[The following post has been authored by Utkarsh Mani Tripathi, student at NALSAR University of Law, and the third winner in the IRCCL Blog Writing Competition 2022-23.]
Minority oppression is the unfortunate corollary to the predominance of the majority rule in corporate governance. Whereas the decision-making process of a company is often likened to a democracy, it ignores the significant coercion that the majority shareholders might, willingly or not, exert on the minority.
An example of this can be found in freezeout mergers, where the majority shareholders of a company buy out the shares of the minority, often through legal caprice, ejecting them from their interest in the corporate entity. Majority shareholders have attempted such mergers for several reasons, the chief among them being:
reducing minority control;
reducing public shareholding as a means of going private (in order to avoid observing the SEBI regulations);
informational privacy; and
locking away the minority holder from sharing in potential profits.
A freezeout merger could prove to be one of the most elaborate examples of structuring of transactions. To be sure, litigation involving such mergers is rare in India. Most minority squeeze-outs are done through more direct means, such as share consolidation, and others. Freezeout merger could very well be the next frontier of minority oppression in India, and existing provisions have only limited minority protections.
As with other example of minority oppression, Indian courts are likely to put the burden of proof on the petitioner, the minority shareholder, requiring them to prove the unfairness of a specific merger which they feel is against their interests. This burden of proof may belie the actual forces exerted by the majority over the minority holders, and its impact on intra-corporate trust. This piece will analyse whether the burden of proof in litigations involving freezeout mergers should be placed on the minority shareholders. Further, it proposes some new measures to reform the procedure in order to introduce fairness and accountability.
The Modus Operandi of a Freezeout Merger
Let us consider the example of the majority shareholder attempting to prevent the minority shareholders from partaking in the additional potential profits from an impending transaction. They may do this so as to acquire all the profits themselves and exclude the minority shareholders. Such a scenario is easily foreseeable in countries such as India which have traditionally had a corporate regime with concentrated and entrenched majorities.
In order to undertake the removal of the minority holders (the public shareholders) from the rolls of the company, the majority shareholders set up another company – a shell company – which has no shares of its own. This company is then made to initiate a merger process with the original company. As only the majority holders are interested in such a transaction, they vote in favour of the transaction, and the dissenting minority holders are instead offered a compensation for the cancellation of their shares. This ends up with the entire control and shareholding of the new company effectively in the hands of the majority shareholders.
The impact of such freezeout mergers on the minority shareholders is immense. Besides the obvious consequences associated with shareholding financials, it also destroys the minority’s legitimate expectations of a share in the company’s profitable transactions. Besides these unrealized gains, the minority shareholders are also affected by often unfair buyout prices, ending up being short-changed for the value of their shares.
Hence, the procedure of freezeout mergers has acquired significant ill-repute among minority shareholders.
Should Freezeout Mergers be Banned?
It must be noted that, keeping in mind the ill-effects of such mergers noted above, minority holders are actionably worse off only when a) an unfair procedure is adopted for the buyout, and/or b) unfair prices are offered for the buyout. If instead both prongs of the transaction are demonstrably fair, meaning the majority confirms to the fiduciary duty owed to the minority holders, the decision to undergo a freezeout merger may often be in the company’s best interests.
There is a necessary, constant tension between the rights of the minority shareholders and that of the flexibility of a company. The latter is mostly modulated by the decision-making prowess of the majority, and as such, it is indeed possible that in certain cases minority freezeouts might be adequately justified.
Consider the previous example of the impending transaction and the (apparently) covert freezeout merger. It might so happen that securing the minority holders’ consent might push the expenditure associated with the transaction to such an extent that it is rendered unprofitable. Further, in order to avoid a venture that has been thus made unprofitable, the company might reject the transaction, whose value addition to the larger business community might have been enormous.
In their insightful discussion about the free-rider problem in corporate governance, the authors talk about shareholders who contribute negligibly to the governance of the company that they hold shares in, and instead keep profiting from the company’s transactions. However, when their passivity starts to affect the potential transactions of the company, majority holders are arguably justified in removing them, and thus freezeout mergers effectively solve the free-rider problem. This may lead to more efficient business decisions.
While undertaking a freezeout merger in order to go private may not be an exactly financially gainful procedure, going private might reduce much of the regulatory burden that comes with being a publicly-listed company. It also eliminates the expenses associated with proxy reports and other mandated periodic communication with the regulator. As such, freezeout mergers must not be banned outright.
Legislative Scope
The legislative provisions most closely dealing with freezeout mergers can be found in Sections 235 and 236 of the Companies Act 2013. Though they do not explicitly deal with mergers or others schemes of arrangement, they do set out the procedure by which buyouts are conducted. They are especially relevant for compulsory acquisitions of shares, whereby an offeror company squeezes out the minorities in the second company through an acquisition offer. This being the essential step of a freezeout merger, they can be considered to be the legislative provision on the topic of freezeout mergers. Section 235 clearly stipulates that if the minority shareholders do not agree or give their consent to the transfer or sale of shares within a specified period, their shares are assumed to be cancelled, and they are automatically cashed out.
Given the scant number of cases on freezeout mergers in India, it is necessary that we find the characteristics of the same in the aggregate of other similar transactions. For instance, in the case of Sandvik Asia, the court acknowledged that schemes of arrangement where the minority shareholder was inequitably squeezed out of the shareholding of the company could be held to account, even though they were not, nominally, in violation of the legal provisions. This is because the scheme of a selective reduction of shares was legislatively permitted, and could be easily passed with the support of a shareholding majority, especially in the concentrated company structures such as those in India. This is fertile ground for litigation alleging minority oppression.
Further, in AIG (Mauritius) LLC v. Tata Televentures (Holdings) Limited, the court duly recognized the possibility of a controlling majority effecting a removal of the minority interest through the use of the established voting procedure (under Section 395 of the Companies Act 1956). The procedure did not take into account that the offeror of a mode of arrangement, such as a merger or a takeover, might be the one having the controlling interest in the target company, rendering the whole transaction palpably unfair. It is reasonable to believe that the controlling majority might effect a merger and minority ejection, without inviting these strictures through the legal smokescreen of an unrelated company.
The Burden of Proof
As discussed before, the main grievance that could fuel litigation in the matter of freezeout mergers is the absence of a fair procedure and/or the absence of a fair buyout price. Foreign courts have developed a variety of tests to verify the same. For the purpose of our discussion, the business judgment test and the entire fairness test are relevant.
The business judgement test is believed to defer to the majority shareholders and is in spirit with the philosophy of majority rule. It assumes that more often than not, majority holders are likely to make business decisions that are in the best interests of the company, and absent any extremely weighty evidence of unfairness from the petitioners’ side, the rule does not go into the procedural fairness of the freezeout procedure.
The entire fairness test, on the other hand, puts the burden of proof on the majority holders, who need to demonstrate that fairness and ethical standing were observed in the freezeout procedure. This test has often been accused of being overly subservient to the minority shareholders, due to a perception that it adopts an uncritical stance towards their allegations. This criticism, however, ignores the ground reality that it is much more onerous to demonstrate that fairness of procedure was not followed than that it was.
In most litigation involving minority oppression, Indian courts have largely sided with the business judgement test, reposing their faith in the wisdom of the majority holders.
In my opinion, the burden of proof must ideally lie on the majority, or controlling, shareholders. This is because of the following factors.
Overt and inherent coercion
Majority shareholders exercise an extraordinary amount of control over the minority holders, in both overt and inherent ways. More visibly, they engage in share dilution, capital reduction, and share consolidation, which adversely impact minority holders, and are less stringent in their voting requirements. The majority shareholders actions impact minority holders in less obvious ways, too; consider the mandatory share cancellation in the situation of a minority holder refusing to sell their shares in the case of an offer from the majority holders, which leaves the minority holders with no say in the matter. Inherent coercion has sometimes been held to be an antiquated argument, but scholars have suggested that this is a myopic view, with arguments involving inherent coercion still being in the spirit of corporate democracy and the recognition of its many shortfalls.
Information asymmetry
Quite paradoxically, while one of the purposes of freezeouts is to safeguard confidential and sensitive information from minority holders, the same information asymmetry is also active before the freezeout actually takes place. As discussed before, often the purpose of a freezeout is to prevent the minority holders from receiving a share of the profits from a business transaction. It might so happen that the minority shareholders are prevented from gaining information about such transactions due to the difference in their stake in actual decision-making.
Because it may essentially be an RPT
Freezeout mergers are arguably a very good example of a related party transaction, as they satisfy some characteristics (as per Section 2(76) of the Companies Act 2013) of a related-party transaction. Basically, the offeror in a freezeout merger is a company controlled by the majority shareholders, although not through direct directorship, but through provision of aid and advice to the company from the majority holders in the target company. The same has been held in Sterling v. Mayflower Hotel Corp., where the offering and target companies are essentially the same controlling shareholders on both sides of the transaction, inviting the scrutiny of the courts and/or the market regulator, as the case may be.
As such, all the precautions and concerns associated with RPTs must also, ideally, apply to freezeout mergers.
Thus, the majority shareholders are in an unfairly advantageous position when compared to the minority holders. The consequence of this is that the minority holders are often unable to give sufficient proof to prove the unfairness of the procedure used in the freezeout. For instance, the minority can potentially show the following evidence to prove the same:
Bad faith
Ill intent on the part of the majority holder, which includes:
Preventing the minority from benefitting from a windfall gain.
Locking them out on sensitive information, etc.
Inadequate disclosure of material facts concerning the merger, the buyout prices
The unfairness of the prices, if applicable, has to be of a higher threshold than would be in the interests of the minority holders, as seen in the Cadbury case.
Unfortunately, the minority is nearly always unable to furnish this proof, due to the following reasons:
Courts are much more likely to defer to the majority shareholding on matters of intent and judgment, as the majority holders can easily point to various kinds of justifications.
Certain kinds of evidence, such as previous instances of hostility from the majority shareholders towards the minority shareholders, is difficult to obtain and demonstrate before the court.
The minority holder suffers from informational asymmetry and is forced to agree to the various mandates of the majority holding without sufficient evidence to question it.
As such, the burden of proof must lie with the majority holders, in order to ensure the fairness of the procedure.
As regards the fairness of the buyout prices, it is relevant to refer to the reverse book building process, which is adopted in the case of delisting of a company. Through this price discovery method, it ensures a suitably fair price for the shareholders as the shares are removed from the company roster. I submit that this process must also be applied in the case of scrutiny involving freezeout mergers, as it is very sensitive to the actual stakes of the minority shareholders, and duly takes into account the minuscule differences that differentiate a fair price from an unfair one. It also does away with the cautionary note sounded in the Cadbury case, where a merely nominal difference in prices was not considered actionable enough. As such, it could help the court or the regulator arrive at a much fairer buyout price for the shares.
Conclusion
The Indian jurisprudence concerning freezeout mergers is still stuck in the rut of the business judgement test, where it ends up ignoring the interests of the minority shareholders. While the inherent compromise between the majority and the minority holders’ varying interests is acknowledged, it is proposed that a regulatory stance that views the minority interests through the prism of the company’s overall interests would necessitate a shifting of the burden of proof into a more justifiable position. A version of the entire fairness test, as demonstrated, is successful in doing the same and must be looked at as the most feasible solution for the highlighted problem.
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