Representations and Warranties in M&A and PE transactions, an Indian Context

warranty

The exchange of relevant business information between parties plays a crucial role for the success or failure of any Mergers and Acquisition (“M&A”) or Private Equity (“PE”) deal. Both parties, especially the buyer, rely on the authenticity of such information for closing the deal. In this context, the role of representations and warranties is critical for determining the rights and liabilities of the parties to a transaction.

For instance, the buyer may later find out that one of the seller’s warranties i.e. “grant of a large contract in favour of the target company” or “certain ongoing regulatory investigations will not have any significant impact on business” is untrue, and therefore the value of the business has diminished as of today, from what was represented to him at an earlier point of time during negotiations. That’s where the representations and warranties (“Reps and Warranties”) come into play.

There have been notable cases in India where breach of Reps and Warranties have played a significant role. As recent as in March 2018, Reliance Infrastructure issued a legal notice to Pipapvav Defence and Engineering for a claim of breach of warranties amounting to a significant amount of INR 5440.38/- crores [approximately US$75 million]. It is evident that in commercial contracts, Reps and Warranties have huge implications for businesses.

It is well established that, generally used, (a) representations are factual statements of past or existing facts, and (b) warranties are contractual statements that existing or future facts or events are or will be true. This understanding is supported by the provisions of Section 17–19 of the Indian Contract Act, 1872 (“ICA”) and Section 12 of the Sale of Goods Act.

Despite the above, most modern drafting practices tend to club “Reps and Warranties” together as a single clause. However, considering the difference in the remedies available for breach of representations or breach of warranties, both parties need to understand the implications of entering into such a contract. Here is a guide to the same: –

1) Scope of Reps and Warranties in M&A and PE

Reps and Warranties in a typical M&A and PE deal act as “inducements” by the seller to the buyer to enter into the contract. This requirement of stating often “routine” requirements as Reps and Warranties are important, as “Caveat Emptor” applies in the ICA to a limited extent and silence about a particular fact is not necessarily fraud in Indian law.

Hence, in M&A and PE deals, a representation by the seller will state the past or existing state of affairs of the concerned business, whereas a warranty may go a step further and assert the current and future affairs of the business, including events that may take place post-execution of the contract.

2) Effect of breach of Reps & Warranties

3) “Represents and warranties” — A case for clarity?

As the implications of breach of representations and warranties itself are different, especially from a seller’s perspective, it will be better to differentiate between Reps and Warranties. If this is not done through separate clauses due to the prevalence of a “clubbed clause” in commercial contracts as of today, then, through precise drafting to communicate the intent of both parties. This will help to minimize uncertainty in the scope, interpretation and application of Reps and Warranties before courts.

On the other hand, from a buyer’s perspective, their conduct during the due diligence, subject to the facts and contractual provisions drafted in the particular case, may lead to a dilution of the Reps and Warranties [Infinite land Ltd. v. Artisan Contracting Ltd (2005 EWCA Civ 791)]. Therefore, a differentiation of the Reps and Warranties will help to seek the protection of Representations/ Warranties that are outside the scope of the disclosure letter. However, this needs to be balanced with the advantages a buyer may get from the ambiguous usage of “Seller represents and warrants that…”, which may allow the buyer to pursue a wider set of reliefs before the courts.

Hence, the apportionment and usage of Reps and Warranties in M&A and PE transactions needs to be carefully inserted in each transaction, depending on the interests, objectives and certainty that parties wish to impart into a contract.

Finally, the parties can opt for an “M&A / PE Rep and Warranty insurance contract”, so that the buyer can mitigate and outsource (certain) risk(s) of breach thereof to a third party (Insurance Company), as well as keeping a well-drafted “Entire Agreement” clause to ensure courts will seek for interpretation tools within the contract itself.

A follow-up on some crucial interpretation clauses that can be inserted in future M&A / PE contract, in light of recent Indian judgments, will be taken up in a future post.

Anti-Dilution Rights - How to Work Around the FEMA (TISPRO) Regulations, 2017 for Non-Residents [Part 5 of the five-part series]

regulations

In order to avoid the ‘Pricing Guidelines’ [discussed previously in Part 4 of this story], the additional shares to be allotted to the original investor of the Indian startup company to comply with the Anti-Dilution Rights must be issued under the ‘rights issue’ mechanism under Section 62 (1) (a) of the Companies Act, 2013 instead of ‘preferential allotment’ mechanism under Section 62 (1) (c) of the Companies Act, 2013.

The FEMA (TISPRO) Regulation, 2017, under Regulation 6, clearly lays down the provisions governing the ‘acquisition of shares through a rights issue or a bonus issue’ to a ‘person resident outside India’. Regulation 6 (5), clearly lays down that, “In case of an unlisted Indian company, the rights issue to persons resident outside India shall not be at a price less than the price offered to persons resident in India.” This means that, under ‘rights issue’, the shares can be issued at any price (including price per share lower than the fair market value), provided the Indian company offers the shares under ‘rights issue’ to the other shareholders at the same price.

Generally, all investment agreements, which have Anti-Dilution Rights, have elements of shareholders agreements and are accordingly executed by all shareholders of the investee company (new shareholders of the investee company are inducted into such ‘investment agreement’ therein through addendum). Therefore, contractually, if one can bind the other shareholders of the investee company to reject such shares offered under ‘rights issue’, then the non-resident investor can exercise its ‘rights issue’ and subscribe to such number of shares that is required to comply with the Anti-Dilution provisions.

Anti-Dilution Rights – Exception for Non-Residents [Part 4 of the five-part series]

exception

Contravention of FEMA (TISPRO) Regulations, 2017

It is clear from the ‘Introduction’ [Part 1 of this story] that, if the Anti-Dilution Rights gets triggered, a startup company must issue additional shares to the investor exercising such Anti-Dilution Rights at no price or at a price lower than the value at which the fresh subscription has been made by the new investor.

This actually directly violates the ‘Pricing Guidelines’ under Regulation 11 of FEMA (TISPRO) Regulations, 2017, in the event the original investor is a ‘person resident outside India’ under FEMA (TISPRO) Regulations, 2017. As per the said Pricing Guidelines, no Indian unlisted company can issue shares to a ‘person resident outside India’, at a price lower than the fair market value, determined by a Chartered Accountant or a Securities and Exchange Board of India registered Merchant Banker or a practicing Cost Accountant.

Under the Companies Act, 2013, any fresh issue of securities to a new investor can be made only under Section 62 (1) ©of the Companies Act, 2013, and accordingly the Company within 30 days of such allotment must file a Return of Allotment under Form PAS-3 of the Company (Prospectus and Allotment of Securities) Rules, 2014. One of the mandatory conditions under Rule 12 (7) of the Company (Prospectus and Allotment of Securities) Rules, 2014 is that any shares issued under Section 62 (1) ©of the Companies Act, 2013, must attach a valuation report of a registered valuer (an independent SEBI Registered Merchant Banker or Chartered Accountant in practice having a minimum 10 years of experience) along with the Form PAS-3 filed for this.

Thus, any sale of additional shares by the Indian unlisted company, at no price or a cost below the fair market value determined by a registered valuer under Rule 12 (7) of the Company (Prospectus and Allotment of Securities) Rules, 2014, for the purpose of compliance with the Anti-Dilution Rights will contravene the ‘Pricing Guidelines’ under the FEMA (TISPRO). In the next part of this story, we shall discuss the work-around to this problem.

Anti-Dilution Rights — Weighted Average Method [Part 3 of the five-part series]

average

In Part 1 of the Anti-Dilution Rights story, we discussed the Anti-Dilution Rights in general, and identified that there are two mechanisms for Anti-Dilution Rights protection: i. Full Ratchet Method; and ii. Weighted Average Method.

In this Part 3, we will dig deeper into the Weighted Average Method.

The Weighted Average Method of calculation is used more extensively as this method gives importance to the proportionate relevance of the investments, made in both the rounds.

· Under this method, it is first assumed that all shares of the start-up company issued before the 1st round of investment were subscribed at the price per share similar to the price per share of the 1st round of investment (this is done to take into account the increase in valuation of the start-up company since incorporation to the time of 1st round of investment).

· Thereafter, the price per share at 1st investment is multiplied with the total shares in the start-up company after 1st investment (including the shares issued to the 1st investor).

· The result is then added with the 2nd round investment amount to arrive at the actual investment in the start-up company after the 2nd round investment.

· This is then divided with the total number of shares in the start-up company after the 2nd round investment.

· The result will be the weighted average price per share.

· Thereafter, the 1st round investment amount shall be divided by the weighted average price per share.

· The result will be the number of shares that the 1st investor would have received if the weighted average price per share was the price at which the 1st investment was made.

· This, when deducted by the shares actually received by the 1st investor, will determine the additional shares to be issued to the 1st investor under the Weighted Average Method.

As an example,

Total shares of start-up company before 1st round of investment = 800 shares (Shares before 1st investment)

Calculation:

{100 * (800 + 100)} + 5000} / (800+100+100) = 95

10000/95 = 105.2 shares (105 shares -rounded down)

105–100 = 05 (Additional Shares to be provided to 1st Investor under the Weighted Average Method)

Anti-Dilution Rights — Full Ratchet Method [Part 2 of the five-part series]

Ratchet

In Part 1 of the Anti-Dilution Rights story, we discussed the Anti-Dilution Rights in general, and identified that there are two mechanisms for Anti-Dilution Rights protection: i. Full Ratchet Method; and ii. Weighted Average Method.

In this Part 2, we will dig deeper into the Full Ratchet Method.

The Full Ratchet Method is a simpler method of calculating the number of additional shares that the start-up company needs to provide to the original investor in order to comply with the Anti-Dilution Rights. Under this method, the price at which the new investor has subscribed to the shares of the start-up company (“New Price”) is taken into consideration. Then, the number of shares, the original investor would have received, for his actual investment amount at the New Price is calculated. Thereafter, the number of shares actually received by the original investor in the first round of investment is deducted from the number of shares the investor would have received at the New Price. The result is the number of shares that must be allotted to the original investor in order to comply with the Anti-Dilution Rights.

Formula:

Original Investment/New Price = Shares 1st Investor would have got at New Price (New Price Shares)

New Price Shares — 1st Investor’s Shares = Shares to be allotted to Investor

Calculation:

10000/50 = 200

200–100 = 100 (Additional Shares to be provided to 1st Investor under Full Ratchet)

Anti-Dilution Rights — Introduction [Part 1 of the five-part series]

Contract

In India, the inclusion of ‘Anti-Dilution Rights’ in definitive agreements governing a startup or venture capital deal is quite common. These Anti-Dilution Rights provide protection to the investors against the dip in value of their newly purchased shares in the future event of subsequent investments in the startup company. This is actually quite fair in the case of startups because, at the time of any venture capital investment, startup companies are in a volatile stage and it is quite difficult to predict which way the valuation of the startup company will go in the subsequent rounds of investments.

Anti-Dilution Rights of the investors in a venture capital deal will trigger only when the subsequent rounds of investment in the startup company is made below the value paid by the investor in the original round of investment. Therefore, if the subsequent rounds of investments in a startup is made at a value more than the value at which the original investor had originally invested, then although the original investor’s shareholding in the startup company may get diluted, the value of his shares will actually increase in the market.

In the event the subsequent rounds of financing in the startup company is made at a price per share lower than the price per share paid by the original investor, the Anti-Dilution Rights of the investor gets triggered and accordingly the investor shall have the right to subscribe to additional shares of the startup company at no additional cost or at a significantly lower price. Thus, the original investor gets additional shares to compensate for the loss of value of the shares purchased by him originally. There are two mechanisms for Anti-Dilution Rights protection: i. Full Ratchet Method; and ii. Weighted Average Method. [these methods will be discussed in the coming parts to this story]