THE IMPACT OF INDIA’S 18/25 CAP ON INDEMNITIES IN CROSS-BORDER M&A TRANSACTIONS
It is commonplace in global M&A deals for buyers and sellers to strongly negotiate the seller’s indemnity obligations, and many a times, unsatisfactory seller indemnities result in deals not going through. Effective May 20, 2016, the Reserve Bank of India (the “RBI”) amended India’s foreign exchange regulations (the “FEMA Regulations”), and imposed a requirement to obtain prior RBI approval if an Indian seller’s indemnity obligations to a foreign acquirer (and vice versa) exceeded the newly prescribed limits.
Pursuant to this amendment, only twenty-five percent (25%) of the total consideration can be paid by a buyer to the seller on a deferred basis up to a period of eighteen (18) months from the date of the transfer agreement. If more than twenty-five percent (25%) of the total consideration is sought to be deferred or any amount of consideration is sought to be deferred beyond a period of eighteen (18) months from the date of the transfer agreement, then prior RBI approval is required. Subject to the foregoing restrictions, the deferred consideration can be housed in an escrow arrangement between the buyer and the seller. Further, only if the full purchase consideration has been paid by the buyer to the seller, the seller may give an indemnity in an amount not exceeding twenty-five percent (25%) of the total consideration for a period not exceeding eighteen (18) months from the date of payment of the full consideration.
To simplify this:
- Consideration can be deferred only up to twenty-five percent (25%) and for a period of eighteen (18) months from the date of the transfer agreement.
- Only if the full consideration is paid, the seller can give an indemnity not to exceed twenty-five percent (25%) of the total consideration and for a period eighteen (18) months from the date of payment of the full consideration.
In our experience, the RBI’s approval in a case where either of the foregoing limits for indemnities is exceeded has not been granted. Moreover, there is no clarity on whether the parties should approach the RBI for its approval at the time of signing the definitive agreement (such as a share purchase agreement) or only prior to invocation of the indemnity obligation when making the payment. However, practically speaking, parties often decide to obtain the RBI’s approval only at the time of invocation of the indemnity obligation in order to facilitate the closure of the deal. A downside to this approach is that if the RBI does not grant approval for the indemnity payment by the Indian seller, the non-resident buyer may have to rely on other contractual remedies (such as damages) to eventually recover its monies.
Prior to this amendment, there was no such restriction on indemnities. Parties tailor-made indemnity provisions to suit their contractual arrangements on the time limitations, aggregate liability caps, de minimis thresholds and baskets, often linking them to the nature of the representation and warranty (including fundamental representations and warranties), covenants, issues relating to title of shares, tax claims (for which there is a right available to the income-tax authority to look-back up to seven (7) assessment years), etc.). Accordingly, the contractually agreed cap (both, monetary as well as time) on indemnification could vary from 25% to 100% of the consideration and was generally unlimited for representations relating to title of shares, authority and existence, etc. Similarly, a time cap of two (2) to three (3) years would be typically imposed, which extended up to the statutory period in case of tax claims and in case of breach of fundamental representations and warranties.
This reduced limit on indemnity of twenty-five percent (25%) of the purchase consideration if paid in full and a time period of eighteen (18) months from the date of payment will certainly leave acquirers exposed, especially if actions for non-compliances or other claims on the target company from the pre-closing period surface after the foregoing indemnity period has run out. In view of this, the necessity of conducting thorough due diligence on the target (and in certain cases on the seller) before proceeding with the deal has become all the more imperative for the buyer. Further, it has also become imperative to obtain representations and warranties insurance to safeguard the buyer. It is also unclear as to why the RBI has included within this amended rule on indemnities in a share purchase transaction between a resident buyer and a non-resident seller, because as per the FEMA Regulations a resident buyer can purchase shares of an Indian company from a non-resident seller for a consideration which is below the fair market value. Moreover, with respect to deferment of payment by a resident buyer, previously, no RBI approval was needed for a deferment clause in a share sale agreement between a non-resident seller and a resident buyer. Therefore, adding something like this in the FEMA Regulations makes little sense.
India’s foreign exchange reserves are at US$399.29 billion as on November 10, 2017, which shows that India has increased its foreign exchange reserves significantly. However, in order to make India an even more favoured destination for foreign investments, it is high time that the Indian government stops micromanaging contractual relationships between parties and lets business make its own decisions. If revoking this rule is not feasible, the RBI should certainly consider making exceptions and provide for increased indemnity periods for breach of fundamental issues, environmental matters, and tax and employment claims. Otherwise, parties will have to come up with unnecessary workarounds, which will have a significant adverse impact on the deal making process in India for investors.