Background

The duty to disclose “encumbrances” arose in 2009 when the Satyam scandal surfaced wherein the promoters had pledged their shares to financial institutions without the knowledge of the remaining shareholders. Thereafter, the norms regarding disclosure of encumbrances were tightened in the interests of investors and other stakeholders involved. SEBI has frequently broadened the definition of encumbrance to include all transactions under its ambit. However, the recent order by SEBI in the case of YES Bank can be considered to be an unprecedented event for companies that try to avoid disclosures to the stock exchanges in India.

Notably, SEBI is not the only regulatory body observing the share pledging activity of promoters. The RBI’s Financial Stability Report of June 2019 has also taken note of the increased promoter activity in this regard. Such activities by promoters raise a red flag about the company’s financial health and its inability to borrow funds through other means. It further demonstrates the risk factor involved in the pledging activity that can hamper the growth of the company.

Revised Position

Regulation 28(3) of the SEBI (Substantial Acquisition of Shares and Takeover) Regulations, 2011 [Takeover Code] had earlier defined ‘encumbrance’ to include a pledge, lien or any other transaction by whatever name called. However, the definition was widened vide an amendment in 2019, to also include:

  • Any restriction on the free and marketable nature of shares, whether directly or indirectly.
  • Any pledge, lien, and non-disposal undertaking.
  • Any transaction, covenant, condition, or arrangement which can be an encumbrance and has been executed either directly or indirectly.

The Takeover Code[i] now requires the promoter to disclose any encumbrance on the equity shares of a listed company pertaining to its creation, invocation, or release. If the promoter defaults in the repayment of debts, it can lead to an invocation of the encumbrance triggering the lender to carry out a distress sale of shares. The share prices will plummet as a result of such a sale thereby hurting the interests of shareholders. These Regulations show SEBI’s intent to protect investors from facing grave consequences due to the value erosion of their shares.

SEBI’s Order in the case of Yes Bank

Facts of the Case

SEBI in its order imposed a penalty of Rs.50 lakhs each on two promoter entities, i.e., Morgan Credits Private Limited [MCPL] and Yes Capital India Private Limited [YCPL], for non-disclosure of encumbrances on their shareholding in Yes Bank Limited [YBL]. Both the entities had collectively raised a staggering amount of Rs.1,580 crores from mutual funds through the issue of zero coupon non-convertible debentures. Furthermore, the two entities had agreed to maintain a cover ratio or borrowing cap under the trust deed executed by them.

Analysis of the contentions raised

SEBI has discussed various issues regarding the failure of non-disclosure of encumbrances by the promoter entities in this case. They are enumerated below:

  • Whether the maintenance of cover ratio or borrowing cap is covered under the purview of ‘encumbrance’ in relation to YBL shares?

The promoter entities argued that the term ‘any transaction’ mentioned under Regulation 28(3) is exhaustive and not inclusive in nature since the transactions are not specifically defined. Further, the entities contended that the cover ratio or borrowing cap does not amount to an encumbrance since they do not affect the marketability of the shares directly or indirectly. Maintenance of cover ratio is essential for financial prudence but does not create an encumbrance on the shares. As a response to the same, SEBI observed that while the agreement does not restrain the company directly from disposing of (sell/purchase) the said shares, the requirement of an asset cover invariably has the same impact on the shares. Breach of the asset cover could result in triggering a default of the underlying debt.

  • Is the principle of Ejusdem Generis applicable?

The other contention of the entities was whether the principle of ejusdem generis is applicable in the current case with respect to Regulation 28(3). This is a principle that focuses on the linguistic implication by which words when isolated have a broad meaning but are reduced in scope due to verbal context.[ii] The phrase ‘any such transaction’ that appears after the words ‘lien’ and ‘pledge’ when construed using the aforementioned principle would imply any encumbrance which is similar to or have the same characteristics as lien or pledge. However, the promoters argued that the transaction entered into by them does not bear any similarity to a pledge or lien and hence would not amount to an encumbrance under Regulation 28(3).

While responding to this contention, SEBI held that the principle of ejusdem generis does not have a universal application and cannot be construed such that it goes against the purpose of the law. Furthermore, SEBI has emphasized on the inclusion of the words ‘by whatever name called’ in Regulation 28(3) that indicates its intent to encompass all transactions. If the intent of SEBI was to restrict the applicability of the obligations to pledge or lien, then the aforesaid words would not be included under Regulation 28(3). Therefore, the Takeover code which is a social welfare legislation must be interpreted keeping in mind the purpose of the law and any provision which frustrates the same must be repudiated.[iii]

  • Does a non-disposal undertaking create an encumbrance?

The FAQ 72 floated by SEBI states that all non-disposal undertakings by promoters will come under the purview of disclosures of ‘encumbrances’ under the Takeover Code. Thus, in light of the FAQ, the scope of encumbrances is wide enough to envisage encumbrances that entail a risk of the promoters’ rights on shares being appropriated or sold by a third party, directly or indirectly. They also include undertakings that encumber or restrict promoters’ rights on the shares held by them which need to be disclosed to the stock exchanges under Regulation 31(1) of the Takeover Code. This explanation rendered by SEBI depicts the inclusive nature of the transactions that are covered under the definition of encumbrance thereby shunning the exhaustive interpretation of the same.

  • Can the Depositories Act override the Regulations of the Takeover Code?

When the applicability of section 12 of the Depositories Act was taken into consideration, SEBI held that the Depositories Act can only supplement and not supplant the SEBI Act and the Takeover Code. Section 12 of the Depositories Act provides for the creation of pledge and hypothecation of securities in the depository system. Therefore, hypothecation being a sub-set of encumbrance which is included in the said Act may fall under the ambit of ‘any such transaction’ under Regulation 28(3). Hence, section 12 of the Depositories Act must be read comprehensively along with Regulation 28(3) to given an inclusive interpretation to the definition of ‘encumbrance’.

Concluding Remarks

It is pertinent to note that the aim of the disclosures mandated by the Takeover Code is to ensure more transparency in the company’s affairs. Timely disclosures by the promoters are essential for investors to make a well-informed decision about whether to invest or not in a company’s shares. Further, if the required disclosures are made by promoters without any concealment, it facilitates the efficient monitoring of transactions by the SEBI in the capital markets.

Moreover, the definition of encumbrance being broadened by SEBI is a welcome move especially since many transactions like non-disposal agreements, non-disposal undertakings, creation of negative lien, and other transactions of similar nature were not covered under the definition of encumbrance. Thus, widening the applicability of the term to encompass any kind of encumbrance is essential to curb malpractices by promoters and ensure market integrity. Several promoters in the past have formed complex structures to bypass the scope of encumbrances but the same will be strenuous to achieve under the new regulatory regime. Due to the widened scope of encumbrance under the new definition, SEBI can now enforce actions against structures that have flouted the Takeover Code even if they are not explicitly specified under the definition of encumbrance.

[i] Regulation 31, SEBI (Substantial Acquisition of Shares and Takeover) Regulations, 2011

[ii] Maharashtra University of Health Sciences and Ors. v. Satchikitsa Prasarak Mandal and Ors. (2010) 3 SCC 786

[iii] SEBI Vs Ajay Agarwal, CIVIL APPEAL NO.1697 OF 2005

Relevant Links-

1. Recent order by SEBI in the case of YES Bank

https://www.sebi.gov.in/enforcement/orders/mar-2020/adjudication-order-in-respect-of-two-entities-in-the-matter-of-yes-bank-ltd-_46477.html

2. The RBI’s Financial Stability Report of June 2019

https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/FSRJUNE2019E5ECDDAD7E514756AFEF1E71CB2ADA2B.PDF

3. FAQs ON SEBI (SUBSTANTIAL ACQUISITION OF SHARES AND TAKEOVERS) REGULATIONS, 2011

https://www.sebi.gov.in/sebi_data/faqfiles/aug-2017/1503313163982.pdf

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