Time will test efficiency of 2013 act for PE investors

By Aakash Choubey, Khaitan & Co

The Companies Act, 2013, which received the president’s assent on 29 August, will replace the decades old Companies Act, 1956. Although only 98 sections of the 2013 act have been notified till date, the 2013 act as a whole will bring in sweeping changes to India’s corporate law regime. It is, therefore, important that private equity (PE) investors analyse the effect of the 2013 act on their existing investments and, keeping in mind the act’s provisions, conduct proper diligence and negotiate adequate contractual protections for their future investments.

Some of the key changes and provisions that PE investors should keep in mind are outlined below.

Key provisions

An investor should ascertain the true status of the Indian investee company. The ambiguity regarding a subsidiary of a public company has been put to rest by the 2013 act, which clearly provides that a private subsidiary of a public company will be deemed to be a public company, even if its articles are in the nature of a private company.

Aakash Choubey
Aakash Choubey

PE investors can continue to invest in shares with differential rights to achieve higher economic returns. However, the 2013 act does not provide any relaxation for private companies, as was provided under the 1956 act. Also, the rights issue process has now been extended to private companies and if an investor proposes to invest in convertible securities of a private company, the price of the resultant shares would have to be determined up front. The concern here is whether the exact price has to be determined up front and there seems to be a conflict with the pricing provisions under the Foreign Exchange Management Act, 1999. Further, investors investing in listed non-convertible debentures of an unlisted company may have to comply with the requirements for investment in a listed company, as the definition of “listed company” under the 2013 act is wide enough to include such investments.

The 2013 act finally settles the position that investors investing in public companies can enforce share transfer restrictions (such as lock-in, tag-along, drag-along, etc.) against the other contracting shareholders. Transfer restrictions in a cross-border joint venture, where the foreign shareholder is a public company, would also work now, as the concepts recognized under sections 4(6) and 4(7) of the 1956 act have not been incorporated in the 2013 act.

PE investors should also bear in mind that the 2013 act provides that: at least one director of the company must be resident in India for at least 182 days in a calendar year; a director nominated by the investor will not be considered to be an independent director (to whom special immunity provisions apply); directors cannot acquire a call or put option in relation to the company’s shares or debentures; and an investor’s nominee director cannot vote where the investor is a party in the agreement put to vote.

Further, with regard to existing investments, as the revised board constitution provisions under the 2013 act may require restructuring of the current board composition, investors should ensure that such board restructuring does not dilute their representation on the board.

The 2013 act also prohibits insider trading by any person, including directors of the company. Since listed companies are already regulated by the Securities and Exchange Board of India (Prohibition of Insider Trading) Regulations, 1992, this inclusion extends the applicability of the insider trading provisions to unlisted companies, which may lead to absurd consequences.

Investor protection and exits

While negotiating investor protection rights, investors should ensure that they do not appear to, directly or indirectly, be controlling the affairs of the company or giving advice, directions or instructions which the board has to follow, as this could now result in the investor being categorized as a “promoter” of the company, which would attract additional obligations and be unfavourable. Investors should also negotiate and include in the articles of the company higher thresholds for amending the protective provisions granted to them under the articles, as the 2013 act allows entrenchment provisions.

Further, the 2013 act restricts investments through more than two layers of investment companies, except when an offshore target has invested in subsidiaries beyond two levels or a company has more than two levels of subsidiaries to comply with applicable law. This may reduce the ability of PE investors to take exposure at the holding company level.

Exits through buybacks (a preferred exit option) will be significantly impacted as the 2013 act mandates a one-year cooling off period between buybacks.

Overall, the 2013 act seems to provide better protection to investors – the scope of the reliefs for oppression and mismanagement has been broadened, class actions have been allowed and private companies have been made subject to greater compliance obligations. However, several provisions of the 2013 act will come in the way of how PE transactions are presently being structured.

Aakash Choubey is a partner at Khaitan & Co. The views of the authors are personal and should not be considered as views of the firm.


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