Private equity – Shareholders’ rights and areas of potential disputes
Authors: Shyam Pandya, Shailesh Poria, Aasim Syed, Rashmi Ramnath
Keeping pace with the evolution of private equity (PE) investments as a mainstream source of funding, there has been a commensurate increase in differences and conflicts with investee companies, promoters and other stakeholders. Such disagreements arise on multiple grounds, ranging from corporate governance, contractual rights & obligations, board nomination and investor exit amongst others. Many of these provisions are documented in a shareholders’ agreement (SHA) or an investment agreement. This article focuses on the key contractual legal rights and obligations in SHAs that engender disputes between PE investors and promoters as well as the effective mitigation, response and resolution strategies.
CONTRACTUAL RIGHTS AND OBLIGATIONS
PE Investors and the promoters typically negotiate their legal rights and obligations in relation to the following:
- Pre-investment liabilities and status of the business, employees, pending litigations, existing contracts and tax & regulatory compliance: Representations and warranties (R&Ws) form the basis on which an investment is made by the PE investor in so far as factual matters for the period prior to the investment are concerned. From an investment transaction point of view, R&Ws are documented in the form of negative or positive factual assertions from the promoters (such as confirming if the investee company does not have any regulatory or third party litigation, if all material business contracts are subsisting and have not been terminated, or confirming that the books of accounts of the investee company reflect its true and accurate financial position). If there are exceptions to ensure that the R&Ws are not breached, the promoters furnish relevant factual disclosure in the form of a disclosure letter. From a documentation standpoint, PE investors usually insist on the promoters to back-stop a breach of R&Ws or a misrepresentation of R&Ws by way of an indemnity. Pursuant to this, should a breach of R&Ws occur, it gives the PE investor the right to seek monetary claims against the promoter.
- Post-investment oversight – board nomination: Whilst as a minority financial investor, PE investors do not usually take the onus of day-to-day operations of the investee company, they usually insist on appointment of a nominee on the board of directors. Where the clause does not provide for requirement of approval of the other shareholder, the appointment must be immediate. Further, the presence of such nominees is also required to constitute a valid quorum for a meeting of the board of directors.
- Veto rights of the PE investor and share transfer restrictions: Under the Companies Act (Act), certain actions of the company require consent of shareholders of the company either by way of an ordinary resolution (which requires a simple majority of the shareholders) or a special resolution (which requires ¾ of the votes in favor of that resolution). In addition to this, PE investors may negotiate to have veto on certain matters. This contractually negotiated right ensures that despite having a minority stake in the company, PE investors have the right to veto certain actions that could potentially affect their investment as well as influence certain critical decisions of the investee company. Usually, veto rights are in relation to raising further debt or equity funds, issuance of shares, approval of accounts, business plans and annual budgets, acquisition or divestment of new business, hiring or terminating key employees as well as statutory auditors. It is pertinent to note that the courts have allowed clauses in the articles that have a higher threshold than those of the Act where the Act is silent on that matter.
- Exit rights: Exit related rights are critical for PE investors. Set out below are some of the key aspects of exit provisions and attendant judicial interpretation:
- Obligation of promoter to provide exit on a ‘best effort’ basis: While exit rights are extremely important for investors, from the promoter’s perspective it is not an absolute obligation since exit is dependent on several factors such as macroeconomic conditions, regulatory framework affecting the industry and other conditions beyond the control of the promoter. In recognition of this aspect, the exit obligation of the promoters is negotiated to be on a ‘best effort’ basis, or exit terms and valuation are based on the approval of the PE investor.
- Put option: Put options are structured in a way that empower the PE investor to require the investee company or the promoter to purchase the securities held by the PE investor at a pre-agreed price or at a fair market value, if the PE investor has not exited. Put option clauses are negotiated either to be on the investee company or personally on the promoters.
- With regards to the investee company, the put option is implemented via a buy-back as per the provisions of the Companies Act. Under the Companies Act, the investee company is required to buy-back its shares or specified securities out of its free reserves, or the securities premium account or the proceeds of the issue of any shares or other specified securities. Additionally, the buy-back should be authorized by the articles of association and approved by ¾ shareholders of the investee company and cannot be more than 25% of the aggregate paid up capital and free reserves of the investee company in any financial year. There are other procedural conditions to be complied by the investee company for undertaking a buy-back of shares.
- A put option in relation to promoters is governed by the Indian contract law and, if the investee company is a listed company, the regulations under the Securities and Exchange Board of India Act, 1992 and the guidelines and circulars issued by the Securities and Exchange Board of India (SEBI) are also applicable. Post October 2013, put options in relation to listed companies have been expressly permitted by SEBI subject to the following conditions: (i) the PE investor should hold the securities for a minimum of 1 year, (ii) the price for the sale and purchase of the security has to be in compliance with applicable laws, and (iii) the put option has to be settled by actual delivery of the underlying securities.
- Non-resident PE Investor: If the PE investor is a person resident outside India in both the above circumstances, the provisions of the Foreign Exchange Management Act, 1999 and the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 (FEMA 20R) are applicable. The pricing guidelines prescribed under FEMA 20R for a transfer of a shares by a person resident outside India (i.e. a PE investor) to a person resident in India (i.e. the promoter or the investee company) require such transfer to be at a price not exceeding (i) the price as per the guidelines and regulations prescribed by SEBI in case of a listed company and (ii) the price as per any internationally accepted pricing methodology for valuation on an arm’s length basis duly certified by a Chartered Accountant or a SEBI registered Merchant Banker or a practicing Cost Accountant, in case of an unlisted company.
In addition, FEMA 20R specifically provides that the guiding principle would be that the person resident outside India is not guaranteed any assured exit price at the time of making such investment/agreement and shall exit at the price prevailing at the time of exit. “Hence, put options on the investee company or the promoters cannot be at a pre agreed price or return and will need to be at the price prevailing at the time of exit.”