Liquidation preference (LP) in its various forms is used widely by foreign investors operating in the Indian market. As with most globally recognised deal protections that are adopted and used widely in Indian M&A deals, the LP has not been tested before an Indian court in a dispute scenario. An unfortunate outcome of this has been the widespread use of global concepts like LP to Indian conditions without at times fully appreciating the nuances of Indian law as applicable to these concepts.
LP as used commonly in M&A documents in India is meant to provide a downside protection to the investor in the case of a liquidity event. The event can be either a winding up of the company, sale of the assets, merger or a complete share sale by the shareholders. In each of these events, the legal nuances that apply vary slightly. These concerns will only arise where the price paid to the investor for their shares is different from the price paid to the founder’s shares or other shareholders. This may well be the case during a distress sale of the business and LP provisions kick in to protect the investors. In the current market, there are already signs of many such ventures funded by VC capital that are on the verge of shutting businesses or selling to competitors at discounted values. It is interesting to understand if the LP protection can actually be enforced in the manner it is reflected in agreements.
Under the prevailing exchange control laws, a foreign investor cannot acquire shares of an Indian company from a person resident in India at a price lower than the prevailing fair market value (FMV) of the shares. Also, they cannot sell their shares to a person resident in India at a price which is higher than FMV. FMV can be determined by using any of the internationally accepted valuation methodologies. The test for valuation is satisfied by submitting a certificate of a chartered accountant (a merchant banker registered with a regulatory authority) confirming the FMV based on their assessment.
In a distress sale, to account for LP, price per share for the foreign investor will have to be higher than the price to be received by founders for their share. It will be difficult to justify a price difference for the same kind of shares with similar rights. In anticipation of such a challenge, it is best to acquire shares of a different class and incorporate the rights to receive LP within the share rights of the investor. The inherent right to receive the LP should justify the differential price in the shares held by the investor and the founder.
Another restriction on investments by foreign investors is that they cannot invest and acquire shares with in-built optionality clauses which allow them an assured exit. This restriction has some history and has evolved over time with certain refinements. It was introduced by the Reserve Bank of India (RBI) due to the practice of foreign investors acquiring shares from Indian companies and incorporating provisions in the agreements where they had the right to put the shares on the promoters to secure an exit at an assured price. If the Indian promoter was unable to provide the investor with an exit through a third party at the end of a defined time period, he was obliged to purchase the shares from the investor at a pre-fixed price. This issue came under scrutiny by the RBI in some investments. The RBI was of the view that an equity investment with a put option for assured returns was in effect a debt investment in the garb of equity and hence illegal. Indian companies are allowed to raise debt from outside India only in compliance with a defined set of rules and regulations.
It is importance to carefully consider the challenges that one may encounter with the implementation of any ‘imported’ M&A concept in India
RBI issued revised regulations which restrict a foreign investor from investing in shares and taking an in-built option which allows them an assured exit. The prevailing law allows foreign investors to obtain an exit by way of a sale to the Indian promoter, provided the price is the prevailing FMV. The guiding principle is that the foreign investor should not obtain an assured exit at the time of making the investment. Given the provision that prohibits the foreign investor from obtaining an assured exit, one argument against the LP can be that the right to receive the base price of the LP is an assured return. This argument may have some merit based on the language of the guiding principle. But, the history behind the restriction is clear that it was intended to prevent put options with guaranteed exits. It cannot be extended to a base price protection which an investor can derive from the proceeds of a sale to a third party. Secondly, there is no obligation on the founder to pay out the LP amount. At best, he may be compelled to secure an exit by achieving a liquidity event and hence scout for potential buyers.
There could also be concerns raised by the Income Tax Department where a differential price is being paid to the shareholders of a company selling shares with same rights. If LP rights are not enshrined within the shares, the tax department may have a stronger ground in staking their claim. There would be no justification for a differential price to be paid to the investor and they could classify the LP as a contractual right to make good the amount to the foreign investor. Any such payment by the founder to the investor to cover the shortfall in the LP amount would be taxed on a different bracket at a higher rate, than the usual capital gains rates. This additional payment will also need to be justified to the exchange control authorities as a legitimate business payment as opposed to a capital account payment.
If Investors had used a compulsorily convertible debenture or preference share (CCPS) with a variable conversion formula, some of the issues highlighted above may have been allayed. The conversion into equity can be triggered upon occurrence of the liquidity event. Upon conversion, the founders will be diluted to such an extent that the collective FMV of the investor equity is equal to the desired proportion of the LP amount. It will need to be a conversion formula enshrined in the CCPS’ rights to account for some of the above points. However, CCPS cannot be converted at a value which is lower than the FMV of the equity share. This FMV will be the price as on the date of the original investment by the Investor and will be the base threshold for conversion.
It is only when a universally accepted concept is actually put into practice do we realise its true implications under Indian law. It is of utmost importance to carefully consider challenges that one may encounter with the actual implementation of any ‘imported’ M&A concept in India. Once the challenges are identified, appropriate structures will have to be conceptualised to mitigate the possible risks.
(Ajay Joseph is corporate partner at Lakshmikumaran & Sridharan. Views are personal.)
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