Post-Covid-19 implications for India's M&A transactions and structures
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Raj Ramachandran
J Sagar Associates, Bangalore
Introduction
The business uncertainties created by Covid-19 have resulted in unique challenges for all stakeholders, including regulators, around the globe. India too has promptly taken a few firm steps, the full impact of which remains to be seen. The impact of Covid-19 and such developments in regulations will necessarily result in changes in deal structuring, so as to address the revised regulations as well as to adequately protect businesses from any impact in the future, given the continuing uncertainty.
Change in FDI policy: Press Note 3
Among the various measures taken by the Indian Government (the 'Government') to face the challenges and threats posed by Covid-19, a significant measure introduced was Press Note 3 of 2020, which reflects the policy of the Government to restrict investment from entities located in neighbouring countries.
While the stated intent of the press note is to 'curb opportunistic takeovers/acquisitions of Indian companies due to the current Covid-19 pandemic', and in this regard, it regulates investment from all entities belonging to countries that share a land border with India, the key impact has been on investment from China. The concern of the Government was that the impact of Covid-19 on businesses and the resultant value erosion should not be used as an opportunity by specified foreign entities to take control of Indian entities. Prior to Press Note 3, foreign investment was regulated only by sector and not by region, except for Bangladesh and Pakistan.
The key aspect to be borne in mind is that, prior to the implementation of Press Note 3, investment from China and other countries, such as the United States, was under the automatic route, barring a few sensitive sectors. This restriction caused considerable concern among stakeholders because the restriction applied not only to new investment, but also to entities where there was existing investment. The result was that Indian companies that had such investors as stakeholders were faced with double jeopardy: not only were they restricted from seeking investment from China when they needed it the most but they were now also faced with a situation in which several provisions in the agreements seemed implausible.
The import of Press Note 3 was far wider, and it also covered indirect transfers and investments.
Implementing and giving effect to various provisions and rights in shareholders' agreements including call options, put options and drag options now seems quite a task because they could trigger Government approval, and cause attendant delays and other business concerns.
Actions under the Information Technology Act 2000
Under separate press releases, the Government, through the Ministry of Information Technology, blocked several apps, 'in view of the emergent nature of threats', and given that 'in view of information available they are engaged in activities which is prejudicial to sovereignty and integrity of India, defence of India, security of state and public order'.
The order was issued by invoking power under section 69A of the Information Technology Act 2000, read with the relevant provisions of the Information Technology (Procedure and Safeguards for Blocking of Access of Information by Public) Rules 2009. The stated intent is to safeguard the interests of Indian mobile and internet users, and to ensure the safety and sovereignty of Indian cyberspace.
The banning of several of these apps, along with the impact of Press Note 3, is already causing some delays and concerns for foreign investment into India, and the M&A transaction landscape will continue to evolve to address the current situation and the continuing uncertainty.
Transaction structuring
Due diligence will play a key role in identifying the risks and potential disruptions to business. Acquirers will require clarity on whether key contracts can be terminated at short notice or for reasons of force majeure, or if key customers are likely to be impacted in the near future. In certain cases, although contracts may not contemplate early termination and it may appear that business will continue as usual, the remedy available, if such a contract is terminated by the counterparty or affected due to other reasons, will also need to be evaluated carefully. The adaptability of the business to the post Covid-19 scenario will also play a key role in the decision-making process.
The outcome of due diligence will largely dictate the structure of the transaction, and the safeguards that will need to be provided for in the transaction documents, after taking into account any likely changes in law or government regulations restricting any actions/activities.
It is likely that there will be divestment of stakes by several stakeholders, and in such cases, the regulations governing (1) deferred consideration; and (2) pricing norms, will assume importance and need to be reviewed carefully while the transactions are structured.
It is also likely that acquirers will stipulate a material adverse change (MAC) or force majeure provision in order to be able to call off the deal or be released from their remaining obligations should there be any subsequent adverse impact on the business.
Some key aspects that are likely to emerge while structuring such transactions are discussed below, having regard to the current foreign exchange regulations.
Deferred consideration/purchase price adjustment
Although an acquirer will undertake due diligence of the business, the true/full impact of Covid-19 remains unclear, and the prospects of the business are not guaranteed. Acquirers are therefore likely to attribute a fair portion of the consideration to the future performance of the company over a defined period of time, and devise a deferred consideration mechanism. While this may not be in the best interest of the sellers/exiting investors, who will prefer a locked box closing mechanism, any fixed-price deal may result in a comparatively lower acquisition price.
The extant foreign exchange regulations governing transactions with a deferred consideration structure stipulate that the deferred consideration will need to be paid by the buyer within a period not exceeding 18 months from the date of the share purchase agreement, and only 25 per cent of the full consideration can be deferred.
Where the seller of the shares is an Indian party and the buyer a non-resident foreign party, the stipulation of the quantum of consideration that can be deferred and the timeline for payment of this ensures that the Indian party receives the remaining consideration within the specified period of time, having received the substantial value upfront.
However, where the seller is a non-resident and the buyer a resident Indian party, the Indian authorities should consider relaxing such a requirement because the benefit of the relaxation would be to the Indian party.
While parties can agree on a purchase price adjustment (both increase and decrease) where certain conditions are met or not complied with, or business targets not achieved, there is also a stipulation under the Indian foreign exchange regulations that the effective price should be compliant with pricing guidelines, and hence, any adjustment contemplated as part of the commercial terms will need to pass this test.
Pricing guidelines
The basic principle of the pricing guidelines is that a transfer between a resident Indian party and a non-resident cannot be at a consideration lower than the fair market value (a minimum floor price) if the seller is a resident Indian party. Conversely, the consideration cannot be higher than the fair market value (ie, a maximum ceiling price) if the buyer is a resident Indian party. The aforementioned principle would not apply if the seller and buyer are both non-residents, and hence, such transactions could be structured with ease, subject only to commercial considerations.
If the acquirer is a foreign-owned and controlled company (FOCC) incorporated in India and the seller is a resident Indian party, the transaction should ideally be permitted at any price and without regard to the deferred consideration norms, particularly where the funds proposed to be used for the acquisition are from internal accruals of the FOCC.
MAC
MAC clauses are quite standard in M&A deals that entitle an acquirer to walk away from the otherwise binding transaction if the business of the target entity is impacted between signing and closing, or there is an unforeseen event, where the business is likely to be materially impacted, that alters the basis on which the various terms were drawn out and agreed.
The cue should be taken from recent changes in law/regulations, such as the introduction of Press Note 3 and the Government order banning certain apps, each of which could potentially have a material impact on the business of the target entity, and similar circumstances would need to be specified as events that constitute a MAC.
The impact of Covid-19 in itself would constitute a MAC for businesses in specific sectors, and given that the full extent of the impact remains uncertain, transaction documents will continue to have sufficient safeguards built in for investors/acquirers to walk away from transactions that are impacted due to Covid-19 without having to suffer any break fees or other consequences.
It is, however, important to have specific objective criteria to determine if a particular event or development would constitute a MAC. Where the criterion is not objective or is open to interpretation that itself could trigger a dispute, this leaves the parties open to liability.
Force majeure
Although it is not typical for transaction documents in M&A deals to include a clause on force majeure, parties are likely to consider including a clause on force majeure in light of Covid-19 or a pandemic in general, or generally to address a situation where a certain obligation/action is beyond the control of such parties. While such provisions were hitherto perceived as an 'easy way out', Covid-19 has highlighted the fact that similar circumstances could result in certain obligations/actions becoming unachievable.
For example, if an Indian entity had executed an agreement with a target for acquisition, and such an Indian entity was directly impacted by the introduction of Press Note 3, the same entity would squarely constitute force majeure because the acquirer Indian entity may have expected to receive funds from its offshore parent to fund the acquisition.
Similar to the case of MAC, it is important to stipulate the criteria as objectively as possible in order to avoid any disputes.
Representations and warranties insurance/warranties and indemnities insurance
The impact of Covid-19 is pushing several companies to seek fresh investment for the continuance of business. In some cases, stakeholders are actively pursuing a sale of the business entity given the uncertainty of a positive business outlook in the near future. Such distressed sale transactions are likely to open up additional challenges and considerations. Typically, sellers will provide representations and warranties to the acquirer in relation to the shares, the business and the entity. These are also backed by indemnity obligations so that, if any liability arises in the future, the acquirer can recover the losses from the sellers.
However, where transactions are undertaken due to the distress of the seller, the acquirer is likely to seek representations and warranties insurance (RWI)/warranties and indemnities insurance. This will ensure that if any claim arises in the future, the acquirer can directly claim from the insurance company instead of being concerned about the potential financial condition of the sellers. A seller in distress may end up exhausting the sale proceeds to meet other liabilities, and the acquirer would not want to be in a situation where an indemnity claim is rendered infructuous due to the bankruptcy of the seller. Such insurances are fairly common in large transactions, and are likely to be resorted to more often.
It is also important to bear in mind that RWI will not typically cover all occurrences of claims/losses. While it will cover a claim where the representations were inaccurate, what will not be covered are breaches of covenants, or where certain liabilities were known beforehand to the parties.
Conclusion
These unique times, where the legal and business impact can be subject to continuous changes around the globe, will require some forward-looking decision-making and focused due diligence, as well as clever drafting in order to protect the interest of the parties involved in such deals.
The views of the author are personal.
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