Luxury Tax law

Due Diligence Administration, Closing and Put up-Closing Administration

July 20, 2022
Jason Wilson

This article is taken from GTDT Practice Guide: India M&A. Click here for the full guide.

 

Due diligence

In India, weddings fall into one of the following two categories: where the selection of the bride and the groom involves their parents; or when two consenting adults fall in love with each other and decide to get married. Irrespective of the category that the marriage fits into, the parents of both the bride and the groom undertake an exercise to ascertain the suitability of not just the bride or groom, but also of their parents and siblings, to understand the pedigree of all persons involved and to arrive at a conclusion, based on their yardstick, on whether the person to be welcomed into the family possesses the qualities that will fit into the family ‘ecosystem’.

The reason that marriage is being talked about in this chapter is because of the similarity of the exercise that is undertaken before the decision is taken to go ahead – be it the wedding or an M&A transaction – which goes by the name due diligence.

Similarity of the approach

This approach drives every due diligence, be it for a domestic or cross-border merger, acquisition or investment, namely, to ascertain the suitability of the target, whether it possesses the necessary qualities that will fit into the ecosystem of the acquirer or investor, and also who the present owners are, their economic health and that of related entities, and what could be the potential disruption that could have been caused in the target.

The guiding principle at the time of carrying-out the diligence exercise is caveat emptor,2 as often businesses wanting to make themselves attractive to a suitor are prone to be ‘dressed up’ by the management, while the tack changes in drafting and negotiating definitive agreements to uberrima fides.

In this chapter, we give an approach to carrying out legal due diligence in India, discussing the rationales and the sources of information with specific examples particular to the Indian context, planning the due diligence and the principles to be adopted to decide on matters that are to be construed to be conditions precedent and conditions subsequent while looking to close transactions in India.

Rationale for the diligence

The broad rationale for carrying out a legal due diligence is to help the acquirer or investor arrive at an informed judgement on whether:

  • the business model, practices and operations as outlined by the target work, factoring in the regulatory environment;
  • the risks inherent in the business model of the target are in alignment with investor’s appetite – certain acquirers or investors are not amenable to exposure to businesses that have certain types of risk (eg, government contracts);
  • to assist the acquirer or investor in ringfencing its investment from any form of litigation or claims arising from past actions of the business or the owners of the business; and
  • to carry out early assessment of any post-deal value creation opportunity, and (where it is an acquisition or a strategic investment) enabling commencement of planning for integration.

Stages in the diligence

Every due diligence exercise needs to go through three stages before the transaction is concluded:

  • planning the due diligence;
  • carrying out the diligence exercise – using publicly available data and information made available by the target; and
  • evaluating the findings of the diligence exercise and taking appropriate action.

Planning the diligence

When the diligence exercise is to be carried out by obtaining information from the target, it is important that it is planned in a way that time is spent only on obtaining and perusing information:

  • that is proprietary to the company;
  • that is not publicly available; and
  • to validate compliances that cannot be assessed through publicly available data.

The nature of the information to be obtained, and the extent of review of the information so obtained, are also dependent on the nature of the transaction and the value proposition or the deal rationale. It is important that these factors are understood and the diligence is carried out to achieve the deal rationale. This approach would assist in administering a questionnaire to the target that is designed to obtain such information to enable decision-making.

This approach has two other benefits: first, it brings in a very focused approach and assists evaluation based on the objective to be achieved and second, it saves time and limits the exposure of information by the target. It is important that time is spent in planning the diligence, which would help a quick turnaround of the diligence itself, and mostly the luxury of a detailed diligence would not be offered by the target itself, as the target might be attempting to woo more than one potential suitor.

This brings in the next dimension in the need to plan the diligence, where the acquirer or investor may not be the only person vying to acquire or become part of the target. In this case, one may not even have the luxury of seeking information, as the target may present a structured data room, with specified information that is outlined in advance, and there are even times when a specific time frame is also provided to carry out the diligence process. Each of these situations calls for a dynamic approach that is not straightforward for all transactions or limited by the same checklist for all transactions.

Sources of information for the diligence

With most corporate reporting to government agencies having become electronic, a large amount of data about businesses is available online, either on payment of fee or at no cost. It is important that, in addition to the information that will be provided by the target company, these external sources of information are accessed first, and information about the target obtained.

The information available publicly about the corporate form of businesses ranges from charter documents, filings based on their corporate actions and decisions, shareholdings, borrowings, financial data, credit rating, pending cases at specialised tribunals, High Courts and the Supreme Court, to information relating to any filings or registered intellectual property (IP) holdings.

Since the aim in this chapter is not to provide a due diligence checklist, we are refraining from listing external sources of information, but do give certain basic checks that can be carried out using publicly available data.

Certain basic checks with publicly available information

Even before any non-disclosure agreement is signed there are certain basic checks that can be carried out from publicly available information.

The matters dealt with below are only illustrative items, and not an exhaustive attempt at providing all information that can be obtained to evaluate the target at a preliminary stage.

Financial information and details of secured borrowing

It is said that ‘the face is the index of the mind’, and equally the financial statements are the index of the business. The annual financial statements of a company are publicly available,3 which also include a cashflow statement, and the acquirer or investor can carry out a complete analysis of the financial statements, which offer a comprehensive insight into multiple aspects of the business. In addition, publicly available information will also provide details of borrowings by the target, if any, and when such borrowings are secured, such details also offers insights into the nature of the security4 offered, which in turn presents the details of assets so encumbered and the quality of the assets that the target owns.

Depending upon the deal rationale, the information presented and analysed from the annual financial statements, and the details of borrowings and the nature of assets, the acquirer or investor can form a preliminary view on the target, the deal structure, valuation, etc.

Regulatory environment assessment

Based on the business of the target, one should be able to assess the regulatory environment that affects the business, and in particular the ability of the acquirer or investor to be able to participate in such business.

Over the years, India has relaxed exchange control and welcomes foreign participation in businesses. There are restrictions on investment in certain types of businesses, which can be ascertained from the foreign direct investment (FDI) manual on the website of the Department for Promotion of Industry and Internal Trade,5 which would help in ascertaining the regulatory environment on foreign investment in the business of the target.

Promoter and shareholder backgrounds and their shareholding

Publicly available data give information about the shareholding of the promoters and other shareholders and the manner of acquisition of such shares (ie, whether allocated by the company or acquired from a third party, and rights associated thereto). These details can be construed using the filings made by the target with the Ministry of Corporate Affairs (MCA),6 and used to ascertain the title to the shares. Having said that, the proprietary information may have to be used subsequently to validate the same. It is equally possible to carry out background checks on the promoters and other shareholders of the company for any criminal antecedents, and there are many agencies providing such background verification as a service.

Compliance checks

The record of information available with the MCA about the company (which is public information available for a nominal fee) will assist the acquirer or investor to carry out a number of compliance checks.

Often, companies fail to file their financial reports or annual returns within the prescribed period of time, with the regulator of corporate affairs, the Registrar of Companies. When such filing is not done (of either of the two documents) for a period of three consecutive years, it leads to disqualification of the directors. While the target company may have filed the financial reports or annual returns in preparing for the acquisition, the disqualification of the promoter director may have already occurred owing to the non-filing of these documents in another entity where they hold the position of director.

An elementary check of the MCA records7 would reveal whether the promoter concerned is eligible to hold office as a director. If the promoters are found to be disqualified, then it can change the entire contour of the transaction, as disqualification entails a five-year wait for being eligible for reappointment.

Intellectual property rights

The information relating to trademarks, copyrights, patents and designs of the target, if the target had filed any applications for registration of any of the above forms of IP, is publicly available.8

With respect to trademarks that come as a part of the portfolio of the target, it is only from publicly available information that the acquirer or investor can obtain information on whether any of the marks of the target are associated with its other trademarks. This would be essential in a transaction that involves only assignment of the IP, or transfer of a specific line of business with the IP portfolio.

As per the provisions of the Trade Marks Act 1999, a trademark that has been associated with another trademark during the registration process has to also be assigned with the other mark and cannot be transferred in isolation, unless necessary steps are taken to dissolve the association between the associated trademarks pursuant to the provisions of the Trade Marks Act 1999.9 Such information should be used at the evaluation stage and action be taken appropriately with a view to closing the deal.

One should not be surprised if the ‘whois’10 credentials of the domain names owned and operated by the target do not actually reflect the organisation name of the target, as the owner of such domain names only contains the name of the vendor who maintains the website for it, or the name of an employee. Since the whois information evidences the ownership of the domain name online, and so long as there is no privacy protection to it, one should look for the same.

Bankruptcy and shareholder activism litigation

If the target has any pending or resolved bankruptcy proceedings that have been initiated before the appropriate judicial forum (ie, the National Company Law Tribunal,11 the appellate body, the National Company Law Appellate Tribunal,12 or a class action suit or disputes with minority shareholders), then the existence of such litigation and the nature of the orders passed are available publicly. However, the nature of the dispute will be known only from proprietary information.

Information that can be obtained only from proprietary information

Statutes requiring financial compliance

While filing and reporting under statutes that require financial compliance are all electronic, the status of compliance can be assessed only through proprietary information. This includes filings under taxation laws, payments for retirement benefits and employee health insurance. While financial statements may reveal the extent of tax refunds due or acknowledged as due from the target, and about any pending litigation with the concerned regulatory authority by way of a note under the heading contingent liabilities, the extent of compliance or impact of non-compliance can be assessed only from the returns and assessments, all of which are proprietary information.

It will also be important to look into any potential tax on shares that have been issued at a premium over the face value,13 that is not backed by an appropriate valuation, which is colloquially referred to as ‘angel tax’ – a tax enacted to curb money laundering. It is now customary practice for acquirers or investors to obtain tax indemnities to the extent of such potential angel tax liabilities.

Corporate records and the shareholding and related conundrum

The records to be maintained by a company are expected to reveal its entire story since incorporation, as matters of critical importance are required to be approved and recorded in meetings of the board of directors or shareholders of the company. As stated earlier, while details of shareholding will be publicly available to ascertain title, the corporate records are to be used to validate the shareholding title to confirm procedural compliance for the mode of acquisition.

There are times that such corporate records, or an unstructured data gathering exercise from the records of the target (if the diligence exercise offers such luxury), can reveal commitments, which may be documented or undocumented, on the capital structure of the company. This may include commitments on employee stock options or friends and family commitments. An open discussion might be warranted with the parties concerned about whether such commitments can be fulfilled in light of the proposed transaction. This can also affect the transaction, based on the risk appetite of the acquirer or investor, as a representation or warranty to this effect may not hedge the risk of any imminent litigation on this count.

 

Material contracts

One of the rationales for carrying out the diligence exercise is to ascertain if the business model of the target works. Every business has its material contracts that are essential for scaling up the business and meeting future projections. It is crucial that the contracting structure of the company is in line with its business model. Businesses may require bespoke contractual engagement protecting their interests and revenue collection and to handle future expansion and scaling up of the business. Whether the contracting model of the company captures the aforementioned principles will be a key information to look out for in the due diligence process. Having said this, a very large portion of business in India still happens without detailed contracts, and mostly through rudimentary purchase orders.

Separately, it is for the investor or acquirer to determine, based on the diligence exercise on the material contracts, whether the target has been performing and has the ability to perform its obligations under these contracts in accordance with the terms and timelines prescribed therein. This not only includes its business-related responsibilities but also any government consents or approvals to be procured, insurance coverage to be used or compliance with data protection laws.

Stamp duty on certain contracts is a requirement in India,14 and the non-payment of stamp duty affects the enforceability of contracts. The risk appetite and the business model of the company would determine the manner in which the lack of payment of stamp duty on contracts is dealt with in the definitive agreements.

In addition, the contracts play a role in identifying matters that are required to be conditions precedent and conditions subsequent to the closing. Often, the target may have a long-period lease from a government-owned industrial infrastructure development company (IIDC), most of which have a provision that any change in ownership would require prior approval of the IIDC, with or without payment of additional lease rental, and entering into a fresh lease agreement. Similarly, one needs to watch out for prior consent or intimation requirements under material contracts for change in control of the company, be it with customers or suppliers or lenders. Therefore, identifying the consent or intimation requirements and procedures is necessary in order to identify conditions precedent to closing the transaction.

Related-party transactions

The promoters of the target company may have holdings and interests in several other entities. Not all public searches can reveal such interests because of the way the entities are structured, and considering that disclosure of ultimate beneficial ownership (UBO) is a recent introduction in the statute book,15 there can still be interests in entities that have not yet crossed the radar of UBO. This may result in several related-party transactions between the entities, either through a subcontracting arrangement or other services being provided to each other, which may not be at arm’s length or even relate to the core business operations.

Some related-party transactions may not be booked in the financial records of the company and, in some cases, liabilities may be booked with affiliates. Therefore it becomes crucial to examine any transactions involving related entities in forensic detail. In addition, loans or other assets lent or leased to the promoters or other shareholders of the company need to be in line with regulatory requirements.

Labour and employment

India has extensive labour law regulations that attract penalties for non-compliance. Depending on the nature of the business, employee strength and compensation levels, companies need to comply with payment of the provident fund allowance, gratuity, employee state insurance or bonuses.16 In businesses involving the running of factories, there are additional compliances under factory and industrial workers regulations.17 Diligence of this aspect is crucial to discover hidden liabilities, if any.

With regard to the employees of the company, apart from applicable employment law compliances, it is essential that the employment contracts contain standard provisions ensuring that any IP developed by employees is ‘work made for hire’, employees are bound by non-disclosure requirements and non-solicitation and non-compete restrictions, where necessary.

Litigation and disputes

Digitisation of litigation in all courts has started and information is available electronically about the existence of litigation in all courts in India. However, owing to the sheer numbers in the courts, it is an enormous task to try and look for the existence of litigation based on the target’s name, unless the litigation is in a tribunal or high court, which owing to the lesser numbers is relatively easy to obtain. However, the information as to the nature of the dispute will be available only from proprietary information. The information so obtained would be of use at the evaluation stage of the diligence exercise.

Environmental, social and governance

Environmental, social and governance (ESG) matters are a key part of the due diligence exercise in today’s world, especially when it comes to private equity or venture capital investment. While ESG issues involve understanding the sustainability of the business model of the company and go well beyond the scope of a legal due diligence, from the legal perspective it is important to ensure adherence to environmental regulations (including procuring of environmental licences, as necessary), compliance with anti-bribery and anti-corruption laws (including the Prevention of Corruption Act 1988 and Prevention of Money Laundering Act 2002) and applicable labour regulations in specific sectors that relate to factory working conditions, working hours and prevention of child labour.

Covid-19

In wake of the covid-19 pandemic, diligence exercises will need to be revamped to take into consideration the impact of the changing shape of the economy, new business sectors of critical importance and market downturn. No matter the business, this pandemic has forced a change in the style of operations, making businesses adapt to a new normal. Diligence on the effect on supply chain, performance of contractual obligations, production and sales networks and ­analysis of the business impact should be undertaken. This also extends to compliance with existing and new regulations (formulated in light of the pandemic) and fulfilment of financial obligations by the company. Risks arising from delays in loan repayments, regulatory filings, renewal of licences or contracts and potential financial exposure should be reviewed.

Of conditions precedent and post-closing management

The due diligence is only half the exercise, and the remainder is in signing the definitive agreements, duly incorporating the findings of the diligence exercise, into any one of the following five categories:

  • matters for which appropriate representations and warranties are to be sought from the target, promoters or founders;
  • matters for which indemnities are to be sought from the target, promoters or founders;
  • covenants that are to be conditions precedent to the closing;
  • covenants that are to be conditions at closing; and
  • covenants that are to be conditions subsequent to the closing.

Principles to be followed

We give here the principles to be adopted for evaluating the findings into the above five areas.

Seeking representations and warranties

A finding that is in the nature of a fact, for example, if the target has no immovable property or if the target were to state that it uses only licensed software for the purpose of its business, representation is required to be taken for such facts.

Seeking indemnities

With a finding that relates to the target, for which no remedial action can be taken by the target or the promoter, or if the target or the promoter is not keen on taking any remedial action before closing, and if such finding is likely to have a monetary impact on the target at a future indeterminable time frame (subject to limitation or prescription), and the acquirer or investor does not intend to bear the consequences of the same, the acquirer or investor should then seek indemnity for the same from the promoter or seller.

Covenants that are to be conditions precedent and conditions subsequent to closing

Here it is important to take into account the risk appetite of the acquirer or investor and also its keenness to close the transaction. There is a need to balance the risks and the commercial consequences when deciding to place items in the two broad areas of conditions precedent and conditions subsequent to closing.

Where there are matters that involve the following, they have to be incorporated as ­conditions precedent:

  • regulatory prerequisites to the closing, for example:
    • approval of a regulatory authority under antitrust law, the Competition Act 2002, or government approval under FDI policy;
    • if the acquisition is of the shares of a listed company, compliance with the provisions of the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations 2011; and
    • corporate actions relating to the issue of shares; and
  • assumptions made by the acquirer or investor while arriving at the valuation prior to the term sheet, and if the diligence exercise had revealed that the assumption had not been actioned by the target, but material to the investor making the investment itself.

Any matters that do not come within the above, and if included as conditions precedent would only delay the closing of the transaction, should be included as conditions subsequent.

Conditions at closing

Upon completion of the conditions precedent to the satisfaction of the investor or acquirer, a date can be set for closing the transaction. On closing, the key actions include:

  • payment of share consideration or remittance of the investment amount, as the case may be;
  • allotment or transfer18 of the securities (including issuing the securities certificate and updating company registers);
  • board reconstitution (ie, appointment or resignation of directors or observers);
  • board and shareholder meetings approving the above actions; and
  • continuation of the existing key managerial personnel, particularly officers at chief experience officer level.

Essential conditions precedent

While we have set out the principles to determine conditions precedent to enable a swift closing of the transaction, there are certain matters that are necessarily to be actioned as conditions precedent to facilitate the closing.

Valuation

As a condition precedent to closing, procuring a report on fair valuation of the shares of the company is a requirement. In the case of shares being issued to a non-resident in an unlisted company, identification of a valuer with the requisite qualification becomes critical considering the different requirements under foreign exchange law and company law. The Companies Act 201319 requires that the company’s shares be valued by a person who is a valuer registered with the Insolvency and Bankruptcy Board of India. However, the pricing guidelines under the Foreign Exchange Management Act 1999 prescribe that the valuation should be certified by a chartered accountant or a merchant banker registered20 with the Securities and Exchange Board of India. If the valuation is done using discounted cashflow methodology, then income tax law21 does not recognise the valuation from a chartered accountant.

To steer clear of non-compliance, the report on fair valuation should best be obtained from a merchant banker whose team includes a registered valuer,22 if the investment or acquisition is to be made in an unlisted company.

Enabling amendments to charter documents

The memorandum of association (memorandum) of the company defines its broad business objects, and the articles of association (articles) act as the by-laws for the management of company affairs. Depending on the nature of the investment, the memorandum and articles of the target may require amendment to enable the issuance of the necessary instrument carrying the rights as agreed to between the transacting parties.

For example, if convertible preference shares are proposed to be issued carrying voting rights on a fully diluted basis, the articles will have to be amended to specifically include an article specifying that section 47 of the Companies Act 2013 will not be applicable to the target company. As per section 47 of the Companies Act 2013, holders of preference shares have a right to vote only on resolutions placed before the company that directly affect the rights attached to the preference shares, and any resolution for winding up the company or for repayment or reduction of its equity or preference share capital and their voting right on a poll shall be in proportion to their share in the paid-up preference share capital of the company.

Regulatory compliance

Targeting ease of doing business, over the past few years the government has been proactive to the needs of the industry and enabling a liberalised regulatory environment. Compliance with regulations involving foreign investment, company law, securities law and both direct and indirect tax laws need to be ensured to avoid any possible exposure to significant liability.

For example, in the case of change of control of a non-banking financial company, prior approval of the Reserve Bank of India (RBI) is mandated.23 Another example would be that, if an acquisition falls under the category of a combination24 under the Competition Act 2002, an application needs to be made to and approved by the Competition Commission of India. Regulations pertaining to the chargeability of tax based on income attributable to Indian business have been brought into effect and upheld by the Supreme Court of India. Thus any transfer of business interest in India through an entity outside India should be analysed for potential Indian tax liability.

Essential conditions subsequent

As with the essential conditions precedent to closing, there are certain matters that would have to be actioned as conditions subsequent to closing.

Amendments to update the charter documents

The articles of a company, in addition to acting as by-laws of the target, are also a contract between the company and its shareholders. Over the years, there have been multiple decisions of various courts25 and tribunals that to make certain covenants binding on the company such as transfer of shares, right of pre-emption, matters relating to quorum for meeting and decisions to be taken at meetings, even if there is an agreement to which the target company is a party, it is necessary that those provisions are enshrined in the articles of the target company. Thus it is important that the articles be amended so as to incorporate therein the various provisions of the definitive agreement that bind the target. Such amendment to the articles would assist in seeking specific performance in the case of any breach.

Corporate reporting and filings

The actions at closing, such as appointment of directors representing the acquirer or investor, investment and allotment of shares to the acquirer or investor, etc, entail reporting to the Registrar of Companies. All such corporate reporting and filings are to be properly identified based on the transaction, and enumerated and actioned, so as to ensure that the actions are immediately complied with.

Reporting to the Reserve Bank of India

This is dealt with separately and is not construed as part of the earlier item. Based on the transaction, there are requirements to report the transaction to the RBI and the administrative body for matters related to foreign exchange. It is essential that the transaction be reported and an acknowledgement obtained from the RBI,26 failing which repatriation of money will become a challenge, and delays in reporting involve payment of compounding fees, which can be equal to the amount of investment. Hence it is essential that reporting to the RBI be done immediately on the closing of the transaction. In the case of a transaction that involves transfer of shares by buying shares from an Indian citizen or entity, the reporting is required to be done immediately after the share transfer proceeds are credited to the account of the seller, and the target can register the share transfer only after acknowledgement is obtained from the RBI.

Conclusion

India is a country comprising over 1.4 billion people and 22 major languages, written in 13 different scripts, with over 720 dialects and with seven major religions being practised. Linked to such diversity is a multitude of customs and practices, which can be significantly different in different parts of the country. While India has a unified business, corporate and tax laws, there is significant difference in ground-level practices. Any diligence undertaken has to factor in these differences in practices, and accordingly build the necessary covenants, comforts and conditions.

India’s population, its diversity, growing affluence and relatively stable democratic set-up protecting a market-driven economic system are surely indicative of a place on which all businesses should set their sights. And hence we sign off by saying ‘Namaste!’ – the Indian way of welcoming everyone.