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Pursuant to the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (‘SAST’), shares taken by way of encumbrance are treated as an acquisition. The scope of the term encumbrance was sharply brought into light by a recent adjudication order by Securities and Exchange Board of India (‘SEBI’) involving 2 promoter entities of Yes Bank Limited (‘YBL’) in March 2020. Whilst this case was decided in the context of an earlier version of SAST, the order has implications on drafting transaction documents and disclosing an encumbrance by promoter entities in financing transactions.
Disclosure Based Regime
In 2010, the Takeover Regulations Advisory Committee (‘Advisory Committee’), required promoters to disclose acquisitions and encumbrances, by whatever name called, on a periodic as well as transaction specific basis, to stock exchanges and the target company. Historically, ‘encumbrance’ was defined as “a pledge, lien or any such transaction, by whatever name called”. From 2013, promoters had to disclose details on encumbrances in a specific format. From 2017, depositories put in place a system to record non-disposal undertakings.
SEBI in its 27 June 2019 board meeting clarified the intention of SAST is to cover all types of encumbrances, by whatever name called, and this is relevant where private limited companies (controlled by promoters of a listed company) issued non-convertible debentures (‘NCD’) backed by the promoters’ pledge of securities (including shares) of a group company or through other forms of encumbrances such as covenants or non-disposal undertakings. Accordingly, on 29 July 2019, ‘encumbrance’ was amended under SAST to include:
- any restriction on free and marketable title to shares, by whatever name called, whether executed directly or indirectly;
- pledge, lien, negative lien, non-disposal undertaking; or
- any covenant, transaction or condition or arrangement in the nature of encumbrance by whatever name called, whether executed directly or indirectly.
Further, SAST now requires promoters of listed companies to declare, on a yearly basis, that they, along with persons acting in concert, have not created any ‘encumbrance’ other than the encumbrances already disclosed during the financial year.
To increase transparency, since August 2019, promoters of listed companies are required to disclose detailed reasons for encumbrances, if the combined encumbrance by promoters along with persons acting in concert equals or exceeds 50% of their shareholding in the company or 20% of the total share capital of the company within 2 working days of creation. Increases in assets encumbered also have to be disclosed. Disclosure on end use of proceeds is required.
YBL Case – Bringing the issue into the limelight
SEBI imposed a fine on 2 promoter entities of YBL for non-disclosure of encumbrances. In 2 separate transactions, Yes Capital India Private Limited (‘YCPL’) and Morgan Credits Private Limited (‘MCPL’, together with YCPL, the ‘Issuers’) issued over Rs1,500 crore unlisted zero coupon NCDs. YCPL agreed to maintain a cover ratio of 3 times, and MCPL undertook to maintain a borrowing cap of 0.5 times. The key issue was whether a ‘cover ratio’, ‘borrowing cap’ and other covenants constituted ‘encumbrance’ on YBL shares. Covenants included: (i) restraining each Issuer’s free sale or purchase of YBL shares; (ii) no further encumbrance on any Issuer entity assets including YBL shares unless a pledge is also provided to the debenture trustee; (iii) not encumbering shares to another party without the prior debenture trustee consent; (iv) maintaining a redemption cover ratio and pledge to be created on specified events occurring; (v) restriction on raising further debt without prior debenture trustee consent. Additionally, YCPL undertook: (i) no encumbrance on YBL shares unless a right of first refusal is given to its NCD holders to lend the proposed borrowing amount; and (ii) if any borrowing is utilised then security cover for the NCDs must be the higher of: (a) security cover applicable to the new borrowing; and (b) 2 times the NCDs amount. SEBI held these restrictions fell within “encumbrance” and should have been disclosed under SAST and fined the Issuer’s Rs.50 lakh each.
Broad Interpretation by SEBI
The key conclusions from a practical perspective which market participants should take into account in structuring are:
- The definition of ‘encumbrance’ is an inclusive explanation and not an exhaustive one;
- “Cover ratio”, “borrowing cap” or any covenant restricting the ability to dispose shares are within the scope of ‘encumbrance’. This applies irrespective of whether tested on percentage holding or market value;
Requiring a company to maintain a certain asset cover or borrowing limit essentially restricts the company from disposing of those shares. Requiring investor consent has the same effect as restricting the ability of the company to dispose its shares; and
- Statutes must be construed in their correct perspective to give effect to legislative intent and statutory provisions
Implications and Conclusion
Anything which may be a burden or impediment on free marketability or transfer of shares is caught under SAST. SEBI will interpret based on spirit and not form on the facts and taking all covenants as a whole. Disclosure of promoters’ transactions are critical to ensure: (a) a target company is not taken by surprise, (b) price discovery, transparency and informed decisions in capital markets; and (c) best corporate governance and to enable stock exchanges and regulators to monitor promoters’ transactions. The overarching rationale for this decision is SEBI aim of investor protection and maintenance of a robust securities market. SEBI will interpret their regulations favouring the securities market and investors. Documentary covenants and structures need to consider this order carefully to ensure promoters of listed companies do not violate SAST in future.