By Unnati Sinha
The author is a student at Narsee Monjee Institute of Management Studies, Mumbai
Introduction
The corporate world has encountered unprecedented difficulty in sustaining business operations, employee health and wellness, solvency levels, and finance sources, as well as balancing the interests of its many stakeholders. In this regard, COVID-19 continues to have a substantial impact on businesses and their activities, including finance, the securities market, contracts, and business dealings.
Numerous factors that bode well for Merger and Acquisition (M&A) include India's increasing appeal as a de-risking hub in light of China's Covid-led constraint, the necessity for internal consolidation, notably in the Covid-affected industries; and the wealth of international investment options for Indian businesses with large cash reserves.
It was anticipated that the recovery would be asymmetrical, that different industries would need to recreate themselves, and that mergers and acquisitions would play a significant role in these efforts. In fact, $5 trillion was invested in M&A activities in 2021, proving that this prediction was accurate.
Mergers & Acquisitions (M&A) are inherently investigations of growth prospects. M&A prospects have changed and found a friendly climate in the post-Covid world thanks to constructive government involvement, a conspicuously buying stock market, and a rather solid banking sector.
An Evident Turnaround
In order to detect the risks and possible business interruptions, due diligence will be a crucial component. Acquirers will want to know if major contracts may be cancelled suddenly or due to a force majeure event, or whether key clients are likely to see an immediate effect. In certain circumstances, even though contracts may not provide for early termination and it could seem that business will go on as normal, the possible remedy in the event that such a contract is cancelled by the counterparty or impacted by other factors has to be carefully considered. The business's ability to adjust to the post-Covid-19 environment will be crucial to the decision-making process.
Following is a discussion of some crucial elements that may likely come up while arranging such transactions, taking into account the present foreign currency restrictions.
Deferred consideration
Even if a buyer will do due diligence on the firm, the Covid-19 pandemic’s full effect is still unknown, and the business prospects are not assured. Therefore, acquirers are likely to design a delayed consideration process and credit a reasonable percentage of the consideration to the business's future performance over a certain period of time. Any fixed-price contract may result in a somewhat cheaper purchase price, even if the sellers/exiting stakeholders would likely prefer a locked box closure procedure.
The buyer must pay the delayed consideration within 18 months after the date of the share purchase agreement, and only 25% of the total price may be postponed, according to the current Foreign Exchange regulations, with a deferred consideration structure.
The specification of the amount of consideration that can be deferred and the time frame for billing of this guarantees that the Indian party obtains the surviving consideration within the stipulated period of time, having received the substantial value straight away, in the event that the seller of the shares is an Indian party and the buyer is a non-resident foreign party. The Indian authorities should consider reducing this condition if the buyer is a resident of India and the seller is not a resident. Although there is a provision in the Indian Foreign Exchange Regulations under the Reserve Bank of India, 1934 that current prices must comply with pricing guidelines, any proposed changes under commercial conditions must meet this threshold. The parties may agree to adjust (increase or decrease) the purchase price in which certain requirements are met or not met or business objectives are not met.
Material Adverse Clause
Material Adverse Clauses (MAC) are common in M&A agreements, allowing the acquiring party to terminate the agreement between signing and closing if the target's business is adversely affected due to unforeseen events. One is entitled to withdraw from any binding transaction subject to any change in various terms which were designed and negotiated. Government orders banning certain applications and the approval of Press Note 3 are just two of these examples of recent legal and regulatory developments that could have a material impact on the operations of covered companies.
Transaction documents will continue to contain appropriate safeguarding measures and the full extent of the impact is not yet known, so, investors and acquirers can withdraw from operations affected by Covid-19. The impact of Covid-19 constitutes the Material Adverse Clauses (MAC) of companies in certain sectors. It is important to establish a clear and objective criterion for deciding whether a particular event or occurrence constitutes a Material Adverse Clause (MAC). If the standards are subjective or open to interpretation and may lead to disagreements, the parties are responsible.
Representations and warranties insurance/warranties and indemnities insurance
Numerous businesses are being compelled to seek new investments due to the effects of COVID-19. Owing to the lack of a promising business view in the near term, stakeholders in certain situations are actively seeking the sale of the company entity. Such troubled sale deals are likely to create new issues and obstacles. Normally, sellers will make representations and warranties about the shares, the company, and the entity, to the buyer. These are also supported by indemnification agreements, allowing the purchaser to claim damages from the sellers in the event of future liability.
However, if the transaction is made because the seller is in a difficult situation, the acquirer may purchase Representation and Warranties Insurance (RWI). As a result, the buyer can immediately file a claim against the insurance company in the future without worrying about the seller's financial situation. Buyers do not want their indemnification claims to be voided by the seller's bankruptcy. Because the distressed seller may use all proceeds from the sale to pay off other debts. These policies are often used in large transactions and may be used more frequently.
Changes in the FDI Policy
The Indian government restricted "Opportunistic Takeovers / Acquisitions" of Indian businesses in an effort to protect businesses from Chinese investment. According to Press Note 3 (2020), the Indian government must now approve direct or indirect acquisitions made by organizations whose potential beneficiaries are situated in nations that border India on land. This legislation ostensibly aims to control Chinese investments made in Indian businesses.
The terms of Press Note 3 (2020) will also apply to Limited Partners (LP) and General Partners (GP) of private equity firms with offices in China since they do not allow any exemptions based on the size of a beneficial Chinese stake. Press Note 3 (2020) also affects foreign portfolio investors who conduct capital market transactions (market intelligence indicates that the government is also attempting to govern market activity), and it is unclear how holdings from Taiwan and Hong Kong will be treated. Chinese investors' indirect overseas investments in Indian enterprises may also result in the need for clearance. Refinements are thus necessary and may differ depending on the circumstances.
India has also blocked a wide range of Chinese apps, including TikTok, PubG, and WeChat on the pretext that they are detrimental to India's national security and privacy in the midst of the COVID-19 epidemic and incidents of cataclysms along the Indo-Sino border. According to recent news reports, India may also explore placing trade restrictions on a few Chinese products. Deal-making is challenging as a consequence of the changing India-China dynamic.
Transaction duration will be strongly impacted by the need for government clearances, with approval times varying depending on the vulnerability of the sector, the kind and magnitude of the investment, etc. In order to determine Chinese involvement, investee firms are also devoting time and money to conduct research on the investing entities (such as evaluating their holding structures and constitution). A 25% threshold for requesting permissions, is being examined, according to recent news reports that quote government sources, although rules or announcements in this respect are pending. However, as they are exempt from these rules, cross-border finance deals made under the "external commercial borrowing" method are unaffected.
Further analysis of the Press Note 3
Press Note 3 of 2020 dated 17 April 2020 provides that “an entity of a country, which shares a land boundary with India or the beneficial owner of an investment into India who is situated in or is a citizen of any such country, can only invest under the government route”
At the current juncture, the expression ‘beneficial ownership’ has not been clearly defined. The lack of a clear definition has created uncertainty for investors as the phrase 'beneficial ownership' is understood in differing ways across India’s present regulatory landscape. Under the Reserve Bank of India’s KYC directions, as well as the Prevention of Money Laundering (Maintenance of Records) Rules 2005, 'beneficial ownership' has been pegged to a threshold of 25%. Similarly, under the Ministry of Finance’s General Financial Rules (GFRs) in relation to restrictions concerning public procurement from land-bordering countries, 'beneficial ownership' is defined as “ownership of, or entitlement to, more than twenty-five per cent of shares or capital or profits of the company”.
On the other hand, the Department for Promotion of Industry and Internal Trade (DPIIT)’s Standard Operating Procedure in relation to the filing and examination of FDI approval applications refers to the threshold set under the Companies Act 2013, which in turn prescribes a threshold of 10% for the determination of significant beneficial ownership. A fixed threshold for the determination of 'beneficial ownership' would greatly benefit investors and clear the current anomaly, where divergent positions are taken by different agencies. This is especially important in the context of Private Equity(PE)/Venture Capital(VC) players, which are essential vehicles to pool investment from various small investors (i.e., LPs) who do not have the ability to control or direct the operations of the PE fund.
Going forward, as long as beneficial ownership of such PE/VC funds held by investors in land-bordering countries is below 25%, a framework may be considered where investments by such Private Equity(PE)/Venture Capital(VC) funds are allowed under the automatic route, basis a declaration from the fund that its General Partner (GP)/ Manager is not in a land-bordering country and that the control of the fund is not held by an investor in a land-bordering country. In fact, this approach would also be in line with the ownership-control test under the present guidelines governing foreign direct investment.
The Future Ahead
It will need some forward-looking decision-making and targeted due diligence, as well as smart structuring, in these unusual times when the legal and commercial effects might be susceptible to continual changes throughout the world, to safeguard the interests of the parties engaged in such acquisitions.
Despite the huge humanitarian and economic effects of the COVID-19 pandemic, history predicts how Mergers and acquisitions (M&A) will go. Businesses that are executing M&A moves, often outshine those that are not, even if the M&A market has shrunk. With the use of Pro-forma estimates and priority expenditure criteria, the post-Covid implementation plan will now be clearly stated upfront. A rigorous real-time assessment of asset quality and personnel concerns will serve as the target validation. Digital resilience's scope and caliber will be precisely specified.
Clauses relating to Force Majeure and major adverse development have never been more important. The same applies to guarantees, liability insurance, and policy coverages.
Therefore, the end of the moratorium period may mark the beginning of an M&A frenzy. Having said that it has become clear that only a strategic goal—whether it takes the form of developing new competencies, acquiring critical personnel and technology, carrying out innovative mergers, or achieving success in brand-new markets, industries, or consumer segments—can sustainably drive M&A agendas to success. Cross-sector mergers will become more common than ever, given the necessity of unconventional alliances to stay ahead of the trend (and competition) in an era of constant unpredictability.