This article discusses certain key legal and regulatory aspects relevant to M&A transactions in India from the perspective of a U.S. investor, while highlighting certain comparisons and differences with relevant U.S. regulations.
Foreign Investment Regulations
Foreign investment in any Indian company (public or private, listed or unlisted)1is governed by a combination of (i) the Consolidated Foreign Direct Investment Policy issued by the Department of Industrial Policy and Promotion, Ministry of Commerce and Industry, Government of India (the "FDI Policy") which is updated twice a year; (ii) the Foreign Exchange Management Act, 1999, as amended ("FEMA"); and (iii) regulations and notifications issued by the Reserve Bank of India ("RBI") under FEMA. In addition, foreign investment in an Indian listed company will be subject to certain regulations issued by the Securities and Exchange Board of India (the "SEBI").
The principal government department that regulates foreign investment in any Indian company is the Foreign Investment Promotion Board (the "FIPB") established by the Government of India.
While the rules related to foreign investment in Indian companies have relaxed over the past ten years, foreign investment is still prohibited in certain sectors such as retail trading (except single brand product retailing), atomic energy, lottery business as well as gambling and betting, and foreign ownership is limited to certain ownership thresholds in other areas.
Foreign investment in permitted sectors can be made either through (i) the so-called "automatic route," where no prior approval of any regulatory authority is required, or (ii) with the prior approval of the FIPB or the RBI. Subject to certain conditions, foreign investment under the "automatic route" does not require prior approval of the FIPB or the RBI if the percentage of equity holding by all foreign investors does not exceed specified industry-specific thresholds. These conditions include certain minimum pricing requirements (see discussion below), compliance with the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997, as amended (the "Takeover Code"), and ownership restrictions based on the nature of the foreign investor.
Foreign investors may invest directly in equity shares of Indian companies or in securities that are fully and mandatorily convertible into equity shares within a specified time period, such as compulsorily convertible preference shares (CCPS) and compulsorily convertible debentures (CCD). CCPSs and CCDs are generally equivalent to preferred shares in the U.S., except for the mandatory conversion feature. CCDs are closer to a pure debt security than CCPSs. There are certain differences between CCPSs and CCDs, including that (i) the holders of CCPSs have limited statutory voting rights as shareholders whereas the holders of CCDs, while they have no statutory voting rights, may be granted such rights as a contractual matter; (ii) the distribution of dividends to holders of CCPSs is subject to the requirements of the Companies Act relating to distributable reserves, whereas interest for debentures is payable regardless of the availability of profits or financial performance; and (iii) the holders of CCDs, as creditors, will have priority over all shareholders, including holders of CCPSs, in the event of a winding-up of the company.
The conversion price of the CCPSs and CCDs must be equal to or higher than the fair value of the shares as determined by a chartered accountant under the CCI Guidelines. Traditionally, there has been some flexibility in structuring investments by foreign investors through convertible securities, for example, by linking the conversion price to the performance of the investee company. However, recent regulatory developments suggest that this position may have changed, and the conversion price now needs to be a fixed price (rather than based on a formula) determined at the time of issue of the convertible securities.
Instruments that are optionally or partially convertible are treated as debt, and any foreign investment through such instruments is required to comply with regulations (the "ECB Guidelines") governing external commercial borrowings ("ECBs"), which are generally stricter than regulations governing equity investments. In general, depending on the nature of the underlying investment, ECBs can be accessed under the "automatic" route, which does not require the prior approval of the RBI, or under the "approval" route, which requires the prior approval of the RBI.
For an Indian company to avail ECBs, it must be an eligible borrower under the ECB Guidelines and the ECB must be raised from a "recognised lender," which includes (i) suppliers of equipment; (ii) foreign collaborators (which are generally understood to be foreign entities providing technical assistance to an Indian company); and (iii) a foreign equity holder if it satisfies the following conditions: (a) for an ECB of up to US$5 million, at least 25 percent of the paid-up equity share capital of the Indian borrower is held directly by the lender; and (b) for an ECB of more than US$5 million (1) at least 25 percent of the paid-up equity share capital of the Indian borrower is held directly by the lender and (2) the proposed ECB does not exceed four times the direct foreign equity holding of such lender. Further, ECB proceeds may only be used for certain permitted purposes as set out in the ECB Guidelines, such as capital investments and acquisitions outside of India, and cannot be used, among other things, for (i) acquisitions in India, (ii) investment in real estate, (iii) working capital purposes, (iv) repayment of existing rupee loans, or (v) general corporate purposes.
Foreign investment in Indian companies is subject to minimum pricing guidelines. Under Indian regulations, the price of shares of an unlisted Indian company issued or transferred to a person resident outside India must not be less than the fair valuation of the shares determined by a merchant banker or a chartered accountant in accordance with the discounted free cash flow method. In respect of an issue of shares by a listed company, see discussion below in section entitled " Public M&A. "
There are also certain reporting requirements to the RBI upon the issue and/or transfer of shares of an Indian company to a foreign investor.
Same Field Restrictions
Subject to certain exceptions, any foreign investment or technology transfer or trademark license in India will require the prior approval of the FIPB if, as of January 12, 2005, the foreign investor had an existing joint venture or technology transfer or trademark agreement in the "same field" of business as the Indian company in which foreign investment is proposed. The foreign investor is also required to obtain a no-objection from the existing joint venture and its Indian shareholders prior to seeking the FIPB approval.
Put And Call Options; Transfer Restrictions
In the context of foreign investments in an Indian company, it is usual for put and/or call option provisions to be included in the transaction agreements. However, the enforceability of such options remains unclear under Indian law in respect of public companies2in view of certain restrictions under the Securities Contracts (Regulation) Act, 1956, as amended (the "SCRA"). This issue has not been finally resolved by the Supreme Court of India.
Further, the Companies Act requires the shares of a public company to be "freely transferable." There is lack of clarity whether provisions such as rights of first offer or refusal, tag-along rights and drag-along rights may be construed as restrictions on the free transferability of shares of a public company and held unenforceable even if such provisions are contained in the articles of association of the company. There are conflicting High Court judgments in this regard and this issue has not been finally resolved by the Supreme Court of India.
Transactions involving shares in listed public companies in India are regulated by the SEBI. The SEBI has issued various regulations in this regard, including regulations governing the acquisition of shares in listed public companies and insider trading.
The Takeover Code regulates substantial acquisition of shares and takeovers of a listed company. It prescribes certain thresholds or trigger points that give rise to mandatory bid obligations applicable to an acquirer of the equity shares or voting rights of a listed company, and it subjects the listed company, its promoters and the acquirer to certain disclosure requirements.
Review of the Takeover Code
In July 2010, an advisory committee constituted by the SEBI has submitted its report on the review of the Takeover Code to the SEBI. Key recommendations of the advisory committee include the following:
• Triggers for mandatory bid obligations. Increase in the acquisition threshold of a mandatory bid obligation from the current level of 15 percent to 25 percent of the voting capital of a listed company.
• Offer Size. A public offer must be for 100 percent of the shares of the listed company instead of the currently prescribed 20 percent.
Recommendations have also been made on various other aspects, including governance matters, indirect acquisitions, voluntary offers, exemptions from mandatory bid obligations, offer price, competing offers and timelines.
The timing of implementation of these recommendations, and the form in which these will finally be implemented, is currently uncertain.
Pricing Restrictions; Lock-up
Preferential allotment of equity shares or convertible securities by a listed company to select persons, such as promoters or institutional investors, is required to be made at a minimum price determined in accordance with certain pricing restrictions. For example, if the equity shares of the listed company have been listed on a stock exchange for six months or more as on the "relevant date,"3such minimum price must be not less than the higher of: (i) the average of the weekly high and low of the closing prices of the shares quoted on a stock exchange during the six months preceding the relevant date, and (ii) the average of the weekly high and low of the closing prices of the shares quoted on a stock exchange during the two weeks preceding the relevant date.
There are also certain lock-up restrictions, including that (a) the equity shares or convertible securities allotted to promoters and promoter groups on a preferential basis (including equity shares allotted pursuant to exercise of options attached to warrants) must be locked-up for a period of three years from the date of allotment, provided that not more than 20 percent of the total capital of the listed company, including capital invested pursuant to a preferential issue, will be subject to the three-year lock-up, (b) the excess equity shares above 20 percent must be locked-up for a period of one year from the date of allotment, and (c) all equity shares and convertible securities allotted on a preferential basis to any person must be locked-up for a period of one year from the date of allotment. Further, the entire pre-preferential allotment shareholding of persons to whom such preferential allotment is made is locked-up from the relevant date until a period of six months from the date of such allotment. The locked-up shares, however, can be transferred among promoters or promoter group entities or persons in control of the listed company, subject to the continuation of the lock-up.
Cross-Border Tax Planning
Many U.S. companies structure their equity holdings in Indian companies through an international holding company structure. Mauritius is the most common jurisdiction because the income tax treaty between the two countries exempts disposals of shares in an Indian company from Indian capital gains tax. The U.S.-India income tax treaty does not exempt such gains. Indian income tax treaties with Cyprus, Singapore and the Netherlands also offer capital gains relief. However, it may be more difficult in Singapore or the Netherlands to either obtain treaty relief (due to anti-abuse provisions in the treaty itself) or to benefit from the local country capital gains exemption.Cyprus is becoming more popular as a holding company jurisdiction. Cyprus is also used as a jurisdiction for lending into India due to the favourable interest withholding rate provided by the treaty.
It is unclear whether international holding companies will continue to provide the same tax benefits for owning Indian shares. The exemptions from Indian capital gains tax are under attack from two different sources. First, in a now famous case against a Dutch subsidiary of the Vodafone group, the Indian government is asserting a substance over form argument in order to tax capital gains realised from the sale of a Cayman holding company that indirectly held Indian shares.In addition, a proposed new direct tax code, effective in 2012, would introduce a general anti-avoidance rule that could also allow for the Indian government to tax indirect offshore capital gains linked to Indian shares, even where an income tax treaty may otherwise provide an exemption.
Competition Law Aspects
In 2002, India enacted a new Competition Act (the "Competition Act"). Certain provisions of the Competition Act dealing with prohibition of anti-competitive agreements and abuse of dominance have been made effective as of May 20, 2009, while other provisions relating to the regulation of combinations through acquisitions, mergers or amalgamations are not effective as yet.
The currently effective provisions of the Competition Act prohibit the entry into any agreement in respect of the production, supply, distribution, storage, acquisition or control of goods or the provision of services which causes or is likely to cause an "appreciable adverse effect" on competition within India, and further prohibit an enterprise or group from abusing its dominant position in a relevant market.
The merger control provisions that are yet to be made effective focus on determining the appreciable adverse effect that a proposed combination would have on the market, and on finding ways to mitigate such effect. This involves a notification and approval process where combinations above certain asset and turnover thresholds need to be notified to the Competition Commission of India for its approval.
A director of a company (whether public, private, listed, or unlisted) has been recognized under Indian law as a person who has a fiduciary relationship with the company. It has been held by Indian courts that directors are to some extent in the position of a trustee. The fiduciary duties of a director recognized under the Companies Act or case law include (i) a duty not to put himself in a position where his interest would conflict with that of the company; (ii) an obligation to act in the interests of the company while dealing with its assets; (iii) a duty not to make secret profits; and (iv) a duty not to exercise his powers for a collateral purpose. For a breach of fiduciary duties, a director may be held liable for civil consequences such as breach of trust.
The Companies Act prescribes civil and criminal penalties for defaults in compliance with certain provisions of the Companies Act that are applicable to the company and every officer who is in default. An executive director is deemed to be an "officer who is in default" if any of these specified sections of the Companies Act is contravened.
The Indian Penal Code, 1860, as amended, does not attach vicarious liability to the directors of a company when the company is the accused. However, there are specific provisions in Indian statutes that attach vicarious liability to officers of a company, including directors. These provisions hold such officers or directors liable in addition to the company, and the penalty imposed on such officers or director depends on the relevant provisions of such statutes. Directors may also be liable for civil and criminal prosecution under other legislation in India, including foreign exchange regulation laws, labor laws, tax laws, and other revenue laws (for example, customs and excise laws).
The Companies Act includes provisions for a company to indemnify its directors against liability in respect of fees, costs and expenses incurred in connection with any proceedings, civil or criminal, provided that a director shall not be entitled to such indemnity where a court determines that such director has acted with or committed negligence, default, misfeasance, breach of duty or breach of trust.
The indemnification and exculpation provisions permitted under Indian law do not seem as director favourable in India versus the U.S. As such, generally, it appears the potential culpability of a director of an Indian company could be higher than a director of a U.S. company. Also, under Indian law, the culpability of an executive director is higher than of a non-executive director.
Enforcement Of Foreign Judgments And Arbitration Awards
Recognition and enforcement of judgments of foreign courts are provided for under the Indian Code of Civil Procedure, 1908, as amended (the "CPC"). The Indian Arbitration and Conciliation Act, 1996, as amended (the "Arbitration Act") provides for the enforcement of foreign arbitral awards in India, provided that the award is rendered in a country that the Indian Government has declared to be a reciprocating territory to which the New York or Geneva Conventions apply. "Reciprocating territories" recognized under the Arbitration Act do not correspond to those recognized under the CPC. For instance, the U.S. is not recognized under the CPC, but is recognized under the Arbitration Act. Accordingly, a judgment of a U.S. court is not directly executable in India but an award by an arbitral tribunal in the U.S. may be enforced by an Indian court.
Execution of a foreign arbitration award is a two-step process undertaken in a single proceeding. The executing court is first required to determine whether the award is enforceable as a matter of Indian law and if it is, to then execute the award through procedure involving the attachment and sale of assets.
An arbitration award passed by an arbitral tribunal in a reciprocating country is presumed enforceable unless the party opposing such enforcement shows, inter alia, that the agreement to arbitrate was invalid under the laws to which it was subject, such party had inadequate notice of the arbitration or the award was beyond the scope of or not contemplated by the terms of the arbitration agreement. An arbitration award will also not be enforced if the subject matter of the dispute was not capable of settlement by arbitration under Indian law or offends India's public policy.
1In India, the major difference between a private company and a public company is that a public company's shares are required to be freely transferable whereas there can be transfer restrictions on shares of a private company.A private company is limited to no more than 50 shareholders.A public company is generally subject to greater regulation under the Companies Act, 1956, as amended (the "Companies Act").Typically a company with less than 50 shareholders that is not listed on an exchange will elect to be a private company.
3With respect to equity shares, "relevant date" is defined as the date 30 days prior to the date on which the general meeting of the shareholders of the listed company is held to consider the proposed preferential issue.
Rahul Patel is a Partner in King & Spalding's Corporate Practice Group.He is also a member of the firm's Hiring Committee. Mr. Patel's practice focuses on mergers and acquisitions, strategic corporate transactions, and general corporate work.Mr. Patel regularly represents leading companies (including General Electric Company, Mahindra & Mahindra Avantha Group, The Home Depot, Inc., Roper Industries, Inc., LexisNexis, Cooper Industries, Inc., SunTrust Banks, Inc. and Oxford Industries, Inc.) in a broad variety of mergers and acquisitions, joint venture and other control and non-control transactions.A significant portion of Mr. Patel's practice focuses on cross-border transactions, particularly transactions involving Indian companies.In addition, Mr. Patel has represented both underwriters and issuers in corporate finance transactions and general corporate and securities matters.
John C. Taylor is a Partner and U.S. tax lawyer in the London office of King & Spalding LLP. Mr. Taylor's practice focuses on U.S. and international taxation, the taxation of financial products, funds, partnerships and mergers and acquisitions.He represents U.S. and non-U.S.-based multinationals and financial institutions in connection with their structural and transactional tax planning, including advice concerning cross-border acquisitions, restructurings, and financings.In particular, Mr. Taylor works with leading tax counsel in many jurisdictions on resolving complex U.S., international and multinational tax matters.
Rajat Sethi is a Partner at the New Delhi offices of S&R Associates, an Indian law firm.Mr. Sethi's practice covers mergers and acquisitions, foreign investment, joint ventures, private equity, venture capital, corporate governance, distressed assets matters and shareholder disputes.He has been recognized as a leading individual by Chambers Asia: Asia's Leading Lawyers for Business in 2010 and IFLR1000: The Guide to the World's Leading Financial Law Firms.He received an LL.B. degree from the Faculty of Law, University of Delhi, an LL.M. from Tulane University Law School and a B.A. (Hons.) in Mathematics from St. Stephen's College.
Gokul Rajan is an Associate at S&R Associates in New Delhi.Mr. Rajan's practice includes mergers and acquisitions, securities offerings, private equity investments and general corporate matters.He received a B.A., LL.B. (Hons.) degree from the National Law School of India University, Bangalore and an LL.M. degree from Northwestern University School of Law.