[Samrudh Kopparam is a 4th Year, BA LLB (Hons.) student at Jindal Global Law School]
Introduction
The past decade has witnessed a surge in Mergers and Acquisitions (M&A) activity in India across diverse sectors, including energy (Rosneft’s 49% buyout of Essar Oil), entertainment (Merger of PVR and Inox), and aviation (Tata’s acquisition of Air India). However, the combined impact of the pandemic and global recession has left companies in a precarious situation—making them targets of acquisitions.
Regulation 2(1)(b) of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (Takeover Code) categorizes ‘acquisitions’ into two distinct types, direct and indirect. To illustrate the concept of an indirect acquisition, we shall consider a scenario where company A acts as an ‘acquirer’ and B functions as an ‘intermediary entity’ which holds a substantial stake in C, the target company. Instead of directly acquiring the shares/voting rights in C, A may opt for a ‘primary acquisition’ of the intermediary entity. By doing so, company A gains a controlling interest in C—the target company—indirectly by virtue of its control over the intermediary entity. Consequently, it can be said that A has ‘indirectly acquired’ C. With this illustrative paradigm serving as a foundation, the present article seeks to critique the legal position on indirect acquisitions and provide remedial avenues.
Scrutinizing the Legal Position of Indirect Acquisitions
Regulation 5 of the Takeover Code primarily addresses indirect acquisitions, which involve gaining control over a target company through the acquisition of shares, voting rights, or control of another entity. Additionally, Regulation 5(2) establishes a sub-category of indirect acquisitions which are ‘deemed’ to be direct acquisitions. Furthermore, a perusal of the Code highlights the differential treatment vis-à-vis delisting (Regulation 5A), offer price (Regulation 8), timing (Regulation 13), etc. between direct, indirect, and deemed to be direct acquisitions. However, at the crux, the Takeover Code and its open-offer obligations blanketly apply to indirect acquisitions when the 25% threshold is breached despite its polar nature.
The concept of ‘indirect acquisition’ found its formal inception in 1997 and lacks extensive jurisprudence due to the overhaul of obligations in the 2011 Code. At the forefront of establishing the ‘indirect acquisition’ jurisprudence is Technip v. SMS Holdings. It involved the shareholding structure of Institut Francais du Petrol, which held shares in both Technip and Coflexip. Another entity, SEAMEC, served as the Indian subsidiary of Coflexip. During overseas investments, SEAMEC found itself subject to the control of Technip, as a consequence of Technip’s control over Coflexip.
In this regard, coming to the question of indirect acquisition, the court introduced the ‘chain principle.’ The principle posits that a person who acquires control over a company may, by virtue of such control, indirectly acquire control over a second company. This creates a ripple effect, triggering mandatory takeover bid requirements when either of the conditions is met, (i) the shareholding in the target company constitutes a substantial part of the assets of the intermediary, or (ii) one of the main purposes of acquiring control of the intermediary was to secure control of the target company. In the present case, Coflexip assumes the role of the intermediary and SEAMEC emerges as the actual target, resulting in the obligation to make an open offer.
The Technip case illustrates the legislative fixation of providing exit opportunities to shareholders via open offers. While open offers accompanied by public announcements act as a reasonable deterrence towards hostile takeovers, it has adverse effects on indirect acquisitions by resulting in regulatory costs for change in controls, particularly of downstream entities. This issue is exemplified in the case of Linde AG and Praxair Inc M&A. Linde AG held a 100% stake in Linde UK, which in turn held 75% of shares in Linde India. The merger was intended to create a new holding company which controlled Linde India, thereby attracting the mandatory requirement to make an offer. While the company argued that it would be granted an exemption under Regulation 10(1)(d)(iii), SEBI, through its informal guidance note, takes a rigid interpretation by denying the exemption. The exemption generally granted under Regulation 10(1)(d)(iii) signifies a progressive step; however, the regulatory authority should adopt a purposive and subjective interpretation rather than a rigid, straight-jacketed, and binary approach of either approval or denial. The rigidity is also highlighted in the ratio of In Re: NRB Bearings India Limited, where the court asserted that the determination of whether the upstream acquisition of shares, voting rights, or control in the intermediary company affects the control of the target company should be considered in tandem with the regulations—providing no room for subjectivity.
The primary object of the mandatory bid is to provide an exit option and benefit existing shareholders. However, as we see in Linde, the shareholders were not substantially affected by the upstream M&A, yet the offer was triggered, posing an impediment to the process. This stance seemingly overlooks the legislative intent of bonafide overseas M&A and becomes a significant roadblock in the process. Moreover, in many instances, large corporations undergoing M&A are compelled to make offers for the outstanding shares of relatively inconsequential downstream Indian entities. In Linde, it represented a relatively marginal portion of the upstream entity, resulting in a heavy regulatory burden for changes in control. Consequently, there is a tussle between providing an exit opportunity for shareholders and facilitating bonafide M&A.
An Old-School Problem: The Divergence in Understanding ‘Acquisition’
In the Pre-2011 era, the computation of ‘acquisition’ gave rise to two primary understandings—proportionality and effectuality. The former relied on a mathematical approach—inherently rigid—whereas the latter sought to understand ‘control’ through indirect acquisition objectively. The tussle between the schools of thought has further broadened with the recent informal guidance note by SEBI to Arch Pharmalabs Limited clarifying that indirect acquisition does not envisage a pro-rating of shareholding through intermediate holding companies, i.e., a mere increase of the acquirer’s stake in the holding company, which it already controls, has no effect on the shareholders’ voting rights in the subsidiary company. Further, in Rhodia v. SEBI, it was held that arguments suggesting unintentional acquisition of an Indian company as a by-product of acquiring a foreign entity, and thus exempt from regulations, were deemed invalid.
In this manner, the 2011 takeover code upholds mandatory offers irrespective of the materiality or proportionality of the target company as long as there was a change in control or thresholds for shares or voting rights. Moreover, the intention behind the acquisition is not the deciding factor. As the way forward, we argue for adopting the ‘effectuality’ perception, which provides wiggle-room to exempt takeover obligations when overseas M&A have negligible effect in domestic jurisdictions.
Remedial Avenues for flexibility of indirect acquisitions
The threshold setting for open offers in indirect acquisitions appears rigid, inflexible, and solely based on mathematical calculations, contributing to higher regulatory costs. It also hinders bonafide M&A which are incidental. Further, they take time and money to implement, which can be a bottleneck in time-sensitive arrangements. While quantifying control is often feasible, we argue for a more inclusive definition of control and the adoption of a ‘look at’ test to assess the materiality of the indirect acquisition. It is essential to examine whether the acquirer genuinely holds the position of being in the ‘driving seat,’ either directly or indirectly and ‘look at’ the entire transaction holistically rather than adopting a fragmented approach to ascertain effectuality. This enhanced flexibility would foster greater strategic alliances among corporations, potentially improving market competition.
A pivotal reform necessitates the amendment of Regulation 5 to afford flexibility to indirect acquisitions that are merely incidental to a larger transaction, so as not to ordinarily initiate a takeover bid. Furthermore, reintroducing a modified chain principle could serve as a prospective solution to objectively ascertain ‘incidental’ effects. For instance, assessing the value of the indirectly acquired company as a percentage of the upstream target could serve as a proxy for identifying the transaction’s purpose. Other factors inter alia assets, policy changes, board structures, market capitalisation, sales, and profits should also be considered. Moreover, SEBI must assert its flexibility over the subjective satisfaction that may arise when the indirect acquisition of a company is unduly restricted due to the imposition of a mandatory bid. In addition, given the sensitivity of the transaction for which such an exemption shall be sought, a timeline must be incorporated to dispose applications promptly and confidentiality is upheld—similar to the regulation of combinations under the Competition Act, 2002.
Lastly, within the Indian context, the legislative intent underlying the anti-takeover regime is explicitly aimed at safeguarding the interests of minority shareholders. Consequently, reforms in this domain should primarily focus on reducing the cost associated with a change in control and preserving shareholder protection. We may strike a judicious balance by incorporating whitewashing provisions, wherein, an acquirer is allowed to circumvent a takeover bid requirement, contingent upon the approval of the target company’s shareholders through a board resolution. This potentially mitigates the costs of a change in control while empowering shareholders to decide whether they consider a takeover acceptable. Albeit the efficacy of whitewash provisions is limited where the primary acquisition is hostile, they may allow takeover bid requirements to be relaxed in the case of a friendly takeover. Moreover, imposing a majority of minority requirements could empower minority shareholders by granting them a decisive role in the deliberations concerning a potential takeover.