Mergers and acquisitions – Transactional challenges in India

Introduction
 
Mergers and acquisitions (“M&A”) are primarily used by companies looking to scale up and grow their businesses. “Mergers” are generally understood as events that result in target entities ceasing to have separate corporate or legal identities and being subsumed into the acquirors, while “acquisitions” are generally understood as events where target entities are acquired but continue to retain their distinct corporate and legal identities. While there are several types of acquisition transactions possible, this article focuses on transactional challenges with respect to acquisition by way of purchase of shares with an emphasis on cross-border M&A transactions in India.
 
Merger “and” acquisition of an Indian company
 
While the terms “merger” and “acquisition” are often used synonymously and as part of the same phrase i.e., “M&A”, the distinction between a merger and an acquisition as stated above needs to be kept in mind. Under Indian law, cross border merger of an Indian company into a foreign company is not permissible, while a cross border merger of a foreign company into an Indian company or merger of two Indian companies, is permissible. An acquisition of an Indian company by a foreign company, or another Indian company is permissible as is an acquisition of a foreign company by an Indian company.
 
Due diligence process and its challenges
 
In an acquisition, the process of conducting an effective legal due diligence (“LDD”) cannot be underestimated. Unlike a private equity transaction, the erstwhile shareholders exit as part of the acquisition. Undertaking a comprehensive assessment of the business, regulatory, environmental and legal risk factors involved in acquiring the company is critical.
 
In India, the LDD process commences with a review of data that is provided by the target company itself. Data except in a few instances is not publicly available and even if available may not be updated or carry any statutory or regulatory certification, especially in critical aspects such as property ownership, share ownership and litigation. India does not have a Government backed title registry which serves as conclusive proof of ownership. As such, no counsel can conclusively certify the status of the company and any diligence is therefore dependent on the quality and integrity of data being made available. Additionally, the closing of an acquisition transaction is often delayed requiring bringdown diligence procedures for the period between the date of completing the LDD and the closing date.
 
In India, LDD generally does not cover financial and tax matters (both direct and indirect tax) and often there are separate firms engaged for financial due diligence (“FDD”) which includes taxation and accounting matters. To effectively understand the risks, it is critical for the acquiror to view the findings of LDD and FDD on the target company as a whole. It also becomes important for legal counsel of the acquiror to understand FDD findings and to be able to effectively draft legal provisions for relevant FDD findings in the transaction documents.
 
The standards of corporate governance and regulatory compliance may often fall short of the expectations of foreign acquirors. This is especially so in areas such as board independence, environment, labour, related party transactions and formalisation of arrangements with key customers and suppliers. Valuation differences occurring because of differences in accounting or revenue recognition standards between those used by the company prior to the acquisition and that applied by the acquiror post-acquisition also become contentious, particularly in the case of an acquisition that is consummated in tranches.
 
Representations, warranties and indemnities
 
In an acquisition, a representation or warranty provided by the target company has little meaning. Accordingly, an acquiror would look to the selling shareholders to provide necessary representations and warranties. While warranties on title to shares, non-encumbrance, ability to contract, etc., are not negotiated heavily, there are often detailed negotiations surrounding operational warranties. In cases where there are individual shareholders selling their shares in the company, these are easier to obtain. However, where selling shareholders are financial investors such as funds, warranties on operational matters will not be readily forthcoming with necessary comfort being restricted to due diligence findings and the satisfaction of conditions precedent. The need for robust warranties on business operations are magnified in cases of companies that operate within regulated sectors and companies engaged in activities with significant potential for tortious liabilities. Foreign acquirors also seek to obtain comfort on matters that fall within the reach of foreign laws that may be applicable to the acquiror (and not necessarily to sellers or target company) such as FCPA/ anti-bribery laws and ESG matters.
 
Indemnities are typically difficult to enforce in India as under Indian law, indemnities are akin to damages and are required to be proved. Liquidated damages tend to be capped even when there is a genuine pre-estimation of losses. Even where indemnities are established, foreign parties may face difficulties in repatriation of sums awarded outside India and may in some instances need regulatory approval.
 
Holdbacks, and escrow
 
Earlier, Indian regulators would not permit holdbacks, escrow and deferred considerations. Recent changes and liberalisation in the legal position have enabled deferred consideration and escrows albeit to a limited extent. While this may not grant complete freedom in structuring transactions, there is a move to ease restrictions and allow greater flexibility on contractual restrictions as opposed to regulatory restrictions. It is however important for acquirors to work closely with banks (Authorised Dealers of foreign exchange) in India and to whom a large amount of regulatory discretion has been delegated by the Reserve Bank of India (RBI) to ensure that structures pass muster.
 
Regulatory and other approvals and costs
 
For a merger between two Indian companies, approval of the relevant court (jurisdictional Company Law Tribunal) as well as approvals from the Registrar of Companies, income tax authorities, creditors and shareholders may be needed. For an acquisition, the need for and timing of regulatory approvals to be obtained depend on the nature of activity of the target company, its status (private or publicly listed) and its turnover and asset threshold.
 
In general, the acquisition of a mid-size knowledge-based services company (such as information technology) that is privately held, would require minimal regulatory approvals. For publicly held large companies, approvals from multiple regulators such as the Securities and Exchange Board of India (SEBI), RBI and the Competition Commission of India (CCI) may be required. Costs of obtaining such approvals are usually borne by the acquiror but these are sometimes negotiated such that these costs are factored into the transaction consideration. Approval of other regulators for change in control is often necessitated in companies that have been allotted land by the Government or which enjoy certain specific benefits and exemptions.
 
Execution of definitive agreements and transfer of shares involves the payment of stamp duties which vary across different states in India. These costs are normally to the account of the acquiror but again can be negotiated and factored into the purchase price.
 
Other considerations
 
Non-compete clauses while quite common in transaction documents are subject to interpretation on enforceability. Acquirors therefore adopt complicated structures to work around this by entering into consulting agreements with exiting promoters to bind them to exclusivity and non-compete arrangements that may also have the effect of assisting in the transition. Acquirors are also often surprised by the transaction costs which are contractually agreed to by the company such as investment banking, financial advisor and legal counsel fees.
 
In conclusion
 
While M&A transactions in India are not atypical, there are certain nuances in doing business in India which may be unique to the geography. Foreign acquirors would do well to understand that often Indian promoters are not well equipped to understand clauses such as indemnities, warranties and conditions precedent. Explanation and education of clients about transaction intricacies could add to timelines. Simplifying documentation and structures works best. Often promoters do not separate their personal assets from the company’s assets and often promoter’s houses, cars, etc. are all owned/registered in the name of the company. Promoters would lose access to all these consequent to a sale of the company. Transfer of such assets prior to completion of the acquisition would have cost, tax and time consequences.
 
Any M&A in India therefore needs to be undertaken understanding not just the legal and regulatory regime but also certain cultural issues specific to India and engagement of experienced advisors is a sine-qua-non in these matters.
 
Manav Nagaraj
manav.nagaraj@tatvalegal.com
 
Manav Nagaraj leads the corporate practice of Tatva Legal Bangalore and has been in practice since 1999. He has experience and expertise in several local and international transactions in private equity, venture capital, mergers and acquisitions, impact investing, fund formation, inbound and outbound investments, debt financing and general corporate and transaction advisory matters. He has advised global funds, financial institutions, family offices, promoters and corporates across healthcare, technology, financial services and fin-tech, auto components, agri-biz and social impact sectors.

Manav has been recognised by Chambers Asia in the Private Equity and Corporate M&A fields for India and regularly speaks on M&A, venture capital, investment, corporate laws and start-ups.