India's strategy of proactively seeking foreign direct investment (FDI) to stimulate its growth is well known and can be traced back to the wide-scale economic reforms undertaken towards the end of the twentieth century.A decade later, the paradigm shift that has taken place can be better observed with Indian corporate houses demonstrating a burgeoning appetite for acquiring foreign...
India's strategy of proactively seeking foreign direct investment (FDI) to stimulate its growth is well known and can be traced back to the wide-scale economic reforms undertaken towards the end of the twentieth century.
A decade later, the paradigm shift that has taken place can be better observed with Indian corporate houses demonstrating a burgeoning appetite for acquiring foreign entities instead of merely being passive recipients of FDI. While the headlines may be hogged by big ticket deals like Bharti Airtel's purchase of the African assets of Zain Telecom and Tata Steel's acquisition of Anglo-Dutch steel manufacturer Corus Group Plc., the diversity in profile of Indian acquirers is increasingly on the rise.
Passage Out of India
The number of mid-sized Indian companies involved in, or actively contemplating, outbound transactions within the range of USD 5 million and USD 500 million has witnessed an upsurge for a multitude of reasons. This includes the desire to gain a foothold in international markets by inheriting the existing clientele and corporate brand name of the target company. For this reason, M&A is preferred over other available routes such as greenfield investments, because it entails a shorter gestation period.
Access to foreign technology and licensed intellectual property also lures many an Indian company into the international M&A game, especially those in the pharmaceuticals, engineering and automotive sectors. Erosion of artificial trade barriers has meant that even smaller firms can now look beyond the confines of their domestic markets for raw materials, technology and intellectual property and larger markets.
The growth of outbound M&A can also be attributed to several macroeconomic reasons. India is reaping the benefits of abandoning a command economy regime for a more market oriented approach which has been augmented by progressive liberalization of the law governing outflow of funds from India, thereby aiding foreign acquisitions by domestic companies. The global economic recession has proved to be a blessing in disguise for acquirers, who have capitalized on a situation of lowered valuations of businesses in recession hit economies.
Liberalization and Rationalization - the RBI Way
Companies contemplating outbound investment need to be mindful of regulatory norms applicable to such transactions. Other than adhering to legal requirements particular to the jurisdiction of the target company, the Indian acquirer also has to comply with restrictions imposed by domestic authorities. Chief of these is the Reserve Bank of India (RBI) which, under the authority issued to it by the Foreign Exchange Management Act, 1999 (FEMA), regulates capital account transactions through the Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations 2004 (FEMA 120) as well as circulars and notifications issued by it from time to time.
Under the existing regulatory framework, direct investment via outbound M&A is permitted in a JV (if stake acquired is partial) or WOS (if entire equity in an existing company is acquired or a new company is set up) so long as subject matter of the investment is not a prohibited activity. Real estate business is a prohibited activity but development of townships or construction of roads, bridges and commercial or residential premises are excluded from the ambit of prohibited real estate activity.
Investment in banking business is yet another prohibited activity which requires prior approval of the RBI. Other than these, direct overseas investment can be made in any activity under either the automatic route, which does not require prior approval from the RBI, or the approval route which covers all applications that do not fall under the automatic route. Investment by or in companies engaged in the financial sector would require fulfillment of an additional set of conditions.
Certain criteria are also required to be satisfied in order for a transaction to fall under the automatic route. Prominent among these is that the size of the investment should not exceed 400% of the net worth of the acquirer company. Included in calculating this ceiling limit of 400% are capital contributions to the target entity made by acquirer as well as loans granted or guarantees issued to or on behalf of the JV or WOS.
Funds originating from the acquirer's Exchange Earners' Foreign Currency Account or from issue of American Depository Receipts (ADRs) or Global Depository Receipts (GDRs) will be excluded while determining such threshold. Recently, the RBI liberalized the extant norms for calculating the net worth by reducing the amount in respect of performance guarantees issued by the domestic acquirer from 100% to 50%.
The aforementioned relaxation, which increases the permissible exposure limit of a domestic firm to overseas investment, should further boost participation in outbound M&A, especially in respect of smaller companies. Relaxation from the requirement of valuation of acquired shares by a registered Category I Merchant Banker registered with SEBI is granted by RBI for investments less than USD 5 million, which could encourage midsized companies to opt for value based buys. Such changes clearly reflect RBI’s approach leaning towards creating policies which will help Indian companies explore outbound M&A.
Amalgamation - Tricky Terrain
The term 'amalgamation', as understood with reference to the Income Tax Act, 1961 (IT Act), means the merger of two or more companies so as to form one entity. The Companies Act, 1956 (Companies Act) stipulates certain procedural formalities which need to be fulfilled in order to effect an amalgamation - a term which has not been defined in this statute.
This is an extremely onerous process and involves, among other things, conducting various meetings, passing a special resolution approving the scheme of amalgamation by members, obtaining approval of scheme of amalgamation by the High Court and making necessary filings before the Registrar of Companies. Listed companies would additionally have to keep the concerned stock exchanges aware about the proposed transaction.
Fulfillment of these requirements has several negative implications including increased costs, lengthier timeframe for execution of such transaction and introducing the proposed deal within the domain of public knowledge. For this reason, Indian companies have formulated their M&A transactions so as to avoid the strictures under the Companies Act attached to amalgamation. Also it must be noted that the Companies Act does not permit amalgamation when an Indian Company is a transferor company.
Curtailing Combinations
The Competition Act, 2002 (Competition Act) regulates business combinations, which includes mergers andamalgamations of enterprises. The Competition Act is relevant even in case of outbound M&A as the regulator under this statute, Competition Commission of India (CCI), has been granted extra-territorial jurisdiction. In case the M&A causes the combined value of the acquirer and target company to exceed certain threshold limits in terms of asset value or net turnover, it will be deemed as a combination.
The legal effect of being classified as a combination under the Competition Act is that the Indian entity would need to intimate the CCI within a period of 30 days from entering into an agreement or obtaining approval by the companies' Board of Directors for the same. Furthermore, the combination cannot come into effect until either the CCI has passed an order determining whether the combination in question will have an appreciable adverse effect on competition, or upon expiry of 210 days from date of giving notice to the CCI - whichever event takes place sooner.
This extended review period has attracted widespread criticism for being highly unrealistic and out of sync with the realities of modern day commerce. An exemption has been granted, for a period of 5 years starting from March 4, 2011, to certain combinations where value of combined assets or turnover exceeds thresholds by a comparatively smaller margin, which should be a source of encouragement for mid-sized companies with outbound aspirations. Though the CCI is attempting to be highly responsive, only time will tell, if delays from CCI could prove to be a cause of worry for M&A activities.
Navigating a Regulatory Minefield
Designing a suitable structure, a key element in any M&A transaction, becomes a paramount issue in a cross border deal due to the fact that the model needs to be tailored keeping in mind the regulatory concerns of multiple jurisdictions. Although FEMA 120 permits various methods for funding overseas direct investment in JV/WOS, deals involving Indian acquirers have historically been executed using cash payouts. This is because alternative methods, although commercially suited for an Indian acquiring entity, come attached with a basket of compliance requirements and procedures that would turn off any potential investor.
For example, swap of shares would result in transfer of shares to non-residents - thereby attracting the applicability of FEMA regulatory framework to such a transaction. Another disadvantage of employing share swaps is that such issue has to obtain prior approval of Foreign Investment Promotion Board and abide by sectoral thresholds as prescribed under the Foreign Direct Investment Policy laid down by the Indian government. In recent times, access to large-scale debt has become tougher due to a reduced appetite for risk in the domestic debt market.
Approaching capital markets involves carrying out wide-ranging compliance-related formalities and is not cost effective for smaller companies. Such entities are hence considering approaching private equity players for funding, which especially is an alternative avenue for ambitious companies possessing a strong balance sheet and exhibiting dynamic growth potential.
As the FEMA regulatory framework specifically permits investment abroad through the mechanism of special purpose vehicle (SPV) under the automatic route, it should be deployed by companies so as to obtain the benefit of relaxed regulatory norms in foreign jurisdictions regarding obtaining finance and availing of tax benefits among others. To this end, companies may choose to structure a single-tier or two-tiered SPV depending on the regulatory fit between India, the jurisdiction of the target company and that of the first level SPV entity in terms of lowered tax incidence and ability to channel funds with minimal spillover.
Another vital consideration, which is often neglected at the time of framing the acquisition structure, is for the likelihood of issues cropping up at a later stage. For example, if the control and management of a company incorporated outside India lies in India then such entity may become liable to be taxed as an Indian resident, thereby negating the benefits of its incorporation in a tax-friendly jurisdiction. With the Direct Taxes Code in the offing, a paradigm shift in structuring deals is expected in the days to come.
Overseas Investment
An Emerging Reality With India's domestic economy growing steadily, despite global markets being stuck in the doldrums, the phenomenon of outbound M&A by Indian firms is all set to gain momentum. Focussed efforts by regulators to liberalize and streamline the existing framework will provide a fillip to smaller firms, which now bear the brunt of a multitude of red tape and procedural formalities. The emerging breed of corporate counsel in India, capable of tweaking tried and tested deal structures to suit the needs of individual clients, should therefore expect to remain busy in the near future.