Common Traps and Pitfalls in an M&A deal

Case study:

As the lead promoter of XYZ Ltd, you are about to close a deal that will boost the company’s image, and create a footprint in the global market. A global giant is acquiring a 50% stake in your company. The deal is all that you dreamed of, a great investor, great technology and you retain management control. It has been in the making for almost nine months now and was scheduled to close on 31^st March. Then the lockdown happened.

Finally, when the lockdown is partially lifted, everybody is excited. The press announcement is about to be made and the promoters are on top of the world. A press conference has been called for 2:00 p.m. tomorrow. Everything seems to be under control. The investor gives you the wire remittance instructions from his bank that they are good to go. You forward this to your bank along with all the supporting documents required to receive foreign direct investment (FDI) and complete the investment.

Oh oh – hold on. At 5:00 p.m. today the bank comes back to you to say that they need the valuation report to be dated not longer than three months prior to the acquisition but yours is based on 31st March financials and the acquisition is happening in September.

You frantically gather your core team and try to explain to the bank the deal has been in negotiations for months now at the valuation that was prepared in April and everything was kept ready to go – its just that the lockdown created some issues and the closing was delayed, etc etc.

Nothing helps. The bank is adamant that they need a new valuation report based on more recent financials, and the transaction cannot close tomorrow after all. The press conference is cancelled, the foreign investors are upset because the money they mobilised is blocked and closing has to be pushed back by a week at least to enable the valuation expert to do a fresh valuation based on more recent financials. The accountants need to be paid extra to prepare the latest financials on a war footing. Another problem – covid has impacted the projections and the new valuation could be lower. You panic and wonder whether the investor will now reduce the acquisition price.

This is just an example of the kind of unexpected last minute pitfalls that a deal can face. In this article, I have listed a few (and there are many more) of these little traps and pitfalls that are encountered in most M&A and private equity deals, particularly in a cross border deal, where with a little bit of extra attention and planning, the last minute bottlenecks could well have been avoided.

Valuation for income tax and FEMA

While most people spend time in getting the Foreign Exchange Management Act, 1999 (FEMA) valuation correct, others like the requirements of the Income Tax act 1961 (IT Act), are either forgotten or not paid much attention to since the valuation report under the IT Act is not required to be filed unless the IT authorities require the same to be filed. Since FEMA states that a foreign investor can subscribe to shares at equal or higher than the FMV, companies commonly issue shares at a higher value.

Section 56 of the IT Act has a few provisions that can create a nightmarish situation; one such provision states that if a company issues shares at more than the FMV, the excess is deemed income in the hands of the company issuing such shares. There are some exceptions and you are allowed to take a DCF method valuation but one must be careful that unless you fall within the exception, the valuation is the same as the issue price.

Downstream investments and structuring

Often Indian subsidiaries of a foreign entity make further domestic acquisitions. People tend to think these are domestic investments and FEMA rules don’t apply. However, such investments are treated as deemed foreign investment. Thus, one of the requirement is that the funds needed for the investment by an Indian subsidiary company must flow from abroad or the investment must be out of internal accruals of the Indian subsidiary company. These FEMA regulations must be carefully understood and implications analysed on a case specific basis, when making a downstream investment.

Convertible instruments and conversion price

While compulsorily convertible instruments like preference shares and debentures are recognised as equity for the purposes of FDI, there are issues when it comes to conversion. If the conversion is at 1:1 and a valuation is done at the time of investment it is fine. However, often, especially in the private equity deal, the conversion ratio depends on the performance of the investee company. There are regulations that are a little complicated and capable of varying interpretations both under FEMA as well as under the Companies Act, 2013 (Companies Act) that have to be complied with, including the requirements to undertake a fresh valuation at the time of conversion and then ensuring that the FEMA, Companies Act and the IT Act are all in sync and one does not fall foul of any of these.

Completion formalities – Companies Act and FEMA

The Companies Act has multiple formalities and forms to be filed before shares can be offered, issued and allotted. There may be other parts to the transaction to be completed on the closing date like stock options, employment agreements, etc, especially in cases of partial acquisition, which may require further compliances under the Companies Act. Another aspect that is sometimes missed out is that even private companies now have to follow a process of making a private placement offer and acceptance of the same by the investor/acquirer before a transaction can be completed. With all these formalities the “same day completion” in the sense that most deals would like, is not possible due to various compliances both under FEMA and the Companies Act. With respect to filings under FEMA, the documentation requirement varies for different authorised dealer banks and the timelines for closing should be determined keeping in mind the requirements and turn around time of the concerned authorised dealer bank.

The above are only examples of some of the common issues that tend to be overlooked which can delay the transaction or later come back to bite the company, necessitating compounding and the penalties for a totally unintended minor non-compliance.

Conclusion

In any M&A deal, hours are spent in negotiating complex clauses, such as governance, transfer restrictions, exit clauses, affirmative rights, management responsibilities, indemnities, dispute resolution, etc and the list is endless. Little time is spent on compliance matters that are seen to be “small things” and these are the ones that cause last minute bottlenecks as seen in the case study above.

In an era of globalisation, for all the hype created on ease of doing business and being investor-friendly, the reality is that our laws and regulations are often so complicated with compliance level reaching absurd levels in some cases, that these kind of last minute hurdles are more the norm than the exception.

So if we are to compete and be a real global player, the mindset of the regulators need to change and we must have significant simplification of regulations. I am not saying that checks and balances are not needed; indeed they are, but everything has to be within limits and until that happens we have to live with the current reality.

DISCLAIMER

This article has been written for the general interest of the readers and is subject to change. This article is not to be construed as any form of solicitation. It is not intended to be exhaustive or a substitute for legal advice. We cannot assume legal liability for any errors or omissions. Specific advice must be sought before taking any action pursuant to this article. For further clarification and details on the above, you may write to Aliff Fazelbhoy, Senior Partner, ALMT Legal.

Contributors: Mr. Aliff Fazelbhoy and Ms. Khusbu Jasani of ALMT Legal, Advocates & Solicitors