The Reserve Bank of India (“RBI”) has liberalized the framework governing payment of deferred consideration in transactions involving foreign investments into India. Notification no. 368/2016 dated May 20, 2016 (“May 20th Notification”) has permitted this liberalization with effect from May 20, 2016. This note discusses the changes introduced by the May 20th Notification and highlights certain legal issues that may require appropriate clarification from the RBI.
The Erstwhile Regime
Hitherto, any form of deferred consideration (including post-closing working capital adjustments, earn-outs and/or post-closing escrow arrangements) required specific approval of the RBI. In our experience of foreign investment transactions with post-closing indemnity arrangements, the RBI approved post-closing indemnity structures on a case-by-case basis. However, the RBI was reluctant in approving foreign investment transactions that involved post-closing purchase price adjustments / earn-outs. The RBI considered transactions involving post-closing purchase price adjustments as grant of credit to a non-resident purchaser, and therefore, was reluctant to bless such structures. This is notwithstanding the fact that the consolidated foreign direct investment policy dated May 12, 2015 (“2015 FDI Policy”) did not prohibit any deferred consideration structure (but only subjected it to the RBI’s approval).
Accordingly, prior May 20, 2016 parties involved in a foreign investment transaction in India would either structure the post-closing price adjustments through a locked-box mechanism or determine the adjustments pre-closing. Appropriate legal structures had also evolved in India for structuring earn-outs without the need for an RBI approval, for example, by selling shares in multiple tranches with each tranche complying with the applicable pricing guidelines.
The New Regime
May 20th Notification permits payment of deferred consideration in share sale transactions involving a non-resident and a resident Indian, under the automatic route, subject to the following conditions:
- the deferred component cannot exceed the lower of (i) 25% of the total consideration payable to a seller; and (ii) the fair market value of the shares determined as per the applicable RBI guidelines;
- Parties may mutually agree upon the structure for disbursement of the deferred consideration. Per the May 20th Notification, deferred consideration may be paid in terms of a post-closing escrow structure (“Escrow Arrangement”) or where the total consideration is paid to the seller on the closing date itself, structured as an indemnity through an escrow arrangement or on contractual terms (“Indemnity Arrangement”); and
- Where deferred consideration is through an Escrow Arrangement, the purchaser is required to pay the deferred component to the seller within a maximum period of 18 months from the date of the share purchase agreement. Alternatively, where the parties agree to an Indemnity Arrangement, the purchaser is obliged to pay the seller the deferred component within a maximum period of 18 months from the date of payment of the full consideration to the seller (i.e. date of closing of the share purchase agreement).
Analysis of the changes
May 20th Notification is a welcome change as it would now offer the contracting parties greater flexibility in structuring foreign investment transactions involving purchase price adjustments and earn outs. Therefore, an immediate fall-out of the May 20th Notification will be a likely increase in post-closing purchase adjustments in M&A transactions in India. However, in order to avoid any RBI approval requirement, parties would need to adhere to the timelines specified under the May 20th Notification. This is significant in the context of an Escrow Arrangement, given that, the start date for the escrow would kick-in from the date of the share purchase agreement itself, and therefore, the actual period for which the escrow would operate post-closing would depend on how soon the parties could undertake the closing. Parties involved in Indian M&A transactions that require regulatory approvals, for example, approval of the competition commission, would need to obtain RBI approval for operating the escrow after the initial permissible period of 18 months.
The following are certain additional observations in the context of the May 20th Notification:
- Both in terms of paragraph 5.1 of Annexure 3 of the FDI Policy dated 2016 (“2016 FDI Policy”) and paragraph 184.108.40.206 of the 2015 FDI Policy, deferred consideration structures required RBI approval only in cases of transfer of capital instruments by a resident to a non-resident purchaser. While in practice, RBI approval was sought even for transfer of capital instruments by a non-resident seller to a resident Indian purchaser involving payment of deferred consideration, this requirement was not expressly mandated by the FDI policy. The May 20th Notification now expressly clarifies that transfer of shares for deferred consideration whether by a resident Indian to a non-resident, or vice versa, would be within the ambit of this notification.
- It is unclear whether the May 20th Notification would apply only to shares or extend to other form of capital instruments. Unlike the 2016 FDI Policy where capital instruments include equity shares of an Indian company and securities compulsorily and mandatorily convertible / exchangeable into equity shares, the May 20th Notification limits the applicability of the circular solely to shares. It would be a welcome clarification by the RBI, if the May 20th Notification was to be made applicable to transfer of any kind of capital instrument under a deferred consideration arrangement.
- May 20th Notification does not specify whether the Escrow Arrangement would be subject to the terms and conditions stipulated under circular no. 58 dated May 2, 2011 (that applies to pre-closing escrow arrangements) (“May 2nd Circular”). If the RBI’s intent is to completely liberalize the mechanism governing for setting-up and operating Escrow Arrangements, there may be little justification to subject pre-closing escrow arrangements to a host of additional conditions specified under the May 2nd Circular (none of which, seem to apply to a post-closing indemnity escrow arrangement). One would need to wait and watch whether the RBI would require an Escrow Arrangement to comply with key conditions of the May 2nd Circular, for example, the condition relating to opening an escrow account with an AD category bank in India.
- Introduction of 18 months as the sunset period for Indemnity Arrangements is ambiguous and may result in hardship to the contracting parties. Previously, Indian regulations did not prescribe any sunset period for a seller’s indemnity obligation (although there was a view, untested though, that enforcement of indemnity claims by a non-resident purchaser against a resident Indian seller would be subject to RBI’s approval). Accordingly, parties to a share purchase agreement contractually agreed upon the indemnity period for claims based on commercial and legal considerations, including the statutory period for instituting claims and recovering losses in India. However, given the change in the regulatory position on account of the May 20th Notification, it is unclear whether RBI approval would be required for Indemnity Arrangements in excess of the 18 months period, particularly, in respect of environmental and tax matters.
- Introduction of a statutory cap on indemnity (i.e. lower of 25% of the total consideration payable to a seller, and the fair market value of the shares determined as per the applicable RBI pricing guidelines) would limit a purchaser’s ability to protect itself from liabilities ensuing post-closing, in excess of the statutory cap. More importantly, it is unclear as to why the RBI would introduce an indemnity cap even in respect of share purchase transactions between a resident Indian purchaser and a non-resident seller, given that, RBI pricing guidelines permit a resident Indian purchaser to purchase shares from a non-resident seller for a consideration below the fair market value.
The changes introduced by the 20th May Notification are a welcome step as it would offer contracting parties greater flexibility in structuring transactions and would align Indian M&A practices with the global M&A landscape. However, it would be useful if regulatory guidance could be offered in respect of interpretational dilemmas arising on account of the May 20th Notification.
M&A transactions in India may also witness rise in alternate form of contractual protections for purchasers, given the introduction of a cap on indemnity payments. Such protections may include an upfront reduction in the purchase price for significant contingent liabilities and/or indemnity insurance arrangements.
Author: Harsh Kumar
Harsh Kumar is a Partner at the Delhi office of Cyril Amarchand Mangaldas
Views expressed herein are personal.