Insurance M&A and the “control” brakes

After a lengthy political logjam, the amendment to the Insurance Act 1938 was approved on March 23, 2015 (and made effective from December 26, 2014). The amendment, amongst other changes, increased the foreign investment limit in an insurance company (including insurance intermediaries, such as insurance brokers) from 26 per cent to 49 per cent.

The deal street is now witnessing a fair amount of M&A activity in the insurance sector. In the last three to four months, some foreign partners have completed the stepping up of their shareholding in their existing insurance joint ventures and several more have announced their intention to increase their existing shareholding. Some private equity investments and plans of some insurance companies to tap into capital markets have also been reported.

One key regulatory facet that poses a challenge on deal execution is the newly imposed requirement for insurance companies to be ‘Indian-owned and controlled’. The ownership test is a non-issue given that the foreign shareholding limit is capped at 49 per cent.

However, the requirement for insurance companies to be Indian-controlled throws up new regulatory challenges. Under the amended Insurance Act, ‘control’ has been defined to include ‘the right to appoint a majority of the directors or to control the management or policy decisions including by virtue of their shareholding or management rights or shareholders agreements or voting agreements’.

This requirement didn’t exist under the old regime (when foreign investment was permitted up to 26 per cent) and theoretically, under the old regime, a foreign partner could ‘control’ an Indian insurance company at 26 per cent shareholding. 

What constitutes ‘control’ has long been a contentious issue and different regulatory agencies have considered this from time to time, be it SEBI in the case of Etihad Airways picking up a stake in Jet Airways or the Competition Commission of India in the same matter.

On October 19, 2015, the Insurance Regulatory and Development Authority of India (IRDA) came out with a set of guidelines to elaborate what constitutes ‘Indian control’ (Control Guidelines). For an insurance company to be ‘Indian controlled’, certain rights are required to vest with the Indian partner or be exercised by the board of directors. These include the Indian shareholder having the right to appoint a majority of the non-independent directors on the board.

Other conditions such as a chairman of the board with a casting vote to be appointed by the Indian party and that appointment of key management persons including CEO/Managing Director to be done through the board or by the Indian partner have also been prescribed.

Further, the Control Guidelines provide that the quorum for any board meetings should include the presence of a majority of the Indian shareholders’ nominee director. In short, the right to take key policy decisions is required to vest with the board of directors or with the Indian partner.

The Control Guidelines also recognise some minority protection rights which a foreign partner could have and would not amount to ‘control’. These include foreign partners having the right to nominate key management persons excluding the CEO (the appointment of such persons is required to be through the board). It is also recognised that the foreign investors’ right to constitute valid quorum for meetings is a protective right and shouldn’t be construed as ‘control’.

An important omission by the regulator in the Control Guidelines has been a lack of clarification on the treatment to ‘reserved matters’ (reserved matters are contractually agreed matters between joint venture partners and the company, on which the company cannot decide without the approval of the shareholding having the veto).

In M&A transactions, it is common for any foreign investor to have this right to be able to protect its investment. We understand that IRDA is likely to permit these veto matters as long as they are in the nature of the ‘minority protection rights’.

However, the absence of any formal clarification by the regulator has created some confusion in the minds of foreign investors as to which rights would be ‘protective’ and which ones would encroach in the ‘control’ territory. Based on an analysis of some recent deals it appears that the veto rights are required to be also made available to the majority Indian shareholder (although, practically the protection may only be required by the minority shareholder).

For foreign investors exploring to invest in this sector, it becomes important to carefully analyse and agree to the contractual terms given that the regulatory regime swings in favour of the Indian partner. Although a set of rights are automatically available to any shareholder under Indian corporate law, through contractual covenants, it should be possible to further increase the safeguards.

These rights could include arrangements such as appointment of a sizeable number of independent directors on the board who will act in the best interest of the company while approving decisions and will not side with any party. Such board composition also appears to be in line with IRDA’s thinking as the regulator has, in its exposure draft on corporate governance guidelines for insurance companies dated February 12, 2016 (which is currently open for public comments), prescribed insurers to have at least three independent directors.

The insurance sector is likely to be among the most active sectors for foreign investment in 2016. As the regulatory regime weighs in favour of the Indian partner, foreign investors should carefully select their rights to ensure they have the necessary contractual protections while ensuring ‘Indian control’ of the company.

Haigreve Khaitan is Partner and Anuj Sah is Associate Partner at Khaitan & Co. Views are personal.

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