A. Introduction:

A recent adjudication order (Order) of Securities and Exchange Board of India (SEBI), in the matter of Yes Bank Limited (YBL), clarifies SEBI’s view on what constitutes an ‘encumbrance’ on shares, bringing within its ambit, any promoter covenants that are entered into to maintain ‘cover ratio’ or ‘borrowing cap’, as they have an impact on the free marketability of listed shares.

Yes Capital (India) Private Limited (YCIPL) and Morgan Credits Private Limited (MCPL) failed to disclose that they had covenanted to maintain the ‘cover ratio’ or ‘borrowing cap’ in relation to the shares of YBL, while raising debt via issuance of non-convertible debentures (NCDs). The disclosure norms under the Regulations require that all encumbrance in relation to listed shares held by promoters be disclosed to the relevant stock exchange. SEBI held both promoters i.e., YCIPL and MCPL to be in violation of disclosure norms under the SEBI (Substantial Acquisition of Shares and Takeovers), Regulations, 2011 (Regulations) and imposed a penalty of INR 50,00,000 (Indian Rupees Fifty Lakhs only) on each of them.

The Order is in line with the recent amendment to the definition of ‘encumbrance’ under the Regulations which include the following:

(i) any restriction on the free and marketable title to shares, by whatever name called, whether executed directly or indirectly;

(ii) pledge, lien, negative lien, non-disposal undertaking; or

(iii) any covenant, transaction, condition or arrangement in the nature of encumbrance, by whatever name called, whether executed directly or indirectly.

B. Facts of the Case:

YCIPL had issued NCDs to Franklin Templeton Mutual Fund under the terms of which, YCIPL was obligated to maintain a cover ratio of 3.3 times of the redemption amount from the date of allotment for12 (twelve)months and 3times thereafter till final redemption date on its shares held in YBL. In other words, the value of shares held by YCIPL would have to be at least 3.3 or 3 times, as the case maybe, the value of NCDs left to be redeemed.

Similarly, MCPL had also issued NCDs to Reliance Mutual Fund, under the terms of which MCPL was obligated to maintain a cap on the borrowing at 0.5 times of the market value of shares of YBL held by MCPL till final redemption date of the NCDs. In other words, the amount borrowed shall always be 0.5 times of market value of shares of YCL held by MCPL.

SEBI has taken a view that conditions for maintenance of ‘cover ratio’ and ‘borrowing cap’ restrict the promoters from disposing of promoters’ shares of YBL. Upon initiation of proceedings against YCIPL and MCPL and upon consideration of the submissions of YCIPL and MCPL, SEBI made the observations as set out below.

C. Observations by SEBI

(i)The obligation for disclosure under the Regulations of any sort of direct or indirect encumbrance on shares held by the promoters in the listed entity, is irrespective of whether the instrument of the transaction is secured or unsecured. Although, in the given case, the instruments issued were unsecured NCDs, which did not have any security on the assets of the promoter, they contained covenants for protection in the nature of lien or covers in favour of the debenture holders such as restriction on the transfer of shares, which create an encumbrance on the promoters’ shares triggering disclosure obligation under the Regulations.
(ii)Referring to the contentions of YCIPL and MCPL, that the Depositories Act, 1996(“Depositories Act”)is the principal regulation governing the creation of encumbrances in the depository system, and the same does not recognize the creation of non-disposal undertakings (NDUs) as an encumbrance, therefore there is no requirement of any disclosures to be made under the Regulations for NDUs, SEBI observed that Depositories Act, merely deals with manner of creation and disclosure of pledge and hypothecation of securities in dematerialized form but does not limit the nature and kind of encumbrance on securities. Further the Depositories Act, and the Regulations are supplemental to each other and not in derogation of each other as they all aim at investor protection.
(iii)While interpreting Regulation 28(3), SEBI observed that the rule of ‘ejusdem generis’ which is a Latin phrase meaning ‘of the same kind’, does not determine that the phrase ‘any such transaction’ shall be intrinsic to pledge or lien under Regulation 28(3).For inapplicability of the rule of ‘ejusdem generis’, SEBI relied on the Hon’ble Supreme Court’s ruling in SEBI vs. Ajay Agarwal and held that a welfare regulation such as the Regulations, has to be interpreted for furtherance of its purpose and not to constrict it, so that the real object of such provision is not frustrated. SEBI further observed that the phrase “by whatever name called” in Regulation 28(3) should be construed in a larger sense and cover a broader meaning to include all encumbrances and restrictions and not to limit the applicability of the obligations only with regard to pledge, lien or other similar transactions.
(iv)The condition to maintain a cover ratio of 3.3 times at all times, if breached, would require YCIPL to either transfer to itself or purchase such additional listed shares as required to maintain the cover ratio or redeem the debentures to restore such ratio, with the approval/ consent of the NCD holders, and not by the free will of YCIPL.
(v)The condition to maintain a cap on its borrowing at 0.5 times of the market value of shares of YBL held by MCPL, if breached, would require MCPL to transfer to itself or purchase such additional listed shares to maintain the borrowing cap or redeem the debentures to restore the borrowing cap ratio with the written consent from the majority of the debenture holders, and upon only their approval would such disposal will be considered valid.
(vi)SEBI concluded that the condition to maintain the required ‘cover ratio’ or ‘borrowing cap’ directly or indirectly restricts the ability of YCIPL and MCPL to dispose of the YBL shares. Thus, such covenants fall under the scope of ‘encumbrance’ under Regulation 28(3) and the promoters would be obligated to make appropriate disclosures under Regulations 31(1) and 31(3) of the Regulations.

D. Conclusion:

The Order is clearly in line with SEBI’s objectives of investor protection, supply of accurate information and maintaining credibility of the stock markets. However, promoters will now have to think twice before executing comfort letters, issuing net worth certificates, providing assurances on asset cover ratio or agreeing to any condition linked toits shareholding of a listed entity. This will in turn effect the ability of promoters facing short term liquidity issues to raise funds and may incorrectly signal distress in an otherwise viable listed company.

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The material contained in this alert is for informational purposes only. The views expressed are not those of K Law and do not constitute legal advice. K Law disclaims all liability to any person or entity for any loss or damage caused by errors or omissions in this alert. The author is this article is Vishal Bhat (Partner).

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