Defining control of Indian firms: Are we there yet?

By : Shriram Subramanian
Last Updated: Fri, Jun 28, 2013 21:02 hrs
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The Reserve Bank of India (RBI) is soon expected to notify the Foreign Exchange Management Act, or Fema rules on the definition of "owned or controlled". The nod from the Cabinet Committee on Economic Affairs is awaited. However, assessing control is a complex and contentious issue in countries across the world. In fact, it has been the subject of many court cases on matters of foreign ownership, taxation, transfer of shares and residency status.

The issue in India has come up because no longer can mere foreign shareholding of a company be used to determine the extent and control of an Indian company. Control has two aspects: de facto control and de jure control. Merely using a shareholding threshold of 25 per cent or 50 per cent foreign ownership to define an Indian company as a foreign-controlled company is looking at it purely from a de jure control perspective - a narrow legal view that doesn't take into account the other aspects and rights accorded to shareholders.

On the contrary, de facto control looks at whether the foreign owner has any direct or indirect influence on strategic decisions taken at the shareholder or the board level, and in the operating day-to-day management. For a proper determination of control, one needs to go beyond the form and look at substance, which translates to recognising de facto control, and not merely restricting the evaluation to de jure control. The concept of de facto control is not just about influencing the composition of the board of directors, but also influencing other powers of the board and management. Positive and negative consents, veto rights, contingent control, put and call options, among others are all examples of control features incorporated into the shareholders' agreement that goes beyond the current shareholding.

The RBI has taken a step in the right direction to raise the issue of de facto control and notify it in the foreign direct investment policies. Other regulations - the Companies Bill, 2012 and the Securities and Exchange Board of India (Sebi) takeover code - seem to recognise the de facto control aspect. The Companies Bill, 2012, pending in Parliament, says: "'Control' shall include the right to appoint majority of the directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders' agreements or voting agreements or in any other manner". The Sebi takeover code paraphrases the same definition of control as that of the Companies Bill.

Many countries such as the US, Canada and Australia recognise the de facto control feature. In legislation where national security or public interest is involved, de facto control is considered. Increasingly, court rulings are looking into de facto control. In India, as sectors such as retail, aviation, defence and nuclear power are opened up to foreign ownership, it is de facto control that needs to be considered.

For one recent transaction in focus, the Jet-Etihad arrangement, if we use the de facto control test, it is likely that Jet Airways will be treated as an Etihad-controlled entity. de facto control is visible in the following rights ceded:

1. Appointing three nominee/investor directors in the current board with strength of seven;

2. Appointing one of its nominee directors as vice-chairman of the board;

3. Having the authority to appoint one of the joint auditors;

4. Having the authority to have at least one of its nominee directors in each of the board committees;

5. Having unrestricted access to Jet Airways' books, registers, records, premises, offices, officers, employees, accountants and consultants;

6. One of the amendments under the heading "investors board member" proposes: "The investor board member shall not be liable for any default or failure of the company in complying with the provisions of any applicable laws. The investor board members shall not be identified as an 'officer in default' of the company or occupiers of any premises used by the company under laws."

The Jet board also proposed modifying the Articles of Association (AoA) of Jet Airways with amendments that provide Etihad Airways superior rights over and above other public shareholders.

In looking at control, an additional distinction needs to be made for control of unlisted companies and listed entities. In listed entities, a shareholders' agreement between the promoters and the other shareholder (Etihad in the case above), discriminates against other public shareholders and gives them inferior rights. Though some of the provisions of the shareholders' agreement may be incorporated in the AoA of the company, and subject to approval by shareholders, it is unfair to the minority investors if there is no open offer made to them owing to any change of control. Investors must have the right to know whether there is a de facto control change. In the absence of an open offer, at the very least, the shareholders' agreement should be a treated as a public document and be provided to the investors for scrutiny in addition to the AoA being approved by majority of the minority shareholders, with the signatories to the shareholders' agreement abstaining.

Globally, the interpretation of de facto control itself is evolving. In India, there needs to be uniform application of de facto control definition and all the regulators should agree on and use a common interpretation. This necessarily means de facto control being defined on a case-by-case basis, and that may be the reason the Foreign Investment Promotion Board is right in seeking additional details in the Jet-Etihad arrangement.

At the end, the true test of control is whether majority shareholders of the Indian company have strategic and operational freedom to take decisions independent of the foreign shareholder.

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