How are M&A transactions in India different today from, say 2-3 years ago? What has improved the most and what has gotten worse?

As India continues to be one of the more attractive investment destinations, M&A activity has progressed significantly over the last 2-3 years. A stable central government with a strong political will - demonstrated by the policy changes and regulatory liberalisation - has given the impetus for steady growth in M&A activity across sectors. On the policy front, several schemes like ‘Make in India’, ‘Skill India’, ‘Digital India’, ‘Start Up India’ and ‘Stand Up India’ have provided a favourable outlook for inbound investments into the country. At the same time, provisions to allow Indian companies to merge into foreign companies is expected to provide some traction to outbound mergers. There are also efforts being made to overhaul dated regulations and the central government has given a major thrust to its agenda of ‘Ease of Doing Business in India’. That M&A activity in India reached a record high of $64 billion in 2016 is proof that domestic and foreign investors are bullish on the Indian market.

From a deal mechanics perspective, there is a greater degree of deal sophistication associated with Indian markets, while processes and structures common in M&A transactions abroad are now being implemented in India too. Use of auction processes for sales have been on the rise. Post-closing escrows for working capital and other adjustments are becoming routine. Indemnity and warranty insurance is gaining traction. Acquisitions through stock have become common, especially in the e-commerce sector. With promoters being more proactive and mindful of their rights and obligations, negotiations have become more balanced. Investors, on the other hand, have accepted the policy framework on no guaranteed return and are looking at other means for a smoother and fruitful exit. In fact, it is the promoters who are seeking more rights including guaranteed returns in the form of upside sharing. Cases involving assured returns to investors are decreasing and there are fewer instances of the negotiations being lopsided in favour of investors.

Despite the progress, there are still quite a few structures which, though common abroad, are difficult to implement in India. A traditional leverage buy-out, which might otherwise seem fairly straightforward, is not permissible under the Indian legal regime. To make a leverage buy-out work, acquirers need to demonstrate an appetite for innovative structures.

Although the policy initiatives are laudable, the letter of the law in some instances deters the spirit which makes deal making difficult. For instance, while the liberalisation of requirements for setting-up an escrow post-closing was a step welcomed by industry, the multiple views and interpretations on what is permissible and what is not has limited its positive impact to a large extent. There is also an urgent need for the Reserve Bank of India (“RBI”) and Foreign Investment Promotion Board (“FIPB”) to clear their stand on internationally accepted structures like post-closing adjustments and share swaps. Other instances are reforms to the merger process and the setting-up of a National Company Law Tribunal which will approve mergers: in reality, as the tribunal is in its nascent stages, it has meant that the approvals seem to be taking longer than the erstwhile approval process through the High Courts. It is imperative that multiple nodal agencies like the RBI, FIPB, Competition Commission of India (“CCI”), Department of Industrial Policy & Promotion (“DIPP”) and Securities and Exchange Board of India (“SEBI”) are in consonance on their views, thereby obviating any divergence in regulatory oversight.

How has the stress in the Indian banking system affected cross-border and domestic M&A transactions in recent times?

Banks in India are facing challenges of moderate loan growth, slow trading gains, surplus liquidity and mounting bad loans. India’s restrictive policies in relation to full capital account convertibility and institutional inefficiencies in enforcement of security, do not make India a natural destination for debt capital. However, with regulatory liberalisation on this front, there is increased interest from raising capital through debt instruments.

Extant exchange control regulations permit investment by foreign portfolio investors in listed non-convertible debentures (“NCDs”) issued by a private company. Using listed NCDs has become a popular tool to raise capital for investors looking for an investment cycle of at least 3 years. Further, using listed NCDs has been commercially preferred if promoters are not willing to part with their equity stake and if the investor is looking for a fixed return on the investment. Creation of security and limited end-use restrictions are some of the key advantages of using listed NCDs. The costs for compliance and listing are also not very steep. As a recent development, investment in unlisted NCDs by FPIs has been permitted. However, certain end-use restrictions have been imposed - such debt cannot be used for purchasing shares of another company. Unlisted NCDs may serve as useful funding tools for capital intensive sectors such as real estate.

Further, international debt funds have shown keen interest in India. Structures have evolved to facilitate their investment in certain debt products and in 2015, the RBI allowed Indian companies to issue rupee denominated bonds overseas (so-called “Masala Bonds”), which has created another avenue for international debt capital to be channelled into Indian companies. Although the initial market reaction to these instruments was mixed, market interest renewed after HDFC listed its Masala Bonds on the London Stock Exchanges in July 2016. NCDs and Masala Bonds are giving greater downstream protection to foreign investors. From a promoter perspective, it is an attractive instrument for borrowers as it neutralises any exchange currency conversion risks.

Investors have been willing to invest funds in distressed assets. Recently, there have been significant enabling changes facilitating wider access to the distressed market in India. By way of background, in the past, some international debt investors have sought to invest in the equity of “asset reconstruction companies” (ARCs), by partnering with Indian groups. Such companies benefit from access to a wider pool of debt and enhanced enforcement proceedings and this is the route through which most distressed investments are undertaken in India. The changes announced in the 2016 union budget, supported by legislative amendments in relation to certain debt recovery legislation, allow international investors to acquire 100% of the shares of an asset reconstruction company and also acquire 100% of any tranche of security receipts issued by such company (although the RBI requires 15% cash consideration on the acquisition of loans). This has been welcomed by the market as an enabling change. One expects this market to mature significantly in the near future, which will help in deleveraging the balance sheets of public lending institutions.

What are the typical timelines for an Indian or cross-border M&A deal, and which parts typically take the longest?

Typically, an M&A deal would take anywhere between 3 to 6 months. The timelines depend on various factors, including the nature of the transaction, the sector of investment, private market or public market instrument, regulatory interface required, structuring and tax considerations, and the number of sellers and buyers. For instance, a majority acquisition by a foreign investor of a privately held company, in the IT sector, can be easily completed in a couple of months as opposed to a majority acquisition by a foreign investor of a public listed company in the telecom sector, which may stretch beyond six months. In the first example, as regulatory approvals are not required, there are no hurdles perceived that will adversely impact deal timelines. For the acquisition of the public listed company, the deal timeline would be significantly longer, including approvals from various regulators such as the Department of Telecommunication, FIPB (or its successor), CCI (if the specified thresholds are breached), and implementation of the open offer process as per the takeover regulations.

Generally, obtaining regulatory approvals is what stretches the deal timelines the longest. While there has been lot of emphasis on ease of doing business in recent times, the reality is that the time taken for obtaining regulatory approvals is often a bottle neck for swift deal making. For instance, although a 30 day timeline is prescribed under law for a CCI approval from the date of application, in fact, such approval takes much longer. The regulator, just to buy more time, seeks additional clarifications from parties even in relation to routine filings.

What are the main cultural aspects of an Indian M&A that foreign investors are most often surprised by? Are there any tips you can give to bridging any cultural or other gaps there?

India’s growth story attracts investment but that comes with its own qualms! We all know how Uber had to mend one of its core principles of not using cash as a payment method only for the Indian market - M&A deals are no different.

Most Indian corporates are tightly held by the promoters and their family members. This leads to a merged identity of the promoter family and the corporate entity. It is common to find promoters and their extended family members occupying key positions, directly or indirectly, in the management of the business and taking important business decisions. Therefore, it is very pertinent for foreign investors to understand the distinct role of the promoters in day-to-day operations of the company. This gains more importance in a scenario where the investor will be running the business alongside the promoters.

Foreign investors need to rethink their strategies and principles to cater to the Indian mindset. It is important that investors do not impose their global practices, rather focus on striking the right balance to ensure they culturally fit.

Any tips on how to deal with Indian promoters or promoter-driven companies for foreign legal advisers?

Corporate governance practices of Indian promoter-driven companies may not always be in sync with the practices followed internationally. As mentioned above, most Indian companies are operated as family enterprises and may not have implemented the best corporate governance practices.

Accordingly, from a diligence perspective, there should be additional focus on related party transactions, compensation and any other incentive pay-outs to promoters, as such payments and transactions may not be documented. Emphasis must also be made on good housekeeping and sanity checks on the general regulatory compliances that are required. Investors must check if relationships of the target with customer/vendors are in a documented form. Intellectual property protection is another area that requires protection - there have been instances, where IPs are registered in the name of the promoters rather than the company. To avoid surprises later on, it is important to have a conversation in advance with the promoters on how they deal with issues relating to corruption and graft and what measures they have put in place for dealing with such instances, if any. Further, a focus should also be on understanding the policies put in place for dealing with sensitive issues such as sexual harassment in the work place, whistle blower protection, etc.

In relation to documentation and structuring investor exits, it is important that the relationship with promoters are cordial, and that such amiability is reflected in day-to-day management. Exit mechanisms will remain mere contractual rights without teeth if the promoter is not facilitating an investor’s exit. To this end, as a structuring tool, upside sharing arrangements may be agreed upon to incentivise promoters to facilitate an exit. However, such an arrangement would require additional corporate governance requirements in case of a public listed company.

A general advice to foreign advisers would be to understand the promoters and determine their experience in deal-making. It may be the case that the Indian promoter is dealing with foreign investors for the first time, and the complexities involved in the deal process may get a bit overwhelming for him. The foreign legal advisers may be required to put in extra hours to hand-hold such promoters through the deal process. It is also recommended that foreign advisers conduct adequate background due diligence to cull out deal-breaker issues.

In your opinion, which are (or have more recently become) the most important aspects of Indian cross-border M&A deals, from a regulatory and legal perspective?

India has become a hotspot of M&A for the past few years. The rapidly-changing legal and regulatory landscape is testament to India’s pro-business approach. Some of the key changes which will impact M&A deals are:

• Deferred consideration, escrow and indemnities: The payment of warranty and indemnity claims historically required RBI approval (although the RBI is unlikely to refuse permission if the claim is supported by a judicial or arbitral award). There were also previous restrictions on the payment of deferred consideration without RBI approval. These restrictions have affected retention mechanisms, earn-outs and even purchase price adjustments. Structural approaches have evolved to work around some of these restrictions, but they all involve complexity. However, recent changes permit deferred consideration and escrows for an 18-month period after the date of the agreement and indemnities with a value of no more than 25% of the purchase price without the need for RBI approval. Although this does not go as far as dismantling the entire regime and the changes do have their quirks (for example, the 18 month period is tied to the date of the agreement rather than closing), it does create some room for the use of routine M&A features in transactions without the need for complex and creative structuring.

• Foreign investment in Limited Liability Partnerships: Limited Liability Partnerships (“LLPs”) that operate in sectors where foreign investment is otherwise freely permitted have been recently categorised as entities eligible to receive foreign investments. This change is significant as LLPs currently offer certain tax and corporate compliance advantages. However, there are also some downsides to the use of LLPs. For instance, the debt funding options available to LLPs are limited and it is not currently possible for LLPs to be subsequently re-registered as companies. It would be worth considering the use of LLPs in relation to joint ventures (we have advised on such structures recently). However, the tax laws in India may change and clients opting to use the LLP form should do so bearing in mind the “change of law” risk.

• Sectoral liberalisation: The foreign exchange regime has been liberalised to a great extent by permitting foreign direct investments (“FDI”) under the automatic route in many sectors, which earlier required approval of the government and increasing the limit of foreign investments in various sectors. A number of sectors, such as defence, pharmaceuticals, real estate and single-brand retail, have all seen helpful changes. Additionally, 100% FDI under automatic route is allowed in ‘regulated’ financial services. Requirements of minimum capitalisation have been done away with.

• Phasing out FIPB: An important development has been the Indian government’s announcement in the 2017-18 Union Budget to phase out the FIPB in the 2017-18 financial year and further liberalise exchange control regulations relating to foreign direct investment in India. While this is an important development for all foreign investors, the government is yet to give clarity as to how sectors with an approval route will be handled. If investors will have to take the nod of individual ministries for sectors, for instance, approaching the department of pharmaceuticals for an investment in the pharmaceutical sector, this move may end up being a bane rather than a boon.

• Exemptions to small targets: In case of a proposed investment in a target company whose assets are less than INR 1000 crores, the Ministry of Corporate Affairs of the Government of India has introduced a notification dated 27 March 2017 that has expanded the scope of the ‘small target exemption’ to include mergers and amalgamations, and has clarified that only the “true target” in case of asset/business acquisitions will now be considered for the purposes of determining the applicability of the asset and turnover thresholds under the Competition Act, 2002.

• Regulating Mergers: India has promulgated new regulations and tweaked existing laws to give a thrust to cross-border M&A activities. The most important development has been on the cross-border mergers front, which will unlock the potential of inbound mergers in India M&A. Whereas the old regime permitted only the merger of an Indian company into a foreign company, the new regime provides for a foreign company to merge into an Indian company. Additionally, SEBI has issued new guidelines to regulate mergers between listed and unlisted companies. Earlier, unlisted companies merged with listed companies as an easy route to listing by circumventing the requirement of detailed disclosures. To curb this practice, the new guidelines envisage a host of disclosure requirements for the unlisted companies as well.

• Insolvency Code: The insolvency and bankruptcy law will make it easier for foreign investors to wind up their investments in India. The Insolvency and Bankruptcy Code, 2016 (“Insolvency Code”) has been operationalised with effect from 1 December 2016. Broadly, the Insolvency Code provides for a UK-style approach to insolvency. It provides for an administration-like process called the insolvency resolution process, which can be initiated upon a default of INR 100,000. The resolution plan needs to be adopted in a time-bound period of 180 days (one time extendable to 270 days). Failure of the corporate insolvency results in liquidation of the corporate debtor. It also introduces UK-style claw-back provisions (for preferences, transactions at an undervalue and extortionate credit transactions) and provides for a clear waterfall of distributions in liquidation. This is a welcome legal development as it seeks to implement insolvency in a time bound manner with greater power in the hands of creditors, but much depends on the development of the institutions and professions that are required to make its functioning a success.

• Dispute resolution: A significant and welcome change has been the amendment to the Arbitration & Conciliation Act, 1996 (“A&C Act”), that has clarified the anomalies that had been created by various judicial pronouncements especially in cases involving a foreign seat of arbitration. The intention behind the amendment is to make arbitration a preferred mode for settlement of commercial disputes by making it more user-friendly and cost effective and leading to expeditious disposal of cases. Separately, a law to set up commercial courts at district courts and commercial divisions at High Courts to exclusively try commercial disputes has also been promulgated, but it is yet to be implemented.

Which areas are most likely to derail a deal or end up raising red flags, in your experience?

Deal breakers are usually on commercial points and it is unlikely for a deal to be called off purely on legal reasons. Typical red flags associated with legal diligence are on account of regulatory consents and approvals that may be required. The timelines taken for approvals from CCI, SEBI or FIPB are hard to predict with certainty and in many cases, may take longer than expected. A deal involving simultaneous approvals from multiple regulators may get entangled if regulators take contrary views on the same subject matter. For instance, RBI and DIPP (government department that formulates FDI policy) have not always been on the same page on a few foreign exchange control issues. Further, there have been instances where the CCI has asked parties to make a re-submission on account of submission of insufficient information.

While dealing with promoters of family driven companies, foreign investors may come across intra-group transactions that may not be in strict compliance with corporate governance norms. Foreign investors, who are indoctrinated with the idea of separate management and ownership in a company, may become sceptical to such family-driven companies.

Use of holding companies for making further investments, has historically triggered regulatory intervention by way of an approval of the FIPB (the government agency responsible for regulating foreign investment). While there has been a change in policy permitting investment into companies which do not have any operations and intend to carry on business in sectors where foreign investment would not otherwise need government approval (and where there are no regulatory investment conditions), the concerns around regulatory capital requirements for “core-investment companies” and the potential categorisation of these entities “non-banking financial companies” still remain.

What are the best measures one can take (ahead of time or at the time of the transaction) to avoid such red flags from ruining a deal?

Prior to entering into commercial negotiations, parties must have a wholesome understanding of the sector they are dealing in. Parties must sit together at the drawing board and chalk out the best strategy to minimize the deal’s exposure to regulators. Estimate of time taken in obtaining regulatory approvals and third-party consents must be factored into the proposed timelines of the transactions. To prevent deals getting entangled in regulatory cross-wires, deal makers must be pro-active in their dealings with the regulators. If the deal envisages simultaneous applications to multiple regulators, parties may minimize the risks by timing their responses strategically before the respective regulators. Applications getting returned by regulators owing to a lack of supporting documents may be averted if parties are careful in ensuring that their submissions are in the format prescribed by the regulator and that it contains adequate disclosures.

The best way to avoid hiccups in a deal involving family-driven companies is to undertake thorough due diligence on the financial and legal aspects. This will considerably bring down the chances of unwelcome red-flags springing up at the closing or post-closing stage.

What do you think is the future of certain offshore structures, in light of the recent treaties and general anti-avoidance rules that kicked in on 1 April?

1 April 2017 is a historic date as far as the tax regime in India is concerned. The tax exemptions available to investments from Mauritius and Singapore have been withdrawn and the general anti-avoidance rules have also been operationalised. Essentially, for claiming any tax exemptions, the investors will need to establish the “substance” test on a qualitative basis to avail tax exemptions.

By way of background, investment into India was, in the past, often routed through Mauritius because equity investments structured in this manner historically benefited favourable tax treaty provisions with regard to capital gains (upon an exit, capital gains tax was not imposed in either India or Mauritius). However, a number of recent amendments have been made to the Indo-Mauritian tax treaty. These changes are unhelpful as far as equity investments are concerned, but positive in relation to debt investments. Further, these changes have been replicated for the tax treaty with Singapore as well.

The changes will mean that this favourable tax treatment will only continue for investments made prior to 1 April 2017 (regardless of when the exit occurs). After this, capital gains arising from the sale of shares acquired in two-year transitional period (1 April 2017 to 31 March 2019) will be taxed at 50% of the applicable Indian capital gains rate and any shares acquired in Mauritius after the expiry of this period will be taxed at the full Indian rate on an exit.

As far as debt is concerned, interest income arising to a Mauritian resident will be taxed at a withholding rate of 7.5% in India. This will make Mauritius attractive for the routing of debt investment into India, provided that “substance” can be established in Mauritius.

What are some of the significant court decisions over the last 12 months that have affected Indian M&A?

We have set out below a few cases that have affected Indian M&A significantly:

• Cruz City - Unitech (11 April 2017): The Delhi Court, while determining the enforceability of an arbitration award that required the Indian counterparty to honour the clauses on a put option with assured return and guarantee (which were alleged to be in violation of foreign exchange laws of India), held that a contravention of specific provisions of foreign exchange laws, even if established, was insufficient to invoke the defence of ‘public policy’ against enforcement of the award.

• Clearwater Capital - Kamat Hotels (20 March 2017): In this order, SEBI held that ‘negative control’, or protective rights should not be construed as ‘control’. SEBI analysed a shareholders agreement wherein certain protectionist rights were granted to Clearwater including (i) right to appoint a nominee director on board of the target company; (ii) right to restrain the promoters from entering into any agreement which would restrict or conflict with rights of Clearwater; and (iii) veto rights on matters such as alteration of share capital, creation of new subsidiaries, merger, disposing of or acquiring any material assets, winding up etc. SEBI held that the abovementioned rights enable the foreign investor to exercise certain checks on the existing management for the purpose of protecting its interest as an investor rather than formulating policies to run the target company and therefore should not be construed as ‘control’.

• Imax Corporation - E-City Entertainment (10 March 2017): The Supreme Court, while determining the enforceability of an arbitration award, held that as the parties had decided to have the agreement governed by the laws of Singapore and have the disputes in connection with the agreement to be settled in accordance with ICC Rules of Arbitration without specifying any seat of arbitration, the parties had agreed to exclude the applicability of Part 1 of the Arbitration and Conciliation Act, 1996 and accordingly the foreign arbitral award passed in accordance with the ICC Rules of Arbitration could not be challenged before the courts of India.

• Essar Projects - MCL Global Steel (6 March 2017); One Coat Plaster - Ambience (1 March 2017): Two benches of the National Company Law Tribunal gave divergent orders in relation to its jurisdiction to entertain insolvency petitions filed under the Insolvency Code. In both the cases, the corporate debtors, in reply to the demand notice, disputed the amount claimed by the operational creditors. The Mumbai bench in the Essar Projects case held that merely denying a claim in reply to a demand notice (without a dispute before a court of law), could not be treated as ‘dispute in existence’ for the purposes of rejecting an application under the Insolvency Code, and accordingly, the application for insolvency had to be allowed. The Principal Bench in One Coat Plaster, however, held that the word “dispute” was an inclusive definition under the Insolvency Code and taking into consideration that the debt sought to be fastened on the corporate debtor was vehemently disputed (despite not being before a court of law), the application for insolvency could not be allowed.

• Shakti Nath - Alpha Tiger Cyprus Investments (9 February 2017): The Delhi High Court, while analysing a shareholders’ agreement which provided a put option in favour of non-residents with assured return and damages for breach of contract, held that the non-resident can claim damages for breach of contract (containing such non-enforceable put option) and that claiming damages for breach cannot be deemed to be an exercise of a put option. This is a welcome step as far as investors are concerned since under the applicable foreign investment laws, assured return in favour of a non-resident is not permitted.

• IDBI Trusteeship - Hubtown (15 November 2016): The Supreme Court has given clarity to the enforcement of structured private equity transactions involving foreign investors. In this case, a foreign investor had subscribed to equity securities in a holding company. The holding company had subscribed to optionally convertible debentures of its subsidiaries (which are not permissible FDI instruments), and the redemption was guaranteed by the Indian sponsor. Upon failure of the subsidiaries to redeem the debentures, the trustee invoked the guarantee on behalf of the foreign investor. The Supreme Court upheld invocation of the guarantee confirming that, regardless of a foreign investor and structuring involved, guarantee between two Indian entities is permissible and subscription of optionally convertible debentures is permissible by an Indian-owned and -controlled company.

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