-SEBI’s Order in Yes Bank promoters indicates long arm of the provision
Munmi Phukon | Partner | Vinod Kothari & Company
While structuring of instruments like debentures, parties resort to various covenants in order to protect the interests of the investors and also to reflect the intent and purpose of the parties more specifically. One fairly commonplace practice with promoters of Indian listed companies to raise funds on the strength of their shareholding in their companies. It is often observed that, in structuring such transactions, companies find innovative ways of creating pseudo security interests on shares. Therefore, a careful analysis of the documentation entered into by the parties is required to conclude whether the covenants amount to creation of an encumbrance or not.
SEBI has recently dealt with such a case, in which SEBI throws some light on what could constitute an encumbrance for the purpose of SEBI (SAST) Regulations, 2011 (Regulations). SEBI considered the covenants mentioned in the debenture trust deed (DTD) executed by the promoter entities of the listed entity at the time of issuance of NCDs and held the promoters liable for non-disclosure of the encumbrance created on the shares held in the listed entity.
Legislative intent and purpose of the SAST Regulations
SAST Regulations are considered to be a social welfare legislation. The aim and intent of the Regulations is to protect the interest of the investors and ensuring market integrity. That is why, the Regulations recognise the importance of event based and periodic disclosures, specifically by the promoters of the entity, through Regulation 29 to 31 thereof. It has always been seen as a measure for ensuring better corporate governance which in turn enables the regulators and stock exchanges to monitor the transactions of the promoters.
Requirements related to encumbered shares under the Regulations
Transactions involving promoters’ shares are considered crucial in order to ensure transparency as regards the ownership/ control of the target company as well as price discovery of the shares in an informed manner. The genesis of the requirements of such disclosures arose in the beginning of 2009 when SEBI made it mandatory by amending the provisions of the erstwhile Regulations.
Later, similar requirements were provided in the revamped SAST Regulations vide Regulation 31 which requires the promoters to disclose about the shares of the target company encumbered by them on a yearly basis to the stock exchange(s) where the shares of the target company are listed and also to the target company. The promoters have also been mandated, by virtue of an amendment made in the said Regulation, to give declaration to the audit committee of the target company and the stock exchange(s) on a yearly basis about not having any encumbrance.
Further, SEBI vide its Circular dated 7th August, 2019 read with its Press Release-PR No.16/2019 requires the promoters to disclose to the stock exchange(s) and the target company, the detailed reasons for encumbrance if the combined encumbrance by the promoter along with PACs with him equals or exceeds, a) 50% of their shareholding in the target company; or b) 20% of the total share capital of the target company and also any positive changes therein thereafter within two working days from the creation of such encumbrance.
Furthermore, Regulation 29 requiring disclosure of acquisition/ disposal of shares of the target company by an acquirer on meeting certain threshold, interestingly, also provides that shares taken by way of encumbrance shall be treated as an acquisition, and shares given upon release of encumbrance shall be treated as a disposal and shall also require disclosure. In this context, it is pertinent to note if the pledgee/creditor gets voting rights also or has the right to cause the shareholder to vote as per the instructions of the creditor, the transaction would well amount to acquisition of control and hence, triggering the Regulation 3 as well.
The term ‘encumbrance’ under the Regulations
The term ‘encumbrance’ is defined under Regulation 28(3) of the SAST Regulations. Further, there has been an amendment to the existing definition w.e.f 29th July, 2019 vide SEBI (Substantial Acquisition of Shares and Takeovers) (Second Amendment) Regulations, 2019. Evidently, the text of the existing definition signifies that it is an inclusive explanation and not an exhaustive one keeping the same open to different interpretations.
SEBI had tried to clarify the broad definition through its FAQs that, non- disposal undertaking (NDU) will be covered under the purview of ‘encumbrance’. The FAQs also clarified that NDUs may, inter alia, include the following:
“- not encumbering shares to another party without the prior approval of the party with whom the shares have been encumbered;
- non-disposal of shares beyond a certain threshold so as to retain control;
- non-disposal of shares entailing risk of appropriation or invocation by the party with whom the shares have been encumbered or for its benefit.”
As mentioned above, the existing text of the definition has been expanded. As claimed by SEBI itself, the amendments have been made in the context of recent concerns w.r.t. promoter/ companies raising funds from Mutual Funds/ NBFCs through structured obligations, pledge of shares, non- disposal undertakings, corporate/ promoter guarantees and various other complex structures, which reads as below:
“(3) For the purposes of this Chapter, the term “encumbrance” shall include,
- any restriction on the 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, condition or arrangement in the nature of encumbrance, by whatever name called, whether executed directly or indirectly.”
Brief of the SEBI’s Order
The Order of SEBI seems to be an attempt of making an interpretation of certain clauses of the debenture trust deeds (DTDs) entered into by the promoter entities in the context of the then definition of ‘encumbrance’ provided u/r 28(3). SEBI found the following clauses in the DTDs and construed the same as creation of encumbrance on the shares of the listed company:
- Maintenance of asset cover ratio at all times i.e. maintenance of equity shares held by the promoters in the listed entity, over and above the borrowing of the promoter.
- In case of breach of the said condition, even though the debentures can be redeemed, however, only with an approval of the debenture holders for such early redemption;
- The requirement of creation of security in favour of the DTs by way of exclusive pledge of the shares held by the promoter in the listed entity while availing any further borrowing and also with prior notice and giving of right of first refusal to the debenture holders;
- Maintenance of borrowing cap at all times i.e. borrowing over the value of the shares held in the listed entity and the requirement of obtaining of a consent of the debenture holders in case of sell, disposal or encumbrance of the said shares.
SEBI contended that the covenants related to maintenance of asset cover/ borrowing cap at all times restrict the abilities of the borrowers/ promoters to dispose of the shares of the listed entity held by them. Therefore, the same should be considered as encumbrance for the purpose of Regulation 28(3). Further, the requirement of obtaining prior approval/ consent of the debenture holders before disposing of the shares tantamount to be a non- disposal undertaking as clarified vide the FAQs which include not encumbering shares to another party without prior approval of the party with whom the shares have been encumbered.
Meaning of ‘encumbrance’ in jurisprudence
In two passages in Salmon on Jurisprudence, 12th Edition, at Page 241 under the sub-heading “Rights in re propria and rights in re aliena” the learned author has stated thus:
“Rights may be divided into two kinds, distinguished by the civilians as Jura in re propria and jura in re aliena. The latter may also be conveniently termed encumbrances, if we use that term in its widest permissible sense. A right in re aliena or encumbrance is one which limits or derogates from some more general right belonging to some other person in respect of the same subject -matter. All other are jura in re propria.”
At Page 242 the learned author has observed as follows:
“it is essential to an encumbrance that it should in the technical language of our law, run with, the right encumbered by it. In other words, the document and the servant rights are necessarily concurrent. By time it is meant that an encumbrance must follow the encumbered right into the hands of new owners, so that a change of ownership will not free the right from the burden imposed upon it. If this is not so — if the right is transferable free from the burden — there is no true encumbrance.”
Thus, the true test of an encumbrance is the concurrence of the right with property – that the right attaches to property and travels along with it. Salmon has discussed encumbrances elaborately and mentions 4 types of encumbrances: leases, servitudes, security interests, and trusts. A lease confers a right to use the property. Servitude is a right to the limited use of the property such as the right of way or easements. Security interests (including mortgages) are encumbrances vested in a creditor. A trust is the obligation attached to property to hold it for the benefit of another.
Madras High Court also in the matter of M. Ratanchand Chordia And Ors. vs Kasim Khaleeli held as below:
“The word “Encumbrances” in regard to a person or an estate denotes a burden which ordinarily consists of debts, obligations and responsibilities. In the sphere of law it connotes a liability attached to the property arising out of a claim or lien subsisting in favour of a person who is not the owner of the property. Thus a mortgage, a charge and vendor’s lien are all instances of encumbrances. The essence of an encumbrance is that it must bear upon the property directly and in-directly and not remotely or circuitously. It is a right in re aliena circumscribing and subtracting from the general proprietary right of another person. An encumbered right, that is a right subject to a limitation, is called servient while the encumbrance itself is designated as dominant.”
An analysis of the meaning of encumbrance
The following important features of encumbrances arise from the discussion above:
- An encumbrance is a burden attached to property;
- If it is a burden for the owner, it must be a benefit for the person holding the encumbrance. This also follows from the discussion by Salmond which has taken encumbrances to be jura in re propria, that is, rights over estate of someone else. That is, the burden created by the owner must be such which can operate as a benefit in the hands of the person holding the encumbrance;
- The burden must necessarily be attached to the asset in question;
- Since the essence of attachment or concurrence of the burden is that the burden will pass on a person acquiring the property, it necessarily follows that the burden must be on an ascertainable, identifiable property;
- A mere restraint on sale or negative covenant is not an encumbrance. A leading English case law on whether a negative covenants “runs” with the property is Tulk v Moxhay(1848) 41 ER 1143. This classic ruling holds that a negative covenant is passable to the buyer of the property only where the parties intended the same to pass, and the burden “touches and concerns” the property. Here, a question of intent of parties will come in.
Different forms of quasi security interests on shares
Negative Lien or Negative Pledge
Negative Lien is used in banking parlance for a borrower to undertake not to create any charge on his property without the consent of the lender.
A negative pledge covenant does not give the negative pledgee a security interest or, in general, any other right in the debtor’s property.
It was held in Knott that Negative Pledgee’s remedies are purely contractual and that the covenant confers no right in the property.
The generally accepted view as mentioned before is that the negative pledge does not create a proprietary or security interest and is therefore not registrable. [Tracy Hobbs, The Negative Pledge: A Brief Guide, 8(7) J.I.B.L.269 (1993)]
A “springing lien” refers to lien granted in the future by a debtor (borrower or lessee) in favor of its creditors whereby the right conferred on the lender springs into a full-fledged lien or pledge either on the happening of certain events, or the discretion of the person holding the pledge.
Whether a so-called springing lien will amount to encumbrance or security interest will depend on intent of parties. If the debtor is free to deal with the subject matter before the trigger events that transform a springing lien into full-fledged lien have taken place, it cannot be said that the lien is an obligation attached to property. Therefore, it will not amount to encumbrance. However, if the lien comes attached with restrictions on sale, it will amount to encumbrance, because the combination of restriction on sale, and automatic attachment of a right on the asset that cannot be sold, in conjunction, will amount to a passable burden on property.
As discussed earlier, an encumbrance carries certain features along with it. A mere restraint on sale or negative covenant is not an encumbrance. Having said so, SEBI’s view in this context may not be in line with the jurisprudence of encumbrance.
However, it is seen that SEBI has been constantly endeavoring to expand the scope of the disclosure requirements, in the wake of various corporate governance failure recently witnessed by the country. SEBI, realizing the recent concerns w.r.t. promoters raising funds through structured obligations, pledge of shares, NDUs and various other complex structures and its impact on the corporate governance structures, had amended the meaning of encumbrance provided in Regulation 28(3). The said amendment has been made to include all such structures including any restriction on the free and marketable title to shares, by whatever name called, whether executed directly or indirectly or any covenant, transaction, condition or arrangement in the nature of encumbrance, by whatever name called, whether executed directly or indirectly.
Considering the amended definition of the term ‘encumbrance’, apparently, SEBI’s intent gets clearer that it wants to include all the possible arrangements/ structures which may carry a potential dilution in the promoter holding. The views held by SEBI are still open for a contest before the Securities Appellate Tribunal.
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 Knott v. Shepherdstown Manufacturing Co. 5 S.E. 266 (W. Va. 1888)