Public M&A: JV’s with exclusivity under SEBI’s scanner – The Linde Case

Public M&A: JV’s with exclusivity under SEBI’s scanner – The Linde Case

Key Takeaways

  • Independent Directors must pay closer attention to transactions with related parties. They should ask- are there any non-price factors that are not reflected in the transaction price? If yes, what is the value of these factors? Can they trigger the materiality threshold and need shareholder approval?
  • Non-price factors could be a non-compete clause, especially crucial in case of hive-off or joint venture transactions (with non-compete from ListCo), and may need careful attention
  • Test materiality by clubbing all related party transactions (RPTs) with a particular related party and not only those in the same contract or for the same purpose

Introduction

The recent SEBI order in Linde India Ltd (“Linde”)¹ case has a clear message for independent directors – don’t contend with management speak, especially while scrutinising RPTs (the SAT has currently granted a stay on procedural grounds without weighing in on the merits). The scrutiny must involve a thorough check of whether the transaction price has baked in all factors that could trigger materiality. In Linde’s case, SEBI concluded, the independent directors failed to do so.

What Makes A Transaction ‘Material’?

There’s a clear brightline test – a transaction that meets either of the two criteria: (a) valued at more than INR 1,000 crore; or (b) more than 10% annual consolidated turnover of the company.

Once a transaction triggers either of these criteria, shareholder approval must be sought. The regulatory intent is that RPTs, while allowed, should be examined by uninterested parties to ensure fairness. This is ensured through two levels of approval – one, by the audit committee and two, by (unrelated) shareholders.

Pushing every related party transaction to a shareholder vote isn’t optimal. Therefore, at the first instance the audit committee scrutinises these transactions and shareholders are only asked to vote on “material” transactions or “Material RPTs”

Part A – Linde’s “Material” Position - The flip-flop: Must you club multiple transactions with the same related party even if they were not a part of the same ‘contract’?

Linde, which wanted to enter into RPTs, first approached its shareholders since it was a Material RPT. When the shareholders rejected the RPT, it went ahead with the transactions by taking a call that shareholder approval was not required.

The company, citing three legal opinions, took a view that as long as the RPTs are not within a contract, or for the same purpose, the value of the transactions shouldn’t be grossed up for the materiality test. For this, the company relied on a few words (“in a contract”) in the Listing Regulations. For short, the opinion seems to be that “materiality” has to be tested on a contract by contract basis and that as long as there was no mothership contract or that the contracts were not for the same purpose, then multiple should not be clubbed together even if they are with the same related party 

A plain text reading of the regulations² suggests otherwise.

Definition of related party transaction (Reg 2(1) (zc)):

““related party transaction” means a transaction involving a transfer of resources, services or obligations between:

(i) a listed entity or any of its subsidiaries on one hand and a related party of the listed entity or any of its subsidiaries on the other hand; or

(ii) a listed entity or any of its subsidiaries on one hand, and any other person or entity on the other hand, the purpose and effect of which is to benefit a related party of the listed entity or any of its subsidiaries, with effect from April 1, 2023; regardless of whether a price is charged and a “transaction” with a related party shall be construed to include a single transaction or a group of transactions in a contract.”

Definition of material related party transaction (Reg23):

“The listed entity shall formulate a policy on materiality of related party transactions and on dealing with related party transactions 138[including clear threshold limits duly approved by the board of directors and such policy shall be reviewed by the board of directors at least once every three years and updated accordingly: 

Provided that a transaction with a related party shall be considered material, if the transaction(s) to be entered into individually or taken together with previous transactions during a financial year, exceeds rupees one thousand crore or ten per cent of the annual consolidated turnover of the listed entity as per the last audited financial statements of the listed entity, whichever is lower.” 

To test materiality, all transactions with a related party during a financial year need to be consolidated. Meaning, a company can’t undertake smaller transactions with a related party to avoid triggering the materiality threshold, and in turn the shareholder approval requirement. The words ‘in a contract’ need to be looked at harmoniously with Reg 23 which requires that all transactions with the same related party be clubbed together rather than limiting it to transactions clubbed together in a contract. The definition of related party seems merely to confirm that a related party transaction can be a group of transactions in a contract, but does not preclude multiple contracts and the test for materiality again seems to just require that all transactions be clubbed, not only those within a single contract.

Hence, in our view there’s no requirement for these transactions to be contained in a mothership contract. In essence, three main points emerge from SEBI’s order:

a. Should transactions be contained in a contract – No, they can either be contained in a contract or in several contracts or not be contained in any contract at all. The only requirement is a transaction (in its generic sense) to exist.

b. Should unrelated transactions be clubbed together for the materiality test – Yes, as long as they are with the same related party. The test exists to flag the conduct (i.e., whether it is a material RPT) while the purpose is judged by the shareholders. In short – the threshold test is plainly for the conduct and not the purpose.

c. Should all transactions with all related parties be clubbed together for the materiality test – No. The regulations are clear on the point that only transactions with that related party have to be clubbed. Even the SEBI interim order in the Linde case tacitly acknowledge this when it says “all transactions with a related party” have to be clubbed

Part B: Must you value the non-compete? The Question Linde’s Independent Directors Didn’t Ask

Every transaction can have a price and a non-price value. There could be provisions in a contract which may not have a sticker price but could have an economic impact. 

In the Linde case, it was a non-compete provision. Linde and its related party carved up products and market areas to avoid competition. In essence, a non-compete clause. The audit committee failed to account for the value of this non-compete while determining “materiality”. SEBI found this to be a violation of the law. 

A plain reading of the regulations suggests that merely because a price was not charged does not mean it must not be considered. For this, we will have to circle back to the intent of the law – i.e., anti-abuse. In fact, this intent is also well articulated in the regulations with the conspicuous mention of “regardless of whether a price is charged” in the definition of RPT.

SEBI’s order makes it abundantly clear that boards must value contractual provisions to determine materiality. Merely looking at the sticker price of the transaction may also defeat the purpose of the law. If that position was taken, it would mean all transactions without a price would necessarily be non-material.

What’s SEBI’s Ask?

A contract necessarily involves a series of bargains, the sum total of which is usually reflected in the pricing. The regulator has a simple ask- boards must ensure that all nonprice factors have been accounted for as well.

To illustrate, consider any joint venture of a listed entity. Usually, while setting up the joint venture company, the listed entity will also enter into a series of obligations (on supply of material, technology etc) but the most important part is usually “exclusivity” i.e., that the listed entity will not directly compete with the joint venture entity. This ensures alignment between the parties, and usually these separate units are set up so that a nascent business can be scaled up by partnering with either an investor or a strategic partner who only wants exposure to that line of business without buying into the larger interests of the listed company.

The regulations seem to require that the exclusivity clauses be valued. Though someone wearing a commercial hat could argue that the price of the transaction would have built in the cost of such clauses. 

But should boards simply make this assumption and not even question the need for a valuation of such non-price factors? 

The lodestar here is not whether the price has been considered but whether it has been considered fairly. For that purpose, the audit committee should not limit its review to a perfunctory matching of prices, but also ensure that the price charged is fairly reflected. This, after all, is the very essence of any anti-abuse mechanism – to identify and cure the mischief.

Here, the mischief sought to be prevented is minority shareholders being adversely impacted by moving value out of the company. Clearly, a mere review of the contract price may not serve the purpose. While the independent directors at the audit committee are not expected to substitute the commercial judgment of the management, they are to at least seek out all the information before greenlighting RPTs. 

SEBI has sent a loud and clear message to boards through this order – the duty to ensure minority shareholders are not short changed is not just a governance requirement but a regulatory one. 

This perhaps starkly illustrates the need and the role of independent directors. They are to act as the adults in the room. Simply put, they are present to ask questions, sometimes uncomfortable ones, from a simple vantage point of a common shareholder – for instance, “the contract prevents us from selling wires to other companies for 2 years, have you considered the financial impact?”.

What could be the aftermath of this decision?

Such valuations haven’t generally been the practice, and it does appear to be one of the first cases where the SEBI has asked for such valuation. This also gains importance given the increase in hive offs by listed companies in search of growth capital. Such decisions often result in a feeder structure where considerable value for shareholders is derived from the subsidiary/affiliate situated below the listed company. This also increases the role of independent directors in ensuring that when such business is moved a layer away from shareholders, that value is actually being created from the move. This entails them taking on more of an active role. If not of an enforcer, then at least that of a curious shareholder.

¹ Securities And Exchange Board Of India Interim Ex Parte Order In Respect of Linde India Ltd, WTM/AB/CFID/ CFID-SEC3/30299/2024-25

² Securities And Exchange Board Of India (Listing Obligations And Disclosure Requirements) Regulations, 2015

¹ Securities And Exchange Board Of India Interim Ex Parte Order In Respect of Linde India Ltd, WTM/AB/CFID/ CFID-SEC3/30299/2024-25

² Securities And Exchange Board Of India (Listing Obligations And Disclosure Requirements) Regulations, 2015

About our Public Equity Practice

Public M&A / PE is arguably the most nuanced field of deal-making in India, considering the myriad legislations and constantly evolving corporate governance practices. Over the last decade, India’s public markets have successfully attracted some of the largest financial and strategic investors,read more

About our Stakeholder Governance Practice

Stakeholder governance has occupied centre-stage in the context of complex corporate transactions in the public M&A sphere. Board responsibility is assuming greater significance especially when questions regarding true value realization, internal control systems and risk management are involved...read more

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  • Mandatory clarification of media rumours – M&A dealmaking compromised and potential creation of a false market?…
Unexplored Strategies in the Fortis Saga: Public shareholders and IHH Healthcare exposed to significant collateral damage?

Unexplored Strategies in the Fortis Saga: Public shareholders and IHH Healthcare exposed to significant collateral damage?

  • Latest SC judgement uncovers Daiichi’s new approach – Fortis, IHH and, public shareholders under the gun for liabilities of Fortis’ erstwhile promoters
  • Public shareholders will need to brace for impact and be proactive – else risk getting the short end of the stick
  • Legal sanctity of the ‘theory of attribution’ possibly misplaced in the Fortis context…
Decoding Boardroom Dilemmas (Part III): Can Nominee Directors Share UPSI with Nominating Shareholders?

Decoding Boardroom Dilemmas (Part III): Can Nominee Directors Share UPSI with Nominating Shareholders?

  • No express framework exists for nominee directors to share UPSI with nominating shareholders
  • Natural expectation that nominee directors should represent their nominators’ interests – not permitted under law
  • Since nominee directors’ fiduciary duty remains towards the company and stakeholders, nominee directors are paradoxically placed and exposed to significant…
Decoding Boardroom Dilemmas – Hiving Off to Fundraise Through Subsidiaries – Commercial Wisdom or Short-Changing Public Shareholders?

Decoding Boardroom Dilemmas – Hiving Off to Fundraise Through Subsidiaries – Commercial Wisdom or Short-Changing Public Shareholders?

  • Transferring a majority-revenue generating business into a private subsidiary (hiving off) and raising funds at the subsidiary level is increasingly seen as a preferred alternative to direct listed acquisitions or slump sales
  • Hiving off may result in a ‘holding company discount’ and public shareholders lose out on value…
Threat of valuation litigation in Public M&A – Carlyle-PNB Effect! 

Threat of valuation litigation in Public M&A – Carlyle-PNB Effect! 

  • SEBI floor price prescription in case of fund raises should not automatically dislodge directors’ duty to exercise independent judgment and maximise shareholder value
  • Target boards to proactively consider appointing an independent banker and running a robust auction process for capital raises…

Research Paper

Public M&A: Do List Cos Really Need Omnibus RPT Approvals?

Public M&A: Do List Cos Really Need Omnibus RPT Approvals?

  • There seems to be an overlap between regular RPT approvals and omnibus approval routecreating ambiguity on what type of approvals must be procured for long term related partycontracts?
  • Listed companies often enter into long term contracts with…
Should Offshore Funds Appoint Directors?

Should Offshore Funds Appoint Directors?

The issue of director duties and attendant liabilities has been a subject of immense debate as the role of directors evolves in the Indian context. India is perhaps a decade behind the west in this evolution process, though rapidly catching up driven by increasingly proactive proxy advisory firms and institutional capital taking significant positions in Indian companies, though activist funds are still a rarity. Transcendence from ‘complying with their obligations’ to ‘performing their duties’ has probably been most transformational and manifested only in the past couple of years…

Tax Structuring & Litigation

Analysis

Ambiguity with thin cap norms: Private credit players risk significant tax leakage

Ambiguity with thin cap norms: Private credit players risk significant tax leakage

  • Accurate reading of thin capitalization norms is highly relevant to maximize IRRs, especially in asset heavy sectors
  • Currently, norms interpreted such that sometimes the entire interest paid to foreign related parties is disallowed for the target (as expense)…
Private Credit: Interest on NCDs recharacterized as dividends 

Private Credit: Interest on NCDs recharacterized as dividends 

  • Tax authorities recharacterized interest income on NCDs as dividends
  • Interest recharacterization has not taken place under GAAR
  • Investors can prevent such mischaracterization by demonstrating the nature of the underlying instrument, periodicity of payments, maturity date, management rights,
    etc….
Denial of tax treaty benefits: Blueprinting defence strategies for PE funds – A tax litigation perspective

Denial of tax treaty benefits: Blueprinting defence strategies for PE funds – A tax litigation perspective

  • Revenue has issued reassessment orders to several global PE/VC funds denying
    tax treaty benefits to grandfathered investments alleging treaty shopping through Mauritius and Singapore between AY 2013-14 and 2015-16

  • Substantial tax, interest, and penalty has been levied invoking judicial anti-avoidance principles based on a supposed lack of commercial substance in these jurisdictions…
Top 5 Tax Considerations When Structuring Debt Investments in India

Top 5 Tax Considerations When Structuring Debt Investments in India

  • Recent developments in the Indian tax regime have brought India closer to global
    norms though hybrid instruments that have come under increased scrutiny

  • GAAR provisions have enabled tax authorities to examine the commercial substance of transactions, underscoring the importance of purpose, pooling, and people…

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