Basic considerations for vendors in an M&A deal
( Xerxes Antia and Devina Narang)
Any M&A transaction typically goes through several stages culminating in the payment of purchase consideration to the target/seller(s) and the transfer of the sale shares to the acquirer(s). However, this is the final stage of usually weeks or even months of activity. Most M&A transactions begin weeks or even months prior to this stage, in some cases even before the target/vendors and investor/acquirer sign the ‘letter of intent’, or any commence negotiations. Based on our past experiences, we have tried to identify certain key areas to be covered by targets/vendors to identify (and where possible remedy) common issues when preparing for a potential M&A transaction.
1. SECURITIES AND SECURITY HOLDERS
The first area that would need to be covered would be the securities of the target company.
Every private limited company in India that maintains its share capital in a physical form (as opposed to an electronic or dematerialized form) is required to issue physical certificates evidencing the ownership of the shares in question (“Share Certificates”) to the applicable holders within a prescribed time frame (two months under current Indian corporate laws). These Share Certificates are required to be duly stamped (by payment of stamp duty) at the applicable rates in accordance with the stamp duty regulations applicable to the company. In addition, the (Indian) Companies Act, 2013 (“Act”) also prescribe certain compliances relating to the issue of Share Certificates and the issuing company’s articles of association (“AOA”) may also prescribe additional compliances in this regard.
For companies that have dematerialized their securities, there would be no Share Certificates (and the shares would be held electronically by the holders in their demat accounts held with a depository participant) and further, the compliances with respect to board/shareholder approvals also differ from private limited companies issuing physical shares, or are omitted altogether in certain cases.
All companies (having physical or dematerialized securities) are required to maintain certain stipulated shareholding records. These records are required to be duly stamped (where necessary), duly signed (by the necessary number of directors/individuals), duly affixed with common seal/round stamp (where required by the company’s AOA) and maintained in a stipulated manner.
In certain cases, there may be lock-in restrictions that would restrict a seller from transferring its shares, these lock-in requirements could be imposed under statute or under the AOA of a company (and/or a shareholders’ agreement applicable to such company). Further, the AOA of a company (as well any shareholders agreement applicable to such company) may prescribe that any transfer of shares would be subject to pre-emptive rights or require specific consent from other members.
Apart from the above, the board of directors/shareholders of a company are also required to approve each issuance, allotment, transfer (except where the dematerialized shares of a public limited company are being transferred) or disposal off securities of the company as well as take note of the transfer instruments and other documents to ensure compliance with the procedural requirements prescribed by the Act in this regard.
Have the shares been properly issued with the requisite approval of the board of directors of the target company and, where applicable, the shareholders of the company?
In case the shares have been issued in a physical form, have the Share Certificates been duly stamped and executed by the target company in accordance with the requirements of the Act as well as the AoA of the company?
In case the shares have been issued in an electronic/dematerialized form, has the correct stamp duty been paid and have the shares been credited to the dematerialized securities account of the holder?
Do the records of the company properly record the ownership of the shares and any transfer of such shares?
In case the transaction involves a transfer of shares, are the shares subject to any lock-in requirements that would need to be waived? Further are the shares subject to any pre-emptive rights and if so, have these rights been waived?
2. FEMA AND FEMA FILINGS RELATING TO INVESTMENTS INTO INDIAN COMPANIES
Pursuant to the provisions of the Foreign Exchange Management Act, 1999 read with its related rules and regulations (collectively, “FEMA”) and depending on the sector in which the target company carries on its business, foreign investment into India can be made either under the ‘automatic’ route for investment (where no prior approval of the Government of India is required for such investment) or the ‘approval’ route for investment (where the prior approval of the Government of India is required for such investment). Over time the number of business sectors under the ‘approval’ route has reduced significantly and presently foreign investment into most business sectors fall under the ‘automatic route’ but there are still a few sectors where any foreign investment would require prior approval. In addition, depending on the business sector that the target company is operating in, FEMA prescribes minimum capitalization norms that would need to be met for foreign investment as well as prescribes lock-in requirements in relation to foreign investment. It is therefore critical to check the business sector in which the target company is operating in to confirm what conditions, if any, would be applicable to such investment. To clarify, this would be applicable regardless of whether the foreign investment in question comprised of the acquisition of existing equity shares or the subscription to fresh shares to be issued by the target company.
In addition, it is important to consider the type of security proposed to be acquired by a foreign investor. Under FEMA only equity shares, compulsorily and mandatorily convertible preference shares, compulsorily and mandatorily convertible debentures and share warrants issued in accordance with regulations prescribed by the Indian securities regulator, the Securities and Exchange Board of India (“SEBI”), would comprise eligible equity instruments for foreign investment purposes with all other instruments being treated as debt and therefore subject to FEMA provisions governing debt.
Further, the issuance of equity shares (or instruments convertible into shares) by Indian companies are also subject to various pricing norms that would have to be met including under the provisions of the Act, under various regulations which are regulated by SEBI in the case of listed Indian companies as well as under FEMA where the shares are being issued to a non—resident investor. Pricing norms would also become applicable under FEMA for any transfer of shares between a non-resident as well as a resident.
Finally, FEMA prescribes certain form filings to be made in the event of transactions involving non-residents. The filings are typically event based and cover a range of different scenarios (which relate to shareholding as well as other scenarios like loans and borrowings). With respect to shareholding, FEMA prescribes filings for allotment of shares of an Indian company to non-residents (“Form FC-GPR”), transfer of shares of an Indian company by or to a non-resident (“Form FC-TRS”), grant of stock options to employees based outside of India (“Form ESOP”) etc. These filings require the Reserve Bank of India (“RBI”) to provide its acknowledgement or approval of the said filings. In the absence of this acknowledgement or approval, future transactions may be impacted as these documents are typically to be submitted as pre-requisites to the authorized dealer banks involved in the transaction before any additional funds are allowed to flow through in connection with the securities in question. Further, these filing requirements are also intertwined with the procedural compliances prescribed under the Act and/or FEMA. For instance, in certain cases such as, Form FC-TRS, the filing is a procedural pre-requisite for a company to take on record any transfer of its shares.
In the event the proposed transaction contemplates that a non-resident entity would be investing in an Indian company:
Does the target company carry on business in a sector that is under the ‘automatic’ route for investment?
If the target company carries on business in a sector under the ‘approval’ route for investment under FEMA, has the appropriate approval been sought for the non-resident investment?
Further are there any other sector specific conditions that have been prescribed under FEMA for the investment?
Does the security that is proposed to be acquired by the foreign investor constitute an eligible equity instrument under FEMA?
Are applicable pricing norms being complied with under FEMA (as well as under any other applicable law)?
In case the proposed transaction contemplates an acquisition of existing shares of an Indian company from a non-resident investor, then were appropriate filings made at the time of the original acquisition of such shares by the non-resident investor?
3. SECTION 281 CLEARANCES
Section 281 of the Indian Income Tax Act, 1961 (“IT Act”), inter alia, states that a transfer of assets (including shares) by an assessee to any other person, during the pendency of any income tax proceedings against the assessee, may be considered to be void, except in case where: (a) the asset is transferred for adequate consideration in the absence of a notice of any proceedings, or (b) with the permission of the ‘assessing officer’. Should the Indian income tax authorities (the Department of Income Tax, Ministry of Finance) take a view that there are pending proceedings against the vendors or that the transaction (being the sale of securities or other assets to the acquirer) has not been undertaken for adequate consideration, there is a risk of the transaction being considered as void. Therefore, to mitigate the potential risk of the transaction being considered void, a certificate under Section 281 of the IT Act issued by the Income tax authorities (“281 Certificate”) is generally requested by an acquirer from the applicable vendor as a condition precedent to completion of the deal. It must be noted in this regard that the obtaining of a 281 Certificate from the Income tax authorities can be a time-consuming and laborious process.
In the event that it would not be feasible to obtain a 281 Certificate from the Income tax authorities either due to the timelines for the proposed transaction or for any other reason, then as an alternative, a vendor could propose providing a certificate issued by a reputable chartered accountant/chartered accountancy firm confirming that there are no pending proceedings against such vendor and the transaction is being undertaken for adequate consideration (“CA Certificate”). However, it should be noted that CA Certificate would not provide the same degree of comfort to an acquirer as a 281 Certificate and an acquirer may require additional protection in such an event in the form of specific warranties or indemnities or even suitable insurance coverage. Further, to be able to issue the CA Certificate, a chartered accountant/chartered accountancy firm would require a certain amount of time to complete its review of the applicable facts and issue the appropriate report, this time frame would therefore need to be considered.
Will a prospective acquirer require a vendor to obtain a 281 Certificate as a condition precedent for the sale? If an acquirer requires that a 281 Certificate is to be obtained what would be a realistic time frame to obtain the same?
In the event that the acquirer accepts a CA Certificate, then what would be the time frame for obtaining the same and would the potential acquirer of the asset also require additional protection?
4. CHANGE IN CONTROL/MANAGEMENT OBLIGATIONS
At times, the various statutory licenses/consents/registrations obtained by a target company or the terms and conditions of any financing contracts, commercial contracts, property contracts or other contracts entered into by such company may contain provisions requiring the company to obtain the prior consent of relevant government authorities and/or applicable counterparties for any ‘change in control’ of the company that may be caused by a proposed transaction. These ‘change of control’ clauses may be triggered due to the proposed transaction as a result of any change in shareholding in the target company. The impact of a failure to comply with such ‘change in control’ provisions may range from a cancellation of a license or consent which could adversely impact the target company’s ability to carry on its business and operations to the cancellation of a financing facility provided to the target company. Further, the obtaining of necessary consents for any proposed change in control of a target company can be time consuming and may often take up to weeks or months to put in place (specially, where there are government authorities or landlords involved).
At times and as opposed to the prior approval of a ‘change in control’, a target company is required to provide an intimation of a ‘change in control’ pursuant to the provisions of any statutory licenses/consents/registrations obtained by such target company or the terms and conditions of any financing contracts, commercial contracts or property contracts entered into by such target. Such intimation may be required to provided either prior to the proposed transaction or on a post facto basis. The consequences of not providing such an intimation generally would not be as severe.
Due to the consequences of failing to duly obtain requisite consents or approvals for a ‘change in control’ of a target company or to provide necessary intimations of such change in control, it is therefore crucial to identify a potential list of such consents or intimation requirements. Given that obtaining the necessary consents and approvals may be time consuming process, it would be advisable to do this in a timely manner.
Will the proposed transaction trigger any ‘change of control’ provisions under either any licenses/consents/registrations obtained by the target company or under any financing contracts, commercial contracts, property contracts or other contracts to which the target company is a party to?
If any ‘change of control’ provisions are triggered by the proposed transaction, would the prior consent of any third party be required for such ‘change in control’ or would any intimation be required to be provided to any third party for such ‘change in control’ and whether such intimation is to be provided either prior to or post the undertaking of the proposed transaction?
5. MCA FILINGS RELATING TO SHAREHOLDERS
Under the Act, certain declarations and disclosures are required to be made with the Ministry of Corporate Affairs (“MCA”) by every company with respect to its ownership and control. Of note, these filings relate to declaration of the company’s significant beneficial owner (“SBO”) as well as nominee shareholders, if any.
The concept of mandatory disclosure of SBO is fairly new in India and was made applicable in 2018. In brief, for companies, an SBO would be an individual/natural person who: (a) holds 10% or more of the shareholding/voting rights/rights to receive or participate in dividend or any other distribution in the Indian company, or (b) has the right to exercise or exercises significant influence or control over the Indian company in question, in any manner other than through direct-holdings alone. Under the Act, the responsibility of making the necessary declarations is on the SBO. Further, the company is required to file the declaration received by the SBO with the MCA, Failure to do so would attract fines and penalties on both. A company that has not received a declaration/necessary information from its SBO is entitled to file an application to the relevant authorities for ordering a restriction on transfer of its shares or any rights connected with such shares.
In India, every private limited company is required to have a minimum of two shareholders and every public company is required to have a minimum of seven shareholders. Often, to meet this minimum requirement, nominee shareholders are appointed to hold shares on behalf of a particular shareholder (usually the holding company or majority shareholder). In such cases, the shareholders (nominee and beneficial owner) are required to file certain declarations confirming their status as nominee and beneficial owner with the company, respectively and the company is required to file such declarations received by the shareholders with the MCA.
It must also be ensured that the Company’s annual returns filed with the MCA disclose an accurate list of shareholders as of the end of each financial year.
Has the target company queried its shareholders/members on whether there would be any SBO of the company? Have the shareholders/members responded to, sought and received clarifications from each of its members as to whether there would be any SBO? Has the company made the appropriate SBO filings with the MCA and are the filings up to date?
Does the company have a nominee shareholder? If yes, whether declarations with respect to nominee shareholding have been made with the target company, and subsequently filed with the MCA?
6. EMPLOYEE RELATED LIABILITIES
Under Indian law, employers are required to make certain statutory contributions on behalf and with respect to their employees, such as, relating to provident fund, gratuity etc. As such, these monetary contributions form part of government mandated benefits available to employees/workmen in India under various labour laws. Rectification of unpaid contributions may be time consuming and procedurally heavy (involving coordination with third party consultants, such as, accountants, auditors or government officials).
Further, companies in India are also required to put in place certain policies for employee health, safety and welfare, such as, a prevention of sexual harassment policy, an equal opportunity policy etc.
A failure to make the mandated contributions or maintain the applicable policies may attract fines and penalties as well as, in extreme cases, be punishable by way of imprisonment of senior officials or key employees.
Has the target company properly paid or, where applicable, properly accrued in its books all contributions required under applicable labour laws? Does the target company have any unfunded liability for any contribution plans that it maintains for the benefit of its employees/workers?
Does the target company maintain all employee and/or labour related policies that it is required to do under applicable law? In the event that any employee or labour policies contemplate any committees to be constituted or other actions to be taken by the company in furtherance of such policies, have such committees been duly constituted or such other actions undertaken?
7. STAMP DUTY AND REGISTRATION
In India certain types of instruments (including various types of agreements and other documents) are required to be stamped/franked for an appropriate value calculated either as per the provisions of the Indian Stamp Act, 1899 or as per state level statues. However, at times and for various reasons either no stamp duty is paid, or inadequate stamp duty is paid on instruments. A company’s agreements and contracts are required to be affixed with stamp duty of appropriate value as per the applicable stamp duty regulations. Under the Indian Evidence Act, 1872 (the primary statute governing the admissibility of evidence in legal proceedings), for an instrument to be admitted as evidence in a legal proceeding, such instrument would first need to have been stamped at the applicable rates. Therefore, if an agreement or contract was not adequately stamped, then prior to seeking to enforce any provision of the same in a legal proceeding, it would be necessary to first rectify the deficiency which would involve adjudication before the relevant stamp authorities in a time consuming process and could also involve imposition of fines of up to 10 times the deficient stamp duty payable on the agreement or contract in question.
In addition, the property related agreements of the company may also need to be registered with the local registrar/other designated authority in certain instances. It may be noted in this regard that registration of a property agreement would require that such agreement be first stamped for the applicable value and thereafter registered with the registrar/other designated authority who may levy additional fees for registration of such agreement. An unregistered agreement may also adversely impact the nature of the rights proposed to be granted under the property agreement in question and may also not be admissible as evidence in court in any action for enforcement rights under such agreement.
Therefore, identifying all unstamped or unregistered agreements (with a special focus on its property and high value customer contracts) and commencing adjudication of non-payment, if any, in advance of any upcoming M&A deal, would be helpful.
Have the various agreements and contracts entered into by the target company been duly stamped at the applicable rates within the prescribed time period?
Whether adjudication proceedings were undertaken where stamp duty was paid after the prescribed time period?
Where any property agreements or contracts entered into by the target company are required to be registered, have such agreements or contracts been registered with the appropriate authorities with the applicable registration fees being paid?
In addition to the above, there are other steps that a vendor or a target company can take to ensure its preparedness for a potential M&A deal, including, assessing and tracking any ongoing litigations against the company or any of its key employees, ensuring that the mandatory policies and procedures pertaining to data confidentiality and privacy are in order, ensuring that the company’s insurance policies are updated, adequate and renewed in a timely manner etc.
The views set out in this article are personal. This article is intended to provide a general guide to the subject matter and is not intended to be exhaustive or conclusive. Specialist advice should be sought about your specific circumstances.