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Preference Liquidation Hit or Miss?


By Priyanshi Singhal

The terms of the transaction documents for mergers and acquisitions are often dictated by the economics of investment and the bargaining position of the parties. The terms so contractually agreed upon must, however, always be within the operative legal framework.

Liquidation Preference (“LP”) is a tool often used to embolden investors seeking security of their investment. LP is crucial, especially where the investors anticipate exit at a value lower than their initial investment. It is for this reason that LP, in its various forms, is becoming increasingly popular with investors seeking to invest in India, even though its enforceability has not yet been tested in Indian courts.
 
For an LP clause to come to pass, a lot depends on the nature of the liquidity event. The application of laws in case of sale, transfer or swap of securities of an Indian company is slightly different from that in the event of court ordered liquidation or winding-up.

The Companies Act, 2013 does not restrict contractual agreements that determine distribution of monies amongst investors in event of transfer or sale of securities.[endnote 1] However, the manner of distribution of funds out of liquidation and winding up is prescribed under law.[endnote 2] Any contractual agreement that might undermine the liquidation waterfall or the priority of payment upon liquidation of assets as prescribed under law is strictly prohibited. However, valid inter-creditor and subordination agreements are required to be respected in the liquidation waterfall under law.[endnote 3]

Any issue or transfer of shares by way of sale or swap to a person resident outside of India is required to be in compliance with and subject to inter alia the pricing guidelines, specified by the Reserve Bank of India (RBI). The pricing guidelines provide threshold for determining inter alia: (i) price in the event of issue of capital instruments of an Indian company to a person resident outside India; (ii) price in the event of transfer of capital instruments of an Indian company from a person resident outside India to a person resident in India and vice versa; and (iii)  price in case of swap of capital instruments of an Indian Company to or by a person resident outside India (Pricing Guidelines).

Foreign exchange laws prohibit the guarantee of an assured return at a predetermined price to a foreign investor.[endnote 4]However, there is not much clarity on what principles of the Pricing Guidelines must be followed in case of liquidation or winding up of an Indian company, the shares of which may be held by foreign investors. LP intends to protect an investor from exiting the company at a price lower than what was initially expected out of its investment at the time of a liquidity event by providing them a downside protection. Given the prohibition on assured returns, it is highly plausible that this right to downside protection may be construed as an assured return.

For the purposes of understanding what would constitute ‘assured returns’ in the context of foreign exchange laws, the following judgments which interpret the phrase strictly in terms of investment and divestment and not damages, are noteworthy:
  • In Cruz City 1 Mauritius Holdings v. Unitech Limited[endnote 5], the High Court of Delhi rejected the objections on enforcement of a foreign award where assured returns would be deemed to be recovered by way of damages for breach of contract, as being violative of provisions of the extant foreign exchange laws. The court clarified that since the assured returns’ provisions in the contract were contingent on performance of contractual obligations and were not an assurance of exit at a pre-determined return, enforcement of these would not be in violation of Foreign Exchange Management Act, 1999.
  • Similarly, in NTT Docomo Inc. v. Tata Sons Limited[endnote 6], the High Court of Delhi highlighted the impact of honouring contractual commitments on foreign direct investment inflow and the strategic relationship between the countries where parties to the contract are located. While the court made reference to the RBI’s internal noting filed in this case, wherein the RBI distinguished between assured returns and downside protection, the judgment does not provide a view on how the FEMA provisions with regard to price protection at the time of exit, have to be interpreted.
One must also understand that remittance out of the assets of Indian companies under liquidation under the provisions of the Companies Act, 2013 is governed by the Foreign Exchange Management (Remittance of Assets) Regulations, 2016. While these Regulations lay down qualifications for remittance of liquidation/winding up proceeds of companies in India, no clarification is provided on the above proposition.

In the absence of sufficient legal precedent, or any clarification by the department, on whether returns featuring out of liquidation and/or winding up proceedings would qualify as ‘assured returns’, accommodating an LP clause under the extent foreign exchange laws, in light of the existing Pricing Guidelines, appears to be a tricky proposition.

What might be helpful is an understanding of various ways in which LP clauses can be drafted for foreign investors to ensure successful implementation. Some basic questions that arise are-
  • Can downside protection be in the nature of contractually agreed upon damages, provided they are not penal in nature or could such protection be as indemnity and most importantly, would such contractual clauses be enforceable?
  • Can protection of investment be achieved without changing the nature of the instrument from equity to debt?
The judgements discussed above point at the inclination of the judiciary towards a flexible and investor friendly interpretation of the strict regulatory provisions. But can LP in its current form thrive? Only time will tell.

[The author is an Associate in Corporate practice, Lakshmikumaran & Sridharan, New Delhi]
 
Endnotes:

  1. Kindly refer to Liquidation Preference: Relevance in Private Companies, as accessed at <https://www.lakshmisri.com/News-and-Publications/Publications/Articles/Corporate/liquidation-preference-relevance-in-private-companies>.
  2. Overriding preferential payments – section 326 and preferential payments – section 327 of the Companies Act, 2013 and distribution of assets – section 53 of the Insolvency and Bankruptcy Code, 2016.
  3. Treatment of subordination agreements within the liquidation waterfall, Report of the Insolvency Law Committee, March 2018.
  4. Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 dated November 7, 2017.
  5. 239(2017) DLT 649.
  6. 241(2017) DLT 65.        

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