The ‘Fit and Proper’ Onus – A Sufficient Defence Against Hostile Takeovers?
[Shikhar is a student at National Law School of India University, Bangalore.]
On 16 January 2023, the Reserve Bank of India (RBI) issued Master Directions on the Acquisition and Holding of Shares or Voting Rights in Banking Companies (Directions). Section 4.1 of the Directions requires any person seeking to acquire major shareholding in a banking company to submit an application to the RBI. Further, by operation of Section 4.3, this application would be proffered to the concerned banking company’s board of directors to deliberate on the application and assign a ‘fit and proper’ status of the intending acquirer.
This article demonstrates that the onus of assigning a ‘fit and proper’ status being on the concerned banking company would act as a hostile takeover defense in and of itself. Further, a lacuna in the Directions will also be highlighted through which possible hostile takeover bids could be made via the ‘proxy fight’ strategy.
By way of clarification, this article will be dealing with private sector banks in particular, as private-sector banks have majority of the shares held by private individuals and institutions, while public-sector banks have majority shares held by the government. This makes the shareholding pattern qualitatively different. Therefore, the modalities of standard takeover strategies and defenses would differ substantially.
Desirability of Regulatory Restraints on Hostile Takeovers
Hostile takeover bids have also been dubbed ‘disciplinary takeovers’ as instances of mismanagement, bad corporate governance practices and shareholder neglect are generally brought to the fore in the process of a bid. Even unsuccessful bids tend to double as ‘wake-up calls’ to instances of mismanagement in a company. Attempts at takeovers also put the internal governance mechanisms of the company to the test. With ever-increasing instances of mismanagement within private-sector banks, such measures could have positive outcomes in terms of efficiency in banking operations and streamlining of workforce. However, the nature of banking services is qualitatively different from most other sectors. A takeover or an acquisition, if unsuccessful, messy or uninformed, could threaten the stability of the financial system as a whole. The Bank of America acquisition of Countrywide Financial Corporation serves to demonstrate this very point. Having been oblivious to the over-exposure of Countrywide to subprime mortgages, the Bank of America was in for a shock when they went through the books after the acquisition. The entire debacle lost them a substantial amount of money, shareholder trust and had an impact on the global financial system during the financial crisis era. Similar issues arose in Bank of America’s acquisition of Merrill Lynch. As the system is built on customer perception and trust, it is necessary to ensure that any possibility for such destabilizing incidents be mitigated.
The aforementioned Bank of America acquisitions also serve to bolster the point that takeovers in the banking sector have historically been found to be ineffective owing to the difficulty in valuation. Owing to factors such as information asymmetry, quality of financial reporting and possibility of high leverage exposure, an optimal valuation could be an onerous undertaking. Coupled with the strategy employed during the takeover by the prospective acquirer, the costs may make the acquisition process an unprofitable venture. Such takeovers with high costs could bear heavy on the management and/or on the funds required for undertaking banking operations effectively. These issues make it clear that regulatory frameworks have to be developed and prevent any destabilizing negative externalities arising out of hostile takeovers in the banking/financial system.
The Onus of ‘Fit and Proper’ as a Takeover Defence
Possibly in pursuance of creating a strong framework, the RBI, through the Directions, requires the board to submit its comments on the proposed acquisition of a major shareholding. This would be through a form which allows for the board to present their opinions on the integrity and reputation of the prospective shareholder, while also soliciting suspicions of a takeover or ‘destabilisation of the management’. Further, the board is also required to assess and determine the ‘fit and proper’ status of the prospective shareholder. In doing so, the board is allowed to construct the criteria for ‘fit and proper’, although they would have to follow the broad contours of the illustrative criteria given by the RBI. The criteria largely revolve around aspects such as the business record of the prospective shareholder, soundness and feasibility of future plans for development, impact assessment on the management of the banking company, historical conformity with good governance standards and assessment of other individuals/entities that are associated with the body corporate (if the prospective shareholder is a body corporate).
This makes it clear that the RBI sets out with the intent of limiting, if not erasing, the possibility of hostile takeovers. This move by the RBI could possibly be to prepare a regulated environment in anticipation of imminent disinvestment by the government and the consolidation of private sector banks. By giving the board the benefit of the doubt with regards to the board’s takeover suspicions, the RBI has effectively bolstered the takeover defence arsenal of banking companies. However, its effectiveness remains to be seen.
The Proxy Fight Loophole
The ‘fit and proper’ standard, largely found in corporate governance jurisprudence, may seem to do well with regards to various hostile takeover strategies like tender offers, but it could fall flat in the face of a proxy fight.
Proxy fights/contests are a hostile takeover strategy employed to target dissident directors on a board or to replace existing directors with new ones that would act favourably towards an acquisition by the concerned acquirer. Such a situation is hard to notice, and even if observable, it would be hard to prove. Owing to the latent nature of the hostile takeover regime in India, the Companies Act 2013 and the Competition Act 2002 have not adequately accounted for such a situation, if at all.
Further, proxy fight strategies, if executed successfully, can disable most takeover defences such as the white knight defence in which a friendly acquirer interrupts the hostile takeover bid by purchasing the target company. It also works to ward off last-resort defences such as the poison pill defence where the shares of the target company are diluted to the extent that it would be unfeasible for the acquirer to take over without paying substantial costs. The reason for the efficacy of the proxy fight strategy lies in one commonality between all such defences – a requirement of board approval for the usage of these defences. As a proxy fight strategy essentially seeks to ‘infiltrate’ the board, these defences would invariably fall flat. Proxy fights have historically been countered through staggered board elections which would make the realisation of the strategy a long-drawn process, thereby rendering them unattractive. However, with the rise in shareholder activism bolstered by the stock-price manipulation scandals/controversies in the recent past, the staggered board approach could be in decline.
In fact, shareholder activism paves the way for proxy fight strategies to come to fruition. It is because this form of activism targets the corporate governance mechanisms and performance through methods such as investor confrontations and formal interventions. Shareholder activism proceeds primarily with the aim of expressing dissatisfaction with the management or to effectuate change in the internal governance mechanisms. When activism of this kind is exercised, it can unsettle a board, or create dissident directors. This makes shareholder activism another factor that the RBI should necessarily consider if it seeks to mitigate/eradicate possibilities of proxy fights that can result in hostile takeover bids.
Further, the proxy fight strategy still retains potency in that it may utilise dissident shareholders to remove a director under Section 169 of the Companies Act 2013.
Therefore, when back-testing the 'fit and proper' onus against proxy fight method of hostile takeovers, it would be noticed that owing to its reliance on the discretion of a board – it would not be able to double as a sufficient defence. Therefore, if the RBI would prefer to avoid this loophole altogether, it needs to work around the issue that most takeover defences such as the white knight, poison pill and the 'fit and proper' standard defences have in common – board discretion.
While the inclusion of the ‘fit and proper’ criteria serves to disable most takeover strategies, it does little by way of mitigating hostile takeovers through proxy fights. Internal mechanisms are the only plausible defence against a proxy fight strategy, in the absence of regulation. Proactive engagement with shareholders at regular intervals to ensure shareholder trust in the board is a necessity to dissuade proxy solicitations. If the indicative intent of the RBI in issuing the Directions was to mitigate possibilities of hostile takeovers, it would have to account for shareholder activism and construct a framework that would work to protect against destabilising activities, while also respecting shareholder liberties.