The tricky issue of 'control', that lies at the heart of every M&A deal, has come back to hauntprivate equity investors. Even with a minority stake, these investors often have veto powers over key decisions of companies they invest in - a practice that was recently frowned upon by the capital marketwatchdog Sebi 

In August 2010, Clearwater Capital Partners, a PE investor, had entered into an agreement with Kamat Hotels, a Mumbai-based listed company owning a chain of hotels, giving the offshore investor certain rights over policy decisions of the company. While it's a customary practice among many PE firms to insist on minority protection clause in shareholder pacts, the regulator has asked the acquirer to make an open offer to shareholders based on regulations and stock price prevailing when the agreement was signed. 

According to the regulator, the agreement gave the PE firm 'control' over the company even though its shareholding was not high enough to trigger the takeover code. "Based on facts, the regulators have on several occasions adopted a position that such rights give rise to (negative) 'control' within the meaning of takeover regulations, thereby attract According to the regulator, the agreement gave the PE firm 'control' over the company even though its shareholding was not high enough to trigger the takeover code. "Based on facts, the regulators have on several occasions adopted a position that such rights give rise to (negative) 'control' within the meaning of takeover regulations, thereby attracting open offer provisions," said Amit Jain, partner, BMR Advisors. Often these special rights, given to a PE when a company is closely-held, continue even after the stock is listed. The development is a reminder to all PE investors how such rights can turn into a regulatory pitfall. 

"Till there is more clarity on the meaning of 'control' in the context of minority protection clauses, investors will need to carefully consider their statutory obligations under takeover regulations," said Jain. 

There is a possibility that another issue, linked to the special rights, could crop up in this case. It relates to the status of Clearwater as a shareholder. According to legal circles, the regulator may categorise Clearwater as a "promoter" if it believes that it had exercised control along with existing promoters. If Sebi takes such a stand, it would put pressure on the foreign investor as well as the original promoters to lower their combined stake inKamat HotelsBSE 0.20 % to 75%. 

Clearwater came out with an open offer after its shareholding in the company rose subsequently, but has challenged the Sebi direction in Securities Appellate Tribunal (or SAT), a quasi-judi-cial authority. The Sebi directions said the agreement gives certain veto rights to the acquirer relating to the policy decisions of the company, due to which the private equity player has acquired control over the company. 

According to the agreement between the company and promoters, the PE investor has the last word on any change in the company's share capital, corporate restructuring, and formation of subsidiary and joint ventures. Clearwater also has the right to nominate a director on the board of Kamat Hotels. The definition of 'control' has been a contentious one. In the dispute between Subhkam Ventures and Sebi, SAT had removed some of the ambiguities over the interpretation of control. "Power by which an acquirer can only prevent a company from doing what the latter wants to do is by itself not control. 

In that event, the acquirer is only reacting rather than taking the initiative. It is a positive power and not a negative power," the tribunal had said. In other words, SAT held that control pertains to 'positive' control — the ability to push through certain actions — and does not cover rights constituting 'negative' control — the right to hold back a company from carrying out certain actions. 

The SAT judgment, which came as a respite for many PE players, reversed Sebi's long-standing position that any rights in the hands of an acquirer will constitute control over a target company. After this was challenged by Sebi in the Supreme Court, the court accepted an out-of-court settlement and observed that the question of law — whether negative control is control — remains open and that the SAT decision would not be treated as a precedent. (Economic Times)