COVID-19 Ramification on Securities Market- Effect on Due Diligence and the MAC Clause

 – Ranjeet Soni & Rohit Shrivastava

Mergers and Acquisitions (M&A) have been affected the most by the scourge of COVID-19. For the first time in 16 years, no M&A transaction over USD 1 billion has been performed worldwide. Considering this situation, the Securities Exchange Board of India (SEBI) relaxed various compliances related to shareholder disclosures. According to new regulations, shareholders can now disclose information about their consolidated shareholding by 1st June 2020. The regulator has mandated all merchant bankers and other intermediaries to submit all the relevant documents in PDF format online to SEBI. In this post the authors put forth the impacts of COVID pandemic on M&A transactions and the change of functions of merchant bankers as market intermediaries under Substantial Acquisition of Shares and Takeovers Regulations, 2011.

RESPONSIBILITIES OF MERCHANT BANKERS AND LEGAL ADVISERS

Under Regulation 27(2) of the Takeover Regulation provides merchant bankers to ensure that all the offer documents are correct, fair, and adequate in all aspects. The Securities Appellate Tribunal (SAT) observed in Almondz Global Securities Ltd. v. SEBI that a merchant banker is required to take dynamic steps to determine the correctness of offer documents. This responsibility has been lifted because of due diligence processes, which helps purchasers determine the authenticity of financial assets.

Due diligence under SEBI (Merchant Bankers) Regulations 1992 makes sure that the acquirer’s financial resources are adequate. As held in Imperial Corporate Finance and Services v. SEBI, the term due diligence is not limited to passively noting the data informed by the client but mandates the merchant banker to take proactive steps to enquire the material information worth finding out. 

In Electrosteel Castings Limited. v. SEBI, the SAT opined a proper definition of the term ‘material information’ is fundamental as it will aid in the determination of necessary information disclosure. This has to be determined from the viewpoint of a reasonable investor. 

Legal advisors under Section 11 of the SEBI Act 1992 are responsible for conducting vigorous due diligence of disclosures and representations made by their clients. Their main task is to assess the possible risks which are apprehended due to omission of disclosure of material information.

The willful concealment of material information, which has the potential to affect the market price of securities, is considered a fraudulent trade practice under SEBI (Prohibition of Fraudulent and Unfair Trade Practices) Regulations 2003. 

Therefore, it is the duty of market intermediaries to be vigilant, so SEBI does not take cognizance in the matter itself.

THINGS CHANGED IN PANDEMIC

The outbreak of pandemic has led the leading economies such as the US, China, the UK, Germany, on the verge of collapse. With this fall of global markets, the risks relating to negotiating M&A transactions have grown exponentially. This risk can be segregated in two significant heads: due diligence activities and Material adverse change (MAC) clauses negotiations. The primary rationale behind the introduction of takeover regulation was the protection of investors. This new regulatory regime mandates transparency between purchasers and investors. This promotes more informed decisions between them.

In India, regulations make the Takeover offers very rigid, which make it very difficult for an investor to withdraw. Regulation 23(1)(d) of the Takeover makes it clear that withdrawal can be affected only after SEBI’s approval, where it is satisfied that to honor the Takeover is totally impossible. In Nirma Industries Limited v. SEBI, the Supreme Court held that reasons like economic non-viability and non-profitability are not adequate to run off from honoring the open offers.

DUE DILIGENCE ACTIVITIES

Because of the new regulatory regime, merchant bankers and legal advisors now have to be very cautious of manipulated and distorted corporate disclosures with intent to suppress the material information. Therefore, the declarations made by the clients of having ‘firm financial arrangements could have a severe deviation in situations of falling corporate valuations. In HSBC Securities Limited v. SEBI, Tribunal observed that merchant bankers should not depend on SEBI, the target company, or the auditor’s response to perform the process of due diligence. As in this pandemic, the formal in-person meetings are not possible; merchant bankers should perform due diligence by means of video conferences or telephonic conversations. 

MATERIAL ADVERSE CHANGE (MAC) CLAUSES

In an M&A transaction, the time between agreements signing and closure of the transaction is significant. This is where the MAC clause comes in light. MAC clause allows the parties to terminate the contract on the occurrence of an event, which brings material changes affecting the viability of the transaction. 

 It is often noticed that there lies a massive burden on the purchaser to invoke the MAC clause. In Luxottica Group SpA v. SEBI, SAT observed that it is possible to make an open offer subject to reasonable conditions, which, if not fulfilled because of reasons beyond the acquirer’s control, makes withdrawal permissible subject to takeover regulations. Regulation 23(1)(c) of the Takeover regulation also allows the acquirer to do so. However, in Nirma Industries Limited v. SEBI, SC held that all withdrawal conditions must fall under a common ‘genus of impossibility’.

The Madras High Court in Subhishka Trading Services Ltd. v Blue Green Constructions & Investments observed that as the transferor company is trapped under financial distress and soon will be undergoing liquidation. This winding up of the company made the transaction impossible. Therefore, open offers can be considered as rigid, still maintaining some space for possibilities that can make honoring of the transaction impossible, and SEBI can allow the withdrawal.

HOW COURTS AND TRIBUNALS MIGHT RULE ON THIS MATTER?

Before coming to any conclusion on this matter, it is pertinent to note the stand of Indian courts on force majeure clauses. Force majeure provision is placed under Section 56 of the Indian Contract Act 1872. This discharges the parties, who are unable to perform their part due to unanticipated circumstances on the grounds of impossibility. In Energy Watchdog v. CERC, the Supreme Court followed a very narrow and restrictive interpretation of the force majeure clause. Also, the apex court summarized that the courts are not vested with the power to absolve parties from the performance of their part until the very foundation of the contract is affected.

ANALYSIS

In common parlance, the due diligence is an iterative process and evolves with time. It is a general rule and seconded by courts in several instances that if buyer seeks specifics, the seller cannot state misleading facts when it is aware of the real facts are material for buyer to make informed decisions. The disclosures should reflect various vital information such as financial performances, supply chain relationships etc. This will create lucidity in decision making processes, thus establishing fair market dealings. Also, MAC clauses should be made as exhaustive as possible.

Before this COVID pandemic, the words ‘pandemics’ or ‘epidemics’ were generally not used in MAC clause. But now, legal advisers should ensure that these words are included in the contract so that their clients have the option to walk away from the contract in case of disproportionate financial impact on the target.

In order to balance the risk of fluctuations in valuations, the seller will now have to push for post-closing adjustments of price. This will also prevent the buyers from abandoning the agreements in case this pandemic prolongs. It will be enthralling to examine the approach and measures SEBI takes for revamping the pandemic hit securities market.

Ranjeet Soni is a 4th Year Student at Dr. Ram Manohar Lohiya National Law University, Lucknow and Rohit Shrivastava is a 4th Year Student at Institute of Law, Nirma University, Ahmedabad.