Deal Talk: Deal Making Insights – Lessons from Proxy Advisory Firms

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September 02, 2024

Deal Making Insights – Lessons from Proxy Advisory Firms

Introduction:

Companies, undertaking business operations in India, are obliged to comply with the Companies Act, 2013 (‘CA 2013’), which requires them to undertake operations and make decisions through two means- (a) board decisions and (b) shareholder decisions.
Matters like inspection of books of accounts, making political contributions, related party transactions, borrowing of money, appointment of key managerial persons and managing director, approval of financial statements, approval of a merger/ amalgamation/ reconstruction etc. require approval from the majority of the board of directors as a board resolution.
Matters like reduction of share capital, amendment to charter documents, buy back, preferential allotment of shares, private placement, issue of stock options, scheme of arrangement etc. require a shareholders majority vote in addition to a board resolution to undertake such activity.
Shareholders majority under CA 2013 is of two types:(a) Ordinary Resolution: A resolution approved by more than 50% of the shareholders by value (voting in person/ proxy/ electronic means). E.g., appointment of directors, approval of financial statements, declaration of dividends; and(b) Special Resolution: A resolution approved by more than 75% of the shareholders by value (voting in person/ proxy/ electronic means). E.g., reduction of share capital, buy back of shares, amendment to charter documents.
The shareholders in a listed entity can be broadly segregated into three buckets – promoters, institutional investors, and retail investors. Therefore, for the purposes of any shareholders resolution, these shareholders would be eligible to vote. However, historically the turnout of retail investors has been substantially lower as compared to the other two buckets given that (i) their interest in the company is focused on financials as compared to governance and (ii) retail investors are dynamic investors and keep changing based on the market position of the company. As per latest data available on the BSE, the average voter turnout for top 20 listed companies in the general meetings was approximately 80%, with maximum votes being cast by the institutional investors and promoters.
In cases of listed companies which are not closely-held by the promoters, the institutional investors have a huge role to play in shareholders vote, given that the turnout of retail investors would be significantly lower, and the promoter shareholding is not high enough to have control over shareholders’ decisions.
While institutional investors play such a huge role in determining the faith of shareholders’ resolutions, they usually have investments in a number of companies which makes it difficult for them to exercise independent diligence in deciding their position in a shareholders’ resolution. This is where the proxy advisors come into the picture to help institutional investors in their decision making with respect to shareholders’ resolutions.
Proxy advisors are person/ entities defined under Regulation 2(p) of the SEBI (Research Analyst) Regulations, 2014¹ which provide advice to institutional investors or shareholders of a company, in relation to exercise of their rights in the company including recommendations on public offer or voting recommendation on agenda items.
Proxy advisors provide advice to the institutional investors and other shareholders by examining the documents of the company in relation to their shareholder resolutions and other factors specific to each company. However, to maintain a transparent system, proxy advisors publicly present and disclose their voting guidelines, where they mention the factors, they will take into consideration while determining their voting position with respect to an agenda.
The power of falling foul of the voting guidelines can be seen in the multiple shareholders’ resolutions which failed upon proxy advisors advising to vote against such agenda. Few key examples of them include the withdrawal of delisting plans by Vedanta Limited in 2021 where the proxy advisors had voted against the proposal of delisting citing undervaluation concerns. In 2019, Tata Motors withdrew a proposed salary hike for top executives after proxy advisors (IiAS and SES) opposed it due to the company’s financial struggles, reflecting their commitment to fiduciary duty and financial prudence.
It may be possible that different advisors provide different advice in accordance with their analysis and voting guidelines. It then becomes critical how the shareholders in their prudence vote in a meeting. For e.g., in the recent ITC De-merger plans, IiAS had advised against the proposed demerger of ITC’s hotel business, stating there is a lack of complete value unlocking for shareholders, while InGovern and SES had raised no concern over the same proposal. The plan was approved by the shareholders.
For deal making, these voting guidelines also help in understanding the chances of a particular structure or agenda item in the deal passing the check of proxy advisors and therefore helps in predicting the voting sentiment of institutional investors and thereby allow for higher deal certainty.

Relevant voting guidelines for deal making:

1. Approval of Special Rights to Shareholders

Deal-making Factor	Many investors look to structure their transactions in such a way that they also have certain rights over the listed company (such as a board seat) to ensure value protection of their investment. Additionally, the promoters of a listed company also seek additional rights as compared to the public shareholders to ensure they can exercise control over the listed entity. However, as per the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (‘ICDR’) all shareholders of the same series of a class shall be treated equally. In order to provide the flexibility to investors for structuring non-control rights and to the promoters for structuring control rights, SEBI through Regulation 31B of SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (‘LODR’) allows for special rights to shareholders of a listed company subject to such rights being approved by a special resolution (i) at the time when they are granted and (ii) every five years from the date of granting such rights
IiAS	IiAS in its general stance will advise to vote AGAINST any special rights. Will generally analyze on a case-to-case basis and advise AGAINST resolutions where: a set of shareholders have board nomination rights disproportionate to their shareholding or if these rights are embedded in permanency and continue even if the shareholding levels drop; when identified individuals (usually promoters) have board permanency or are necessarily required to form quorum for board, board committee and/or shareholder meetings and they are not subject to retirement by rotation; identified/named individuals are permanently appointed as Managing Director, Whole-Time Directors, or Chairperson; investor/investor nominee directors are given veto power on board decisions. IiAS will generally not support any special/ overriding powers to an individual or a group, and will require complete disclosure, where any discrepancy or insufficiency will be raised as a concern.
SES	SES will generally advice to vote AGAINST the resolution unless: controlling shareholder is widely held or if the special rights are for non-promoter Institutional Investors/Lenders as a safeguard; the director proposals are based on merit, regardless of investor affiliation; there is no right to nominate Board committee members. Additionally, SES will recommend voting against special rights irrespective of where such rights are being enshrined in the articles of the company or merely being enforced through an agreement.
Insights for deal-making	While structuring transactions which have a rights package for the investor or the promoters in the listed company, the following shall be considered: the rights are provided through provisions in AoA; the rights package shall be in proportion to the shareholding that the investor or the promoter holds in the target entity (ideally most of these special rights such as board appointment right can be linked to a minimum shareholding level that a shareholder has to maintain to be able to exercise this right); the board nominee shall not be made party to all committees of the board and only key committees which are of important nature for the concerned shareholder who is being granted the special right; the board nominees shall not be permanently appointed to the position of a chairman, whole time or managing director; the board nominee selected by such shareholder with special right shall have relevant experience and also be fit for the concerned board; there is no grant of a veto power, but only sufficient safeguard of interests is observed.

2. Issuance of Preferential Allotment to investors by a listed company

Deal-making	An investor may choose to acquire shares in a listed entity either as (a) a secondary purchase by acquiring shares from an existing shareholder or (b) a primary purchase where the investor is issued shares by the target company. One of the most common methods for investors to make primary investments in target company is a preferential allotment. Preferential allotment is an issue of shares to any person/entity other than the existing shareholders, under Section 62 of CA 2013 and ICDR. Preferential allotment requires a special resolution.
Voting Guidelines by IiAS	IiAS will generally advice to vote FOR resolution of a preferential allotment, on a case-to-case basis, upon review of factors such as: (i) whether the issuance is to promoter/non-promoter (ii) whether the investor is in the nature of financial/strategic (iii) extent of dilution (iv) urgency of funds (v) Debt levels of the company and available cash (vi) Return of the capital employed IiAS will also recommend voting for preferential issues for companies in financial services sector as these have high capital requirements for meeting Basel III guidelines, absorbing credit losses and organic growth. While IiAS recognizes that a public issue is typically costlier and time consuming, IiAS views excessive dilution of existing shareholders by the promoter group as a concern unless companies are undergoing a debt restructuring program or are in urgent need of funds.
Voting Guidelines by SES	SES will in the normal course of action advice to vote AGAINST proposals for preferential issue and/or private placement of shares and/or convertible securities due to their dilutive effect on the shareholders unless: (i) compelling reasons/justifications for the preferential issue have been disclosed; or (ii) such investment is being made by a strategic investor which may be positive for the company; or (iii) where the company adequately explains as to why a rights issue is not a feasible option. The focus is that the issuance shall be beneficial for the company rather than an individual or an entity. Additionally, SES generally recommends that for the purposes of raising capital, the company should undertake a rights issue as compared to a preferential allotment. However, in cases where the price of equity shares offered to select persons under preferential issue is significantly higher than the market price of the share or higher than the price arrived at as per the ICDR pricing formula, it may take a lenient view and recommend voting FOR of the resolution. SES will also consider the dilution caused as a result of the preferential issues made during a period of 12 months, and if the dilution caused over a period of 12 months is significant, then the company should explain as to why rights issue was not feasible. However, in case of financially distressed company or any other apparent reason where rights issue is clearly not practically feasible, then, SES may take a lenient view.
Insights for deal-making	Based on the positions taken by IiAS and SES, an investor planning to acquire shares of a target company through preferential allotment shall keep the following points in consideration: (a) There should be sufficient explanation for the need of capital being raised as part of the preferential allotment; (b) The company shall reflect detailed reasons on why preferential issue was undertaken as compared to a rights issue given that preferential allotment would lead to a dilution whereas rights issue to existing shareholder would avoid dilution of the shareholders; (c) The investors shall also verify the extent of dilution that has taken place in the last 12 months by other investments in the target entity as if there is a significant dilution in the last 12 months, the proxy advisors might take a negative position with respect to the agenda.

3. Issue of Warrants

Deal-making Factor	Another instrument for structuring which is used by promoters and investors alike are warrants issued by a listed entity. Issuance of warrants is governed under the ICDR which states that at least 25% of the conversion price in case of warrants shall be paid upfront, and rest upon conversion of the options attached with the warrants into equity shares. Additionally, as per ICDR, warrants can have a maximum tenure of 18 months.
IiAS	IiAS will generally advice to vote AGAINST the resolution for issuance of warrants. As per IiAS, warrants issued to promoters give them the option to ride the stock prices of the company for 18 months. Additionally, a promoter might decide not to subscribe to the remaining 25% at the end of 18 months, which could have material implications on the long-term plans of the company. They will advise voting FOR the resolution only if: The exercise period is less than 18 months, and the upfront payment is more than 25%; Made to government-controlled entities, non-promoter shareholders or technical collaborators; Issued at a significant premium to the market price; Confirmation from the company that the allottee will pay the remaining amount irrespective of the market price prevailing on the date of exercise; The company offers the same terms of issuance to both promoters and non-promoter shareholders; Granted to an institution or a listed company; The promoters have a track record of completely subscribing to warrants issued in the past.
SES	Will generally advice to vote AGAINST the resolution if the issue is of Naked Warrants i.e., not attached with non-convertible debentures, unless: Compelling reasons are provided for such issue; Warrants are issued at a significant premium.
Insights for deal-making	When structuring a transaction involving warrants being issued by a listed entity, in case such warrant issuance is to a promoter the following considerations shall be considered: The issue is attached to non-convertible debentures; The exercise period is shorter, there is significant premium and there is more than 25% upfront payments; The terms of the warrants are consistent with the warrants previously issued to promoters/non-promoters; Past track record of the promoters with respect to conversion of warrants held by such promoters; There are justified reasons including urgency, and experience of the company in issuing Warrants.

4. Issue of Debt Instruments/ non-convertible debentures on a Private Placement Basis

Deal-making Factor	Issue of non-convertible debentures / debt securities on a private placement basis under Section 42 of CA 2013 requires a special resolution.
IiAS	Will generally advice to vote FOR the resolutions unless such issuance is not within borrowing limits of the company.
SES	Will generally advice to vote only after a case-to-case analysis considering borrowed amount to the size and operations of the company and will not raise concerns where sufficient reasons are provided.
Insights for deal-making	Investors structuring their transactions through debt instruments shall ensure that the target company is within the borrowing limits and the issue size shall be in-proportion to the size and operations of the company and shall not be significantly huge comparatively.

Conclusion:

In conclusion, Proxy Advisors have become instrumental in the realm of deal-making, primarily by serving as a vital check on transaction structures to safeguard shareholder interests. Their role in scrutinizing deals has ensured that proposals detrimental to shareholders do not go unchecked, thereby promoting transparency and accountability in corporate governance. With the Securities and Exchange Board of India (SEBI) stepping in to regulate the activities of Proxy Advisors, there is an increased emphasis on transparency in their recommendation processes. This regulatory oversight mandates that Proxy Advisors provide clear voting guidelines, ensuring that investors and promoters have a comprehensive understanding of the factors influencing their recommendations. By closely monitoring these guidelines, stakeholders can better structure transactions to align with shareholder expectations, thereby enhancing the likelihood of favourable outcomes during shareholder voting. Ultimately, this increased transparency and understanding can help in achieving greater deal certainty, as stakeholders can anticipate and address potential concerns from shareholders proactively. As a result, the evolving role of Proxy Advisors, coupled with regulatory efforts by SEBI, is fostering a more informed and balanced approach to corporate deal-making, ensuring that the interests of all stakeholders are adequately protected.

Author:

Anurag Shah, Divyansh Bhardwaj and Nishchal Joshipura

You can direct your queries or comments to the relevant member.

¹https://www.sebi.gov.in/legal/regulations/aug-2021/securities-and-exchange-board-of-india-research-analysts-regulations-2014-last-amended-on-august-03-2021-_34615.html

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