Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Towards a new takeover code

I wrote a piece
in today’s Financial Express about aligning the
takeover code more closely with market prices.

It has long been evident that the SEBI takeover regulations have been
founded on a fundamental and deep rooted distrust of market
prices. But it is only a high profile situation like Satyam that makes
us realise that this distrust has made the regulations unworkable.

Sebi has announced that it “recognised the special
circumstances that have arisen in the affairs of [Satyam] and
concluded that the issue needs to be dealt with in the general
context. Accordingly it was decided to appropriately amend the
regulations/ guidelines to enable a transparent process for arriving
at the price for such acquisition”.

I would argue that treating market prices with greater respect is
perhaps the simplest solution to the problem which is by no means
confined to situations of fraud like Satyam.

The takeover regulations stipulate that if any person wishes to
acquire 15% or more of the shares of a company, then such an acquirer
must make an open offer to the shareholders to buy at least 20% of the
shares of the company. It is also stipulated that the open offer must
be at a price which is the highest of (a) the average market price
during the previous 26 weeks, (b) the highest price at which the
acquirer has bought shares of the company in the previous 26 weeks and
(c) the price at which the acquirer has agreed to buy shares from the
promoters or other shareholders.

In the Satyam case, the problem is that share prices have fallen by
more than 80% and the 26 week average is possibly much higher than
what any acquirer would be willing to pay. The argument that is being
floated is that the prices before January 7, 2009 were based on a
fraudulent set of financials and therefore, those prices should
somehow be disregarded.

Unfortunately, the problem extends far beyond Satyam. For about
half of the BSE 500 companies, the last six month average share price
is greater than the current market price by 40% or more. For
two-thirds of the BSE 500 companies, the six month average exceeds the
current market price by 25% or more. Normally, there is a control
premium that an acquirer has to pay to take over a company and
therefore the acquisition price is about 20-30% above the pre-bid
market price.

In today’s situation, for somewhere between half and two-thirds of
the top 500 companies, the takeover regulations mandate an offer price
that is higher than a reasonable control premium. Sebi has unwittingly
shut down the market for corporate control for about half of India’s
largest companies. This is absolutely unacceptable.

Fraud is not the only reason why a company’s share price can fall
dramatically. Changes in fundamentals of the company, the industry or
the entire economy can lead to sharp falls in market prices. Within
the BSE 500, for example, many of even the better companies in real
estate, infrastructure, textiles, steel, metals, aviation and
commercial vehicles are in the situation where the six month average
price is 40% above the current market price.

The purpose of the takeover regulations is to create a healthy and
vibrant market for corporate control which allows companies to become
more efficient through acquisitions and restructuring. In today’s
depressed conditions, this mechanism is needed more than ever.

Unfortunately, in India, there are some vested interests of
merchant bankers and small investors who would like the takeover
regulations to become a mechanism for providing a free lunch to
minority shareholders. The same investors who clamour for ending fuel
and food subsidies are eager to get their own free lunches through
open offer pricing.

For the takeover regulations to serve their true purpose, they must
give primacy to freely functioning markets and get away from the
administered pricing regime that they have become today. To begin
with, we should abolish the 26 week average for large liquid stocks
where market prices are more reliable.

But even for small stocks, we should rely on the intelligence of
the investors. After all, there is no regulation which requires new
issues of shares to be made at prices linked to the last six months
average share price to take care of market manipulation. We simply
expect investors to make their own assessment before buying
shares. Why can we not expect them to make their own assessment before
selling shares?

Another funny thing is that a potential acquirer is not allowed to
reduce the offer price in response to changed conditions. In the US,
we have seen companies pay a break up fee and walk away from
acquisitions when there is a severe adverse change in economic
conditions. In India, we have designed the regulations to discourage
hostile acquisitions: even if hostile acquirers discover serious
problems, they can not easily walk away. We should allow bid terms to
be negotiated by contract and not frozen by regulations.

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