses ) of the MCD we get that an administrative committee of higher functionaries (“Committee”) takes a sound reasoned judgment with conclusive evidence wherein the defaulter is given 15 days’ time period of challenge the Committee decision.

Process : Evidence of WD has to be examined by this Committee herein a show cause notice is issued to the defaulter and a reasonable opportunity for tendering an explanation to the allegations of WD via the mode of written submission in a personal hearing and after this, an Order recording WD with proper reasoning is passed by the Committee. 

Review: Any order passed by this Committee is reviewed by another committee headed by the Chairman and other directors of the lender bank (this was the bank affected by WD) called as Review Committee and the order becomes final after it has been confirmed by the Review Committee but it is pertinent to note that the Review Committee has given the opportunity to be heard to the defaulter. 

Supreme Court judgments

SBI (State Bank of India) v. Jah Developers Pvt Ltd, in the Supreme Court it was held that the Committee constituted is not holding judicial power hence lawyer cannot appear before the said Committee wherein the court held that since cruel punishment is meted to a Defaulter under MCD hence MDC should be interpreted in a reasonable manner. 

Mahindra Bank v. Hindustan national Glass & Industries,  – It was held that WD under clause 2.1 also includes borrower units that have not paid back the loan money as per the said contractual payment obligation of guarantee or derivatives. 

Conclusion

When dealing in the securities market it is important that the security should be marketable, a professionally managed company should be preferred while investing, and do a background check to make sure that there is no person on the Board of Directors who is a wilful defaulter. 

References

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