The author is Sathya Pratheeka, a third year student at ICFAI Law School, Hyderabad.
Reverse Mergers (RM) have emerged as a notable phenomenon in the Indian corporate landscape, presenting an alternative route for companies to achieve strategic objectives and access capital markets. Diverging from the customary paradigms of conventional mergers predicated on acquirer-target dynamics, reverse mergers manifest as a distinctive modus operandi wherein a privately held entity (Private Company) merges with a publicly listed shell company (Public Company) (a dormant entity with minimal business operations created to hold funds and manage another entity’s financial transactions, is known as a shell company), thereby conferring upon itself the status of a listed entity in the stock market.
In simple terms, when an active Private Company merges with a dormant Public Company, it is called a Reverse merger wherein the Private Company buys most of the shares of the publicly listed company after which both merge.
The legal landscape governing reverse mergers in India is muddled with regulatory gaps and ambiguous provisions. This article seeks to address this legal quandary by highlighting the regulatory gaps in provisions governing reverse mergers in India, emphasizing best practices followed in international jurisprudence, more specifically in USA and China, and suggesting the way forward for RMs in India.
CURRENT LEGAL FRAMEWORK:
Under the current legal framework, reverse mergers in India are regulated but not prohibited. Section 232(2)(h) of the Companies Act, 2013 provides that: “ where the transferor company is a listed company and the transferee company is an unlisted company,—
(A) the transferee company shall remain an unlisted company until it becomes a listed company.
(B) if shareholders of the transferor company decide to opt out of the transferee company, the provision shall be made for payment of the value of shares held by them and other benefits in accordance with a pre-determined price formula or after a valuation is made, and the arrangements under this provision may be made by the Tribunal:”
This provision was incorporated to prevent the Private Company from taking advantage and ensuring that the Private Company goes through the process of listing by satisfying all the compliances.
Further through SEBI circular, it was provided that listed companies undergoing mergers require mandatory approval from SEBI, by way of getting a No Objection Certificate (“NOC”) from SEBI, further SEBI circular mandates that Pre-scheme public shareholders of the listed firm and qualified institutional buyers of the unlisted entity must collectively control at least 25% of the shares in the “Merged” company after the RM and also suggest for Lock-In requirements.
While these provisions seek to regulate reverse mergers, though by explicitly not mentioning RM, there are a few ambiguous provisions that might pose a threat to all the stakeholders, thus escalating the need for a proper and systematic regulatory framework for reverse mergers in India.
REGULATORY GAPS IN THE EXISTING FRAMEWORK:
1. Lack of Explicit Guidelines Regarding the Determination of Consideration Offered to Shareholders of a Company During an Exit Scenario in Reverse Mergers:
In the merger, the Private Company shareholders are issued a majority stake in the shell company in exchange for their operating company shares.
As per Section 232(h), “a provision is made for the payment of the value of shares held by them shall be paid which shall not be less than the amount specified by SEBI''. While it is mentioned that the value of shares is to be given to the exiting shareholders, no specific guidelines are provided for the determination of the value which shall be paid to the existing shareholders as a consideration. The events which can be considered for the determination of the value of shares given to the shareholders of the transferor company are not provided. The absence of specific guidelines for the same can jeopardize the interests of the shareholders of the Public Company. Further section 232(h) provides that the transferor company shareholders shall be given the value of their shares and “other benefits”. It is nowhere defined as to what the other benefits given are. This may lead to the distribution of disproportionate benefits to the shareholders of the Public Company. The absence of a clear definition of the same is detrimental to the interest of the shareholders of the Public Company.
2. Lack of specific guidelines for mitigating the risks associated with reverse mergers:
In Reverse Mergers, the risks and liabilities associated with the public shell Companies are carried forward to the merged entity. There are various risks associated with reverse mergers, such as, reverse mergers can be used as a way for companies with questionable financials or poor prospects to gain access to public markets. This can lead to the dumping of risky stocks onto unsuspecting investors. Further, lack of investor confidence, particularly if the private company's track record or industry is not well-known, can result in limited trading activity and low demand for the merged company's stock. This illiquidity can negatively impact the ability to raise capital or exit position, etc. All these risks pose a greater threat to the merged entity. The lack of guidelines for mitigating the same can prove counterproductive for the merged entity.
3. The risks associated with cross-border reverse mergers:
Although cross-jurisdictional reverse mergers are currently not widely recognized in India, their prominence is expected to grow rapidly due to the significant increase in reverse mergers within the country. Cross-border reverse mergers are an easy way for foreign private entities to enter the Indian Stock market without needing to comply with the cumbersome listing process. However, such cross-border mergers have risks associated with them such as financial risks including exchange rate fluctuations, potential access or control of personal or confidential data by foreign entities that may pose risks to national security, etc. If there are no provisions mitigating the risks associated with such reverse mergers, it can endanger the interests of the Indian entities.
4. Lack of guidelines for the complete disclosure of the information by the transferor company and ambiguity of delisting regulations:
When a public shell company merges with a private company, it is important to have an absolute disclosure of information by the public company as non-disclosure of essential information like unrealized debt, pending litigations, etc can be detrimental to the interests of the Private Company. There are further chances that the public company with a mal intention of gaining undue advantage from the merger with the private company may hide vital information which may reduce the valuation of the public company or may jeopardize the deal itself. Hence, the lack of proper regulations about information disclosure can affect private transferee companies' interests. Further, it remains unclear if the Delisting Regulations apply to the RMs. Lack of clarity on the same can lead to the delisting of companies without complying with the Delisting Regulations.
Recommendations and Way Forward: A Hybrid Approach
While discernible regulatory gaps persist within the existing Indian framework, it is imperative to address and rectify these deficiencies through the implementation of a novel regulatory framework. Drawing inspiration from the regulatory frameworks of the United States and China, given the exponential surge of reverse mergers in these jurisdictions, selective incorporation of certain provisions into the Indian framework becomes warranted. Noteworthy provisions found within the US framework, such as Rule 419, propose the inclusion of an opt-out option for dissatisfied investors, whereby if a minimum threshold of 80% chooses not to participate, the merger cannot happen, thereby safeguarding the interests of Public Companies. Furthermore, another crucial provision mandates the disclosure of pre-audited financial statement from both public and private entities after the reverse merger. These provisions can be assimilated into the Indian regulatory framework to ensure comprehensive stakeholder protection.
In the Chinese regulatory framework, the rules governing asset restructuring of listed entities are applicable to RMs as well. Article 25 of the Administration Measures for Significant Asset Restructuring of Listed Companies entails the review of a detailed RM proposal plan, akin asset reconstruction plan review, before the actual merger takes place. This plan is subject to scrutiny by the CSRC's Restructuring Committee (CRC), which subsequently approves the proposed reverse merger. Although a similar mechanism exists in India through the requirement of obtaining a NOC, the extent of scrutiny remains limited. Therefore, it is recommended to establish a dedicated committee, akin to China's CRC, for meticulous examination of reverse merger schemes or proposals.
The author opines that the prevailing Regulations predominantly aim to impede reverse mergers rather than effectively regulate them. Consequently, the framework should draw inspiration from both the US and Chinese legal frameworks, while duly considering the interests of majority and minority stakeholders involved in reverse mergers. It is essential to incorporate provisions that mitigate the risks inherent in cross-border mergers. Additionally, the ambiguities present in the existing Indian regulatory provisions concerning reverse mergers, as highlighted earlier in this article, must be precisely defined to eliminate potential loopholes. Furthermore, the author suggests that reverse merger provisions should have a separate regulatory mechanism to adequately address the distinct risks associated with RM and enable more robust regulation.
The provisions dealing with Reverse Mergers in India are ambiguous and are muddled with loopholes. Though existing provisions seek to regulate the RMs, there are regulatory gaps as highlighted which can jeopardize the interests of stakeholders. These gaps can be filled in by the introduction of a new regulatory framework by drawing in positive aspects from the regulatory provisions from the legal framework in USA and China.