Cross Border Investment Exit Routes : Planning Before the Transaction
Introduction : Transaction agreed upon in the term sheet, is unenforceable according to Indian legislation. India serves as a clear illustration of what is expected. The laws surrounding exits in this country account for more than just the commercial aspects. If a foreign investor is selling to a resident buyer or enforcing the right of sale through a put option, for example, this will automatically involve compliance with exchange control regulations and company law, legislation regulating foreign investments, and tax law.
We will discuss the importance of keeping rights to exit and transfer limitations in mind and their tax implications before the transaction is finalized. We will also talk about drag along, tag along, put and call options and provide a useful checklist for the exit planning process.
Legal Provisions
Foreign Exchange Legislation
The Non-Debt Instruments Rules of the Foreign Exchange Management Act, 2019 permit equity instruments to include an option clause. One of the requirements is that there must be a minimum lock-in period of one year (or the specific term for the industry involved, whichever is longer), and no right or entitlement to exit at a guaranteed price exists. Expert commentary interprets the requirement as being that the exit price will have to be calculated based on fair market value at the time of exit. The usual traps include guaranteed internal rates of return and floor prices.
Securities Law
The notification from SEBI dated 3 October 2013 allows contracts for preemption purposes. This includes the right of first refusal, tag-along and drag-along rights, provided that they are contained in either SHAs or articles. In addition, purchase/sale options for securities are permitted, provided that the seller has continued ownership for a minimum duration of one year, and contracts settled through actual delivery. Any contracts must conform to FEMA’s established practices, and contracts entered into before the notification cannot be considered valid as per the notification. Previously, SEBI was against options as they did not comply with the provisions of the Securities Contracts (Regulation) Act of 1956. The notification is valid regardless of section 18A of the Act.
Corporate Law
In accordance with section 2(68) of the Companies Act, 2013, a private company has to limit the transfer of its shares. On the contrary, the shares of a public company may be transferred freely according to section 58(2). However, there is a condition that makes any agreement between two or more parties regarding transfer of securities a contract under law. When the company refuses to transfer shares, it has to give reasons for refusal within thirty days. Sections 241 (oppression), 66 (reduction of capital), 68 (buy-back) as well as sections 230–232 (schemes of arrangement) are additional ways of exit.
Company Law
According to section 2(68) of the Companies Act, 2013, it is mandatory for a private company to include restrictions on the transfer of its shares in its Articles of Association. On the contrary, shares in a public company are freely transferable, as provided by section 58(2), although the proviso helps to ensure that any agreement between two or more persons on the transfer of securities can be construed as a valid contract. The company that rejects the application for a transfer must provide specific reasons for refusing the application. Exit routes are also determined by sections 241 (oppression), 66 (reduction of capital), 68 (buy-back), and sections 230-232 (schemes of arrangement).
Publicly Traded Firms
SEBI LODR Regulation 31B, which has been in effect since June 2023, mandates that the special privileges accorded to shareholders in a listed company must be validated through a super majority of shareholders every five years. The rights include such things as right to refusal and tagging along.
Income Tax
The latest tax law has been created to enhance the previous tax law as per the Tax Act of 1961. Though tax has been improved greatly, indirect transfer clauses broaden the definition in a way that it provides revenue generated from Indian sources due to different transactions with Indian assets.
Legal Analysis
Exit Clauses have Multiple Layers
The structure of exit clauses involves commercial, corporate and regulatory elements. In many contracts, only commercial terms are clearly set. A put option may be well drafted in commercial terms, but when it requires fixed return, it goes against FEMA’s stipulation that prohibits guaranteed exit prices. Hence, it is important to consider the validity of the clause in the Indian legal context.
Restrictions on Transfer
Commonly the restrictions include matters of lock-in, ROFR, right of first offer, requirements of consent and pre-emptive rights. The apex court of the country ruled that restrictions on transfer of shares must be confined to transfer laid down in the articles and in the absence of any restriction in the articles, neither the company nor any shareholder can claim that a restriction exists. Subsequently, the High Court of Bombay confirmed the existence of ROFR between shareholders in a publicly listed company and even raised the doubt as to whether it is necessary for it to even appear in the articles. The provision under Section 58(2) has now made such agreements valid contracts.
The two lines of authority involve different types of companies and different facts. The law is not uniform. The surest way of drafting is to copy any SHA limitations into the articles of incorporation and state so in the SHA.
In addition to the above, there is another layer of complexity with foreign investors: the buyer. A sale to a resident or non-resident changes the pricing and reporting obligations under the FEMA, and sectoral limits and/or approvals may apply to the exit itself.
Drag along Rights
The right of drag-along enables the majority or a specified holder to compel other parties in a sale. This eliminates hold-out risks, and the buyer can take over the entire company. However, there are three matters to consider.
Triggers and price are crucial aspects in that the contract must specify who can use the right, what is the shareholding threshold and what is the minimum price.
Protections for the dragged holder should guarantee same conditions for all sellers and limit the warranties and indemnities.
Enforceability. The validity of the provision is accepted, although actual enforcement is determined by the manner in which it has been drafted. The Supreme Court in the case of Tata Sons upheld a provision of the articles that allowed the board to compel a member to sell his shares and declined to find oppression simply because some minority interests were aggrieved. Courts will enforce a drag-type provision within the articles, although a risk exists that a party aggrieved by its application may file a complaint of unfair conduct under section 241.
Tag Along Rights
The concept of tag-along rights refers to the situations in which minority stakeholders are given the right to participate in the deal on the same conditions as the majority. The document should reference its characteristics such as triggering events, basis of pricing and the notification period. In cases of publicly traded firms, Regulation 31B implies that the right needs to be certified for five years. Additionally, one should verify the existence of triggering events as per SEBI Takeover regulation.
Put and call options
With a put option, an investor has the authority to demand that the promoter or corporation purchases its own shares. Conversely, with a call option, either the promoter or another third party holds the right to purchase the stock. The SEBI regulates both of these operations while applying the one-year holding and settlement conditions. There are a few practical points about this situation.
Pricing. The exit price must be linked to the fair market pricing instead of the fixed return value. The Bombay High Court supported the put option which is tied to the fair market pricing and does not guarantee any return.
Obligor. Your put option with a company poses capital-maintenance challenges like the buy-back provisions (section 68). However, this puts an extra burden on the promoter, and a put against the promoter will be easier to arrange but may depend on the promoter’s repayment capacity.
Remittance. A valid award does not resolve the situation. It has been held that while Indian courts have enforced awards on put options and even though a violation of the Foreign Exchange Management Act (FEMA) cannot by itself be construed as a public-policy ground, the approval of the Reserve Bank of India remains essential for the remittance process.
Tax Implications
Tax forecasting should take place at the entrance. There are three points to note. First, select the holding jurisdiction based on reality and not just treaty rates. In Azadi Bachao, the Supreme Court ruled that treaty shopping is not illegal per se, but the case about Tiger Global indicates that there has been a significant movement away from that position and now the Mauritius treaty has a main purpose test. Second, indirect transfers (the sale of foreign holding companies that have significant revenue from Indian assets) remain taxable. Third, the type of exit affects the tax outcome. The sale of shares, buyout, and scheme are taxed differently, therefore, the method of exit not taking into account tax implications can diminish the net proceeds. Buyout money, for example, is now taxed as capital profit.
Case Laws
In V.B. Rangaraj v V.B. Gopalakrishnan (1992) 1 SCC 160. The Supreme Court ruled that limitations on transfers that are not in the articles mentioned do not have any binding effects on the company or shareholders. Therefore, it is essential that the restrictions in the SHA be part of the articles.
Cruz City 1 Mauritius Holdings v. Unitech Ltd. (Delhi HC, 11 April 2017). The court implemented an award from the London Court of International Arbitration concerning a put option that mandated buying at a price providing a rate of return of 15% IRR after tax. The court interpreted the public-policy defence as extremely limited, while the payments remain under the control of the Foreign Exchange Management Act (FEMA) and the Reserve Bank of India (RBI). The court is regarded as pro-enforcement, but it does not provide safety during the drafting stage of guaranteed-return clauses.
Practical Implications
The exit plan is an exercise that should be carried out at entry. Below is a checklist that investors can use to avoid disputes subsequently.
Checklist for exit planning
Determine exit routes. Identify realistic exit routes (strategic sale, IPO, repurchase, promoter buyout, or secondary sale) and structure the plan around those routes most likely to occur.
Check FEMA and sectoral limits. Verify limits and compliance, and the pricing/ reporting that the buyer would have to comply with.
Reproduce SHA provisions in the articles. Incorporate ROFR, tag, drag, and transfer limitations in both instruments.
Develop structures judiciously. Employ fair-value computations, at least a year of moratorium, deliverable settlement, and solvent counterparty. Eliminate guaranteed returns.
Specify drag-along protections. Clarify the triggering event, floor value, equal conditions, and liability limits.
Explain the concept of tag-along mechanics. Explain the trigger, pricing mechanism, notice period, and five-year approval period under Regulation 31B for companies whose shares are listed.
Develop a plan for the tax situation. Calculate the result after taxation in each case, analyze the subject, and establish tax liability and indemnity risk.
Select a forum. Identify the location, law, organization, and plan the variance of RBI approval for transfer of funds.
Assessing the worth of documents and obtaining approvals. Identify who is responsible for valuing shares as well as the techniques applied. Identify, as well, all approvals needed from all boards, shareholders, and regulators.
Conduct review regularly. Reassess the exit arrangements after any changes in regulation, financing, or business activity. Exit conflicts occur when things are unclear: a murky drag-along provision, a valuation clause with multiple interpretations, or a put option for a company that is not permitted to buy back its shares. Writing a good agreement upfront is much cheaper than a lawsuit later on.
Conclusion
An exit is defined as the moment when the investments are executed legally. In India, the exit rights will be influenced by the foreign currency rules, the company’s legislation, and the stock market’s laws. Any clause which does not comply with any of these rules may become unverifiable or expensive. Drag and tag along rights along with put and call options are efficient mechanisms only if they comply with the articles of association of the company and that of FEMA and SEBI regulations and if proper planning concerning taxation is carried out at the very beginning.
Investors who regard the exit as an element of the initial agreement, not something to consider afterward will be able to minimize their potential losses and decrease the danger of being involved in a disagreement. It is advisable to consider the exit strategy prior to the transaction so that all the parties have reasons to reach an agreement.
Author: Swaraj Pawar in case of any queries please contact/write back to us via email to content@khuranaandkhurana.com or at Khurana & Khurana, Advocates and IP Attorney
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