Introduction

The Securities and Exchange Board of India (SEBI) has issued an important circular (Circular) dated 14 June 2017 relating to recording of non-disposal undertakings (NDUs) with a depository. Currently, depositories do not offer a mechanism for implementing NDUs unlike pledge transactions. An NDU, often referred to as a ‘negative lien’, constitutes a contractual lock in on shares provided by shareholders or promoters, in favour of lenders, without involving any actual alienation of securities or transfer of the beneficial interest such as in the case of a pledge of shares. The NDU provider retains all title and interest in the shares which are subject to the NDU and in the event of a transfer of title or interest in such shares to a third party (having no knowledge of such restriction), the rights of the lender under the NDU would be limited to the right to claim damages from the NDU provider for breach of the contractual provisions of the NDU. Under the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (Takeover Regulations) an NDU is covered within the scope of disclosures required to be made for ‘encumbrances’ on shares.

Salient Features

The Circular acknowledges the lack of a framework that captures the details of NDUs in the depository system and accordingly creates an investor-friendly enabling mechanism whereby depositories can capture and record NDUs, as an extension to the existing disclosure requirements under the Takeover Regulations. For this purpose, the following procedures and compliances have been prescribed for depositories and/or the parties to the NDU:

Procedure for recording of NDU

  • The depositories would have to develop a separate module/transaction type in their system for recording the NDUs.
  • Both parties to the NDU (i.e. the promoter/beneficial owner and the lender/trustee) will have to open separate demat accounts with the same depository and be compliant with the extant KYC norms.
  • Further to execution of the NDU agreement, the parties are required to make an application through the depository participant (where the beneficial owner holds his shares) to the relevant depository for the purpose of recording the NDU. This application is required to include details of the beneficial owner (such as the ID number, PAN, email address, signature, name of the entity) in whose favour the NDU is being created along with quantity of the securities.
  • The beneficiary entity in whose favour the NDU is being created is required to authorize the depository participant to access the signatures as recorded in that entity’s demat account.
  • The depository participant is required to satisfy itself that the shares are available for the NDU (i.e. are not subject to other encumbrances) and thereafter record the NDU and freeze for debit the requisite quantity of securities in the depository system. Once the freeze is created, the depository/participant is required to inform both parties of the NDU regarding the freeze of the NDU shares.
  • The depositories are required to make suitable provisions for capturing the BO ID and PAN of the beneficiary of the NDU and to make available to the relevant depository participant, the details of the authorized signatories recorded in the beneficiary entity’s demat account.
  • All freeze and unfreeze instructions for recording of the NDUs would be subject to 100% concurrent audits.
  • No depository participant shall be allowed to facilitate or be party to any NDU outside of the depository system.

Effect of the freeze on NDU Shares

The Circular provides that once the freeze for debits is created under the NDU for a given quantity of shares, the depository shall not facilitate or effect any transfer, pledge, hypothecation, lending, rematerialisation or in any manner alienate or otherwise allow dealing in the shares held under NDU till receipt of instructions from both parties for the cancellation of NDU.

Procedure to unfreeze NDU Shares

To ‘unfreeze’ or terminate the NDU arrangement, the parties are required to make a joint application to the depository through the depository participant of the beneficial owner. Upon such unfreeze of the shares, the depository is required to inform both the parties in the form and manner agreed upon at the time of creating the freeze. The unfreeze is effected in the depository system after a cooling period of 2 business days from the date of cancellation which may extend to a maximum of 4 business days.

Timeframe for implementation

A timeframe of 4 months has been given to the depositories to implement the provisions of the Circular, i.e. by 14 October 2017. The depositories are required to make all suitable amendments to all relevant bye laws, rules/regulations, carry out necessary systemic changes, disseminate the provisions of the Circular on their websites and so forth. Further, the depositories are required to communicate to the SEBI the status of implementation of the Circular as a part of their monthly development reports.

Comment

The Circular reflects the intent of the regulator to eliminate existing loopholes in recording of NDUs which allowed promoters and shareholders to self-regulate their obligations under a NDU in the absence of a watertight legal mechanism to ensure actual compliance of the NDU. This Circular will be welcomed by investors for offering a mechanism which significantly mitigates a possible risk of breach of NDUs and therefore transforms this hitherto contractual arrangement into a transparent and viable security arrangement monitored by independent depositories.

It would now be possible to record NDUs in the depository system like a pledge, once the depositories put in the necessary mechanisms in line with the Circular. Practically, most investors and lenders are likely to insist on adopting this recording mechanism for all prospective NDU arrangements and the existing practices of executing merely contractual NDUs will definitely dwindle as a consequence. For listed shares, the mechanism of disclosures to stock exchanges was already in place and following the Circular, this would now extend to dematerialized shares as well. In that sense, the Circular is likely to impact all holding company financing structures involving dematerialized shares. This is favourable for lenders who would be able to exercise greater effective control than the prevalent practice of lock-box arrangements without requiring RBI approval. However, if the contracting parties prefer to keep the NDU arrangement out of the public domain, then a contractual NDU or dealing in physical shares may be the only option to implement such financing structures.

However, certain clarifications may be required for implementing the Circular; for instance, there is presently no format of application prescribed for recording an NDU and presumably the task of formulating a suitable format has been left to the relevant depositories. The Circular also contemplates an increased role for the depository participants, who are inter alia required to satisfy themselves regarding the availability of shares for NDU – it is not clear to what extent this obligation needs to be performed and if there is any liability for negligence or oversight by the depository participants regarding any existing encumbrances on the NDU shares.

It would also be interesting to see if, in the backdrop of this formalized mechanism for the recording of NDUs, the RBI revises its stance on requirement of its prior approval for NDUs in the context of offshore financing structures.

Whilst the exact manner in which the depositories implement this direction of the SEBI remains to be seen, the Circular is not expected to affect legacy trades. Whilst the proposed recording system is intended to strengthen contractual NDU arrangements, the SEBI direction does not appear to create an approval based framework whereby regulatory approval is required for non-adherence to the proposed system, in which the enforceability of the NDU is called into question. This makes it crucial that the Circular does not affect legacy trades. Further, in prospective NDU arrangements where the parties opt out of adopting this depository recording approach to an NDU, the only downside will be the lack of an effective controlling mechanism without adversely impacting the underlying non-disposal arrangement.