Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

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Thu, 05 Feb 2009

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.

Posted at 08:44 on Thu, 05 Feb 2009     View/Post Comments (5)     permanent link