By: Shuchi Agrawal & Isha Ahlawat
At the heart of corporate management and ownership, lies a mutual agreement among shareholders about how to manage the company. However, achieving consensus among all shareholders may not be feasible at all times, and this has given rise to “majority-owned and controlled corporations.” This principle found firm footing in company law early on in the case of Foss v. Harbottle (hereinafter ‘Foss case’), where the courts indicated that they would refrain from interfering with a company’s decisions, if they were made by the majority, except in some instances, such as fraud or oppression. The Utilitarian school of thought lent weight to this approach as it provided the majority with greater power to make decisions.
“Squeeze-out” or “freeze out” provisions as they are known in some jurisdictions, enable the majority shareholder to compulsorily acquire the equity shares of the minority shareholders of a company, by giving them fair compensation in return. In India, minority squeeze-outs may be effected under section 235 of the Companies Act, 2013 (hereinafter ‘Act’). Majority shareholders having at least 90% shareholding in a particular company can acquire shares held by minority shareholders, during a takeover. The 90% threshold is consistent with the majority principle, established in the Foss case.
However, in AIG (Mauritius) LLC v. Tata Tele Ventures, an attempt was made to interpret section 395 of the Companies Act, 1956, the provision similar to Section 235 under the Act in a manner that upholds the concept of shareholder democracy in India. It was held that the 90% requirement would only be met if it comprised of “different and distinct persons.” This qualifying factor had been established in order to justify “overriding” the interests of the minority shareholders, but it poses unique challenges in the context of “closely-held private and unlisted companies.” The shareholding of such companies may be held by a very few people, who may have a large shareholding. In such an event, it would be difficult for them to meet this threshold.
Other regulations that govern squeeze-outs in India are section 230 (11) and (12) of the Act which have been notified by the Ministry of Corporate Affairs recently and the Companies (Compromises, Arrangements and Amalgamations) Amendment Rules, 2020. Further, the Takeover Notifications were also notified, which allow shareholders of an unlisted company, “holding at least 75% securities” along with voting rights to compulsorily acquire the shares of the minority shareholders, after a court approved compromise. Another method of initiating a minority squeeze-out is the reduction of share capital, under section 66 of the Act. Under this method, a company buys back certain issued shares, and cancels them, which may cause the “exit of a shareholder.” In Sandvik Asia Limited v. Bharat Kumar Padamsi and Ors., it was held that reduction of share capital could be used to squeeze-out minority shareholders if they had been offered fair compensation, and the actions were taken according to the relevant Act.
Further, another method of conducting a minority squeeze-out is the consolidation of shares. This exercise allows the company to consolidate the “nominal value of shares,” which causes the number of shares to decrease, but increases the nominal value of every share. A reverse stock split, however, is more commonly done when the price of the shares reduces, in order to attract investors or prevent delisting. Provisions governing consolidation of shares are to be found in section 61(1) (b) of the Act, and Rule 71 of the National Company Law Tribunal (NCLT) Rules, 2016.
PROTECTING MINORITY SHAREHOLDER’S INTEREST
While all the aforementioned approaches serve as effective methods for effecting a minority squeeze-out, these approaches may place the minority shareholders in a vulnerable position, devoid of sufficient protection. Fair valuation and pricing of shares is an important consideration in a minority squeeze-out exercise. For a takeover to take place, a valuation report needs to be prepared, which must mention the highest price which had been received by any person for selling a share, during the previous 12 months, and the “fair price of shares” of the relevant company. The fair price of shares has to be determined based on multiple factors, such as earning per share, and “return on net worth.” In the Cadbury India Limited judgment, certain principles had been established to ascertain whether a selective share capital reduction would be fair. These principles made it necessary to fairly evaluate share prices, by taking into account previous share prices and offers. Nonetheless, the same judgment also stated that simply receiving a smaller monetary compensation, than what a shareholder may want, would not constitute “prejudice.” Only forcing “a class of shareholders” to sell their shares at a price which is far lesser than what would be considered reasonable and just would constitute prejudice. However, the fair valuation of shares is a difficult procedure, and may place the minority shareholders at a disadvantage. For instance, a minority squeeze-out may be initiated at a transitory time when the shares of the company are “lowly valued” or immediately before a profitable transaction which would raise share prices.
On a more fundamental level, minority squeeze-outs deprive the minority shareholders of their property. It has been claimed that by making squeeze-outs valid under law, the dispossession of property has been legalized. Squeeze-outs could also be said to violate the principle of proprietary interest, which stipulates that all shareholders have a proprietary interest in the company and must be protected against any attempts to obstruct the peaceful enjoyment of the possession. Nonetheless, European courts have clarified that proper management of a company is a matter of public interest, and hence, squeeze-outs are valid under law. Despite this, minority squeeze-outs raise concerns regarding shareholder democracy, which has been defined as the shareholder’s ability to influence the company’s governance and decisions, due to ownership rights. Further, ownership patterns such as diffuse or concentrated shareholdings are directly impacted by the extent to which a jurisdiction protects minority shareholders.
From an economic perspective, when legal mechanisms to protect the minority shareholders are available, then investors are more inclined to diversify their investments, instead of accumulating a majority shareholding in a public company. On the other hand, it has also been suggested that a flexible regime for squeeze-outs, such as one that exists in US where squeeze-outs can be effected at a threshold of merely 50% of the shares, might be beneficial since it addresses a holdout problem and a free rider problem in the market for corporate control. Moreover, squeeze-outs may also lead to more “value-increasing entrepreneurial projects and to more efficiently managed companies” as costs related to minority shareholders diminish. However, as discussed previously, minority squeeze-outs also have a risk of expropriation, i.e. “a transfer of value from the minority shareholders to the controlling shareholders.” Thus, the primary function of a law that regulates minority squeeze-outs is to efficiently deal with the second agency problem and maintain a balance between the interests of the majority and the minority shareholders.
MINORITY SHAREHOLDER PROTECTION IN SQUEEZE-OUTS- LESSONS FROM COMPARABLE JURISDICTIONS
In the US, the main agency problem that corporations often witness is that of opportunism of managers vis-à-vis shareholders. Since this is often not the case in India due to the presence of concentrated shareholding and ubiquity of family- owned business conglomerates, it is prudent to analyse minority shareholder protection in jurisdictions that face agency problems and have corporate ownership similar to India. In the EU for instance, corporations often face the risk of opportunism of controlling shareholders vis-à-vis minority shareholders.
Articles 3 and 4 of the Third Council Directive Concerning Mergers of Public Limited Liability Companies (Third Directive) and Articles 5 and 15 of the Thirteenth Directive on Takeovers (the Takeover Directive) govern the process of squeeze-outs in the EU. The former applies when two corporations merge. Shareholders of both the corporations receive shares according to an exchange ratio that has been approved by the shareholders and boards of both the parties. To discern whether the ratio is fair, an independent expert is appointed by the judiciary and damages can be sought in case the ratio is found to be unfair later. The Takeover Directive on the other hand offers a two-step approach and member states can choose either. Under the first approach, the controller of a listed firm must launch a mandatory bid, which is a tender offer for the shares that remain, if the bidder has crossed a specified threshold of the firm’s voting rights. Under the second approach, the squeeze-out can be conducted by seeking the consent of the majority of the minorities.
Although EU law provides a far greater degree of protection to minority shareholders than most other jurisdictions, Professor Aurelio Gurrea-Martínez has suggested that in order to make European takeover law more protective of the interests of public investors, it should be amended in three ways– Firstly, a non-frustration rule for corporate directors should be implemented at the level of the firm. Secondly, the shareholders of the concerned European corporations should be empowered to allow the managers to use any “anti-takeover defense, including poison pills and staggered boards.” Thirdly, the mandatory bid rule which exists in European takeover law should become default at the level of a firm. These amendments primarily seek to better equip a company to fight a hostile takeover and can be considered for adoption into India too. India has largely been immune to the phenomenon of hostile takeovers, except fora few instances, such as India Cements Limited’s acquisition of Raasi Cements Limited in 1998, and thus, Indian lawmakers have given it scant attention. The Takeover Code modelled on UK City Code on Takeovers does not sufficiently protect the rights of minority shareholders and must be evolved to protect vulnerable shareholders in a squeeze-out.
Lessons can also be learnt from Australia where minority shareholders can challenge a resolution of the majority in a general meeting if it is felt that it constitutes a fraud on the minority. This can be useful in combating situations in India where capital reductions can be approved by “majority of the minority” voters even though they may be prejudiced against the interests of a small minority. Moreover, the takeover regime under Australia’s Corporations Act, 2001 is based on Eggleston principles that promote fairness, equality of opportunity and protection of minority shareholders over economic efficiency. It must be noted, however, that Australia’s laws on takeovers are considered to be among the most restrictive in capitalist economies and transplanting them directly may cause problems for a developing economy like ours. In this regard, looking at squeeze-out reform in a developing economy like South Korea, which also has a predominantly concentrated shareholding pattern is important. In South Korea, similar to the US long-form merger, a cash-out merger exists that enables shareholders in the company that is subject to a takeover, to receive cash or property apart from shares in the acquiring company. Additionally, a supermajority-type squeeze-out device like India also exists where a dominant shareholder having more than 95% of the outstanding shares can make minority shareholders sell their shares. However, similar to the right granted in UK’s Companies Act, 2006, South Korea, as a “counterpart to a dominant shareholder’s squeeze-out right”, protects minority shareholders with corresponding sellout rights where “minority shareholders may require being ‘cashed out’” in the presence of a dominant shareholder, who has more than 95% of the company’s shares.
On a perusal of minority squeeze-out and takeover regulations in different jurisdictions, it is evident that the level of protection afforded to minority shareholders in India is weak. Since courts in India have tended to show a promoter-bias by largely refraining from interfering in a company’s domestic matters, save for specific instances, as long as the resolutions have the support of the majority, relying solely on courts to protect minority shareholders during squeeze-outs would be a mistake. In the EU too, strong regulations are preferred to protect the interest of minority shareholders rather than relying on possible judicial intervention. There are jurisdictions such as the UK and Singapore, which have squeeze-out regulations that are similar to that of India to a great extent, and where courts have adopted an interventionist approach and squeeze-outs have been closely scrutinised if they are alleged to have been conducted in a manner detrimental to the interests of the minority. Such an approach is lacking in India.
Other protections borrowed from best practices internationally, such as giving minority shareholders the power to challenge a resolution in a general meeting if it constitutes a fraud on them or, requiring a “majority of the minority” vote to effect a squeeze-out, or giving SEBI greater powers of investigation and adjudication to regulate squeeze-outs, since it possesses greater financial and commercial expertise compared to regular courts, must be considered. Majority of minority vote is used in India for several purposes such as compulsory acquisitions, related- party transactions and so on but not for squeeze-outs. India can also consider restricting the types of squeeze-outs that are allowed, like the EU does, to impose checks and balances on the wide powers of discretion that controllers enjoy. Whichever route is adopted, the goal of minority protection must be balanced with the need to protect squeeze-outs that enhance value.
Cite as: Shuchi Agrawal & Isha Ahlawat, ‘Minority Squeeze Outs Under Takeover Law: An Analysis’ (The RMLNLU Law Review Blog, 5 October 2021) <https://rmlnlulawreview.com/2021/10/05/minority-squeeze-out/> date of access