This article has been written by Rolin Fernandes pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho.

This  article has been edited and published by Shashwat Kaushik.

Introduction

The concept of companies was first introduced in the 17th Century and founded the backbone of the nation’s economy. Companies have also lent a hand towards innovation. It was evident that the larger companies were always the ones that dominated the markets and influenced the buying capacity of the general public. Thus, through mergers, smaller companies would join the ideation process, utilising the resources and influence of the larger company to sustain and pursue their vision. Mergers would also help other companies enter the realm of the industry. 

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Meaning of merger

A merger is a financial deal between two companies where they come together to form a new company. The primary purpose of a merger is for companies to increase their size in terms of market share or for companies to penetrate a new market.  The companies that are participating in a merger are approximately the same size when it comes to the number of employees, consumers and operational costs. 

Merger of equals

The principle is based on the concept that companies that merge are almost identical in size. The sole purpose of this combination of companies is to increase their market share, reduce competition and create synergy. More often than not, these kinds of mergers also fuel expansion into new markets. Citibank and Travellers are classic examples of the merger of equals. 

Meaning of reverse merger

There are various ways, other than an initial public offering,  through which a company can go public. A reverse merger is an alternative to an IPO through which privately held stocks are made publicly available. Moreover, the process of making the stock of a company public through an IPO is more time-consuming and can take up to a year before the actual listing on the stock exchange. Whereas, the process of reverse mergers is less time-consuming and a swifter process of going public. 

Process of reverse merger

The first step towards a reverse merger is for a private company to purchase 51% of shares in a publicly listed company. These public companies act as shell companies for the private company. The shares of the private company are then swapped for the publicly held shares of the public company. There is no capital raised during this process, but the time taken is less than a traditional IPO to get listed on the stock exchange. 

Examples of reverse merger

  • Idea Cellular and Spice Communications (2008): This was one of the most notable reverse mergers in India. Idea Cellular, a leading telecom operator, acquired Spice Communications, a smaller telecom player, in a $2.5 billion deal. The merger resulted in the creation of Idea Cellular Limited, which became the third-largest telecom operator in India at that time.
  • Bharti Airtel and Zain Telecom (2010): Bharti Airtel, India’s largest telecom operator, acquired Zain Telecom’s Indian operations in a $10.7 billion deal. The merger helped Bharti Airtel consolidate its position as the leading telecom player in India.
  • Aditya Birla Group and Idea Cellular (2018): The Aditya Birla Group, a leading conglomerate in India, acquired Idea Cellular in a $11.3 billion deal. The merger created India’s largest telecom operator, with over 400 million subscribers.
  • Tata Motors and Jaguar Land Rover (2008): Tata Motors, a leading automobile manufacturer in India, acquired Jaguar Land Rover, a British luxury car manufacturer, from Ford Motor Company for $2.3 billion. The merger helped Tata Motors enter the global luxury car market and become a leading player in the automotive industry.
  • Vedanta Resources and Cairn India (2011): Vedanta Resources, a leading mining company, acquired Cairn India, an Indian oil and gas company, in a $9.6 billion deal. The merger helped Vedanta Resources expand its presence in the oil and gas sector and become a leading player in the natural resources industry.
  • Reliance Industries and Infotel Broadband (2013): Reliance Industries, a leading conglomerate in India, acquired Infotel Broadband, a telecom infrastructure provider, in a $1.3 billion deal. The merger helped Reliance Industries enter the telecom sector and become a leading player in the Indian telecom industry.
  • Bharti Airtel and Telenor India (2017): Bharti Airtel, India’s largest telecom operator, acquired Telenor India, a smaller telecom player, in a $400 million deal. The merger helped Bharti Airtel strengthen its position in the Indian telecom industry.
  • In 1994, Godrej Soaps which is in the manufacturing business of soaps, did a reverse merger with their loss-making subsidiary, Gujarat Godrej Innovative Chemical and named it Godrej Soaps Ltd. 

These are just a few examples of reverse mergers that have occurred in India. Reverse mergers can be a strategic tool for companies to expand their operations, enter new markets, or consolidate their market position.

Regulatory challenges of reverse mergers

Income Tax Act

Section 72A of the Income Tax Act permits the merger of a sick company with a financially resourceful company by inculcating tax incentives for such a merger. It is important to determine the losses of the company purely from the business proceeds and not from the capital gains or assets held by the sick company. 

Companies Act

The Companies Act does not restrict mergers in any manner but it does enforce some regulatory restrictions that need to be followed by the companies when indulging in a reverse merger or a backdoor IPO. Section 232 of the Companies Act, 2013 prevents a private company from gaining the benefit of a public company through the process of a backdoor IPO. These companies do not automatically gain such benefits. They need to get approval from the court and the securities board. 

SEBI

The notification dated 4th February 2013 clearly stated that all companies undergoing mergers would be required to get mandatory approvals from SEBI. Thus, it is safe to say that the concept of reverse mergers is not prohibited but strictly regulated by the Companies Act and SEBI, respectively. 

Bihari Mills Case

The Gujarat High Court laid down the tests and parameters for considering a reverse merger:

  1. If the assets of the holding company exceed the assets of the subsidiary company.
  2. If the net profit of the holding company exceeds the net profit of the subsidiary company.
  3. If the consideration offered by the subsidiary company exceeds the value of the net asset of the holding company.
  4. If the equity share capital to be issued by the subsidiary company as consideration for the acquisition exceeds the amount of the equity capital of the subsidiary company in issue before the acquisition.
  5. If the issue of shares in a subsidiary company would result in a change in control of the subsidiary company through the introduction of a minority holder.

India bulls Financial Services Pvt Ltd with India bulls Housing Finance Ltd.

The company sets its business around mortgages and the promoters of Indiabulls Financial Service invested Rs 451 crore of capital in the company in the form of warrants convertible into equity of Rs 218 each. India Bull Finance Service Ltd. allotted one share of Indiabulls Housing Finance for every share of the parent company currently held by its shareholders, subject to regulatory requirements.

Investor protection in reverse merger

The companies go public and release their shares to the general public to raise capital that is sourced from people’s income. People usually invest a percentage of their hard-earned income. People must be made aware of the usage of their income. In the case of a reverse merger, investor protection is low due to the lack of statutory provisions regulating the process. 

Shell companies

The primary concern when it comes to investor protection is the lack of transparency in the financials and business of shell companies due to their minimal operating history. This lack of adequate information makes it a challenge for investors to evaluate the prospects of these shell companies. There is a lack of informed risks and higher potential losses. 

Inadequate information

During a reverse merger, the level of due diligence that takes place is not adequate and the level of scrutiny is not the same as that of a traditional initial public offering. This can leave investors open and uninformed about the risks that could be incurred.

Insider trading

Reverse mergers involving shell companies lack the level of scrutiny and regulatory provisions that encourage insider trading due to the lack of knowledge and information that is available to the general public. This also encourages insider trading to some extent because of the lack of statutory regulations. The nature of a transaction can create a wide array of opportunities for irregularities that could be used for insider trading. The members of the company could have information that is not disclosed to the general public and is vital to deciding the future of the company. This kind of information could be used for insider trading. 

Uncertainty and market manipulation

The entire process of uncertainty and lack of clarity in the merger leaves discrepancies in the future performance of the merged combination of the companies. This leaves investors in the dark when it comes to the future performance of the combined entity. This uncertainty can be used to manipulate the market, causing an inflation in the stock prices of these shell companies, creating a false sense of valuation for these stocks before the merger and selling their shares at high prices, causing significant losses to other investors. 

Lack of regulatory compliances

Reverse mergers, which involve companies from different jurisdictions, tend to raise regulatory compliance and governance concerns. These differences tend to create difficulty in complying and maintaining transparency and accountability. Weak compliances and regulatory systems lead to weak and irregular financials.

Cases relating to investor protection arising out of reverse mergers

Satyam Computer Services – Maytas Properties Reverse Merger

In 2008, Satyam Computer Services, a leading Indian IT company, attempted to execute a reverse merger with Maytas Properties and Maytas Infrastructure, two real estate companies founded by the family members of Satyam’s founder. The proposed merger drew intense criticism from investors and the corporate community due to concerns over corporate governance and transparency.

Regulatory challenges and investor protection issues

Lack of arm’s length transaction

The proposed reverse merger was viewed as an attempt by Satyam’s management to transfer company funds to the family-owned entities without adequate justification, potentially harming minority shareholders’ interests.

Inadequate disclosures

The merger proposal had inadequate information about Maytas Properties and Infrastructure, causing discrepancies about the valuation and financial health of the target companies.

Market manipulation suspicions

Investors suspected insider trading and market manipulation as the share prices of the family-owned entities significantly surged before the merger announcement, leading to concerns about unfair advantages for insiders.

Regulatory reforms to enhance investor protection in reverse mergers

Regulatory reforms play a crucial role in enhancing investor protection in reverse mergers. These reforms aim to address potential risks and ensure fair and transparent transactions.

  1. Enhanced disclosure requirements:
    • Expanded disclosure regulations require companies involved in a reverse merger to provide detailed information about the transaction, including the financial condition, management structure, and potential conflicts of interest.
    • Investors can make informed decisions based on comprehensive and accurate information.
  2. Stricter due diligence:
    • Regulatory reforms mandate thorough due diligence processes by both companies involved in a reverse merger.
    • Independent experts evaluate the financial health, legal compliance, and business prospects of each company.
    • This helps identify potential red flags and mitigate risks for investors.
  3. Regulatory approval:
    • Certain jurisdictions require regulatory approval before a reverse merger can proceed.
    • Regulators assess the fairness of the transaction, ensuring that minority shareholders’ interests are protected.
    • Approval processes provide an additional layer of oversight and protection.
  4. Independent valuation:
    • Reforms emphasise independent valuation of the companies involved in a reverse merger.
    • Qualified professionals perform valuations to determine the fair exchange ratio of shares.
    • Independent valuations help prevent potential undervaluation or overvaluation, safeguarding investor interests.
  5. Minority shareholder rights:
    • Regulatory reforms focus on protecting the rights of minority shareholders in reverse mergers.
    • Shareholders are entitled to receive adequate consideration for their shares, including cash, stock, or a combination of both.
    • Reforms ensure that minority shareholders are treated fairly and their interests are considered.
  6. Cooling-off periods:
    • Some jurisdictions enforce cooling-off periods between the announcement of a reverse merger and the shareholder vote.
    • This period allows investors to review the transaction details, seek professional advice, and make informed decisions.
    • Cooling-off periods prevent hasty or pressured decisions that could disadvantage investors.
  7. Scrutiny of related-party transactions:
    • Regulatory reforms pay special attention to related-party transactions in reverse mergers.
    • Related parties include individuals or entities with close ties to the companies involved.
    • Scrutiny of related-party transactions helps prevent conflicts of interest and ensures fair treatment of all shareholders.
  8. Post-merger compliance:
    • Reforms extend beyond the initial reverse merger transaction.
    • Companies are subject to ongoing compliance requirements, including regular financial reporting and adherence to corporate governance standards.
    • Post-merger compliance ensures continued protection for investors and maintains market integrity.
  9. Investor education:
    • Regulatory bodies and financial institutions play a role in educating investors about reverse mergers.
    • Educational materials, webinars, and seminars help investors understand the risks and benefits associated with reverse mergers.
    • Informed investors are better equipped to make sound investment decisions.

Regulatory reforms for reverse mergers seek to strike a balance between facilitating capital-raising and protecting investor interests. By implementing stringent disclosure requirements, due diligence processes, and regulatory oversight, regulators aim to create a fair and transparent market environment for all participants.

Importance of corporate governance

Unlimited power in the hands of an individual could lead to undefined supremacy and advantage over other common people. Thus, corporate governance is a mandatory set of rules and regulations that need to be followed to safeguard the investor’s interest in the company. A reverse merger can cause a shift in the management and board, which may no longer align with the interests of the investors and a rigid corporate governance practice can safeguard and protect the trust of the investors in the company. Good corporate governance will ensure transparency between the companies and the investors, which is usually absent in the case of a reverse merger. This practice would ensure that the investors are protected at all times during the process of the merger. Practising good corporate governance through implementing good ethical conduct and integrity will help foster investor confidence. 

Good corporate governance practices

The companies and regulatory authorities should focus on investor education, which will help these investors achieve a sense of financial literacy and gain knowledge about reverse mergers and the risks that are associated with such kinds of mergers. There should be periodic and regular audits of these companies to make sure that they stick to the disclosure norms. Companies should voluntarily seek pre-approval from the regulatory authorities for reverse mergers, which would help them achieve a transparent and smoother transition between the companies.

How insider trading can occur in a reverse merger

There are a number of ways that insider trading can occur in a reverse merger. One common method is for insiders to purchase shares of the public company before the merger is announced. This is known as “front-running” the merger. Once the merger is announced, the price of the public company’s stock typically rises, allowing the insiders to profit from their purchase.

Another method of insider trading in a reverse merger is for insiders to sell shares of the public company after the merger is announced. This is known as “shorting” the merger. Insiders who short the merger are betting that the price of the public company’s stock will fall after the merger. If their bet is correct, they will profit from the decline in the stock price.

The risks of insider trading

Insider trading is a serious crime that can carry significant penalties. In the United States, insider trading is punishable by up to 20 years in prison and fines of up to $5 million and in India a fine is imposed which may not be less than Rs. 10 lakhs but may extend upto Rs. 25 crores or three times of the profit made from the insider trading, whichever is higher.

How to protect yourself from insider trading

There are a number of things that investors can do to protect themselves from insider trading. One important step is to be aware of the risks of insider trading and to be vigilant for signs of suspicious activity. Investors should also avoid trading on rumours or tips from unknown sources.

In addition, investors should be aware of the following red flags that may indicate insider trading:

  • A sudden increase in trading volume in a particular stock.
  • A significant increase in the price of a stock without any apparent news or developments.
  • Trading activity that occurs just before a major announcement, such as a merger or acquisition.

If investors suspect that insider trading may be occurring, they should report their suspicions to the Securities and Exchange Commission (SEC). The SEC is the federal agency responsible for enforcing insider trading laws.

Conclusion

Reverse mergers are a good corporate strategy for companies to gain more market share and venture into newer aspects of the market. But, while this strategy benefits the companies, it has its differences from a traditional IPO, which comes with risks to their investors, who are the general public. The concept and process of reverse mergers are not regulated by the appropriate statutory provisions of the law and, at the same time, come with lots of discrepancies, like non-transparent transactions and a lack of information to the public regarding such corporate actions, which cause danger to investors. 

References

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