Due Diligence, The Acquirer And Hostile Takeovers

If a potential acquirer is seriously evaluating multiple options to acquire a target entity, an easy way to avoid insider trading issues would be to limit the due diligence to publicly-available information. However, doing so would considerably restrict the ability of the potential acquirer to get a complete understanding of the listed target.

Illustration of men talking and eavesdropping
A hostile takeover by an ‘insider’ appears counter-intuitive. The Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations 2015 (Insider Trading Regulations) bars an insider, who, amongst others, includes a person in possession of or having access to unpublished price-sensitive information (UPSI), from trading in securities of a listed company. There are limited circumstances envisaged under the Insider Trading Regulations, which permit an insider to trade in the listed securities. Therefore, the question is whether a potential acquirer, who has received UPSI during its due-diligence of a listed target, be permitted to launch a hostile open offer. Through the scope of this write-up we intend to evaluate the prospects of such an acquirer from making an offer for a hostile takeover of a listed entity while in possession of UPSI. 
Setting the premise 
In the laissez faire era, profiting from trades based on insider information was considered a perk that came with the job. Starting with the United States in 1934, most countries have developed stringent restrictions to prevent an insider from making profits based on information that is not generally available with the public. The change is reflective of the overwhelming acceptance around the world that there should be no information asymmetry between participants of a publicly-traded company. The insider trading regulations are thereby crafted with the intention to purge the information asymmetry by requiring prompt disclosure to the public or restraining insiders from accessing the market. This principle has always conflicted with another well-established concept of mergers and acquisitions worldwide, i.e. due diligence by an acquirer. Due diligence is a critical investigation exercise carried out by a potential acquirer to understand, assess and factor the nature of risks before making the investment decision. Since what constitutes UPSI is subjective, it is highly likely that a potential acquirer may come across UPSI of the target as a by-product of the due diligence process. Accordingly, the question that arises in public-listed transactions is whether a potential acquirer should conduct a detailed due diligence exercise. 
To address this conflict under Indian insider trading regulations, the N. K. Sodhi Committee, in its report dated 7 December 2013 on the extant SEBI (Prohibition of Insider Trading) Regulation, 1992 (Sodhi Committee Report), identified the inevitability of due diligence for material transactions and recommended that a carve-out for disclosing information to potential acquirer(s) be included as a special exception with strings attached. This recommendation suggested that a predictable, clear and conditional framework should be included to address the issues relating to disclosure of UPSI to potential acquirers of listed-company securities. 
Insider Trading Regulations 
Taking into account the recommendations of the Sodhi Committee Report, SEBI replaced the erstwhile regulations with the Insider Trading Regulations. The new Insider Trading Regulations identified limited instances where the board of directors of the target could disclose UPSI to potential acquirers after execution of a confidentiality agreement:
(i) Regulation 3.3(i) permits disclosure of UPSI by public-listed companies in connection with a transaction, which would result in an open offer under the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations 2011 (Takeover Code) and where the board of directors are of an informed opinion that the proposed transaction is in the best interest of the target. The rationale for the above, as provided under the Insider Trading Regulations, is that the acquirer under the open offer would anyway be required to disclose all necessary information to the public shareholders under the Takeover Code process. 
(ii) Regulation 3.3(ii) of the Insider Trading Regulations provides that even in case of a transaction that does not result in an open offer, UPSI may be shared with the potential acquirer, provided the board of directors are of an informed opinion that it is in the best interest of the target, and such UPSI is disseminated (in the form determined by the board of directors) publicly at least two trading days before the proposed transaction is effected.
As these disclosures continue to restrict the recipients from trading in the publicly-traded securities, they ensure that there is no information asymmetry between the public and the potential acquirer. 
However, while the safe harbour under Regulation 3 contemplates a friendly deal involving the board and the potential acquirer, it does not offer clear solutions to cover situations when the negotiations fail (especially in bid situations).  
Issues in a hostile takeover 
The Takeover Code does not explicitly recognise hostile takeovers. Rather, it is commonly understood that it would have to be implemented through acquisition of more than 25% of shareholding or voting rights through various mechanics such as, inter alia, purchase from the market over a period of time through creeping acquisition or undertaking block/bulk deals, followed by an open offer under Regulation 3 of the Takeover Code, or undertaking a competing offer under Regulation 20 of the Takeover Code. 
In a bid process involving takeover of a publicly-listed company, many potential acquirers may conduct due diligence before making their offer to the management and controlling shareholders. The acquirer winning the bid would be permitted to undertake the transaction, either (i) under Regulation 3.3 (i) of the Insider Trading Regulations if the acquirer undertakes the mandatory takeover process under Regulation 3 of the Takeover Code with support of the target and its board; or (ii) under Regulation 3.3 (ii) of the Insider Trading Regulations, if the open-offer process is not required to be undertaken, and public disclosure is adequately made. 

However, the position of law with respect to other acquirers, who may want to undertake a hostile bid (including a competing bid), is unclear. Since the clarificatory note under Regulation 3.3(i) of the Insider Trading Regulations recognises that an open offer acts as an effective method for cleansing UPSI, it can be argued that as long as an open offer is launched, whether friendly or hostile, any UPSI available with the acquirer can be deemed to have been cleansed. However, an alternate view can be that Regulation 3.3(i) of the Insider Trading Regulations should be strictly interpreted to mean that the open offer that is offered cleansing protection is only the transaction that was contemplated by the board when approving the UPSI disclosure. This view has support under the Sodhi Committee Report, which recognised that there was a need for differentiating open-offer transactions that were signed off by the board of directors’ vis-à-vis general open offers or transactions. Having said so, in case of a bid scenario, a losing bidder may be able to make a competing offer, in the event the construct of transaction contemplated by the board under Regulation 3.3 of the Insider Trading Regulations is wide enough to cover the bid process itself. Further, the protection of Regulation 3.3 (ii) may also not be available with the hostile acquirer, as the Insider Trading Regulations specify that the target board has to determine the form of dissemination of UPSI to the public and does not contemplate general disclosure on its own volition by the hostile acquirer. Nevertheless, potential acquirers in most cases would be barred under a confidentiality agreement entered from making suo moto disclosures to third parties. Therefore, in the above scenario, the proposed hostile acquirer would continue to be restricted from trading in securities of the listed target, till all such UPSI available with the proposed acquirer is cleansed through public disclosure or a cooling-off period has resulted in the UPSI becoming ‘stale’. 

Is there a way out?
If a potential acquirer is seriously evaluating multiple options to acquire a target entity, an easy way to avoid insider trading issues would be to limit the due diligence to publicly-available information. However, doing so would considerably restrict the ability of the potential acquirer to get a complete understanding of the listed target. 
As a second option, the potential acquirer should obtain assurances from the board of directors (through undertakings in the confidentiality agreement) that the due diligence data will not include UPSI. Given the very nature of UPSI, it may be difficult for the board of directors to determine and classify whether a particular piece of information constitutes UPSI. 
In addition, the potential acquirer may consider building a smaller ‘clean team’ that has access to diligence documents and ensure that the confidentiality agreement is executed with the clean team, rather than the potential acquirer as whole. Therefore, in the event negotiations fall through, the potential acquirer can go ahead and make a hostile takeover offer, while maintaining the defence available under Regulation 4 of the Insider Trading Regulations: that the clean team that accessed UPSI is not involved in the hostile takeover offer. While this seems to be viable in theory, in practice, such an acquisition may expose the potential acquirer to SEBI investigations. 
The strongest safeguard for the potential acquirer comes from the confidentiality agreement. The potential acquirer should prudently draft this agreement to protect its larger interests, by inter alia (i) including the mechanism for cleansing; and (ii) carefully defining the ‘purpose’ and ‘transaction’ clauses. In short, the rule of thumb for any potential acquirer of a listed entity is to negotiate the confidentiality agreement and negotiate it hard. 
About the authors:
Sudhir Bassi is Executive Director at Khaitan & Co.
Ashraya Rao is Principal Associate at the firm.
Yashashree Mahajan is Associate at the firm.

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