The general cross-border M&A climate – an introduction
According to the United Nations Conference on Trade and Development (UNCTAD), India attracted foreign direct investment of US$49 billion in 2019, representing an increase of 16 per cent compared with the previous year. The sectors that drew the most investment were the services industries and information technology. When juxtaposed with the global data on foreign direct investment, which according to UNCTAD remained flat in 2019, it appears that the M&A climate in India is thriving.
UNCTAD had expected foreign investment into India to increase at a moderate level in 2020. However, at the time of writing, the world is caught in the throes of the covid-19 pandemic, making any projections for the next 12 to 18 months difficult.
While, historically, India may have been an attractive destination for foreign investment, such investment is not without significant risk. Investors have been concerned with certain factors such as the high debt accumulation, reactionary approach to legislation and protectionist policies pursued by the government. This chapter will explore some of the key legal and regulatory challenges faced by foreign investors when investing in Indian businesses. This chapter focuses on investments in equity instruments.
Foreign exchange – regulatory framework
At the outset, it should be noted that the Indian economy is a regulated one and any foreign investment from other countries into India is regulated under the Foreign Exchange Management Act 1999 read with the Foreign Exchange Management (Non Debt Instruments) Rules 2019 (NDI Rules) and the Foreign Exchange Management (Debt Instruments) Rules 2019 (DI Rules), issued by the Department of Economic Affairs, Ministry of Finance, Government of India.
The NDI Rules set out the basis on which foreign investment can be made into India and, generally speaking, divide foreign investment on the following basis:
- foreign direct investment (FDI);
- foreign portfolio investment (FPI);
- foreign venture capital investment (FVCI); and
- investments by non-resident Indians.
The NDI Rules also deal with foreign investment in units of investment vehicles (which are, essentially, entities registered and regulated by the Securities and Exchange Board of India (SEBI) and includes alternative investment funds (AIFs), real estate investment trusts (REITs) and Infrastructure investment trusts (InVITs)).
Foreign direct investment
FDI may be made by an investor into equity instruments issued by Indian private and public (including listed) companies and into limited liability partnerships (LLPs), provided that investment in a listed company should be 10 per cent or more on a fully diluted basis to qualify as FDI.
Foreign portfolio investment
An FPI vehicle that is registered with SEBI is permitted to invest in equity instruments of an Indian company listed or about to be listed on a recognised stock exchange in India, subject to certain conditions and, in particular, the individual and aggregate limits noted in the chapter 'Smart Acquisition Structures in M&A: AIF, FPI and FDI'. This route has been made available to enable trading of listed securities by foreign players on the stock exchange. In addition, an FPI can invest in Indian depository receipts of companies resident outside India and listed on Indian capital markets, or units issued by domestic mutual funds, Category II AIFs, REITs or InVITs, subject to the terms and conditions set out in the NDI Rules.
Foreign venture capital investment
FVCI vehicles that are registered with SEBI are permitted to invest in:
- securities of Indian companies that are engaged in certain specified sectors;
- units of venture capital funds or of Category I AIFs or units of scheme or of a fund set up by a venture capital fund or Category I AIF; and
- equity or equity-linked instrument or debt instrument of Indian startups irrespective of the sector in which such startup is engaged in.
Some of the key benefits of using an FVCI vehicle to invest in India include the fact that the pricing guidelines on issuance or transfer of Indian securities do not apply and the FVCI vehicle has the opportunity to invest in different types of equity and equity-linked instruments of the Indian company and is not restricted to just equity instruments. This enables an FVCI to invest in optionally convertible instruments such as optionally convertible debentures, which are redeemable in nature. See further details on pricing guidelines below.
The chapter 'Smart Acquisition Structures in M&A: AIF, FPI and FDI' explores some of the common acquisition structures that can be used for routing foreign investment into India, within the constraints of the NDI Rules, in further detail. The rest of this chapter will delve into some of the issues under the NDI Rules that affect FDI into Indian entities.
Regulatory interventions and challenges
Foreign direct investment into an Indian company
Prohibited sectors for foreign investment
Foreign investment and foreign technology collaboration is prohibited in certain sectors or activities (Prohibited Sectors), such as atomic energy or railway operations, lottery business including government or private lottery, online lotteries, gambling and betting business including casinos, the manufacture of cigars, cheroots, cigarillos and cigarettes, of tobacco or of tobacco substitutes, chit funds and Nidhi companies, trading in transferable development rights, real estate business or construction of farmhouses.
Automatic route versus approval route Sector norms
With respect to certain other sectors (Specified Sectors), the NDI Rules specify the level of foreign investment permitted in such sector (ie, the sectoral cap) and whether such foreign investment is permitted under the automatic route (ie, without the requirement of obtaining any regulatory approval) or under the approval route (where prior permission of the government would be required before foreign investment can be received by the Indian company operating in such sector). Further, the NDI Rules also contain FDI-linked performance conditions (eg, a minimum capitalisation requirement) that must be complied with when investing in a Specified Sector.
Where foreign investment with respect to a Specified Sector is under the automatic route, such investment can be made without prior approval of the government, provided that the sectoral caps are not breached and the FDI-linked performance conditions are complied with. If a particular sector is not in the list of Prohibited Sectors, Specified Sectors or otherwise dealt with in the NDI Rules, then generally speaking, 100 per cent foreign investment is permitted in such sector under the automatic route.
Investment in holding entities
It should be noted that if foreign investment is proposed to be made into an Indian investing company not registered as a non-banking financial company (NBFC) with the Reserve Bank of India (RBI) or in core investment companies, prior government approval will be required.
In order to infuse foreign investment into Indian companies that do not have any operations and also do not have any investments in other Indian entities, government approval is not required for undertaking activities that are under automatic route and are without FDI-linked performance conditions, regardless of the amount or extent of foreign investment. However, approval of the government will be required for infusion of foreign investment in such companies for undertaking activities that are under the approval route, regardless of the amount or extent of foreign investment.
Under the automatic route, the Indian company may issue equity instruments to persons resident outside India against swap of equity instruments, import of capital goods, machinery or equipment (excluding secondhand machinery) or pre-operative or pre-incorporation expenses, without having to obtain any government approvals.
Indirect foreign investment
The NDI Rules also set out the manner in which indirect foreign investment in Indian companies and the transfer of ownership or control from residents to non-residents in Indian companies is calculated. This may have an impact on whether government approval is required in certain types of companies and may also affect the quantum of foreign investment in certain sectors. For further details on indirect foreign investment, see below.
Recent amendments further restricting foreign investment
Pursuant to a recent amendment to the NDI Rules notified on 22 April 2020, any foreign investment by an entity resident in a country that shares a land border with India or where the beneficial owner of such foreign investment is a person situated in or a citizen of such country, can only be undertaken with the prior approval of the government, irrespective of the sector or quantum of foreign investment. Additionally, any direct or indirect transfer of existing or future FDI that would result in the beneficial ownership resting with a person situated in, or a citizen of such country would require prior government approval.
This amendment has given rise to major concerns about its manner of application, not in the least because it is unclear what the government means by ‘beneficial ownership’. Other concerns include the following:
- there is no ownership threshold or percentage above which such government approval is triggered;
- not only FDI but also indirect foreign investment (ie, by virtue of a multijurisdictional acquisition of an offshore target that has a direct or indirect Indian subsidiary) will be affected;
- additional capital infusion in a company by existing investors from the restricted countries (either by way of a rights issue or preferential allotment), is also likely to require prior government approval. It remains to be seen whether a bonus issue of securities by an Indian company to a shareholder that is from the restricted countries would also fall within the restrictions imposed by amendment; and
- as no carve-outs have been made for transfers to affiliates, it is likely that transfers to affiliates of existing investors from the restricted countries would also be affected and would require prior government approval.
At the time of writing, we understand that the government is considering issuing clarifications, although it remains to be seen whether all of the concerns will be adequately addressed. In the absence of any clarification, at-risk investors must be prepared to apply for government approval and be ready for its consequent impact on the timelines for deal closure.
Foreign investors must keep in mind that any foreign investment into India (except if being routed through an FVCI vehicle) will be subject to the pricing guidelines set out in the NDI Rules.
The table below summarises the restrictions on pricing of equity instruments that are:
- issued by listed and unlisted Indian companies to persons resident outside India (NR);
- proposed to be transferred by a person resident outside India (NR) to a person resident in India (R); and
- proposed to be transferred by a person resident in India (R) to a person resident outside India (NR). The pricing guidelines do not prescribe any restrictions when it comes to a transfer of equity instruments between two persons resident outside India.
|Issuance to NR||Transfer from NR to R||Transfer from R to NR|
Price to not be less than the price calculated in accordance with the guidelines issued by SEBI
Cap on price
Price to not be more than the price calculated in accordance with the guidelines issued by SEBI
Price to not be less than the price calculated in accordance with the guidelines issued by SEBI
|Unlisted company (private or public)||
Price to not be less than the price arrived by a practising cost accountant, chartered accountant or SEBI-registered merchant banker, as per any internationally accepted pricing methodology
Cap on price
Price to not be more than the price arrived by a practising cost accountant, chartered accountant or SEBI-registered merchant banker, as per any internationally accepted pricing methodology
Price to not be less than the price arrived by a practising cost accountant, chartered accountant or SEBI-registered merchant banker, as per any internationally accepted pricing methodology
NR – person resident outside India
R – person resident in India
As will be noted from the table, there is a cap on the price at which a foreign investor can exit its investment in an Indian entity in favour of a person resident in India.
As per the NDI Rules, the guiding principle is that the foreign investor must exit at the fair market price prevailing at the time of such exit. Importantly, an investor cannot be promised any kind of assured return on exit, at the time of making its investment.
Where the Indian company is proposing to issue securities that are compulsorily convertible into equity shares, then the conversion formula must be determined upfront. Further, the price at which equity shares are issued on conversion of convertible instruments cannot exceed the fair market value of such equity shares as of the date of issue of such convertibles.
Deferred consideration, use of escrows and treatment of indemnities
The NDI Rules set out certain rules governing deferred consideration, use of escrows and treatment of indemnities. These requirements limit the types of alternative pricing structures that can be used for routing foreign investment into Indian companies – in particular, the earn-out structures that are preferred in other jurisdictions.
Where a transaction involves the transfer of equity instruments between a person resident in India and a person resident outside India, an amount not exceeding 25 per cent of the total consideration may be paid by the buyer to the seller on a deferred basis or settled through an escrow arrangement between the buyer and the seller. Further, where structures involve deferred consideration or escrow arrangement restricted to amounts equal to or below 25 per cent, the deferred consideration must be paid, and the escrow arrangement must be settled, within a period of 18 months from the date of the transfer agreement (and not the date of transfer).
With respect to indemnities, if the buyer has paid the consideration in full, then the NDI Rules permit the buyer to be indemnified by the seller for a period not exceeding 18 months from the date of payment of the full consideration, provided that, the aggregate indemnity amount does not exceed 25 per cent of the total consideration paid for the purchase.
All of the above is subject to the overall principle that the net amount received by the seller should not be in violation of the pricing guidelines discussed above.
Structuring put and call options
The NDI Rules provide that a person resident outside India who holds equity instruments in an Indian company, which equity instruments are subject to put option or call option rights, may only transfer such equity instruments upon the exercise of the relevant option right after a minimum lock-in period of one year has passed. Further, the transfer of such equity instruments shall be subject to the pricing guidelines set out in the NDI Rules and will not involve any assured return for the exiting investor. This severely curtails the ability of investors to structure ‘downside protected’ investments, where they are allowed to exit at a mutually agreed floor price that may be higher than the fair market value at the time of exit.
In the event that the put or call option is over equity instruments of an Indian public limited company, then note should also be taken of a circular issued by SEBI in this respect. This circular prescribes additional conditions that apply irrespective of whether the person holding the equity instruments is resident in or outside India. These conditions include:
- the ownership of the underlying securities must be continuously held by the selling party for a minimum period of one year from the date of the option agreement;
- the price payable for the purchase of the undertaking securities pursuant to the exercise of the option is in compliance with all applicable laws; and
- the sale and purchase is settled by actual delivery of the underlying securities.
Creating pledge over Indian securities
The NDI Rules also prescribe the circumstances in which a pledge can be created over the equity instruments of an Indian company or units of an investment vehicle, as follows:
- Where the Indian company has raised external commercial borrowing from a person resident outside India, then the promoter of such Indian company may pledge the shares of such Indian company or that of its associate resident companies for the purposes of securing the external commercial borrowing, subject to certain conditions.
- Any person resident outside India may create a pledge over equity instruments of an Indian company or units of investment vehicle in favour of:
- a bank or NBFC in India to secure credit facilities being extended to such Indian company for bona fide purposes; and
- an overseas bank to secure credit facilities being extended to such person or a person resident outside India who is the promoter of such Indian company or the overseas group company of such Indian company.
Other than as set out above, it is not permitted for persons resident outside India to create security over the equity instruments of an Indian company or units of an investment vehicle held by them. On the invocation of the pledge, any transfer of equity instruments of the Indian company or units of the investment vehicle must be in accordance with the sectoral caps, pricing guidelines and other related conditions set out in the NDI Rules.
Indirect foreign investment into an Indian company
Meaning of indirect foreign investment or downstream investment
Indirect foreign investment or downstream investment means an investment made into the capital instruments or capital of an Indian entity (ie, the receiving entity) by:
- another Indian entity that has received foreign investment and is not owned and controlled by resident Indian citizens or is owned and controlled by persons resident outside India (FOCC); and/or
- an investment vehicle whose sponsor or manager or investment manager is not owned and controlled by resident Indian citizens or is owned and controlled by persons resident outside India.
The NDI Rules define ownership by reference to the beneficial holding of more than 50 per cent of the equity instruments and control as the right to appoint majority of directors or to control the management or policy decisions of the company, including by virtue of their shareholding or management rights or shareholders agreement or voting agreement. Given the ambiguous definition of control, there has been considerable debate on the contours of this term – especially around veto rights that are commonly found in joint venture agreements and whether negative control (by virtue of such veto rights) would amount to control for the purposes of the NDI Rules.
For the purposes of calculating foreign investment, foreign currency convertible bonds and depository receipts, being in the nature of debt, will not be treated as foreign investment. However, any equity holding by a person resident outside India resulting from conversion of any debt instrument under any arrangement will be reckoned as foreign investment.
Conditions relating to downstream investment
The Indian entity that has received the indirect foreign investment is required to comply with the entry route, sectoral caps, pricing guidelines and FDI-linked performance conditions set out in the NDI Rules. In other words, downstream investment by such Indian entities will be treated on a par with foreign investment into an Indian investee company. Key points to note in the context of downstream investments are as follows:
- The Indian entity making the downstream investment (ie, the FOCC) is required to bring the necessary funds for investment from outside India and is not permitted to use funds borrowed on the domestic Indian markets. However, the FOCC is permitted to make downstream investments through its internal accruals (ie, profits transferred to reserve account after the payment of taxes).
- The equity instruments of an Indian entity that has received indirect foreign investment may be transferred by an FOCC to:
- a person resident outside India, without adhering to the pricing guidelines;
- a person resident in India, subject to adherence of the pricing guidelines; or
- another FOCC, without adhering to the pricing guidelines.
- The equity instruments of an Indian entity that has received indirect foreign investment may be transferred to an FOCC by a person resident outside India, without adhering to the pricing guidelines, or a person resident in India, subject to adherence to the pricing guidelines.
Additional listed company considerations
In addition to the matters outlined above, where the foreign investment is being proposed in listed securities, the rules and regulations issued by SEBI (which regulates entities whose securities are listed or about to be listed on any recognised stock exchange in India) also need to be taken into consideration.
Lock-in under the ICDR Regulations
In the event that an investment into a listed Indian company involves a preferential allotment of equity shares or instruments that are convertible into equity shares of such company, then there are certain lock-in restrictions under the SEBI (Issue of Capital and Disclosure Requirements) Regulations 2009 (ICDR Regulations) that must be kept in mind. Under the ICDR Regulations, the securities so issued to the investor (not being a promoter of the listed entity) will be locked in for a period of one year from the date of trading approval. In cases where the investor held any equity shares in the listed company prior to such issuance, such equity shares will be locked in from the relevant date until passage of six months from the date of trading approval.
Where such securities are issued to the promoter or promoter group on a preferential basis, the lock-in period is three years from the date of trading approval. However, no more than 20 per cent of the share capital of the listed company can remain locked in for a period three years from date of trading approval other than any equity shares allotted pursuant to the exercise of a conversion right, which must remain locked in for a period of one year from the date of trading approval.
The SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 2011 (Takeover Regulations) apply to any direct or indirect substantial acquisition of voting rights, or control of a company whose securities are listed on any recognised stock exchange in India. In such a situation, the Takeover Regulations require the acquirer to make an open offer to further acquire at least 26 per cent of the voting capital of such company. Essentially, the Takeover Regulations protect the interests of the public shareholders by requiring acquirers to provide an exit opportunity to them, in the event of an acquisition of substantial voting rights or control over a listed company.
Under the Takeover Regulations, the obligation to make such a mandatory open offer by an acquirer is triggered upon the occurrence of the following events:
- if an acquirer, either by itself or along with persons acting in concert, intends to acquire shares or voting rights in a listed company to exercise 25 per cent or more of the voting rights in such company;
- if an acquirer, who already holds 25 per cent or more but less than 75 per cent of the shares or voting rights in a listed company, intends to acquire additional shares or voting rights that would entitle the acquirer (along with persons acting in concert) to exercise more than 5 per cent of the voting rights in such target in any financial year; or
- if an acquirer intends to acquire control over the target by appointing majority directors, controlling management, policy, etc.
However, the Takeover Regulations also set out some exemptions from the obligation to make a mandatory open offer, which should be explored in the context of any M&A transaction triggering one of the conditions set out above.
The Takeover Regulations also permit a voluntary public offer to be made in respect of a listed company where an acquirer holds more than 25 per cent but less than 75 per cent of the shares or voting rights in a listed company, and wants to consolidate its holding in the target company. The acquirer may do so by making a public announcement to acquire a minimum of an additional 10 per cent of the total shareholding of the target company.
Insider Trading Regulations
The other key legislation to bear in mind when considering an investment in a listed company in India is the Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations 2015 (Insider Trading Regulations). The Insider Trading Regulations govern the manner in which unpublished price-sensitive information may be disclosed or procured. It further prevents any person who holds unpublished price-sensitive information with respect to a listed entity from dealing in the securities of such listed entity. Accordingly, the Insider Trading Regulations should be carefully explored so that any investor is not inadvertently made an insider, restricting its ability to invest in any given listed entity.
Direct or indirect foreign investment into an Indian LLP
As a general rule, FDI in LLPs does not require any prior government approval. However, investment in LLPs is not permitted under the FPI or FVCI route. Further, FDI in LLPs is subject to certain conditions, such as:
- FDI is permitted in LLPs operating in sectors or activities where 100 per cent FDI is permitted under the automatic route and there are no FDI-linked performance conditions. Government approval is required for FDI in LLPs if the above condition is not satisfied.
- An LLP or Indian company having foreign investment is permitted to make downstream investment in another company or LLP in sectors in which 100 per cent FDI is allowed under the automatic route and there are no FDI-linked performance conditions, subject to certain conditions.
- FDI in LLPs is subject to compliance with conditions of the Limited Liability Partnership Act 2008.
The NDI Rules permit the conversion of an LLP having foreign investment and operating in sectors or activities where 100 per cent FDI is allowed through automatic route and there are no FDI-linked performance conditions into a company under the automatic route. Similarly, the conversion of a company having foreign investment and operating in sectors or activities where 100 per cent FDI is allowed through the automatic route and there are no FDI-linked performance conditions into an LLP is also permitted under the automatic route.
Foreign investment in an LLP, whether by way of capital contribution or a secondary acquisition from a person resident in India, cannot be less than the fair price as calculated an approved valuer, chartered accountant or a practising cost accountant as per any valuation methodology that is internationally accepted or otherwise adopted in accordance with market practice.
M&A in the context of the IBC
Resolution process pursuant to the IBC
The introduction of the Insolvency and Bankruptcy Code 2016 (IBC) has brought about a significant change in the Indian M&A landscape. The IBC is a single code that attempts to consolidate existing laws relating to the reorganisation and insolvency resolutions of corporates and partnerships as well as individuals. The entire process, including the institution of insolvency proceedings until approval of a resolution plan (resulting in a reorganisation) or liquidation is intended to work in a time-bound manner and, hopefully, provide respite to various stakeholders otherwise submerged under the burden placed by the stressed assets.
The main advantage of the IBC resolution process is the extinguishment of all historical liabilities of the corporate debtor if and to the extent provided for under the resolution plan. This was further clarified by the Insolvency and Bankruptcy Code (Amendment) Ordinance 2019, which states that the effect of the approval of a resolution plan by the relevant authority should result in:
- the extinguishment of all liabilities of the corporate debtor existing at or relating to the period prior to the insolvency commencement date; and
- no action being taken against the property of the corporate debtor, in relation to the offences committed in the period prior to the insolvency commencement date.
However, this immunity is available only in cases where the resolution plan specifically provides for change in the management or control of the corporate debtor to a person not being a promoter managing or controlling the corporate debtor or any related party or a person against whom a complaint or report has been filed before the relevant authority in relation to the aforementioned offence.
Corporate Insolvency Resolution Process
The IBC provides for the insolvency resolution process known as the Corporate Insolvency Resolution Process (CIRP) pursuant to which any financial or operational creditor, or the corporate debtor itself, may file an application before the National Company Law Tribunal (NCLT) to commence the CIRP of a corporate debtor on a payment default of 10 million Indian rupees. This limit was previously 100,000 Indian rupees and was increased to 10 million Indian rupees as a result of the covid-19 pandemic. However, it remains to be seen whether such limit will be brought down again in the future.
The NCLT, after determining the existence of a debt and if a payment default has taken place, will pass an order admitting the insolvency application and for commencement of CIRP against the corporate debtor (ICD). From the ICD, a moratorium becomes operative for a period of 180 days (extendable up to a maximum of another 90 days) (CIRP Period). During the CIRP Period, no suit or legal proceeding can be commenced (including any action to enforce security interest) against the corporate debtor and no pending proceeding can be proceeded with against the corporate debtor.
On the ICD, a resolution professional (RP) takes over the management of the corporate debtor and ensures that the corporate debtor remains a going concern. The RP invites resolution plans for the corporate debtor, which ultimately is put before the committee of creditors. The resolution plan approved by the committee of creditors is put before the NCLT. Once the resolution plan is approved by the NCLT, it will be binding on all parties involved and be implemented by the successful applicant. In order to aid this process, SEBI has amended the Takeover Regulations to include an exemption from the requirement to make a mandatory open offer if the acquisition of securities of the listed entity is pursuant to a resolution plan that is approved by the NCLT under the IBC.
At the time of writing, the government has suspended initiation of fresh insolvency proceedings for defaults occurring on or after 25 March 2020 for a period of six months, which may be extended to one year at the discretion of the government. A separate framework for insolvency resolution of micro, small and medium-sized enterprises is also being proposed.