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Category: Company Law (page 1 of 19)

How do e-Wallets like Paytm work?

abhishek-ray   In the dawn of demonetisation, most of us have found ourselves adapting to new payment mechanisms and methods. The government’s strong push towards a cashless society seems to be ushering in the age of the e-wallet. Paytm alone is responsible for more transactions per day than the combined average daily usage of all the debit and credit cards in India. Mobile wallets, which many of you are using these days, are a type of pre-paid instrument. But what are pre-paid instruments? How do they work?

Here are some frequently asked questions, which should provide some clarity on the conceptual and regulatory framework behind pre-paid instruments in India.

I am hearing this term for the first time. What is a pre-paid instrument?

Pre-paid instruments are payment instruments that facilitate purchase of goods and services, including by way of funds transfer, against the value stored on such instruments. The value stored on these instruments represents the value paid for by the holders of such instruments.

The issuers of pre-paid instruments have tie-ups with various merchants, and you can use the value stored on your instruments to carry out transactions with these merchants.

Ok. That’s a very legalese definition. Did the Reserve Bank of India come up with it? What is the regulatory framework for pre-paid instruments?

Actually, yes! The Reserve Bank of India (RBI) first provided the guidelines on pre-paid instruments (let’s just call them PPIs) in 2009. Over the years the RBI, issued several notifications (yes, they were not as dynamic as today!) in relation to PPIs. It then decided to consolidate all these notifications in a Master Circular (which gets updated on a yearly basis). Pre-paid instruments are subject to the Payment and Settlement Systems Act, 2007.

The latest Master Circular – Policy Guidelines on Issuance and Operation of Pre-paid Payment Instruments in India was notified on 01 July 2016. You can have a look at that here. You will find all the definitions and other details in this Master Circular.

Cool! So I guess then a PPI is a regulated instrument and one needs to have the approval of the RBI to issue one?

Yes. The RBI provides licenses to issue PPIs. All persons proposing to operate payment systems and involved in the issuance of PPIs have to seek authorisation from the Department of Payment and Settlement Systems, RBI, under the Payment and Settlement Systems Act, 2007.

Ok. If mobile wallets are one type of PPIs, what are the other types?

PPIs can be issued as smart cards, magnetic strip cards, internet wallets, mobile accounts, mobile wallets, paper vouchers and any such instrument, which can be used to access the pre-paid amount. A mobile wallet (Paytm, Mobikwik etc.) is one type of PPI. However, this is a dynamic sector and entrepreneurs are devising new prepaid mechanisms everyday.

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Mobile Wallets like Paytm and Mobikwik are Pre-Paid Instruments

Broadly the RBI classifies PPIs into the following types: Closed, Semi-Closed and Open Payment Instruments.

What are Closed System Payment Instruments?

These are payment instruments issued by a person for facilitating the purchase of goods and services from him/it. These do not permit cash withdrawal or redemption. As these instruments do not facilitate payments and settlement for third party services, issue and operation of such instruments are not classified as payment systems. (A pre-paid card in your canteen or a food court can be considered a type of closed system payment instrument.)

What are Semi-Closed System Payment Instruments?

These are payment instruments, which can be used for purchase of goods and services, including financial services at a group of clearly identified merchant locations/establishments, which have a specific contract with the issuer to accept the payment instruments. These instruments also do not permit cash withdrawal or redemption by the holder.

Mobile wallets like Paytm and Mobikwik are semi-closed payment instruments.

What are Open System Payment Instruments?

These are payment instruments, which can be used for purchase of goods and services, including financial services like funds transfer at any card accepting merchant locations (point of sale terminals) and also permit cash withdrawal at ATMs.

Debit cards are open system payment instruments.

Are there any limits in relation to the value that I can store in the PPIs?

Currently, the limit is Rs. 20,000 per month for PPIs where minimum details of the customers have been collected.

This limit can be extended up to Rs 1,00,000 per month after collecting the appropriate KYC (Know Your Customer) documents from the holders.

Ok. So what can I do with my pre-paid instruments?

Let’s only consider semi-closed PPIs from now on, as these are the most commonly used. Your scope of usage of a semi-closed PPI is dependent upon the number of merchants the PPI issuer has tied up with. Generally you can use your PPI for payment of utilities with these merchants and for transferring money to other PPIs.

e.g. Paytm has a tie up with Uber and not with Ola. So you can use your Paytm wallet to make a payment for Uber but not for Ola.

Ok. So what happens to the money after I transfer it to my PPI?

Every PPI issuer (like Paytm, Mobikwik etc.) is required to create an escrow account with a bank, where all the money collected from its customers are credited. This account is a non-interest bearing account. The PPI issuer is required to create a security on this account in favour of the PPI holders (customers like you and me). Therefore the holders are secured and in the event of liquidation/bankruptcy of the PPI issuer, the merchants/PPI holders shall be given preference to the other creditors of the PPI issuer.

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There are strict norms, which regulate any debit or credit of this escrow account. However at no point of time can the amount in the escrow account be less than the aggregate of the balance amount in all the corresponding PPIs and all pending payment instructions in favour of the merchants. So don’t worry, your money is safe with a PPI issuer!

Can I redeem the money stored in my PPI?

No. You are not allowed to redeem your money from a semi-closed PPI. However if that particular PPI is being closed or if the RBI decides to stop this entire product of PPIs (highly unlikely, the RBI usually does not reverse a decision), the customers shall be allowed to redeem the amounts stored in the PPI, within the expiry date of the PPI.

Who can issue PPIs? Are all PPI issuers NBFCs or banks?

Only banks can issue Open PPIs. Non Banking Financial Companies (NBFCs) and other persons can issue Closed and Semi-closed PPIs. These persons need to have a minimum paid-up capital of Rs. 500 lakh and minimum positive net-worth of Rs. 100 lakh at all times. Only companies incorporated in India are eligible.

As mentioned earlier, the authorisation of the RBI is required.

If I keep my money in my bank account it earns me interest. Can I earn interest on the amount stored in my pre-paid instrument?

The money in the wallet or PPI can only be used for transactions against the value stored in such instruments.

You will not earn interest on the amount stored in the wallet.

I heard of an offer where I can get cashback points if I use a mobile wallet. How does this work?

These are usually marketing offers. The merchant may be offering the product at a discount to increase sales. The discounted amount is then credited back into the PPI.

At times, the PPI issuer may also credit the PPI with an additional amount to incentivise customers. A PPI can be funded/reloaded by third parties, so the PPI issuer is transferring the cashback amount to your PPI.

Hope this is of help! Do take some time to go through the RBI Master Circular for more details.

Abhishek is a legal and business strategy consultant with ePaylater, one of India’s first one- click checkout payment solutions. This article should not be construed as legal advice. The views expressed in this article are his personal views and opinions. He can be reached at abhishek.ray@epaylater.in.

Written by myLaw

[Video] Share transfer restrictions – Learn the practical stuff, understand the legal debates

A corporate lawyer’s job includes facilitating mergers and investments by and into businesses. Really experienced corporate lawyers become extremely familiar with shareholders’ agreements and joint-venture agreements but young corporate lawyers and law students working at corporate law firm internships are known to look at terms like ROFR, ROFO, tag-along, and drag-along with wonder.

These different types of share transfer restrictions are a massive and complicated topic. To make it easier to understand, we spoke to Arjun Rajgopal (Principal Associate, Khaitan & Co.) and Umakanth V., an Associate Professor at National University Singapore, and among the most respected names in Indian corporate law.

What we have below are two videos which contain a completely lucid, simplified, and practical explanation of shareholder restrictions. In the first part, we discuss their purpose, their different types, and how they work.

In the second part, we look at how Indian laws have treated share transfer restrictions and the massive debate over their enforceability. What did the Companies Act, 1956 say about them and how have things changed with the new Companies Act, 2013?

If you want to be a corporate lawyer, you cannot afford to miss these two videos.

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Click here to watch Part 1

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Click here to watch Part 2

Written by myLaw

FDI in e-commerce: Everything you need to know

DivyaSinha_SwethaPrashant_JSagarAssociatesThe Department of Industrial Policy and Promotion (“DIPP”) recently released Press Note No. 3 (2016 Series) dated March 29, 2016 (“PN3”), setting out guidelines for foreign direct investment (“FDI”) in the e-commerce space. We will look at the evolution of the law and policy on foreign investment in the e-commerce space, and in particular the scope and implications of PN3.

India’s FDI law

Foreign investment in India is governed by the Consolidated FDI Policy (“FDI Policy”) and the Foreign Exchange and Management Act, 1999 (“FEMA”) and related rules and regulations. The DIPP, which is the foreign investment regulatory arm of the Ministry of Commerce and Industry of the Government of India, makes amendments the FDI Policy by issuing press notes. Rules under the FEMA, however, are notified by the Reserve Bank of India (“RBI”).

FDI in e-commerce – the story before PN3

FDI has been permitted in the e-commerce space in a limited manner since the year 2000. According to Press Note No. 2 (2000 series) (“PN2”), FDI of up to 100 per cent was allowed in an e-commerce company under the automatic route (that is, without the approval of the government) as along as that company was engaged in business-to-business (“B2B”) e-commerce. If such a company was listed overseas however, 26 per cent stake in it had to be divested in favour of the Indian public within a period of five years. On the other hand, FDI was not permitted in retail trading, that is, in business-to-consumer (“B2C”) e-commerce. The policy had also categorically specified that the restrictions applicable (at that time) to domestic trading would be applicable to e-commerce as well.

On trading (including wholesale, single-brand retail, and multi-brand retail), the FDI Policy witnessed many changes since 2000, but in the e-commerce space it remained mostly stagnant until the end of 2015. Among minor changes made during this period, the requirement of mandatory disinvestment of 26 per cent stake in favour of the Indian public was dispensed with in 2006. “E-commerce” was also defined in the FDI Policy in 2010 to mean the activity of buying and selling by a company through an e-commerce platform.

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In 2014, the DIPP released a discussion paper seeking comments from various stakeholders for formulating the guidelines on FDI in the e-commerce sector. While it was still in the process of formulating the policy on FDI in B2B e-commerce, it released Press Note No. 12 (2015 series) (“PN12”), which liberalised the FDI Policy in the B2C e-commerce sector in a limited manner.

Shackles on single-brand B2C e-commerce

According to PN12, FDI in B2C e-commerce was permitted in ‘single-brand product retail trading’ as follows:

(a) single-brand retailers with physical stores were permitted to sell their products online as well; and

(b) Indian manufacturers were permitted to sell their own single-brand products online as along as the manufacturers are: (i) the investee companies (that is, those which have received FDI); and (ii) the owners of ‘Indian brands’ (that is, those that are owned by Indian residents or Indian companies owned and controlled by Indian residents); (iii) manufactured 70 per cent of the value of the products in-house; and (iv) sourced the remaining 30 per cent from other Indian manufacturers.

Single-brand retailers and Indian manufacturers with FDI who want to sell their single-brand products through e-commerce also need to comply with a few other conditions set out in PN12. Currently, FDI is permitted up to 100 per cent in Indian entities engaged in single-brand retail trading. FDI beyond 49 per cent requires government approval but below that threshold, it can be under the automatic route.

So far as multi-brand retail trading goes, FDI is permitted up to 51 per cent under the approval route subject to certain funding, sourcing, and other conditions. The FDI Policy on multi-brand retail e-commerce by Indian companies with FDI, however, did not change and the restriction continued by implication. Consequently, Indian companies with FDI who are engaged in multi-brand retail trade are not permitted to undertake B2C multi-brand e-commerce.

Several regulatory snarls and the litigation faced by e-commerce players during the last few years appear to have prompted the DIPP to clarify the FDI Policy on B2B e-commerce space through PN3.

PN3: Laying the boundaries for FDI in B2B e-commerce

As discussed above, FDI of up to 100 per cent was already allowed in B2B e-commerce under the automatic route (that is, without the approval of the government) since 2000. PN3, in addition to reiterating the FDI policy on B2B and B2C e-commerce that is currently in place, has distinguished two models of e-commerce – the “inventory based model” and the “marketplace based model”. It clearly states that FDI of up to 100 per cent will be allowed without any government approval only in “marketplace based models” and that FDI in “inventory based models” is prohibited.

PN3 has also redefined the term “e-commerce” and clearly defined the concept of “e-commerce entities”. It stipulates some operating conditions for e-commerce entities with FDI for undertaking “marketplace based” e-commerce retailing.

“E-commerce” and “e-commerce entities”

The term “e-commerce” has been redefined to mean the “buying and selling of both goods and services, including digital products over both digital as well as electronic network”. This is broader than the previous definition, which was restricted to the buying and selling of goods by a company on an e-commerce platform. The new definition covers services also and clarifies the forms of e-commerce platforms (such as computers, television channels, webpages, and mobiles).

The term “e-commerce entity” on the other hand, has been defined for the very first time. It includes Indian companies, foreign companies, and offices, branches, or agencies owned and controlled by non-residents, which conduct e-commerce business. As a result of this new definition, it is now clear that foreign companies can invest in “marketplace based” B2B e-commerce. This will also enable foreign investors to acquire existing Indian entities operating marketplace B2B e-commerce.

It is, however, interesting that the definition does not include limited liability partnerships (“LLPs”). On a plain reading, it appears that FDI will not be permitted in LLPs that undertake B2B e-commerce. This position, however, contradicts the FDI Policy on LLPs, which was recently amended in PN12 which allowed FDI up to 100 per cent in LLPs operating in sectors where 100 per cent FDI is permitted under the automatic route and where there are no performance-linked conditions. The DIPP should provide some clarity on this front as it could impact the structuring of FDI in the B2B e-commerce space.

“marketplace based” and “inventory based”

As FDI is permitted only in marketplace-based models, it is important to understand the difference between “marketplace based models” and “inventory based models”.

The “marketplace based model” of e-commerce is defined as the provision of an information technology platform by an e-commerce entity on a digital or electronic network. A marketplace-based e-commerce entity, PN3 clarifies, cannot own any inventory by itself. If any marketplace-based e-commerce entity with FDI gains ownership over such products and services, then it will be considered an inventory-based e-commerce entity. Therefore, at no point can a marketplace-based e-commerce entity gain ownership over the goods. The title to the goods and services should remain with the seller.

A marketplace-based model is essentially a B2B model where the e-commerce entity is merely acting as a facilitator between sellers and consumers. In this model, an e-commerce entity will not sell goods or provide services directly to the consumers. The actual sale of goods or services takes place between the seller and the end consumer. The e-commerce entity will earn a commission from the seller for the services provided by it to the seller.

FDI_ECommerce_B2BModel

The “inventory based model” on the other hand, has been defined as e-commerce activity where the inventory of goods and services is owned by the e-commerce entity and those goods and services are sold directly to the consumers. An inventory-based model, therefore, is essentially a B2C model where the e-commerce entity has ownership over the goods and the sale of goods and services takes place between the e-commerce entity and the end consumer.

As we discussed above, PN12 only permitted manufacturers and single-brand retailers to undertake B2C single brand retail trading through e-commerce. If an e-commerce entity with FDI undertakes the inventory-based model, then it could be considered to be undertaking (the currently prohibited) multi-brand retail trading e-commerce.

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One way to determine whether e-commerce entities are undertaking marketplace-based e-commerce is to examine the treatment of inventory or merchandise in their accounts. If they are accounting the merchandise or inventory in their own balance sheet, then they could be considered “inventory based models’ and will attract penal provisions of the applicable foreign exchange laws.

Operating guidelines for B2B e-commerce: Support functions, pricing of goods and services, and revenue generation

The DIPP has, for the first time, stipulated operating guidelines for marketplace-based e-commerce entities with FDI.

Support functions: E-commerce entities have been allowed to provide logistics, warehousing, order fulfilment, call center, payment collection, and other support functions to the sellers. These support services will allow e-commerce entities to generate revenues for themselves in addition to any commission or fee that may be charged from the seller. Leading e-commerce entities such as Amazon, Flipkart, Jabong, and Myntra provide warehousing services to sellers. As long as they are merely providing support functions to the sellers, they will not be in violation of the policy. PN3 also states that if e-commerce entities undertake payment collection, they should also ensure that their service is in conformity with the relevant RBI guidelines. These guidelines endorse the principles of a marketplace-based B2B model.

Pricing of goods and services: E-commerce entities cannot “directly or indirectly influence the sale price of goods or services” and are obligated to maintain a “level playing field”. This guideline has been seen as a measure to curb the predatory pricing tactics of e-commerce entities and to create a level playing field with offline traders. There have been allegations that leading e-commerce players, in order to attract customers on the platform, are using innovative methods to influence sellers to substantially mark down prices or provide deep discounts on their products and services. For example, some e-commerce entities such as Amazon refund the amount denoting discounts provided by the sellers on the platforms. Some e-commerce players like Patym provide cash back on the products purchased on the platform to the consumers. In a true marketplace-model however, sellers are in control of the pricing of the products and services, and any markdown or discounts on the maximum retail price on the platform are offered directly by the sellers. The e-commerce entity, which is merely a facilitator between the sellers and the consumers, does not influence the pricing of products and services offered by the sellers on the platform in any way.

While PN3 does not explain the parameters for determining “influence”, this guideline is expected to impact offline arrangements (such as the funding of discounts) between sellers and e-commerce entities as they may be considered to amount to influencing sale prices. Despite this regulation, many e-commerce websites continue to provide discounts and cash back offers. The pricing models adopted by sellers and e-commerce entities will need to be studied in greater depth to determine if e-commerce companies are in violation of this provision. The DIPP should clarify the intent of this provision to ensure that e-commerce companies with FDI are not violating this guideline.

Sourcing: E-commerce entities cannot derive more than 25 per cent sales on their platform from a single seller or any of the e-commerce entity’s group companies. This guideline is intended to ensure that e-commerce entities do not carry out B2C e-commerce in the garb of a marketplace model using convoluted business structures. This provision will definitely impact those e-commerce players who derive more than 25 per cent of their sales from their vendors or group companies. For instance, it is reported that both Flipkart and Amazon India generate sales beyond 25 per cent from their group companies, WS Retail Services Private Limited and Cloudtail India Private Limited, respectively. These e-commerce players will need to restructure their business models to toe the line with PN3. Further, there is no clarity on the duration for calculating the cap on sales, that is, whether this cap will be calculated on a financial year basis or otherwise. The DIPP should also clarify the intent of this provision to ensure that e-commerce companies with FDI are not violating this guideline.

Other conditions: The responsibility for the delivery of goods to the customer and customer satisfaction following a sale on the technology platform as well as providing any warranty or guarantee of goods and services lies with the seller. This guideline is in line with the principles of a marketplace-based model. If such responsibility lies with the e-commerce entity, then it will no longer be considered a mere facilitator, and any sale on its platform could take on the colour of B2C multi-brand e-commerce retail, which (as we have discussed previously) is currently prohibited, except for single-brand retailers and manufacturers.

The guideline on the delivery of goods by the seller, however, appears to contradict the guideline which allows e-commerce entities to provide support services to the sellers. This may be a drafting flaw, which the DIPP will need to clarify to ensure that e-commerce companies with FDI are not violating this guideline.

PN3 also states that e-commerce entities are permitted to enter into transactions with sellers registered on the platform on a B2B basis. This guideline is very ambiguous since it does not clarify what kind of B2B business e-commerce entities are expected to transact with sellers on. For example, if the sellers sell their goods to e-commerce entities, it would be considered as a B2B business since e-commerce entities are not the ultimate consumers. This would, however, violate the guideline that e-commerce entities gaining ownership over the goods will no longer be considered marketplace-based e-commerce entities. This ambiguity needs to be clarified by the DIPP.

Going forward – the search for a level playing field

The introduction of PN3 may encourage foreign investors, who may have been hesitant to enter this space till now due to a lack of regulatory clarity, to invest in the Indian e-commerce space. It also provides legitimacy to the existing businesses of e-commerce companies with FDI that have been operating on the marketplace model in India. E-commerce companies with FDI will definitely need to re-examine their business structures to ensure that they are in compliance with PN3.

Having said that PN3 may not really create a level playing field between e-commerce entities with FDI and e-commerce entities without FDI. PN3 could impact e-commerce companies that already have FDI or intend to raise FDI, but not e-commerce companies without FDI. While the FDI Policy will govern only those e-commerce companies with FDI, no similar restrictions apply to e-commerce companies without FDI under other laws. The latter category may, for instance, continue to provide deep discounts on similar products and services or generate revenues beyond 25 percent from a single vendor or group company. Further, there are no similar restrictions on offline retailers without FDI. The government, which is keen on attracting foreign investment in this sector, should re-examine this policy to ensure that the interests of both offline retailers as well as e-commerce entities are adequately protected. While PN3 is a good move, there is room for further fine-tuning a few aspects of the policy by the government, especially with respect to the pricing of products and services and limits on revenue generation.

Swetha Prashant is a Principal Associate at J. Sagar Associates. Divya Sinha is a Junior Associate at the same firm. The views expressed in this article do not represent the firm’s view in any manner.

Written by myLaw

Panama Papers: Explained by myLaw

We have been tracking the Panama Papers scandal with a lot of interest. The papers leaked to a German newspaper blew the lid wide open on thousands of offshore shell companies set up by Panamanian law firm Mossack Fonseca in tax havens around the world, implicating several politicians, heads of state, businessmen and celebrities from various countries. But where does India figure in all of this? What laws have the 500 Indians named in the documents allegedly broken? What could the consequences be? Amidst all of the noise and overwhelming amounts of information out there, join us as we make sense of it all and understand the Panama Papers from an Indian law perspective.

Written by myLaw

Governance rights, anti-dilution rights, exit mechanisms and other key elements of a shareholders’ agreement

PrivateEquityLawyer_AngiraSinghviShareholders’ agreements govern the rights and obligations of the shareholders. The company is also made a party to such agreements so as to make it binding on the company. Among other things, they set out the various rights of shareholders and provide for the conduct of business, the transfer of securities, and how to resolve deadlocks. Often, the company is also made a party to such an agreement and in an investment transaction, this is done at a “closing” by holding board and shareholders’ meetings that result in the amending of the original articles of association.

Governance rights

These rights set out the level of control that a private equity investor may exercise in the management of the target company.

The common methods of exercising control include:

– the ability to appoint the investor’s representatives to the board

The number of such representatives depends on the level of investment. In cases where the number of representatives is less than 50 per cent but more than 20 per cent, the investor attempts to ensure that the quorum required for any meeting cannot be complete without some or all of its representatives present and voting.

Where the parties cannot agree on such compulsory quorum requirements, a list of “affirmative vote” items is set out. These are items that the board cannot take a decision on without the investor’s consent. Some common “affirmative vote” items include entering into key agreements, the appointment of key personnel, the incurring of indebtedness and creation of security, and bringing about any changes to the business. How comprehensive this list of items is, also depends on the negotiations and the investment. For most startups, the investment is low and their independence in relation to the operations of the business is often instrumental to a transaction. Achieving a balance between such independence and the security of investment is a key point in the negotiations.

– provision of voting rights

In most cases, since the money is routed through a tax-friendly jurisdiction, investment is made in the form of compulsorily convertible instruments with a conversion pricing formula. This means that the instrument shall convert into equity at a later time (with a specific conversion event that should be clearly set out) under a formula that the parties agree on.

Until recently, it was assumed in the agreement that the instruments have already been converted into equity. The proportion of the investors’ (assumed) holding in the entire shareholding of the company would entitle the investor to exercise higher voting rights. After recent amendments to the company law however, only equity shareholders are entitled to vote. It is not clear whether convertible instrument holders can exercise their right to vote in the company. This may have substantially curtailed the voting rights of private equity investors. So while it may be safe(until challenged) to retain in the agreement, voting rights on the basis of an assumed conversion, there may even be a case to increase control at the board level until there is more clarity in the law.

Anti-dilution rights

Usually, in any investment transaction, it is stipulated that if the company carries out a share split, issue of bonus shares, consolidation of shares, combinations, recapitalisations or any similar event that may result in the dilution of the shareholding of the investor, including the issuance of any securities by the company, then the investors will be protected against any dilution of its shareholding in the company. For instance, it may be provided that the company shall take all necessary steps (including but not limited to the issuance of new shares) to ensure that the investors maintain their shareholding at the level prior to the occurrence of such event, without any consideration. However, in a case where there is additional funding required by the company and a party provides for such funding without a similar contribution by the other party, dilution of the non-contributing party cannot be avoided.

Transfer of securities and exit mechanism

At the time of investment, the terms of exit are also clearly set out in the transaction documentation. Sometimes, in a joint venture or a private equity investment, some restrictions are placed on a party’s right to transfer shareholding because their involvement in the company has some value that is not monetary alone. The common forms of restrictions placed on the transfer of securities are lock-in, right of first refusal or offer, tag along rights, and drag along rights. Further, unless there is a sale of the entire shareholding of the company to a competitor, a part of the shareholding is not permitted to be sold to a competitor.

Lock-in refers to a period following the closing of a transaction during which the investor will not be able to sell his shares to a third party. This restriction is essential to maintain a sense of continuity and settlement to the business. In private equity transactions, the investor is not the person who intends to run the business of the company. It invests in the capabilities of the promoters to run the business in a particular manner. In some cases, the involvement of the promoters is key to business and it is not ideal if the promoters divest their shareholding and cease to be a part of the business mid-way through the investment cycle. Therefore, a private equity investor will usually require an undertaking from the promoters that they will not exit from the business of the company, including through the selling of any shares.

Rights of first refusal or offer, and tag along and drag along rights are particularly important when either party wishes to sell its stake to a third party. Prior to the conclusion of such a sale, any of these restrictions in the shareholders’ agreement will require the selling party to offer its shareholding, first to the other shareholder party at a price at which it was contemplating the sale to a third party. In several cases, the selling party provides the other shareholder party an offer at which a third party is ready to purchase its shares. The shareholder party then gets a right to either accept or refuse such offer. Upon a refusal, the selling party is free to sell those shares to a third party but not at a price lower than the price that was offered or provided to the other shareholder party.

Sometimes, when the sale of shares to a third party is acceptable, the other shareholder party is also entitled to sell its stake along with the selling party to such third party. It is often the case that when the promoter sells its stake to a third party, the investor is no longer keen to be in the company or may not be keen to maintain such a high stake in the company any longer and may “tag” its shares along for sale to the third party. This is usually when the promoter retains some shareholding in the company.

The sale of an entire shareholding (known as a buyout) is usually governed by different terms and the provision of drag along rights are very common in such cases. Drag along rights refer to a right where a selling shareholder is entitled to drag the shares of the other shareholder and sell them to a third party at the same price and terms as that of its shares.

Exit rights

In mature private equity transactions, the investor is provided a basket of exit rights including taking the company to an initial public offer where preference is sometimes given to investors’ shares. There may also be provisions for the protection of investors’ money when things go wrong with the target company, a consideration that also influences the investor’s choice of instrument. In private equity transactions, usually, an internal rate of return or a pricing formula based on an acceptable manner of share valuation is determined at the very outset. At the time of exit, a put option is provided to the investor through which it can sell its shareholding to the promoter this pre-determined valuation. On some occasions, parties also have a call option where the other party’s shares may be purchased at a pre-determined value.

 

Angira Singhvi is a Partner with Khaitan & Khaitan and handles general corporate, joint ventures and private equity investments.

Written by myLaw

Learning to draft a termination clause? Start with the events of termination.

Drafting_for_Business_Deepa_Mookerjee.jpgAfter our discussions on condition precedent clauses, restrictions placed on transfer of shares, and the meaning of ‘call’ and ‘put’ options, let us now turn our attention to the termination clause, one of the last clauses we usually see in a shareholders agreement but no less significant. It is in fact a vital clause that contains the mechanism by which an agreement can be terminated and the shareholders can exit the company.

A termination clause typically contains two main elements: (1) the events of termination; and (2) the consequences of such an event occurring. In this post, let us look closely at some common events of termination:

– Material default by one party: Take the case of A Limited and K Limited, two parties to a shareholder agreement. K Limited commits a material default and is unable to cure that default within a specified period of time. A Limited should then have the right to terminate the agreement.

While drafting this clause, clearly define the term ‘material default’. This ensures that the agreement cannot be terminated for minor ingressions and that only serious defaults will trigger the clause. Also, it reduces the scope for parties to dispute whether a ‘material default’ has in fact occurred.

Next, the defaulting party should always be provided a specified time period (known as the ‘cure period’) to rectify the situation, and only the non-defaulting party should be given the right to terminate the agreement. Specify that to invoke this clause, the non-defaulting party must always send a written notice to the defaulting party.

– Deadlock: A deadlock typically occurs when parties are unable to agree on a vital issue necessary for running the business of the company. While drafting, always define a ‘deadlock situation’. An example could be a company’s inability to hold a board meeting on three consecutive times for want of quorum.

For example, if K Limited would like the company to take a loan and A Limited disagrees and whenever K Limited tries to organise a board meeting to discuss this issue, the directors representing A Limited do not show up and so since no proper quorum is constituted for a board meeting, it can be considered a ‘deadlock situation’.

Often, the occurrence of a deadlock situation can act as a termination event. Parties may feel that it is impossible to run the business in such a situation and they would rather terminate the agreement. Discuss with your clients whether they would like a deadlock to be a termination event or whether they would prefer to resolve the situation through other means (such as arbitration).

Further, if a deadlock situation is considered an event of termination, always specify a mechanism by which one party can send a written notice to the other party specifying that this is a deadlock and it would like to terminate the agreement.

– Insolvency of the company – A Limited and K Limited are shareholders in One Limited, a corporation that is bankrupt and going through insolvency proceedings. Obviously the shareholders will then wish to terminate the agreement since it is not possible to continue running the business. While drafting this clause, it is best to specify that the agreement will terminate automatically on the occurrence of this event. This will eliminate procedural steps such as a notice being sent by one party to another.

– Cancellation of the license required to carry on business: The shareholders agreement concerns a banking company. A bank requires a license from the Reserve Bank of India to carry on business. If this license is cancelled, the bank ceases to function. Therefore, cancellation of the license (in a regulated entity) should be drafted as an automatic termination event.

– Change in law (resulting in the business of the company becoming illegal): Currently, the law permits private entities to operate airlines (subject to the necessary approvals). Assume that over a period of time, the government changes the law and nationalises all airlines. This means that private entities can no longer operate airlines. Consequently, any shareholders agreement to operate a particular airline must automatically terminate.

There is one important distinction among termination events that comes to mind when we study these clauses – some do not result in automatic termination and require parties to send written notices to each other (for instance, in case of material default or deadlock situations) and in other cases, there is an automatic termination (in case of a change in law, insolvency, or cancellation of a license). Always keep this distinction in mind while drafting. Ask your clients whether they are comfortable with certain events leading to automatic termination. After all, the thumb rule while drafting is always to reflect the interests of your client.

Finally, remember that a termination clause usually comes into play when the parties are disputing or have an issue they cannot resolve. In such a scenario, it is necessary that the termination clause is clearly drafted and sets out in a very precise manner, the events of termination and their consequences. If the clause is open-ended or vague, it is unlikely the parties will be able to follow the clause since they will end up arguing over the very intent of the clause itself. As a lawyer, your role is to try to amicably resolve the dispute or at the very least provide the most efficient way to exit from a situation that cannot be resolved!

With this, we come to the end of this post. In my next post I will write about the consequences of termination.

Deepa Mookerjee is part of the faculty on myLaw.net.

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One regulation to rule them all: new LODR regulations will compel more transparency in listed companies

DeekshaSinghOnce a company is listed on a stock exchange, it is subject to a number of on-going conditions and disclosure requirements. It must comply with them in order to maintain its status as a listed company. While some of these conditions can be found in the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements), 2009, the majority can be found in the listing agreement between the company and the stock exchange on which the securities of the company are listed.

According to Section 21 of the Securities Contracts (Regulation) Act, 1956, when securities are listed on any recognised stock exchange, the issuing company must comply with the conditions of the listing agreement of that stock exchange. Simply put, a listing agreement is a statutorily mandated contract, between the listed company and the stock exchange where it is listed, which sets out various obligations of the company to protect the interests of the public shareholders and the capital markets at large. The Securities and Exchange Board of India (“SEBI”) has prescribed the format for a model listing agreement (“Model Listing Agreement”). You can find a version of the listing agreement that is substantially the same on the website of the National Stock Exchange here.

It is natural to wonder how listing agreements—which are private agreements between stock exchanges and the companies listed on them—can have the force of law. Even though they do not have the authority of law behind them, they have been treated as such so far.

To properly codify the requirements laid out in the listing agreement, the SEBI, in September, issued the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“LODR Regulations”). The LODR Regulations serve to consolidate and streamline the provisions of the various listing agreements in operation for different segments of the capital markets, such as equity listings, listing of debt instruments, preference shares, Indian depository receipts, securitised debt instruments, units of mutual funds, and any other securities that the SEBI may specify. Further, by issuing these regulations, the SEBI is ensuring that there is no overlap between regulations, as there used to be with listing agreements. All pre-listing requirements have been excluded from the LODR Regulations. They only deal with post-listing requirements.

BombayStockExchangeThe LODR Regulations have been divided into two parts. The substantive provisions are incorporated in the main body of the regulations and the procedural requirements are incorporated in the form of Schedules to the regulations. The LODR Regulations also capture the corporate governance principles found in Clause 49 of SEBI’s Model Listing Agreement.

Listed companies will still have to enter into a listing agreement within six months after the LODR Regulations come into effect. This version however, likely to be shorter than the one currently in use.

With the LODR Regulations and the listing agreements, the intent is to ensure that once a company is listed on a stock exchange and its shares are easily accessible to the public, the shareholders and the public should be able to evaluate the position of the company, and to avoid establishment of a false market in its securities. Investors must be informed of all significant decisions affecting the performance and future viability of listed companies. The LODR Regulations ensure this by providing a comprehensive disclosure framework that companies need to comply with to maintain their status after their listing.

Immediate effect of the LODR Regulations  

The LODR Regulations will become effective on December 1, 2015, with the exception of two regulations—Regulation 23(4) and Regulation 31A—that became effective on September 2, 2015, when the LODR Regulations were notified.

Regulation 23 deals with related party transactions, and sub-clause (4) of this regulation states that:

All material related party transactions shall require approval of the shareholders through resolution and the related parties shall abstain from voting on such resolutions whether the entity is a related party to the particular transaction or not.

This provision has been given immediate effect to bring the requirement for shareholders’ resolution for related party transactions in line with the latest amendments to the Companies Act, 2013.

Regulation 31A relates to disclosures relating to promoters and the re-classification of promoters as public shareholders under various circumstances.

There does not seem to be any apparent reason why these two provisions have been given immediate effect, except perhaps to indicate that active steps are being taken to meet corporate demand on the relaxations on these issues, as was done to amend the Companies Act, 2013 earlier this year.

Deeksha Singh is part of the faculty on myLaw.net.

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Learn to draft a share purchase (or subscription) agreement for a private equity transaction

PrivateEquityLawyer_AngiraSinghviOnce due diligence has been conducted on the target of a private equity investment and the investor, satisfied with the outcome of due diligence, is ready to invest, the stage is set for drafting the documents needed to complete the transaction. Drafts of these documents are usually prepared while the due diligence proceeds simultaneously.

The key documents

The documents that are fundamental to a private equity investment are (1) the share purchase agreement (“SPA”) or the share subscription agreement (“SSA”) depending on how the investor acquires shares in the target; (2) the shareholders’ agreement (“SHA”); and (3) the disclosure schedule. Since a private equity investor invests in the company for a fixed amount of time rather than in the assets owned by the company, asset transfers are quite rare.

An SPA provides for the transfer of shares to the investor. It is executed when the shareholders of the target company agree to transfer their shares to the investor. Under such an agreement, the investor purchases shares that are already in existence. An SSA on the other hand, provides for a new issue of shares. Such an agreement is preferred when parties decide that instead of the current shareholders transferring their shares to the new investor, the company would issue new shares to the investor. The investor subscribes to these new shares and hence the name, “share subscription agreement”.

An SHA provides for the rights and obligations of the parties inter se, that is, in relation to each other. It includes provisions for the manner in which the target company will be governed and run after the closing. Common items covered in an SHA are the appointment of directors, the conduct of board and shareholders’ meetings, shareholding, the raising of finance, and the transfer of shares.

A disclosure schedule sets out the documents and information that the target has provided or given access to the investor during the due diligence process or at any time before the execution of documents.

Let us now discuss these documents in greater detail. I will cover SPAs and SSAs in this article and SHAs and disclosure schedules in the next one.

As we have seen, an SPA or an SSA (as the case may be) provides the framework for the investor to become a shareholder in the target company. Let us now see some of the major issues that this document will cover.

Transfer or issue of shares

The agreement will state whether the shares are being issued or transferred to the investor. It will also set out the price at which the shares are being issued or transferred, the mode of transfer or issue, and the manner in which the consideration is transferred. While the transfer is stipulated in the agreement, it actually takes place during the board meeting that is conducted at the time of closing the deal. I will discuss the details of how this should be conducted in a later article on closing.

While drafting this clause, it is also useful to keep in mind certain specific aspects that may affect a transfer.

Documents in escrow: The parties may, for example, only want the transfer to take effect from a later date. Until that date, they may want the executed documents to be deposited in an escrow account. While drafting such conditions, you should be able to identify any procedural and secretarial issues such as those in relation to the validity of resolutions for a particular period or the validity of share transfer certificates. An escrow arrangement for instance, will not work unless those documents are valid for the entire period of escrow.

Sale to a foreign party: Similarly, a sale to a foreign party must adhere to the pricing norms contained in the FDI Policy.

Encumbrances: In the case of a transfer of securities, lawyers advising on the transaction should ensure that the transfer is free from all encumbrances. For example, the shares may be pledged to third parties against loans and advances or there may be a charge on the assets of the company. Due diligence should be thorough so that any such possibilities can be crossed out. Further, documentation should mention that all transfers are without any encumbrance. Charges can be searched on the Ministry of Corporate Affairs’ website and a lawyer can draft the ‘transfer’ clause accordingly.

– Authorised share capital: In case of a new issue of shares, a lawyer should also ensure that the company will continue to comply with the ceiling of authorised share capital after such issue. Under law, a company cannot raise more capital than the authorised share capital provided in its memorandum of association. In case the capital after the raise is likely to exceed this amount, the memorandum should be amended to reflect that.

– Nature of security: In case the issue involves a party resident outside India and the automatic route is intended for the investment, a lawyer advising on the transaction should also ensure that the nature of security is such that it is a plain vanilla equity or that is compulsorily convertible into equity and advise the client accordingly.

Conditions precedent to closing the transaction

On completing the due diligence, lawyers advising the investor will be able to identify some key items that the target entity should fulfil before closing the transaction. For instance, the target company may not have complied with some laws.

Some common conditions precedent include:

(1) that target entity should obtain some prescribed licenses;

(2) that it should issue appointment letters to its employees in a prescribed format;

(3) that it should complete the statutory books and pending filings;

(4) that it should obtain necessary corporate approvals and resolutions for entry into the transaction; and

(5) that it should obtain a valuation of shares.

The SPA or the SSA will contain these conditions. A condition precedent has to be fulfilled by the seller after the agreement is executed but prior to closing the transaction. The buyer usually has the option to provide an extension of this period or even to cancel any such compliance as a condition precedent if it is not fundamental to the investment. Common examples of such conditions are the obtaining or renewal of ancillary licenses, such as, the license to operate a lift. However, fundamental conditions such as the license to operate the business or any corporate approvals necessary to undertake the transaction, cannot be dispensed with.

The SSA or SPA will also provide a date by when each of the conditions precedent should be complied with. This is usually called the “long stop” date. The agreement will stipulate that unless the conditions are complied with by that date, the agreement, despite execution, will terminate and there will not be any closing of the agreement.

Closing

The “closing” is the point at which the transaction is completed. Shares are transferred, money is paid, the board undergoes changes, and the necessary corporate actions are undertaken to formally make the investor a part of the target entity. Closing is usually undertaken 30 to 60 days after the execution of transaction documents. During this time, the target entity fulfils the stipulated conditions precedent or seeks from the investor, a waiver from fulfilling them.

On the closing date, a board meeting is organised. The main actions undertaken at such meetings include the issue or transfer of shares (as the case may be); the appointment of directors nominated by the investor; and the approval of the amended form of the target’s articles of association and then placing them before the shareholders for final approval. We will discuss the need for such appointments and amendments in a later post on SHAs. The process of closing will also be discussed in detail in subsequent posts.

Following the board meeting, a shareholders’ meeting is also organised. Some matters that are passed by the board, such as an amendment to the company’s articles of association, require shareholders’ meeting for final approval.

Once the closing has been successfully completed, an investor formally becomes a part of the target company. All these aspects are stipulated in the SPA or the SSA usually after the clause on conditions precedent. This clause provides the time and date of closing and also lists out the actions that will be undertaken on the closing date. Since there are numerous actions to be completed, usually, it is provided that upon one last action being completed, all closing items will be deemed to have been completed. This clause also provides the manner in which consideration will flow from the buyer to the seller unless a separate clause on consideration is provided for. There are several ways in which a transfer of shares may take place. For example, it may be in dematerialised form or through the endorsement of share certificates. Consideration may be paid through cash, cheque, or wire transfer. All these aspects are provided for in the clause providing for transfer or issue of shares. Where the investor is a foreign entity, Form FC-GPR in the case of an issue of shares or Form FC-TRS in case of a transfer of shares, need to be filed with the Reserve Bank of India. After all these actions are completed, share certificates are finally issued to the buyer and then the closing is deemed to have been undertaken.

This clause has a large bearing on the completeness of a transaction from a procedural point of view. All items should be carefully listed and completed in accordance with company law and the applicable secretarial standards.

Representations and warranties backed by indemnity

You will remember from studying the law of contracts and sale of goods that representations and warranties are usually made by a seller to a buyer regarding the product that is up for sale. To understand this clause in the SSA or the SPA, you can consider the target company as a ‘product’ that is being sold by its current shareholders. Extensive representations and warranties are made to ensure there will not be any liabilities or adverse consequences for the investor.

They include representations and warranties about the authority and capacity of the parties in entering into the transaction; corporate matters, filings, resolutions and approvals; licenses and approvals for the transaction and business; business of the company; taxation, accounts and records; borrowings; intellectual property; related party transactions; assets; and litigation.

As lawyer advising the investor, you should ensure that your list of representations and warranties should be extensive and cover every aspect in relation to the target company. A lawyer advising the target company will attempt to narrow down the list. For example, if the target company has already provided the investor with some information during the due diligence, you may refrain from providing any representation or warranty on that very aspect as the investor is expected to know the correct state of affairs. Also, if the investor has clearly come to know of any shortfall in the company’s affairs, you may not want to provide a representation or warranty to that item.

These representations and warranties are backed by indemnity. While agreeing to indemnify the investor, the company and its current shareholders promise to save the investor from any loss caused to the investor for any breach, falsity, or shortfall of the representations and warranties. It is important to draft the clause on indemnity carefully to ensure that liability is predictable. A company will want to cap its liability as much as possible while an investor will want to do the opposite.

This brings our discussion on drafting SPAs and SSAs to a close. I will discuss SHAs and disclosure letters in my next post.

Angira Singhvi is a principal associate with Khaitan Sud and Partners and handles general corporate, joint ventures and private equity investments.

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Doing solid due-diligence for a private equity investment – here are the key steps

PrivateEquityLawyer_AngiraSinghviEvery private equity investor conducts due diligence on a target before the transaction is finalised and the documents are executed. Through this, a third party (and even the target entity itself) is able to know its actual position vis-a-vis the standards in various sectors.

With a legal due diligence, an investor wants to:

– ensure that the information provided by the target (and which forms basis for the investment) is accurate;

– find out any additional information the advisors should have been told, but were not;

– probe into the assumptions in the business plan and evaluate the possibility of achieving the targets set;

– identify the principal risks to the business and chalk out a mitigation plan; and

– conduct a more detailed analysis of the current state of the company.

There are several types of due-diligence, such as legal, financial, operational, and environmental. As lawyers advising on a private equity transaction, your focus area will be on the legal due diligence.

The term ‘legal due diligence review’ (“LDDR”) refers to the evaluation of whether the target entity has compied with various laws in letter and in spirit. This helps in identifying the major legal risks faced by the investor. Let us look at the steps involved in an effective LDDR.

Step 1: Prepare and circulate the LDDR checklist

An LDDR checklist will note all the possible documents needed from the target entity and to sub-divide them, they are typically grouped based on the areas of law.

Checklist

Image above is from Oliver Tacke’s Flickr account and has been published under a CC BY 2.0 licence.

For example, you will need the incorporation documents of the target, the details of the shareholding and transfers made, the contracts that the company has entered into with third parties, environmental compliances, certificates of payments made under the Payment of Bonus Act and so on. You can accordingly sub-divide the LDDR checklist into main sections such as “General Corporate”, “Shareholding”, “Material Contracts”, “Finance”, “Employment”, and “IPR”. These sections can then be further sub-divided.

For instance, the general corporate information required from the target can include:

–  the company’s certificates of incorporation and commencement of business and the memorandum and articles of association, along with all amendments that have been made so far;

– the addresses of the registered office of the company, other office(s) of the company, and other locations from which the company operates;

– the legal structure of the group of which the company is a member, preferably in the form of an organisation chart, stating the names and addresses of all the companies in the group with the percentages of participating interest and describing the relationship between the company and other affiliated group companies, partnerships, and (un)incorporated business associations within the group;

– a summary of the history of the company;

– a brief description of the company business, for example, the business areas, the main products in each, and geographical presence;

– the details of any alliances entered into or to be entered into by the companies including copies of the agreements;

– the details of any branch, agency, place of business, or any permanent establishment of the company outside India including address, brief description of business carried on and numbers of personnel involved;

– the copies of all documents relating to any scheme, merger, amalgamation or restructuring, asset transfer, or acquisition involving the company or any of the group companies or subsidiaries.

The intention, as you can see, is to obtain as much information as possible.

Step 2: Know all the applicable laws

For an effective LDDR, the legal advisor should be aware of all the laws applicable to the target’s business. It is important to assess whether the target has complied with all thse laws and the consequences of any non-compliance. These consequences may pose risks for the target company and therefore, the investment as well.

For example, if the target is required to obtain a particular license prior to manufacturing a product and if it has not been obtained, there is a risk of having to cease the manufacturing activity. This may lead to immense losses to the target and therefore, the investor. Unless you know that this license was required, you will not be able to assess whether the company has complied with this legal obligation.

It is also important to understand the application of local laws. Land laws, for example, vary from state to state. Depending on the state in which activity is carried on, all applicable local laws should be identified.

Step 3: Review and comprehensively analyse documents

After circulating the LDDR checklist, a representative of the target entity, usually their lawyer or company secretary, will assess the applicability of each point. The relevant documents are then provided to the investor’s legal advisors.

documentsThese documents should be reviewed in detail by the lawyer and all possible outcomes should be analysed. For example, in case of an outstanding term loan shown in the books of the target, you should analyse all the restrictions in the term loan agreement such as whether any further funding (by the investor) is permitted, whether there are restrictions on the payment of dividend to the investor, and whether the charges are enforceable. If these activities require the prior permission of a lender, it may not be easy to recoup the investment. If an outstanding loan is shown in the balance sheet, for instance, all relevant documents should be obtained from the target in order to assess any restrictions on the investment, the enforceability of any charge, and the value of secured assets.

To take another example, agreements that reflect the business of the target need to be obtained and evaluated. Often, agreements have not been entered into and some times, such contracts have been entered into with related parties. This can be seen from the corporate details provided by the target. If there are any related party agreements, you should check whether all the required provisions have been complied with.

Since the LDDR is an investigative activity, it is important to keep your eyes and ears wide open. Often, attempts are made to hide information that may be detrimental to an investment. A glaring example is the Ranbaxy transaction. Important information was concealed during the due diligence and as a result, the joint venture party incurred losses. You may need to request the target for clarifications and seek further information backed by documents before you are satisfied on all the issues.

Step 4: Think about what can be done to mitigate risk

After the review of all the documents, you will often notice that further action is required to mitigate the investors’ risks. Usually, they belong to the following categories:

(i) obligations that have to be fulfilled as a condition precedent to closing the investment;

(ii) representations and warranties backed by indemnity;

(iii) creation of escrows; and

(iv) conditions subsequent.

For instance, after the review of loan documentation, you may conclude that prior permission is required before additional funding is brought in. It is your duty to make your client aware of this stipulation and then include it among the conditions precedent to closing the transaction.

Similarly, if the target is facing litigation with respect to an event prior to the investment, the investor should not be required to bear its costs. The amount of potential loss should either be set aside in an escrow or adequate representations and warranties backed by indemnity should be stipulated in the transaction documents.

Step 4: Draft and finalise the LDDR report

The outcomes of an LDDR exercise are usually set out in a report. Depending on your understanding with the client, it may either be a long form report or a report setting out only the main issues.

You should bear in mind that the report should be structured in a manner that all sections are classified and organised in the order of importance. Issues should be clearly identified and all risk mitigation solutions should be clearly set out.

In my next post, I will discuss the transaction documents in a typical private equity investment.

Angira Singhvi is a principal associate with Khaitan Sud and Partners and handles general corporate, joint ventures and private equity investments.

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The four types of laws that all private equity lawyers must know

PrivateEquityLawyer_AngiraSinghviTo advise on private equity investments and their structure, lawyers need to be aware of the many laws that affect transactions. Let us look at the four major categories of laws that can regulate a private equity transaction.

1. Foreign investment laws

When investment flows in from countries located outside India for investment in some business activity and not merely stock or trading, the amount is treated as foreign direct investment (“FDI”) and the investment needs to comply with applicable regulations. Many private equity funds are based out of tax havens such as Mauritius and the British Virgin Islands and FDI is routed through such jurisdictions.

Every year, some time in the months of April or May, the Ministry of Commerce and Industry issues an FDI policy, governing areas such as the kind of instruments that may be issued, sectors in which investment may be freely made, and the procedure of issue. The policy is reviewed every year and changed if necessary.

Depending on factors such as the business sector, the nature of the instrument, and the intended percentage of shareholding, FDI can fall under the automatic route or the government route. Under the automatic route, the investor can directly invest into the target company without obtaining any prior approval from the government. Under the “government route” or the “approval route”, prior approval is required from the Foreign Investment Promotion Board. For example, prior government approval is necessary in mining, coal and lignite, and real estate unless some prescribed conditions are complied with.

The Foreign Investment Promotion Board is housed in the Department of Economic Affairs of the Ministry of Finance.

The Foreign Investment Promotion Board is housed in the Department of Economic Affairs of the Ministry of Finance.

Structure of the target: FDI investment into a company or a venture capital fund (not being a trust) is most straightforward because there are fewer restrictions and the investment is permitted through the automatic route. While investors may prefer investing in trusts and LLPs to take advantage of tax and operational benefits, additional structures are required for an FDI investment.

Types of instrument: Indian companies can issue equity shares; fully, compulsorily, and mandatorily convertible debentures; and fully, compulsorily, and mandatorily convertible preference shares under the automatic route subject to the pricing guidelines or the valuation norms prescribed by the regulations under the Foreign Exchange Management Act, 1999 (“FEMA”).

Convertible instruments get converted into equity after a specified period of time. A prescribed conversion formula determines the value of that instrument or the equity shares to be issued. Unless they are compulsorily convertible, they do not fall within the category of permitted instruments under the automatic route.

All other instruments (including optionally convertible instruments) are considered debt and require compliance with the Reserve Bank of India’s guidelines on external commercial borrowing.

The price or conversion formula at the time of conversion of a convertible capital instrument should be determined at the time of its issue according to any internationally accepted pricing methodologies and on arm’s length basis for unlisted companies. For listed companies, a valuation has to be made under the Securities and Exchange Board of India( Issue of Capital and Disclosure Requirements) Regulations.

In order to use the automatic route, the instruments need to be fully paid up and comply with the pricing norms, failing which, the government’s prior approval is required.

Reporting of the investment: The FDI policy requires that any amounts received by the target entity against capital should be reported to the Reserve Bank of India. An amount received against the transfer of existing shares should be reported by filing Form FC-TRS. An amount received against the issue of new shares should be reported by filing Form FC-GPR.

Business sector: FDI policy restricts the level of investment in certain sectors. In such sectors, investment above a certain percentage of the total shareholding requires the prior approval of the government. In some sectors, even indirect shareholding or control is not permitted. For example, in defence production, air transport services, ground handling services, asset reconstruction companies, private sector banking, broadcasting, commodity exchanges, credit information companies, insurance, print media, telecommunications, and satellites, no transfer is permitted that may result in ownership or control by foreign entities.

2. Laws governing listed companies

Acquisition of shares: Ordinarily, shares are freely transferrable in listed companies (unless there are agreements to the contrary). Some provisions of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (“Takeover Regulations”) however, can hinder the acquisition of shares in a company.

Any acquisition of shares or voting rights that will give the acquirer (or persons acting in concert with the acquirer) 25 per cent or more of the voting rights in the target company can only go forward after the acquirer makes a public announcement of an open offer to acquire at least 26 per cent of the voting shares from the public shareholders of the target.

The Takeover Regulations also lay down norms that apply to acquisitions where the acquirer already holds or controls a substantial amount of shareholding in the target company. Further, under Regulation 4 of the Takeover Regulations, irrespective of the acquirer’s shareholding or voting rights in the target company, it shall not acquire control over a target company without making an open offer for acquiring shares.

The term ‘control’ is significant for private equity transactions because investors tend to insist that their active consent should be taken before any main action affecting the company is taken, such as any future financing, entering into any agreement above a certain value, appointment of directors, deciding upon agenda of board and shareholders’ meeting, restrictions on sales and company assets, and sale of shares to third parties. Even when they have a minority stake in the company, they insist upon such rights and often, this list is so wide that it may be interpreted as exercising control over the company.  According to the SEBI, an agreement that incorporates such a condition would give the private equity firm ‘control’ over the company even though its shareholding is not high enough to trigger the Takeover Regulations.

In addition to the requirement of having to make an open offer, the target company and its board of directors become subject to a few other obligations. For instance, during the offer period, no person representing the acquirer (or any person acting in concert with him) can be appointed as a director on the board of directors of the target company.

If the private equity investor decides to acquire the entire public shareholding resulting in the delisting of the company, even more regulations apply in the form of the Securities and Exchange Board of India (Delisting of Equity Shares) Regulations, 2009 (“Delisting Regulations”). The company must be listed for a period of at least three years and the delisting cannot result from a buy-back or preferential allotment of shares by the company.

3. Insider trading regulations

It is an offence under the Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 2015 to ‘deal in securities’ while in possession of unpublished price-sensitive information, that is, any information that, if published, is likely to affect the price of the securities of a company. The Companies Act, 2013 has also introduced provisions on insider trading. Section 195 of the Act, which applies to unlisted companies also, lays down punishments of imprisionment and hefty fines for their contravention.

4. Other company law aspects

Since private equity investments are usually made in companies, a detailed understanding of the Companies Act, 2013 (“Act”) is necessary before advising on transactions. Some of the important provisions are discussed here.

Layered investment: Investments through more than two layers of investment companies, preffered by private equity investors because of their tax efficiency, are not permitted under the Act.

Restrictions on transfer of shares: Unlike its predecessor, the Act allows shareholders of ‘public’ companies to enforce restrictions on the transfer of securities. Private equity investors therefore, can freely stipulate conditions on the transfer of shares such as drag-along rights, tag-along rights, and right of first refusal (all of which will be explained in detail in a later post on transaction documents). The Act only protects these conditions as if they are a contract between private persons, and so, to bind the company, it may be advisable to incorporate these provisions into the articles of the company.

Differential voting rights: The Act also contains provisions relating to different classes of shares. Barring a few situations, private companies cannot issue preference shares with voting rights.

Representation on the board: In order to safeguard their investment, private equity investors usually nominate one director to the board of the target company. As their legal consultant, you should be able to advise the investors about the consequences of such an appointment. A director who becomes ‘aware’ of any contravention by way of his participation or receipt of information and does not object to such contravention can be subject to prescribed punishments. Such liability extends to non-executive directors as well.

Amendments to a company’s articles: The articles of a company are amended following a private equity investment to reflect the amended understanding amongst shareholders. You should verify whether the current articles of the company contain any provisions that may only be altered after following procedures that are more restrictive than those applicable in the case of a special resolution, and that these procedures are complied with at the time of the closing. Such provisions may also be inserted in the articles to protect the interests of the investor in its capacity as a minority shareholder.

Apart from these major laws that are essential to advice on private equity transactions, some other laws are important at the stage of conducting due diligence over the target. Let us look at those laws in a later post on conducting due diligence.

Angira Singhvi is a principal associate with Khaitan Sud and Partners and handles general corporate, joint ventures and private equity investments.

 

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