The European Lawyer

India Employment

11 Mar 2010

International Acquisition Finance - India

Editors: Amarchand & Mangaldas & Suresh A. Shroff & Co. - Cyril Shroff

1. OVERVIEW OF THE MARKET
1.1 Has India witnessed any significant changes in acquisition finance trends over the last few years? Who are active players in the acquisition finance market in India?
The Indian economy has grown by leaps and bounds in the last decade or so, and that has fuelled both inbound and outbound acquisitions in the country. Whilst restrictions on debt financing of acquisitions continue to exist, India has witnessed increased usage of innovative financial instruments to fund such acquisitions, some of which are attributable to exposure to private equity players. As per the Grant Thorton’s Annual Dealtracker M&A Market Insight (“Market Insight”), private equity players have been the most active players with 2.03 billion $ worth deals in the year of 2005 rising to 19 billion $ in the year 2007. Venture capital funds and foreign institutional investors are also significant players in acquisition finance market.

1.2 What are the typical target industries in India?
In year 2007, it was the steel industry followed by telecom industry which overshadowed most of the acquisition deals with 29.15% and 22.17% of deal value, respectively. In the year 2008, however, as per the Market Insight, 2008, trends have been different with banking & finance sector leading in January-February and automotive industry leading in March-April 2008. Real estate companies, infrastructure companies, telecom companies, information technology companies and large scale manufacturing companies are other typical targets in India

2. DOCUMENTATION
2.1 What are the basic Indian laws applicable to acquisition finance in India?
The Foreign Exchange Management Act, 1999 and the rules and regulations made thereunder coupled with the foreign investment policy of the Government of India notified through various press notes form the primary set of laws applicable to an acquisition finance transaction involving a non-resident party. 
In relation to listed companies, applicable laws include the Securities and Exchange Board of India Act, 1992 (the “SEBI Act”) and the rules, regulations and guidelines made thereunder, the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 (“Takeover Code”), the SEBI (Disclosure and Investor Protection) Guidelines, 2000 (the “DIP Guidelines”), and the listing agreement with the stock exchanges. 

Other applicable laws include the Transfer of Property Act, 1882, the Indian Contract Act, 1872, the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Act, 2002 (“SARFAESI Act”), the Recovery of Debts due to Banks and Financial Institutions Act, 1993, the Companies Act, 1956, and Income Tax Act, 1961.   

2.2 What kind of documentation is usually used in an acquisition finance deal?
The nature of documentation varies with every transaction. Typically, the transaction documents would comprise of a loan agreement, inter-creditor agreement, security agreement, non-disposal undertaking and power of attorney (in case of “lock box” arrangements), and subscription agreement (in case of equity linked transactions). The transaction documents are usually drafted and executed in English language.

3. ACQUISITION FINANCE STRUCTURES
3.1 What are the typical structures followed in an acquisition finance deal in India?
Indian foreign exchange management laws do not permit external commercial borrowings (“ECBs”) or issuance of pure debt instruments by Indian entities, inter alia, for the purpose of acquiring a company (or a part thereof) in India, except in cases where proceeds of the ECB are proposed to be used:
(a)  for overseas direct investment in joint ventures/wholly owned subsidiaries established by the Indian company abroad subject to the guidelines on Indian direct investment abroad;
(b) to acquire shares in the first stage of disinvestment process of public sector units as well as the mandatory second stage offer to the public under the government’s disinvestments programme.

In relation to acquisition financing by banks in India, the RBI guidelines restrict an Indian bank’s ability to finance the acquisition of equity shares. A promoter’s contribution towards equity cannot be funded by a bank. Banks cannot finance the acquisition of equity shares except in certain circumstances as set out below.

Banks are permitted to extend loans upto specified limits to corporate against the security of shares held by them to meet the promoter’s contribution to the equity of new companies. The extension of such credit is subject to certain restrictions which are laid down in the Banking Regulation Act, 1949, including that the bank must ensure that no advances made by a bank are to be used by a borrower to acquire or retain a controlling interest in the company or to facilitate or retain inter-corporate investments.

Banks are also permitted to finance the acquisition of companies that are engaged in implementing or operating an infrastructure project. Financing by banks of acquisition of shares of an offshore company by an Indian company, is also permitted.

The restrictions on acquisition finance have given birth to offshore lending mechanisms whereby special purpose vehicles are set up outside India to raise funds offshore for making acquisitions in India. Further, this has led to increased usage of hybrid financing products, such as fully / partly convertible instruments, warrants, etc. Such instruments are also common in case of listed companies since by virtue of these, the financier can avail of benefits of a fluctuating capital market by phasing out conversions; and can also avert public offer risks related to indirect acquisition of substantial shares or voting rights in the listed target company.

Back-up financing instruments such as guarantees, stand-by letters of credit, keep-well agreements etc are usually used either where the financier is a group company or a multinational bank catering to the group or where the actual interest of the financier is in a parallel transaction.

Having said the above, it is needless to state that financing through equity remains a preferred option, subject to certain commercial and tax considerations.

3.2 What kind of issues should be considered while structuring an acquisition finance transaction?
The issues differ vastly depending on the nature of the target. For example if the target is a listed company, any direct or indirect acquisition of shares, voting rights and/ or control in such entity beyond certain specified thresholds will attract disclosure and in some cases, open offer requirements under the Takeover Code. Further, in the event, target is a private company, one could impose restrictions on transfer of its shares; however, in case of a public company, the same may not be possible.

In the event the target is engaged in regulated sectors, such as real estate, insurance etc, there are limitations on the amount of equity financing that can be undertaken. Further, in the event the equity financier has existing ventures in India as of January 12, 2005, any induction of equity in an entity engaged in the same sector as the existing entity will require prior approval of the Foreign Investment Promotion Board of the Government of India, except in certain specified circumstances.

Further, issues such as the instrument of investment and security creation need to be carefully considered. Compulsorily convertible instruments, whilst delay trigger of open offer processes in the case of listed companies, such instruments are subject to pricing norms and cap on maturity period- depending on the route of investment.

In relation to security creation, creation of pledge on shares or security on immovable property in favour of a non-resident requires prior approval of the RBI. Whilst ‘lock-box’ arrangements are frequently adopted in relation to shares, enforceability thereof still remains untested.

4. REGULATED TARGETS 
4.1 Which are the highly regulated sectors in India?
Under the current foreign investment laws, whilst no foreign investment is allowed in sectors such as lottery business, atomic energy, gambling and betting, and retail trading (except for single brand retail trading); foreign investment in other business sectors is allowed either under the automatic route, or under the approval route (i.e. requiring an investment approval from the Government of India/ Reserve Bank of India (the “RBI”). Whilst sectors such as the alcohol distillation and brewing, manufacture of paper, certain specified non-banking financial companies etc are under the automatic route, sectors such as print media, tea plantation etc are under the approval route.

It may be noted that sectoral guidelines also stipulate certain caps on investment, such as 74% in banking sector and 26% in insurance sector under automatic route; and 26% in print media under the approval route. Further, while real estate remains a highly regulated sector, construction and development of real estate has been substantially opened for foreign investments subject to certain restrictions.

It may further be noted that in addition to foreign investment laws, one must also comply with the sector specific laws and regulations for investment restrictions or aggregation and ‘look through’ principles, such as in the case of banks, and print media

5. LISTED TARGETS
5.1 What are the typical issues which arise in an acquisition finance transaction involving an Indian listed company? 
The foremost issue that arises in relation to a listed company is the application of the Takeover Code to the acquisition as well as to the financing.

The provisions of the Takeover Code get triggered upon any substantial acquisition of shares or voting rights in a listed Indian company. Under the Takeover Code, an acquirer may acquire upto 15% shares or voting rights in an Indian listed company, without triggering any open offer requirement. Further, where an acquirer is holding 15% or more but less than 55% shares or voting rights, no open offer is required unless the further acquisition is of more than 5% shares or voting rights in a financial year. However, any acquisition of shares or voting rights, whether directly or indirectly, above the limit of 55% mandatorily requires an open offer of 20% voting rights to the shareholders of the target company at the price calculated as per the Takeover Code. The limits mentioned above are required to be computed taking into account the holdings of the persons acting in concert with the acquirer.

The open offer is required to be made for atleast 20% of the voting capital of the target, except in certain specified circumstances such as where the open offer which results in breach of the minimum public float requirements specified in the listing agreements executed with the stock exchanges. In light of the strict provisions pertaining to open offer requirements as prescribed under the Takeover Code and the application thereof even in the cases of indirect acquisition of shares, voting rights and control, acquirers of shares, voting rights or control in an Indian company or those financing such acquirers need to be vary of such provisions and should structure their acquisition and acquisition financing keeping in mind the threshold requirements. It may however be noted that acquisition of shares by banks and public financial institutions as pledgees is exempt from the open offer requirements under the Takeover Code.

Further, in the event a listed company is desirous of raising funds for acquisition finance by way of preferential allotment or qualified institutional placement of convertible instruments, it may be noted that the provisions of the Takeover Code get triggered only upon conversion of such instruments into equity shares. Such convertible instruments will be subject to the pricing norms contained in the DIP Guidelines.

5.2 Are there any certain funds requirements applicable to acquisition of an Indian listed company?
Under the provisions of the Takeover Code, in the event of trigger of an open offer, the acquirer is required to upfront maintain in escrow, a minimum amount of:

• 25% of the consideration payable under the offer, if the total consideration payable under the offer (assuming full acceptances) is upto and including Rs. 100 Crores.
• 25% of the consideration payable under the offer up to an amount of Rs. 100 Crores and 10% thereafter, if the total consideration payable under the offer (assuming full acceptances) exceeds Rs. 100 Crores.
• 50% of the consideration payable under the offer, in the case of offers which are subject to a minimum level of acceptance and the acquirer does not want to acquire a minimum of 20%.

6. MEZZANINE DEBT AND INTERCREDITOR ARRANGEMENTS
6.1 What are the common techniques of providing mezzanine debt to Indian entities?
The nature of mezzanine financing in India has recently undergone some changes. Earlier, optionally convertible preference shares and debentures were treated as equity for the purposes of foreign exchange laws, thus taking them out of the purview of the ECB guidelines. However, pursuant to certain clarifications issued in the year 2007, optionally convertible preference shares and debentures are now recognised as ECB, and accordingly, in cases where ECB is not permitted, such instruments are being avoided for providing mezzanine finance. Compulsorily convertible instruments with equity kickers, such as warrants, preference shares, and debentures, have become common for offshore mezzanine financing.

6.2 What is the nature of restrictions applicable to mezzanine financing?
Foreign exchange laws of India stipulate certain restrictions in relation to the rate of return that can be offered in relation to preference shares- it cannot exceed 300 basis points above prime lending rate of State Bank of India (a premier bank in India). Though, after the recent amendments to law, it is unclear whether compulsorily convertible debentures will also be subject to the same interest rate restrictions, most companies choose to observe such restrictions in the fear of falling into RBI’s penalties trap.

7. EQUITY KICKERS
7.1 What are the basic issues which should be considered in relation to structuring equity kickers? What are the common techniques used to surpass those issues? 
Under Indian foreign exchange laws, issuance of equity, conversion of convertible instruments into equity in favour of non-residents and transfer of equity from a resident to a non-resident entity is not permitted at a price lower than the prevailing market price, computed as per the guidelines issued by the RBI. Further, there are restrictions in relation to the maximum maturity period allowed in case of convertible instruments issued by listed companies. The maximum maturity period of a convertible instrument issued by a listed company is 18 months, in the case of preferential allotment and 60 months in case of qualified institutional placement. Furthermore, in the case of listed companies, the extent of conversions undertaken could have open offer implications for the acquirer. In order to overcome these issues, whilst some equity kickers are structured at an offshore level in tax haven jurisdictions; others are structured as put options or safety net arrangements.

8. SECURITY
8.1 Are there any restrictions on provision of security in relation to an acquisition finance transaction? What are the typical security structures?
An Indian public company and a private company that is a subsidiary of a public company, is not permitted to provide security for the purpose of acquisition of its own shares or shares of its holding company. However, a private company may provide security or financial assistance to the entity acquiring or purchasing its shares or its holding company’s shares.

Any pledge of shares in favour of a non-resident entity requires a prior RBI approval. Further, Indian law does not permit transfer of immovable property in favour of a non-resident entity, except in certain specified circumstances.

Non-disposal undertakings coupled with appropriate powers of attorney in favour of the financier/ its nominees, shortfall undertakings, keep-well arrangements, creation of security at an offshore level, etc are some of the commonly followed structuring alternatives in order to overcome regulatory restrictions applicable to security creation in favour of a non-resident.

8.2 Are there any limitations in relation to provision of guarantees?
Under Section 372A of the Companies Act, 1956, no company is permitted to, directly or indirectly make any loan to a body corporate, or provide a guarantee or security in connection with a loan made by or to a body corporate, or acquire, by way of subscription, purchase or otherwise the securities of any other body corporate, exceeding 60% of its paid up share capital and free reserves or 100% of its free reserves, which ever is more. In case a loan or guarantee or an investment in excess of these limits is to be furnished or made, it must be approved by a special resolution of the shareholders in a general meeting, subject to certain exceptions. This provision does not inter alia apply to a private company unless it is a subsidiary of a public company; and to loans made by and guarantees or securities provided by a holding company to its wholly owned subsidiary. However, as noted above, no security (including a guarantee) can be provided with a view to secure the loan assumed by a parent for the purpose of acquiring shares in the company providing the security.

Further, subject to the restrictions contained in Section 372A as above, an Indian entity may extend any form of guarantee - corporate or personal / primary or collateral / guarantee company in India to an overseas entity in relation to an entity in which it has an equity stake, provided that:
 (i) All financial commitments including all forms of guarantees provided by such party are within 400% of the networth of the Indian party;
 (ii) The guarantee is not “open ended”; and
 (iii) Reporting requirements are complied with.

Prior approval of the RBI will be required in the event any of the above-mentioned conditions are not satisfied.

9. CORPORATE THIN CAPITALISATION RULES
9.1 Are there any corporate thin capitalisation rules in India?
India does not have any specific norms in relation to corporate thin capitalisation. Indian tax authorities have recently woken up to this legal black-hole, and thin capitalisation rules are expected to be part of the new tax code which is in the offing.

However, ECB norms stipulated by the RBI, act as a check to excessive leveraging of Indian companies by offshore lenders. The ECB norms not only stipulate the permissible quantum of long term and short term debt, but also affix the maximum permissible interest rate in relation to such debt.

Further, the Indian transfer pricing guidelines regulate rate of interest payable in relation to certain foreign transactions involving “associated enterprises”. Under such guidelines, Indian tax authorities have the power to reset interest rate in a loan transaction between two or more associated enterprises in the event the agreed interest rate is not affixed on arms’ length principles. It may however be noted that such guidelines don’t place any restrictions on the quantum of permissible debt, and merely seek to regulate erosion of state revenue by entities reducing their corporate taxable income.

10. FINANCIAL ASSISTANCE
10.1 Are there any restrictions in using the target’s assets / cash flow for the purposes of acquisition finance?
Apart from the restrictions on creation of security on Indian assets as described above, there is a general prohibition on public companies and private companies which are subsidiaries of public companies from giving any financial assistance (whether directly or indirectly) whether by means of loan, guarantee, security or otherwise for the purpose of / in connection with purchase or subscription of shares in the company or in its holding company.

10.2 Are there any restrictions applicable to an onshore target in relation to distribution of its funds upwards in order to enable the acquirer to repay the debt incurred in acquiring the target?
In India, dividend can only be declared out of the profits of a company. Further, redemption of preference shares can only be made out of (i) profits of the company or (ii) proceeds of a fresh issue of shares made for the purpose of redemption. The premium, if any, payable must be provided from the profits of the company or the company’s security premium account before such redemption.

As regards buy back of shares, it can only be effected out of free reserves, monies in the securities premium account, or monies raised from the proceeds of issue of shares (which must be of a class different from the shares being bought back). One way of using the target’s funds for repayment of debt however is by merging the acquirer/ borrower with the target company.

11. DIRECTORS’ LIABILITY
11.1 Briefly describe general principles of director’s liability applicable to companies giving financial assistance in relation to acquisitions. 
Directors are considered as “officers” of company and are therefore subject to penalties under the Companies Act, 1956, as ‘officers in default’. Whilst default in compliance with the provision of financial assistance for purchase of its own shares or that of its holding company make a director liable for a monetary penalty; a default in compliance with Section 372A of the Companies Act, as described above, could make a director liable to  imprisonment which may extend to two years. In addition to a monetary penalty, it may further be noted that any instrument seeking to exempt or indemnify a director from a liability, which by virtue of law, would otherwise attach to him in respect of any negligence, default, misfeasance, breach of duty or breach of trust, is void. 

In respect of economic offences relating to securities laws, the SEBI Act provides for punishment with imprisonment for a term of up to ten years, and/or with a fine, which may extend to Rs. 250,000,000 or thrice the amount of profits made out of the contravention, whichever is higher, both for contravention of the SEBI Act or any rules or regulations made thereunder including the Takeover Code and the SEBI (Insider Trading) Regulations, 1992.

12. LENDERS’ LIABILITY
12.1 Briefly describe the rules in relation to lender’s liability in the acquisition finance context.
Whilst lender’s liability is a matter of contractual arrangement in India, in the case of Mardia Chemicals v Union of India (AIR 2004 SC 2371), the Supreme Court of India for the first time has expressly recognised that lenders have an implied duty of good faith and fair dealing with respect to borrowers.
It may also be noted that the RBI has issued guidelines on lender’s liability called “RBI Guidelines on Fair Practices Code for Lenders”, which pertain to applications for loans and their processing, loan appraisal, disbursement of loans and post disbursement supervision.

13. LEGAL OPINIONS
13.1 What are the specific issues that a legal opinion in an acquisition finance transaction should cover? Are there any standard carve outs for such opinions?
Whilst the nature of the legal opinion and the contents thereof will depend on the nature of the transaction and the governing law of the transaction documents, typically, a legal opinion should cover issues relating to (i) validity, binding nature and enforceability of the transaction documents; (ii) confirmation that except as stated therein, no approvals are required for the purposes of performance of the obligations contained in the transaction documents; (iii) the nature of fee, duties and taxes required to be paid; and (iv) enforcement of foreign decrees/ awards, as applicable, etc.  As regards standard carve outs, it is market practice to specifically carve out issues in relation to the nature and scope of the due diligence; issues where legal position is ambiguous or doubtful such as enforceability of put options in a public company, and enforceability of ‘lock-box’ arrangements etc.

14. POST-ACQUISITION RESTRUCTURINGS
14.1 Briefly describe the common techniques used for post acquisition restructurings, including squeeze outs.
Post acquisition restructuring techniques usually depend on the nature and extent of acquisition carried out. In the event the acquisition is that of a business undertaking as opposed to share acquisition, the post acquisition restructuring typically is centered around achieving synergy in business through mergers and combinations, which could assist the acquirer in generating a profit pool for repayment of the financing undertaken for the acquisition. Such mergers are, at times, undertaken with listed entities, in order to achieve access to larger cash flow. In the case of share acquisitions, acquirers normally wish to consolidate their holdings, which in the case of listed companies, could lead to adoption of minority elimination processes like buy-back, issuance of convertible instruments in court based restructurings, creation of artificial majority amongst the minority shareholders for undertaking variation of class rights, undertaking delisting through reverse book building offers, etc.

15. DEBT RESTRUCTURING
15.1 What are the typical modes of debt restructuring in India? To what extent, can the creditors control such debt restructuring proceedings?
Debt restructuring in India can be undertaken through both court and ‘out of court’ mechanisms. A court mechanism is typically carried out through a creditors’ scheme of arrangement under Section 391-394 of the Companies Act, 1956. The creditors in such scheme have complete flexibility in proposing a debt restructuring mechanism, subject to the same being approved by at least a majority of the creditors representing 75% in value of the creditors, and shareholders of the company present and voting.

‘Out of court’ mechanisms include corporate debt restructuring (“CDR”) scheme notified by the RBI, and rehabilitation scheme under the auspices of the Sick Industrial Companies (Special Provisions) Act, 1985 (“SICA”). A CDR mechanism is governed by the RBI. It is a non-statutory, voluntary system based on inter-creditor and debtor-creditor agreements providing for corporate debt restructuring of the accounts financed by multiple banks or financial institutions and such accounts need not necessarily be non performing assets. The CDR mechanism is for the benefit of banks and financial institutions, wherein the secured creditors can initiate the process and participate in restructuring the borrower company. However, the mechanism is available only for accounts with an exposure of Rs.100 million or more by banks and financial institutions. For the restructuring under the mechanism an approval of 75% of lenders by value and 60% in number is required. However, reference to CDR could be triggered by (i) any or more of the creditor who have minimum 20% share in either working capital or term finance, or (ii) by the concerned corporate, if supported by a bank or financial institution having stake as in (i) above.

SICA provides for voluntary rehabilitation of a sick/loss making company which has eroded its net worth within the specified parameters. A reference for debt restructuring by the company itself can be made to Board for Industrial and Financial Reconstruction (“BIFR”) constituted under the statute, however any proposal therein will have effect only if passed and implemented upon the consent of all creditors and/or the government or other bodies which are providing any financial assistance or concession or sacrificing their rights/dues. As part of the rehabilitation exercise, BIFR proposes financial reconstruction, takeover of management, sale/lease of undertaking/assets, rationalisation of management and merger/ amalgamation etc.

BIFR also has power to recommend winding–up of the company in case the scheme for rehabilitation is not workable. It may further be noted here that whilst the SICA has been repealed by the legislature, it has not yet been enforced and fresh references continue to be entertained by the BIFR until now.

15.2 What is the status of a convertible debt instrument holder in an insolvency proceeding? 
Until conversion, holders of convertible debt instruments rank as creditors in an insolvency proceeding, unless the terms of the instrument provide that, upon insolvency, the instruments would automatically and compulsorily convert to equity shares of the company.

15.3  What is the extent of control that can be exercised by a creditor in an insolvency proceeding?
A creditor is entitled to file a winding up petition before the court for winding up of the company if the company is unable to pay its debts. A company is said to be unable to pay its debts:
 (i) if a creditor, to whom the company is owed a sum of Rupees 100,000 or more has served on the company, a demand requiring the company to pay the sum so due and the company has for three weeks thereafter neglected to pay the sum, or to secure or  compound for it to the reasonable satisfaction of the creditor;
 (ii) if execution or other process issued on a decree or order of any Court in favour of a creditor of the company is returned unsatisfied in whole or in part; or
 (iii) if it is proved to the satisfaction of the Court that the company is unable to pay its  debts.

Under law, the priority of payments on winding up are as follows- (i) statutory dues, which have become due and payable; (ii) workmen’s dues; (iii) secured creditors to the extent they participate in the proceedings, rank pari passu with workmen’s dues.

16. ENFORCEMENT OF SECURITY
16.1 Briefly describe the process involved in enforcement of security in India.
Security created in relation to financing may be enforced either through one of the mechanisms described above or through court process under the provisions of the Code of Civil Procedure, 1908 (“CPC”). Under the CPC, there may either be an attachment and sale of the properties or arrest and detention. Further, the court may appoint receivers before or after decree.

In addition to the above, the domestic lenders have a remedy of summary proceedings under Recovery of Debts due to Banks and Financial Institutions Act, 1993. The creditor may also utilize the self–enforcement method under the SARFAESI Act. However, the definition of the “secured creditor” and “banks” and “financial institutions” is restricted to domestic lenders and banks which have Indian operations. Usually, inter-creditor agreements are entered into for availing of benefits under these statutes. Since these procedures are court driven, the timelines in relation thereto can range from 2 years to several years, depending on the nature of the transaction.