1. INTRODUCTION
As one of the fastest growing economies in the world, India attracted a total foreign direct investment (“FDI”) inflow of USD 919 billion during April 2000 to March 2023 with an FDI inflow of USD 70.97 billion in the financial year 2022-20231 . Other than a very limited set of sectors, 100% FDI is permitted under the automatic route. As a result of major FDI policy reforms and sector specific policies and incentives, there has been a significant boost in ‘mergers and acquisitions’ (“M&A”) being undertaken in the jurisdiction. While the Indian corporate law regime provides for a mechanism to undertake M&A transactions through court driven streamlined processes, usually parties enter into contractual arrangements for consummation of M&A transactions.
From a legal perspective, other than negotiations in relation to typical aspects of M&A transactions, such as warranties, indemnity, stand still obligations, exclusivity, control and management, which have been thoroughly deliberated for the past several years, set out below are certain notable considerations which may have a significant impact on negotiations or structuring an M&A transaction along with the definitive documents.
2. STRUCTURING CONSIDERATIONS
2.1 Issuance of ESOPs to promoters and directors
The (Indian) Companies Act, 2013 (the “Act”), permits Indian companies to issue stock options to its “employees” pursuant to an employees’ stock option plan/ scheme, where such options issued to employees are exercisable into shares of the company (“ESOPs”). It is crucial to note that the Act prohibits the grant of ESOPs to the promoter group. Additionally, the Act also prohibits the grant of ESOPs to a director of the company (who directly or indirectly) holds more than 10% of the outstanding equity shares in the company.2 However, if a company is a recognised ‘start-up company’3 , the promoter group and directors are permitted to be considered as ‘employees’ eligible for issuance of ESOPs.4 It should be noted that a minimum 1 (one) year cliff period should be observed between the grant and vesting of ESOPs on the employees/directors.5
For companies other than ‘start-up companies’ or which cease to be a ‘start-up company’ including on account of the turnover threshold being breached (which should be checked at the due diligence stage), alternative structuring options may need to be considered for incentivising the promoters or directors, taking into account considerations from a commercial perspective (such as impact on the shareholding pattern and the profit and loss statement). Other than valid contractual arrangements, parties may consider the issuance of sweat equity shares, bonus pay-outs under the employment agreement which are linked to performance, and grant of stock appreciation rights where the right to receive cash consideration is linked to appreciation of the value of the securities of the company.
Additionally, the foreign exchange regulations governing overseas investments, provides that subject to certain requirements and compliances, directors and employees of an Indian entity (which is inter alia a subsidiary of an overseas entity or in which the overseas entity has direct or indirect equity holding) are permitted to subscribe to shares of the overseas entity pursuant to exercise ESOPs granted by such overseas entity.6 Further, the overseas entity is also permitted to repurchase such shares subject to certain requirements being fulfilled. It may however be noted that remittances towards subscription to shares pursuant to exercise of options is counted towards an individual’s investment limit prescribed under the liberalised remittance scheme by the Reserve Bank of India.7
2.2 Layering Rules under the Act
To prevent creation of shell companies for diverting funds or money laundering, the Ministry of Corporate Affairs notified the Companies (Restriction on Number of Layers) Rules, 2017 (“Layering Rules”). The Layering Rules restrict companies to have more than two layers of subsidiaries in India.8 However, as per Rule 2(1) of the Layering Rules, one layer which consists of one or more wholly owned subsidiary or subsidiaries is not considered while computing the number of layers (“WOS Exemption”). It should be noted that the drafting of the WOS Exemption appears to be ambiguous and therefore open to interpretations, i.e., whether the WOS Exemption is applicable at the ‘first’ layer and therefore, a direct wholly owned subsidiary or subsidiaries of a holding company is only to be exempted, or the WOS Exemption is applicable to wholly owned subsidiary at any layer. A careful examination of the Layering Rules should be undertaken while structuring M&A transactions, specifically those involving the creation of new subsidiaries.
2.3 FoCCs and Deferred Consideration
The Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (the “NDI Rules”), prescribe that Indian entities which have received foreign investment and are ‘owned’ and ‘controlled’ by residents outside India (“FOCC(s)”), are required to comply with the entry routes, sectoral caps, pricing guidelines and other attendant conditions for foreign investment.9
While FOCCs must comply with certain requirements mandated for foreign resident entities, permissibility of a deferred consideration pay-out by / to FOCCs is not clearly indicated in case of a transfer of securities. As per the NDI Rules, payment of deferred consideration up to 25% of the total consideration to be paid within a period of 18 (eighteen) months from the date of execution of the definitive documents, is permitted in case of transfer of equity instruments between a person resident in India and a person resident outside India.10 Since, the NDI Rules do not expressly permit deferment of consideration in case of transfer to / by FOCCs, there is a heavy reliance on the views adopted by the authorised dealer banks in this regard. Currently, the common view adopted is that atleast consideration equivalent to the fair market value of the securities should be paid by the FOCC upfront (in case the FOCC is a buyer) and the remaining consideration may be paid as per contractual terms.
2.4 Valuation and Anti-Dilution Protections
Raising capital or providing an exit to the existing investors (which had previously acquired the securities of the company at a higher valuation) as part of an M&A transaction, at a lower valuation typically triggers antidilution protections of the existing investors under the shareholders agreement / articles of association of the companies.
While contractually the parties may agree to a particular mechanism for protecting the value of their shares/ investment, the implementation of these protections specifically vis-a-vis a foreign investor may pose regulatory challenges under the NDI Rules. Therefore, for implementing these protections, parties should inter alia keep in mind the applicable pricing guidelines, determination of the conversion formula for compulsorily convertible securities upfront as per the NDI Rules and ensuring that the price at the time of conversion should not in any case be lower than the fair value worked out at the time of issuance of the relevant convertible securities.11 If commercially aligned, issuance of bonus shares for implementing these protections may be considered. In this regard, it is interesting to understand if and how, a ‘selective’ bonus issue of shares or a renunciation of the right to receive bonus shares by selective shareholders, would be permissible under the Act and the foreign exchange regulations. These aspects become relevant since certain benefits may only be applicable to identified shareholders as opposed to all shareholders of the company. Alternatively, in cases where an existing investor is exiting the target, it may be considered if a different valuation can be prescribed (and to what extent) to the different class of shares typically held by investors, i.e., preference shares.
2.5 Accounting Standards
As per Section 133 of the Act read with the Companies (Indian Accounting Standards) Rules, 2015, implementation of Indian Accounting Standards (“Ind AS”) has been made mandatory for certain listed and unlisted companies (along with their holding companies, subsidiaries, associate companies or joint venture companies). With Ind AS being mandated for certain companies and others tilting towards the adoption of Ind AS, compliance with these standards should also be factored into while structuring and negotiating an M&A transaction. This becomes crucial considering the difference in the treatment of certain concepts under the Ind AS vis-à-vis the Act.
For instance, while the Act differentiates between equity shares and debentures based on the nature of the instrument issued, Ind AS also takes into account the rights provided to the holder of such instruments in the definitive documents. For example, drafting of exit related clauses which require the company to buy back shares of the investor holding equity instruments in the company may be construed as an ‘obligation’ on the company.12 In the event that this right is construed as an ‘obligation’, equity instruments held by the shareholder may be classified as a liability and in turn a debt instrument under Ind AS.
Further, while classifying a company as a subsidiary of its holding company, the Act does not specifically identify the heads of decision making which indicate ‘control’ of a parent company over its subsidiary company. However, as per the terms of Ind AS, certain reserved matters are identified which should lie with the majority shareholder to classify the company as its ‘subsidiary’.13 In the event that these reserved matters (such as reserved matters linked to appointment or remuneration of key employees of the company) lie with the minority shareholder, consolidation of the financial statements of the parent and subsidiary company under Ind AS may be a challenge.
3. CONCLUSION
Stated above are a limited set of considerations while structuring an M&A transaction. While the Government of India and the regulatory bodies have and continue from time to time to introduce various measures and policy incentives from the perspective of ease of doing business in India and attracting foreign investment, there will continue to be various requirements and compliances that will need to be adhered to while investing in India. Accordingly, advise from tax, financial and legal advisors should be taken into consideration (and at the right time) while structuring M&A transactions to provide the most commercially beneficial outcome.
