Are liquidation preference arrangements legally enforceable in India?
Khaitan & Co, Mumbai
Khaitan & Co, Mumbai
With the contours of the global economic landscape undergoing a period of constant change – due to factors like technological disruption, geopolitical concerns and the fallout of the Covid-19 pandemic – investors everywhere are looking for more reliable ways to minimise risks and protect the value of their investments.
One method which has become a common provision in transaction documents is the liquidation preference arrangement (LPA). An LPA is perhaps one of the most crucial strategies sought by investors to protect the value of their investments. It seems to strike an ideal balance between ensuring an expected benchmark return on investment and safeguarding against reduction in value. However, one crucial question continues to cast a shadow over this method, is an LPA enforceable under Indian law?
What is a liquidation preference arrangement?
The basic construct of an LPA involves the payment of the investment amount along with an agreed rate of return to the named investors, with priority over the other relevant shareholders.
In a transaction document, the liquidation preference arrangement is set in motion in case of occurrence of a liquidation event – ie, an event that results in the realisation of cash for a company or all shareholders such as insolvency, winding up, sale of assets, change of control, a merger and so on. Liquidation preferences can be categorised as non-participating, participating and hybrid, depending on whether the investor is accorded a right to participate in the liquidation proceeds.
The stakeholder pyramid – who gets priority?
The holders of equity shares are at the bottom of the stakeholder pyramid when it comes to distribution of liquidation proceeds. According to the Companies Act 2013, a preference shareholder is granted a preferential right of repayment in case of winding up or repayment of capital, whereas a debenture holder is comparable to a creditor of the company.
Section 53 of the Insolvency and Bankruptcy Code 2016 (IBC) sets out the waterfall mechanism for distribution of the liquidation proceeds: settlement of dues of debenture holders is the highest priority, followed by preference shareholders and lastly equity shareholders.
For private limited companies, the priority battle between equity shares and preference shares could be resolved by the exemption afforded to such companies by the Ministry of Corporate Affairs on 5 June 2015. This exemption allows private limited companies to exclude the applicability of section 43 and section 47 of the (Indian) Companies Act 2013 by amending their memorandum of association or articles of association as necessary. By doing so, a differential class of equity shares can be created, whereby such class of shares could take precedence over preference shares in the event of a winding up. Otherwise, it would be challenging for an investor holding equity shares to enforce its liquidation preference right in priority to the preference shareholders.
The enforceability of a liquidation preference arrangement
The appointment of a liquidator under the statutory provisions of law would not be bound by the provisions of a liquidation preference arrangement set out in the transaction documents by contracting parties. Nevertheless, a view could be taken that the company (through articles of association) and the promoters, by being parties to the transaction documents, would be contractually bound by such liquidation preference provisions.
This would give the investor a cause of action against the company and the promoters, requiring due performance of such liquidation preference provisions. The liquidation preference clause may be structured in a manner that requires the promoters to compensate the investor for any deficit in the liquidation proceeds, pursuant to distribution of such liquidation proceeds in accordance with law. While the promoters could make payment of the requisite residual sum of money to the investor’s credit, such disbursement may lead to tax implications.
A pertinent question then arises as to how the overriding nature of the IBC in relation to other legislation (including the Indian Contract Act 1872) would play out in a court of law.
The position of law in respect of liquidation preference rights pertaining to the holders of the same class of shares is that the liquidation proceeds would be paid in full or in equal proportion, contingent upon the sufficiency of such proceeds. For instance, if multiple investors hold the same class of securities without the company having created a different class of securities in its capital (for example, Series A equity shares, Series B equity shares and so on, which are basically ordinary equity shares), offering precedence to one investor over the other investor in such a case would not be considered to be in consonance with section 53 of the IBC. Therefore, to accord preferential treatment to an investor as per the liquidation preference arrangement, the investor should ensure that it holds a separate class of shares.
Since a liquidation preference arrangement appears to offer an assured or minimum guaranteed return to the investor, granting liquidation preference to a foreign investor could be construed as providing it with an assured exit. As a consequence, this could flout the regulations set forth by the Reserve Bank of India. In the event the liquidation comprises the sale of shares, one must be wary not to contravene the pricing guidelines while structuring a liquidation preference clause for such foreign investor.
The conversion dilemma
A participating or hybrid liquidation preference right entitles the investor to participate in the liquidation proceeds based on its pro-rata shareholding. While computation of such pro-rata shareholding is a straightforward process in the case of an equity shareholder, it may be a cumbersome process in the case of an investor holding securities that are convertible into equity shares (a preference shareholder or debenture holder). Consequently, it is essential to negotiate the exclusions and inclusions in the definition of ‘fully diluted basis’ or ‘as-converted basis’ in a prudent manner.
Where an investor is a holder of securities convertible into equity shares, a participating or hybrid liquidation preference clause may require an investor to convert their securities into equity shares for the purpose of receiving the pro-rata entitlement in the liquidation proceeds. Alternatively, there could also be a situation where the investor converts its securities into equity shares voluntarily or in accordance with a mandatory provision prescribed under law. If such security is converted into equity shares prior to the occurrence of a liquidation event, the investor could lose the status of priority in the eyes of the law as they would now hold equity shares, making the liquidation preference arrangement redundant.
In conclusion, considering the ambiguity surrounding the enforceability of a LPA, it would be rational to evaluate the extent of the agreement when negotiating a liquidation preference clause.