RBI’s Restrictions On Deferred Consideration: Ready For Covid-19 Second Wave?BloombergQuintOpinion
In cross-border transactions, deferred consideration is one of the most useful means of resolving differences in the valuation of companies between buyers and sellers. It means only a part of the consideration for shares is paid at the closing of a transaction, with the rest being paid later, perhaps based on future performance. However, foreign investment into India is constrained by various limitations in respect of deferred consideration. This is due to the FEMA (Non Debt Instruments) Rules, 2019, and the Consolidated FDI Policy of 2020, which stipulate that only 25% of the total consideration may be deferred, for a maximum period of 18 months, termed the ‘18-25’ limit.
This is further exacerbated by the Reserve Bank of India’s requirement that an externally certified fair value be agreed on upfront and paid to an Indian seller, whereas globally, a price agreed between a willing buyer and a willing seller constitutes fair value in and of itself. Correspondingly, the adjustability against price gets tied to this number and becomes inflexible towards the negative. Such restrictions are absent in most developed jurisdictions and represent the RBI’s efforts to monitor the inflow and outflow of foreign exchange and to ensure that Indian parties get the full value of their equity without undue delay.
Deferred consideration was completely prohibited except through RBI approval until 2011. In 2016, the RBI amended the FEMA (Transfer or issue of security by a person resident outside India) Rules, 2000, and brought about the ‘18-25’ limit in operation currently.
This move, hailed as radical in 2016, may today be considered archaic and impractical, especially in light of the changing landscape of private equity and M&A.
This necessitates a critical evaluation of the ‘18-25’ limit, which has been attempted here. While these limits may be exceeded with the RBI’s approval, and though the RBI has improved its responsiveness, the approval process does cause undue and unpredictable delays.
The Impact Of Covid-19
Undoubtedly, the pandemic has caused an unprecedented jolt to the global economy. Not only have business revenues and the values of acquisition deals deteriorated, but there has also been a significant impact on deal structuring. The uncertainty and slowdown caused by the pandemic create greater scope for disagreements on valuation, especially in complex cross-border deals. While sellers would vie for pre-Covid valuations of their company and remain confident about future performance, buyers would naturally require mitigation of risk, both in terms of the present and future performance of the company. In such situations, deferred consideration structures can significantly alleviate the concerns of both parties and enable the seller to get the maximum valuation possible, while also leaving reasonable recourse to the buyer.
Whenever there is significant uncertainty in the business climate, deferred consideration structures assume importance. For example, the 2008 recession led to a tremendous increase in the use of earn-outs in the developed world.
It is widely opined that these trends will persist even in the aftermath of the pandemic.
Liberalising ‘18-25’ Limit: Making The Case For A 3-Year Limit
Viewed in the global context, where deferred consideration is being used in an increasing number of deals, the RBI’s restrictions significantly affect the ability of Indian parties to structure their transactions and obtain the best value for their companies.
18 months is simply too short and 25% of the purchase consideration, too less. Naturally, it would affect the value of foreign investment into Indian companies since beyond the 18-month period, investors can neither structure higher prices in installments nor on the basis of future earnings of the company. Moreover, there does exist a possibility that sellers attempt to inflate the value of the company prior to an acquisition or a funding round. Due diligence prior to transactions, while helpful, may not always present a complete or accurate picture for the simple reason that most of the information being relied upon is supplied by the seller.
The 18-month limit in most cases would only afford the buyer one audit cycle to evaluate the actual state of the company after the transaction, and thus, even if any ‘creative accounting’ is discovered subsequently, there will not be any direct recourse to the purchase consideration itself.
Further, the time limit of 18 months commences from the date of execution of the transaction documents and not closing, which is when the share transfer actually becomes operational, the consideration is paid, and the new owners/investors begin to assume control. Hence, in cross-border transactions, where often a significant period of time elapses between the date of execution and closing, buyers have an extremely shortened window to evaluate the affairs of the company, and vary the consideration on that basis.
Impact On Indemnities
In terms of the ‘18-25’ rule applying to indemnity holdbacks or escrows, the full consideration must be paid and only 25% of the same may be held back or placed in escrow for indemnities, for up to a period of 18 months. This leads to certain anomalies in the context of contractual indemnities in India.
First, the statutory period of limitation for contractual indemnity claims is 3 years, with the ‘18-25’ rule effectively halving the ‘secured’ time available to a buyer.
Second, the nature of representations and warranties usually determine the extent of indemnification. For example, indemnification on fundamental breaches, title of shares, or the capacity of parties to transact, is usually uncapped and may extend to the entire amount of consideration.
In such extreme situations, the recourse available is quite apparently insufficient. Moreover, it is common for investors to rely on specific indemnities, which often pertain to the full consideration amount, and are used as a tool to resolve gating issues that may prevent or significantly delay closing.
In order to remedy these issues, we believe that the time limit for deferred consideration must be extended to a period of at least 3 years, with an extension where a dispute is initiated. This would ensure at least two audit cycles before the final consideration is due, and thus afford buyers sufficient time to evaluate the company without the effects of any padding of valuation that may have taken place, while at the same time remedying the contrast with statutory limitation.
Additionally, if the threshold of 25% is made flexible, it would sufficiently address the issue of parties being severely restricted from structuring their transactions effectively, as well as render the Indian position on par with global standards. The monetary threshold also needs to be adjustable negatively within the fair value determined for the purposes of the RBI’s pricing guidelines as reasons for adjustment do actually represent negative factors determined post facto.
With the second wave of Covid-19 underway, it is hoped that the government and the RBI are alive to the shortcomings in this policy, and are prepared to do the needful at the earliest.
Arjun Rajgopal is Partner, Abhilasha Gupta and Abhiroop Saha are Associates - M&A and Private Equity, L&L Partners, New Delhi.
The views expressed here are those of the authors, and do not necessarily represent the views of BloombergQuint or its editorial team.