When the Script is Deceptive: Misuse of Toehold Acquisitions in Private Placement Bidding

By Filzah Belal
Filzah Belal is a final year undergraduate law student at National Law University and Judicial Academy, Assam.

The capital market is a free platform for trading in securities, but what happens when external forces act on the market? It influences the prices of the shares, but not at all in an organic way. In this article, I will discuss one such situation when the prices are influenced by external forces in the share market to gain unfair profits – when prospective acquirers gain ‘toehold acquisitions’ in order to enjoy an upper hand in private placement procedure and do so by increasing activity in the script of the company which inorganically increases the shares’ price. Toehold acquisitions are those acquisitions which are done by a prospective investor. These acquisitions are usually done so that the target company knows that the investor is interested in investing Toehold acquisitions are often small acquisitions (hence the reference of the term to the size of a ‘toe’), but they are significant enough to come to the attention of the target company.

In certain situations, toehold acquisitions may become an unfair trade practice. The regulator of the capital market in India is called the Securities and Exchange Board of India (SEBI). The SEBI (Prohibition of Fraudulent and Unfair Trade Practices) Regulations, 2003 (hereinafter, the PFUTP Regulations, 2003) under Clause 3(a) provides that no person shall directly or indirectly buy, sell, or otherwise deal in securities in a fraudulent manner. The definition of fraud under the regulation includes “an active concealment of a fact by a person having knowledge or belief of the fact in a deceitful manner while dealing in securities.” Here the term to be emphasized upon is in a “deceitful manner.”

When a prospective investor acquires a toehold in the target company, he can buy all the shares at once from the share market at once. However, when he chooses to buy these shares in fragments, he increases the activity in the script of the target company. It falsely results in a higher number of market activity in the shares [1] of the target company, thereby increasing the share prices of the target company. This can be inferred as ‘price manipulation’ under the PFUTP Regulations, 2003. 

In SEBI v. Kishore R. Ajmera [2], the Hon'ble Supreme Court of India observed that, “The proof of manipulation almost always depends on inferences drawn from a mass of factual details. Findings must be gathered from patterns of a transaction, the nature of the transactions, etc.” Therefore, to determine whether a party has made several transactions in the target company to manipulate the share prices depends on the party’s intention.

Manipulation is intentional or willful conduct designed to deceive or defraud investors by controlling or artificially inflating the price of securities [3]. Since the prospective investor knows that he can buy all the shares at once instead of buying them in fragments, he shows intent. 

In a private placement, when a prospective investor acquires a toehold, it gives him an added advantage over the other bidders. Toeholds are non-controlling equity stakes which can give their owner the opportunity to interact with the target or its management in ways that are not available to other bidders [4].

In such a situation, it gives the prospective investor double advantage –one, that he gets an upper hand during the bidding procedure involved in a private placement; and second, if that prospective bidder is selected, he gets unfair profits because of the increased share prices (done manipulatively). 

Toehold purchases are not negative in every context and are not per se invalidated by the law at every instance. However, manipulatively increasing share prices can be done even without the intent of gaining an upper hand during the private placement procedure. However, the one constant about trading in capital markets is profit motive. 

Although a genuine increase in the script of the company can also lead to an increase in share prices, it cannot be called “manipulative” because it happened through the natural forces in the market. In contrast, a toehold acquisition by way of multiple transactions done intentionally to increase activity in the script of the company cannot be said to have happened by way of natural forces in the market.

Moreover, it is detrimental to the interests of the other participants in the market. Not only does the company look better because of increased share prices in front of its competitors, but the company also attracts new investors to buy shares under the impression that higher share prices will get them increased profits, which fades once the activity rate of the company’s script returns to normal. In a similar way, it also gives higher hopes to the existing shareholders of the company who may buy more shares as the increasing share prices may look promising, again, only until the activity rate of the company’s script returns to normal. Therefore, toehold acquisitions should not be used as a means to gain unfair profits and/or an upper hand in the private placement process. The practise is unethical and legally questionable.

The opinions and views expressed in this publication are the opinions of the designated authors and do not reflect the opinions or views of the Penn Undergraduate Law Journal, our staff, or our clients.

Citations:
[1] “SEBI v. Kishore R Ajmera: Voluminous Trading in Illiquid Scrips.” 2016. IndiaLaw LLP Blog. November 23, 2016. https://www.indialaw.in/blog/blog/commercialcorporate/sebi-v-kishore-ajmera-voluminous-trading-illiquid-scrips/#_ftn1. 
[2] “Order of the Hon'ble Supreme Court, in the Matters of Kishore R. Ajmera, Ess Ess Intermediaries Pvt. Ltd. & Other Tagged Matters.” 2016. SEBI. February 23, 2016. https://www.sebi.gov.in/enforcement/orders/feb-2016/order-of-the-hon-ble-supreme-court-in-the-matters-of-kishore-r-ajmera-ess-ess-intermediaries-pvt-ltd-and-other-tagged-matters_31815.html. 
[3] “Ernst & Ernst v. Hochfelder - 425 U.S. 185, 96 S. Ct. 1375 (1976).” n.d. Community. Accessed October 31, 2019. https://www.lexisnexis.com/community/casebrief/p/casebrief-ernst-ernst-v-hochfelder. 
[4] Paul, Sertsios, and Giorgo. 2012. “Getting to Know Each Other: The Role of Toeholds in Acquisitions.” SSRN. November 16, 2012. https://ssrn.com/abstract=2176481.