Friday, May 27, 2011

Non Compete Fee: Is SEBI going too far for investor interest

In a recent Securities Appellate Tribunal (SAT) judgment SEBI directive to include non-compete fee in offer was turned down. E-Land Fashion China Holdings Limited, the appellant appealed to SAT with regards to SEBI directive to amend its offer letter by adding the Rs. 15/- of non-compete fees to the offer price of Rs. 60/- per equity shares offered to the equity shareholders of the target company Mudra Lifestyle Limited.

Non-Compete fee or Control premium is an amount over and above the agreed purchase price paid to the promoters of a target company preventing them from engaging, whether directly or indirectly, in the similar business for an agreed ‘non-compete’ period. It is often a case that the promoters are hands on with the business and know each and trade secrets. They have the right contacts in that particular business and are usually repertoire of high end technical / commercial information. Therefore, in order to protect the interests of the acquirer and also of the small shareholders who decide to stay with the company, a non-compete fee is paid to the promoters for not engaging in similar business for a period of time. Such, amount is not added to the price offered to the ordinary shareholders of the company, unless it is more than 25% of the offer price as mandated in Regulation 20 (8) of SEBI (SAST) Regulations, 1997, or simply Takeover Code.

However, a contrarian view can also be taken with regards to non-compete fee or control premium. It can be argued that it is a way of benefiting a large shareholder for the control over the target company, denying other shareholders the same benefit. Even SEBI Takeover Advisory Committee in its report dated July 19, 2010 suggested that such payment would not be fair on the minority shareholders of the target company, as the benefit should accrue to the company not only to a particular group of shareholders.

Coming back to the case, it was argued on the behalf of the SEBI that since the original promoter still hold 18.8% of the post offer shareholding and will have the right to appoint two directors, jointly select two independent directors and will select one Joint Managing Director, it can be presumed that they will be in the joint control of the target company.

The counter arguments provided by the representatives of the appellant focused on decided cases of Tata Tea Ltd. and Cementrum IBV and the fact that the directors of a company can also resign from their directorships. It was urged that the outgoing seller have managerial as well as financial capability to compete with the target company and to avoid such eventuality such non-compete fee is paid to the promoters.
The Tribunal concurred with the views of the appellant and held such payment to be valid and not to be added to the offer price. Defending its view, following logic was propounded by the Tribunal:

“It is the case of the appellant which is not disputed by the Board that Mr. Murarilal
Agarwal and Mr. Ravindra Agarwal are family members who were earlier promoters
of Bombay Rayon Fashions Ltd. which was carrying on business similar to that of the
target company. They separated from that company and promoted the target company and built it up as a strong competitor in the Indian textiles business with the assistance of Mr. Vishwambharlal Bhoot. The promoters have more than 20 years of experience in textiles business and have extensive knowledge of the market and intimate knowledge of the target company’s business, employees, suppliers, customers, systems and technological know-how. In this background, they are capable of offering competition to the target company. The appellant, on the other hand, belongs to the South Korea based E-Land Group of Companies which has limited operating experience in the textile manufacturing industry in India. Having taken over the target company, it would like to take the benefit of the knowledge and expertise of the promoters in managing such a business in India and it is for this reason that they are being associated with the target company. In this background, we are satisfied that the promoters have the capability of building a strong business from scratch and as a result of their understanding of the market they have the ability to compete with the business of the target company. If they were to do that, it would neither be in the interest of the target company nor in the interest of its shareholders. We are further satisfied that the payment of non-compete fee in the instant case is not an attempt on the part of the appellant to reduce the cost of acquisition to discriminate against the public shareholders.”

The Tribunal had the similar view in earlier cases of Tata Tea Ltd. and Cementrum IBV. In the case of Tata Tea Ltd the Tribunal had held “When an acquirer takes over a business from the outgoing seller(s), it is obvious that the sellers have specific knowledge of that business and have access to and are in possession of crucial trade secrets of the target company which if disclosed or misused would be detrimental to and could cause irreparable harm to the target company and its continuing shareholders and by virtue of their association with that business, they (out going sellers) are capable of offering competition to the business being taken over. In such cases, it would be legitimate for the acquirer to enter into a non-compete agreement with the promoter sellers if he feels threatened by a lurking fear of competition from them. It is neither for the Board and not even for this Tribunal to analyse the threat perception of the acquirer. We are of the view that a non-compete agreement would then protect not only the target company but also its continuing shareholders.”

Therefore, in all above cases, it was held by the Tribunal that non-compete fees is valid given the position of the promoters in the market and the law which mandates it. SEBI though have the right to vet the offer in terms of Regulation 18 of Takeover Code and suggest changes which should be carried out by the acquirer. However, it must tread carefully while deciding whether non-compete fees should necessarily added to the offer price for the benefit of the ordinary shareholders. It is an unalterable fact, that in many cases it is the promoter’s ingenuity that gets his business to new height and same ingenuity can be used against the company when he sold out, and instead of benefiting the ordinary shareholder it would only harm the existing holders, who in good faith acquired the company. It is up to the SEBI for not going too far in name of investor protection and let the investors decided themselves what is good for them.

© Tarun Mitra

May 27, 2011


7.      The Economic Times, “ Non-Compete Fee: SAT Rejects Sebi Directive” May 26, 2011

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