Deal structuring eased, teething troubles remain

In any cross-border mergers and acquisitions (M&A) transaction, until recently, the parties were not allowed to enter into an escrow arrangement for a period beyond six months, or defer the purchase consideration unless a prior approval of the Reserve Bank of India (RBI) is obtained. RBI has now amended the foreign exchange regulations, enabling the parties to enter into escrow arrangements for up to 18 months' period under the automatic route. Within the same time period, RBI has also allowed to pay deferred consideration to the seller subject to the same not being more than 25 per cent of the aggregate purchase consideration.

CHANGING DEALSCAPE

• RBI now allows parties to enter into escrow arrangements for up to 18 months
• Buyer allowed to pay deferred consideration to the seller to the tune of  up to 25 per cent of the aggregate purchase consideration
• A seller could furnish indemnity, instead of escrow arrangements, for the deferred consideration

An escrow arrangement gives the acquirer an opportunity to lay his claim on escrow funds (being a fraction of the sale proceeds), if subsequent to the acquisition the seller fails to meet its specific obligations or breaches certain warranties. Likewise, deferred payment mechanism is used to determine true purchase price for a target company, particularly when such determination is contingent on working capital calculations or when the purchase price comprises certain performance-linked incentives payable to seller. Prior to the amendment, deferred considerations in a cross border M&A transaction required approval from RBI as it viewed such deferment as credit facility offered to the acquirer. Allowing escrow arrangements and deferred payments in cross border M&A transactions will now promote structures with purchase price adjustments and performance-linked earn-outs.

The amended regulations also enable a seller to furnish indemnity instead of escrow arrangements for a deferred consideration. One technical glitch in the amended regulations is the limitations prescribed on indemnity. In any secondary purchase transaction, providing indemnity to the acquirer for future claims is a standard norm. Strangely, the amended regulations provide limitations on indemnity furnished by seller to the acquirer. It is provided that if the seller has received full purchase consideration, then seller may offer indemnity for an amount not more than 25 per cent of the total consideration, and for a period not exceeding eighteen months. It appears that now indemnity can be offered only up to 25 per cent of the purchase consideration, and that too for a limited period of eighteen months. It should be a commercial decision between the parties to agree on higher or lower indemnity thresholds or time periods.

Interestingly, the amended regulations also provide that the total consideration finally paid to seller must be compliant with the RBI pricing guidelines. Addition of this condition creates ambiguity. The current RBI pricing guidelines allows a non-resident party to sell or acquire shares of an Indian company at market price (for listed shares) and certified fair price (for unlisted shares). So, if the purchase consideration ultimately received by the resident seller from the non-resident acquirer does not satisfy the pricing guidelines (which may be a possibility on account of indemnity claims), does it lead to the acquirer waiving its claim on the indemnity amounts or a reduced indemnity pay-out due to this restriction? For example, if an acquisition by a non-resident acquirer were to happen at Rs 100, being the certified fair price in compliance with the pricing guidelines, what would happen in the event the resident seller has to indemnify the acquirer for Rs 20? Applying the amended regulations, it seems such indemnity payment can never happen as it will lead the aggregate transaction value to be non-compliant with the RBI pricing guidelines.

Deferring the purchase consideration for structuring earn outs, escrow arrangements for hold-backs and contractual indemnities are globally accepted practices in any cross boarder acquisition. RBI's prior approval requirement for them was proving to be a hindrance for these arrangements. To a large extent, RBI has smoothened the deal structuring in a cross-border M&A transaction on these fronts. However, the teething issues highlighted above need a closer review.

Puneet Shah is principal associate, and Sambhav Ranka, partner at IC Legal, Advocates & Solicitors & Partners