Reported by: banking|Updated: September 23, 2016
While structuring cross border transactions involving transfer of shares, one of the key aspects always debated and negotiated is indemnity by the seller to the buyer. Another key aspect is the final total consideration/ valuation.
The RBI notification of 20 May 2016 amending FEMA 20 addresses both these aspects, albeit to a certain extent, by permitting indemnity payments and deferred consideration with an escrow mechanism.
Prior to this RBI notification, the right of the buyer in a secondary share purchase transaction to seek an indemnity claim would be structured as a contractual one requiring compliance by the seller. Additionally, if the seller were an Indian resident, indemnity payment to a non-resident would also trigger the necessary regulatory approvals.
INDEMNITY RELATED ASPECTS
With the 20 May notification, the RBI seems to have made a sincere attempt to address the indemnity related aspects. It would now be possible for the buyer and seller to have an escrow arrangement in place to deal with indemnity provisions in the contract. The indemnity amount can be placed in such escrow and the mechanism can be documented to detail the manner in which the indemnified party/ buyer can receive the amounts placed in the indemnity escrow. The indemnity payment permitted under such arrangement is a maximum of 25% of the total consideration and the escrow arrangement can be for a maximum of 18 months from the date of payment of the full consideration.
Indemnity provisions are intended to protect the buyer from any regulatory or third party claims that may come up post the consummation of the transaction. Given the ability of regulatory authorities to make a tax claim for 7 financial years and the law of limitation for general claims being 3 years, the buyer would typically require/ seek protection for such period. In certain cases, the extent of indemnity cover sought by the buyer could be higher. Such arrangements will still require to be appropriately structured and may not fully benefit from the 20 May notification given the 18-month time period for the escrow arrangement and the 25% limit on the indemnity amount that can be placed in escrow.
As regards the other key aspect of final total consideration/ valuation, most often, the buyer and seller may not be able to pin this down. One of the reasons for this is that the seller would have based his valuation on a very optimistic basis and the buyer would be inclined to accept a more conservative projection. This leads to a certain gap in the final consideration. Deferred consideration/ pay-out is ordinarily the way in which such deals could be structured, although Indian law did not permit such deferred consideration arrangements under the automatic route for cross border transactions where the buyer is the non-resident party. Accordingly, parties have had to approach the regulatory authorities seeking approval for such deferred consideration arrangements.
With the 20 May notification, the RBI has, to a certain extent, addressed this issue. Pursuant to the notification, parties can now structure the transaction with a deferred consideration and escrow mechanism. Here again, the deferred consideration/ pay-out can extend to a maximum of 25% of the total consideration and the escrow arrangement can be for a maximum of 18 months from the date of the transfer agreement.
Unlike in the case of indemnity pay-out in terms of quantum and time period, a 25% deferred consideration during an 18-month period should facilitate many transactions.
The prior instance of permitting an escrow arrangement for facilitating FDI transactions was in 2011 when a 6-month escrow was permitted under the automatic route. The escrow under circular 58 of 2011 was permissible for primary as well as secondary transactions. Primary FDI transactions will continue to be governed by circular 58/ Deposit Regulations and secondary cross border transactions will henceforth be governed by the 20 May notification, with parties having to ensure compliance with applicable pricing guidelines.
The provisions governing permitted debits and credits in the Deposit Regulations may require to be addressed given that the monies in escrow under the May 20 notification could move to the buyer as well as the seller in case of indemnity/ deferred pay-outs. The non-interest bearing nature of the escrow will also require to be considered in light of the 18-month period and the quantum of amount in escrow, at least where the Indian party is placing the monies in escrow.
The 20 May notification will definitely ease the structuring of transactions without having to adopt complex mechanisms to address the indemnity and deferred pay out arrangements or seek approval from the regulatory authorities.
Raj Ramachandran is a Partner with J. Sagar Associates, Advocates and Solicitors. The views are personal.