Don't fear a studious regulator

The Competition Commission of India (CCI) has expressed its intent to study shareholder and investment agreements by private equity investors to understand market realities about exercise of control better. The intent has set in motion a range of fears among the private equity industry about the State getting too closely involved in understanding commercial nuances in private investment agreements. 

The fears are misplaced. In fact, such fear is the cause of uninformed regulation of market systems. Not just the CCI, but every other regulator should expend energy and study commercial contracts in the segments of society they regulate. The absence of understanding of what agreements tend to contain, has led to many a policy blunder and clumsy enforcement. 

The CCI is not a sectoral regulator and has no licensing powers. However, even sectoral regulators that have licensing powers tend not to acquaint themselves with commercial contracts in their markets. When they do get involved with commercial contracts, they tend to slip into being prescriptive about what contracts should contain. The need is to understand market realities that get reduced to writing in contracts — it is only by appreciating dozens of share purchase agreements and schemes of arrangements that one can understand how mergers and acquisitions (M&A) in a sector work, what the risks are, and how parties arrange their affairs to deal with these risks in a mutually acceptable manner.

The Securities and Exchange Board of India (Sebi) gets into stipulating what a contract between a stock broker and her client should contain. Or indeed, what an agreement between a mutual fund’s trustee company and the asset management company must contain. However, unless it gets involved in reading a wide range of agreements in transactions involving mergers and acquisitions, it would remain disconnected in its policy approach and its enforcement. The same is true for stock exchanges too.

Going by the kind of queries listed companies receive even from the stock exchanges, it seems the regulatory system is disconnected from what conventional agreements governing mergers and acquisitions contain. Recently, a listed company that sold its entire business as an undertaking was asked questions by a stock exchange about whether it was normal to have the conventional clauses it had in its sale contract. Ranging from questioning the provision of representations and warranties for the business to an indemnity for undisclosed risks and losses, and asking whether it is normal to cap the indemnity exposure, it was evident that the regulatory system is clueless about conventional commercial provisions in M&A transactions. 

Worse, a provision limiting the indemnity exposure was perceived by the regulator as a requirement to keep aside a pool of funds to meet a future liability to pay under the indemnity. Buying the line of reasoning of the stock exchange, Sebi passed an “urgent” order without even hearing the company, asking it to freeze an amount equal to the entire proceeds of the slump sale. Of course, the order was set aside at the threshold by the Securities Appellate Tribunal, but the lack of understanding of conventional and universal principles of M&A activity sent a chill down the spines of M&A practitioners.

Now, the CCI is keen to understand shareholder agreements.  This is an important domain that needs to be understood to appreciate how one player in the market may influence another.  What is “influence” and how it differs from “control” and the implications of the two, are vital facets of competition law. Without such understanding, legislatively undefined concepts such as “controlling influence” and “influential control” are being devised on the run, and this can only be detrimental to the economy — these concepts are vital for securities regulations, competition law, company law, and indeed insolvency law. 

Take the case of affirmative rights in the governance of a company. They are conventionally given to minority shareholders — aimed at getting their consensus on specific matters to protect those matters from decisions taken with muscular majoritarianism.  However, depending on who you ask, regulatory officials would vary in their perception of these provisions — some would say they depict “control”, others would say “influence” and some others, may come up with new concepts like “controlling influence”. 

If regulators had a greater understanding of market realities, universal conventions, global market practices and their implications, the market would benefit from a better appreciation. Therefore, the fear of a state agency wanting to know more about the ecosystem is misplaced. A consequence of regulatory agencies not being abreast with market realities is erosion of informed judgements in the first instance from them. This naturally has a spillover effect on the evolution of jurisprudence from appellate forums above and, on a bigger canvas, creates a disconnect between the market and the law. That is a danger one must zealously guard against.

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