Juhi Mehta and Natasha Rao
In contrast to the global trend, M&A and other investment activity in India has seen steady growth over the last year. There has also been a significant recovery from the downturn in deal activity between 2022 and 2023 in India.
To support this growth, simplifying compliances and promoting ease of doing business in India has been a mantra of the Indian government for some time now. However, India has historically been, and continues to be, a compliance-heavy jurisdiction, with the extent of prescribed compliances and existing non-compliances by intended targets often coming as a surprise to investors who are used to doing business in less compliance intensive jurisdictions.
However, not all non-compliances are show-stoppers and it is important to assess their potential impact not only on the deal at hand, but also on any future plans of the investor for the target. An upfront impact assessment ensures that the non-compliances are dealt with in a commercially sound and efficient manner.
In this article we discuss the approach to dealing with non-compliances under sector agnostic legislations which may not be showstoppers in themselves, but which individually or collectively could impact deal value or deal logistics.
Categorising non-compliances
The diligence exercise typically throws up non-compliances under sector agnostic legislations such as the Companies Act, 2013 (“CA 2013”), Foreign Exchange Management Act, 1999 (“FEMA”) (where the target has received investment from overseas), taxation legislations and the entire suite of labour laws that are in force in India. Understanding the implications of non-compliances is key to addressing them in a manner which supports the deal, and solving for them. Broadly, consequences or implications of these non-compliances are considered under the following heads:
Non-compliances which result only in monetary penalties: Depending on the non-compliance, monetary penalties may range from a few dollars to a substantial amount, may be capped or continue to add up till such time that the non-compliance is actually rectified and may apply either only to the target, its officers and directors or both. For example, where the target is in violation of the requirement of having at least one resident director on its board, both the company and its directors are punishable with a fine that can extend up to INR 3 lakhs (~USD 3500) in case of the company and INR 1 lakh (~USD 1200) in respect of each director of the company. On the other hand, a non-compliance with the requirement of producing any information sought for by the registrar of companies may result in exposure to a fine of INR 1 lakh (~USD 1200) for both the target as well as its officers/ directors, and in case of a continuing failure, an additional uncapped fine which could extend to INR 500 (~USD 6) for every day that the non-compliance persists. Non-compliances with determinable monetary penalties are easier to address; the challenge lying with instances of non-compliances where monetary penalties cannot be quantified upfront.
Non-compliances which may result in imprisonment of directors and officers of the company: Several Indian laws prescribe not just monetary penalties for non-compliances but also imprisonment of directors or other officers of the company who are charged with ensuring compliance. For example, if a company fails to pay gratuity contributions as per the law in force, the directors/ officers of the company can be imprisoned for up to 2 years. This is in addition to the fines that may be imposed on them. While the thumb rule is that only directors /officers who were responsible for ensuring compliance would be likely to be imprisoned, investors should be wary of implications of continuing non-compliances.
Non-compliances which are likely to affect deal timelines: Certain non-compliances may have a considerable impact on deal timing. For example, regulations now require all Indian private limited companies (with some exceptions) to issue shares in dematerialised form. If the target company or the selling shareholder have not completed demat related formalities, this can materially impact deal timelines. Similarly, where the deal envisages cross-border issuance or transfer of shares, any non-compliances with foreign exchange control reporting requirement for prior issuances or transfers of shares involving non-residents can materially impact deal closure.
Non-compliances which are likely to affect future business plans of the investor: There may be instances where the existing non-compliances do not have an immediate impact on the deal at hand but they can potentially impact the investor’s plans to restructure or reorganise the Indian entity / business. For example, where a deal involves only an indirect transfer of the Indian entity, existing non-compliances with foreign exchange control regulations at the India entity level may make it difficult for the investor to carry out any restricting plans for the Indian entity.
Determining how best to address non-compliances from a deal perspective
Some key factors that determine how a non-compliance is addressed in the context of a deal are:
the exposure that the buyer may have in both monetary terms as well as in terms of goodwill;
impact not only of the non-compliance itself, but also of the available remedial options, on deal timelines;
determining which party is best suited to address the non-compliance; and
assessment of the impact of non-compliances on future plans of the investors.
On the basis of these factors, risks arising from non-compliances may be addressed through one or more of the following:
Rectification, either as a pre-condition to closing or as a condition subsequent: Where the non-compliance is such that it is best addressed by the seller, its rectification may either be addressed as a condition precedent to closing or as a condition subsequent, depending on its impact on deal timelines. For example, non-compliance with reporting obligations under foreign exchange control regulations would best be addressed by promoters of the Indian entity as this would require knowledge of facts that they are best suited to access.
Reduction in purchase consideration: where the consequence of non-compliance is monetary, can be determined upfront and highly likely to crystallise, parties may agree to a reduction in the purchase consideration.
Specific indemnities: which compensate the buyer for loss arising from specifically identified non-compliances. The monetary and time limits, and de-minimis amounts for such indemnities are also typically negotiated.
Assumption of risk by buyer: where the consequences of the non-compliance are not material or the likelihood of consequences materializing are low or risks can be addressed through implementation of housekeeping measures, the buyer may opt to assume the risk.
Conclusion
While there is no one-size-fits-all formula to determine what treatment a specific non-compliance deserves, not all non-compliances have to become a showstopper or impact deal-timelines. A commercially savvy determination of the potential consequences of non-compliances can go a long way in ensuring a smooth deal closure.