Updated: Aug 29
By Clasis Law
An important aspect of shareholder protection is exit rights. It is common for exit clauses to be incorporated in most shareholder agreements and these clauses may be instigated or enforced by investors pursuant to efflux of time or upon the occurrence of certain events. The most common types of exit clauses that are incorporated in a shareholders agreement are: (a) Put Option, which entitles a shareholder who is selling his shares to require the other shareholders to purchase the shares; (b) Tag Along Clause, which typically gives a minority shareholder the right to have its shares bought on the same terms, including price, as the selling shareholder; and (c) Drag Along Clause, which gives the selling shareholder the right to compel all the other shareholders to sell to a third party on the same terms as the selling shareholder. All of the above exit clauses enable an exit by way of transfer of shares. Transfer of shares of a private limited company is governed by the provisions of the Companies Act 2013. However, given that India is an exchange controlled jurisdiction, in case of a transfer of shares by or to a foreign shareholder, such a transfer would also be governed by the Foreign Exchange Management Act, 1999 and the rules and regulations enacted under it (“FEMA”), more specifically the Foreign Exchange Management (Non-Debt Instruments) Rules 2019 (the “Rules”) as amended from time to time. From a macro-economic perspective, while India is an attractive and lucrative destination for foreign investment, an ease of exit and repatriation for foreign investors also plays an integral role in attracting FDI into any jurisdiction. The Rules provide for a stricter level of compliance which is in addition to the compliances under the Companies Act 2013, especially in relation to exits. Pricing Guidelines One of the key aspects is the requirement of adherence to the pricing guidelines which have to be complied with when shares are to be sold / bought by non-resident investors to / from Indian residents. An exit through private arrangement involving foreign shareholders has to be in accordance with these pricing guidelines. Normally, private equity investors would insist on internal rate of return based exit price in shareholder agreements. Further, it is also not uncommon for investors, especially strategic based investors to require shareholder agreements to provide for put options which set out minimum put option price. However, the guiding principle in the Rules is that the foreign investor is not guaranteed any assured exit price at the time of making such investment or otherwise and should exit only at the price prevailing at the time of exit (i.e. the fair market value) and cannot exit at a price higher than the fair market value. This concept of ‘assured returns’ has been prohibited by the Rules especially in the context of an equity instrument having optionality clauses. It means that if at the time of exit the price of shares are less than at the time of investment (due to poor financial performance or for any other reason), the investor would have to exit at such lower price itself regardless of any commercial projections that may have been made at the time of investment and the investor cannot impose any other price (whether lower or higher) at the time of such exit. This can create interference in enforcing exit clauses given that such clauses are triggered by investors pursuant to efflux of time or upon occurrence of certain events and investors would want to ensure viable provisions in the shareholders agreement to protect their investment or commercial interest, which may include providing for payment obligations entailing payment higher than the prevailing fair market value. Further, at the time of performance, where the payment obligation to the investor under the exit clause entails payment higher than the fair market value, the foreign investor may face resistance on the ground that such clauses are invalid under the Indian regulatory regime. While ‘assured returns’ are specifically prohibited under the Rules, selling at price higher than the prevailing fair market value may still theoretically be possible if the parties involved take special permission from the Reserve Bank of India (RBI). However, such permission would be purely at the discretion of the RBI given that there aren’t any guidelines for the RBI in this regard. Even upon compliant exits from a shareholders’ agreement perspective, it may be noted that there are other varied restrictions on repatriation and outward remittance depending upon the status and corporate vehicle of the foreign investor. Also, India has gained a notorious image of having an ambiguous tax framework which needs to be appropriately considered. These aspects can have the potential of dissuading a prospective foreign investor. Precedents It must be said that it’s not all dark in relation to exit clauses as the courts in India have not strictly been voiding exit clauses as assured returns and have appeared to be broadly pro-exit. This can be evidenced from Cruz City 1 Mauritius Holdings v. Unitech Limited, 2017 (3) ARBLR 20 (Delhi), in which Unitech was obliged under the shareholders agreement to purchase shares of Cruz City in their joint venture at a price that yielded an internal rate of return of 15% if project was delayed. In relation to enforcement of this, an arbitral award was made for damages. It was argued that the provision provided for an assured return at a predetermined price to Cruz City and the award would not be enforceable in India. However, the Delhi High Court noted that such put option could be exercised only within a specified time and at the instance of an event (project not being commenced within prescribed period) and held that this was not an open ended assured exit option. The court also held that RBI circulars (as applicable therein) prescribing assured returns would not be applicable where foreign investor found its claim in breach of contract. In another case, NTT Docomo Inc. v. Tata Sons Limited, 241 (2017) DLT 65, under the shareholders agreement, Tata undertook to find a buyer for Docomo's shares at a specified sale price if Tata Teleservices Ltd (TTL) failed to meet key performance indicators. In the event that Tata was unable to find a buyer, it was obliged to purchase Docomo's shares in TTL. Thereafter, TTL failed to satisfy the key performance indicators and Docomo initiated arbitration against Tata for enforcing the obligations under the shareholders agreement. An award was passed in favour of Docomo to receive higher of the fair value of the shares or 50% of the purchase price. Interestingly, when Docomo moved Delhi High Court for enforcement of the award, RBI intervened in the matter and filed for an intervention application taking a plea that the foreign award should not be enforced on the basis that the same was in violation of the rules laid down under FEMA. However, the Delhi High Court was of the view that this was in the nature of ‘downside protection’ rather than an assured return and that the award was one of damages which is not under the purview of RBI (i.e. FEMA). In fact, the court went in so far as to observe: “The issue of an Indian entity honouring its commitment under a contract with a foreign entity which was not entered into under any duress or coercion will have a bearing on its goodwill and reputation in the international arena. It will indubitably have an impact on the foreign direct investment inflows and the strategic relationship between the countries where the parties to a contract are located." However, it should be noted that while the above precedents are an encouraging sign, these provide for enforcement of an award/damages in relation to assured returns and in no way repudiate the existing FEMA provisions prohibiting assured returns. COVID-19 Another aspect which needs to be looked upon is the ongoing COVID-19 pandemic. It would be interesting to note how exits would be impacted as a result of this pandemic. It is difficult to assess at the moment as the lockdown restrictions have not eased off fully and the market would take time to recover. However, COVID-19 has definitely had an adverse impact on valuations and as a result, the private equity investors (who were looking to exit in 2020) may not be able to get the desired valuation and this pandemic may spoil their exit plans.
Subject to access to adequate reserves of capital and risk appetite, investors may elect to acquire new assets at lower valuations enabling exits for existing investors in the short term or in the alternative the existing investors may choose not to exit and assist their portfolios through the economic crisis and wait to exit with a higher return in the future.
Furthermore, the government vide press note dated 17 April 2020, amended the FDI laws with a view to help curb potential opportunistic takeovers of companies at low valuations as a result of the crisis. The amendment provided for direct or indirect FDI from bordering countries (including beneficial owners) to require government approval, regardless of whether the target Indian company is engaged in a sector which is otherwise allowed FDI without approval as per FEMA. While this move would enable protection of ‘forced acquisitions’ it would limit exit options for private equity investors who would not be able to sell their stake to entities from bordering countries, especially China which has considerable number of potential private equity and strategic investors.
It is no doubt that India still is an attractive destination for foreign investors. While the courts have taken a pro-exit and investor friendly approach as seen above, steps need to be taken to facilitate exits to increase investor confidence, especially in a post-COVID-19 world. The previous trends indicate that investors prefer to exit by strategic sales of their equity holdings as exiting through the public market can be cumbersome.
The pricing restrictions along with stringent and ambiguous tax framework coupled with varied restrictions on repatriation and outward remittance can be quite a stumbling block for a foreign investor to invest in an Indian company. Keeping this in mind, it may be considered to ease pricing restrictions / permit prescribed range of share premiums over fair market value to enable the investor to exit and protecting its interest. This along with a more investor friendly tax framework, providing flexibility in outbound remittance and even allowing more choices of instruments, would help increase investor confidence and thereby facilitate an increased influx of FDI.
Disclaimer: The above is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to herein. This has been prepared for information purposes only and should not be construed as legal advice. Although reasonable care has been taken to ensure that the information in this publication is true and accurate, such information is provided ‘as is’, without any warranty, express or implied, as to the accuracy or completeness of any such information.
About the authors:
Vineet Aneja, Managing Partner & Head of the Corporate Practice
T: + 91 11 4213 0000 | M: +91 98104 05782
Vineet is the managing partner and heads the Corporate Practice of Clasis Law. He has over 23 (twenty three) years of experience in a range of areas, including mergers and acquisitions, joint ventures, private equity, corporate advisory, employment and compliance.
His skill set includes a deep transactional understanding as well as significant industry expertise across industries as diverse as manufacturing, media, medical devices, fashion, technology, telecommunications, infrastructure, hospitality, retail and financial services.
Client feedback has highlighted the value his experience adds to both the legal and commercial sides of transactions.
Recognitions and Accolades
Recognized as one of the top 100 lawyers in India, for consecutive years, by India Business Law Journal’s (Vantage Asia) A-List for the year 2019 & 2018.
Recognized as one of the leading corporate transactional lawyer in India – 2019 by Acquisition International.
Recognized by Startup City as one of the 25 Most Trusted Corporate Legal Consultants to watch in 2019.
Recognized by as one of India’s most Trusted Corporate Lawyers by the Indian Corporate Counsel Association in its 2018 publication of “The Vanguards – Trusted Corporate Lawyers”
Awarded for outstanding performance in Commercial Law by Advisory Excellence in the year 2018.
Jaydeep Bhambhani, Senior Associate
T: + 91 11 4213 0000
Jaydeep is part of the Corporate team with Clasis Law and has experience in corporate commercials, transactions and M&A/Private Equity.
He has been involved in advising in relation to general corporate, compliance, commercial and transactions in various sectors including real estate, telecom, IT, private equity funds and retail trading in India, UAE and cross border jurisdictions. Further, he has experience in advising in legal issues involving India entry routes, exit routes, investment structures for foreign entities, FEMA related issues, aviation (regulatory) and security laws.
He also holds a specialization in Energy Laws.