Ensuring liquidation preference to protect investor rights

Investment agreements generally include provisions for liquidation preference. Investors have the right to receive a specific amount before other shareholders on the occurrence of pre-defined liquidation events such as acquisitions, the merger and sale of substantial shareholdings or of substantial company assets.

Typically, these investors are entitled to receive their initial investment or a multiple thereof before the remaining proceeds are distributed to other shareholders. Liquidation preference is generally available at all stages of investment from seed round to various growth rounds. However, the manner of liquidation preference is usually dependent on the stage of investment. Liquidation preference serves as downside protection for investors, especially where the company is sold at an undervalue. However, liquidation preference clauses are not always enforceable.

Under section 43 of the Companies Act, 2013 (act), holders of preference share capital have a preferential right either to repayment in the case of a winding up of the company or repayment of capital irrespective of a fixed premium being prescribed in the charter documents of the company. However, the Ministry of Corporate Affairs provided, by its notification of 5 June 2015, that the section does not apply to private companies if it is expressly excluded by the company’s charter documents. Therefore, liquidation preference clauses in private company agreements are only enforceable if the articles of a private company exempt it from section 43.

Public companies cannot exclude the applicability of section 43 of the act. Should such a company wish to create a liquidation preference in favour of some shareholders, it will have to comply with the requirements for the issue of shares entitled to differential rights.

Where liquidation preference is to be granted to a non-resident investor, this must comply with the requirements prescribed by the Foreign Exchange Management Act, 1999, and its rules. The Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (rules), govern foreign investment in India through capital instruments. The rules prescribe pricing guidelines for the sale of shares by a person resident in India to a person resident outside India and the other way around. Under the rules, the sale of equity instruments by a person resident outside India to a person resident in India cannot be for a price exceeding the fair market value determined by any internationally accepted pricing methodology. The guiding principle for pricing such equity instruments is that the person resident outside India is not, at the time of investment, guaranteed an assured exit price and will exit at the fair value prevailing at the time of exit. This is the antithesis of a liquidation preference.

If a liquidation preference clause is triggered by the liquidation of the company, all proceeds will be distributed in accordance with the waterfall mechanism of section 53 of the Insolvency and Bankruptcy Code, 2016 (IBC). Under the IBC, settlement of amounts due to debenture holders is the highest priority, followed by preference shareholders and then the equity shareholders. The resolution professional will not be bound by any contractual agreement between shareholders.

It is vital that liquidation preference clauses are carefully drafted to safeguard the interests of investors. If investors are to receive the intended downside protection, they should ensure that the charter documents of a private company exclude the applicability of section 43 of the act. In the case of a public company, investors must check that the shares are issued in accordance with provisions governing shares with differential rights. To the extent that investors reside outside India, they should satisfy themselves that clauses do not fall foul of the pricing guidelines under the rules. Investors must also be aware that any liquidation preference clauses may not be effective if the investee company becomes insolvent and is admitted into corporate insolvency resolution under the IBC.

In summary, meticulous consideration of and alignment with applicable local legal requirements are essential to ensure that liquidation preference clauses are, and remain, effective in protecting the interests of investors in diverse and difficult regulatory regimes.

Parag Bhide is a partner and Mitali Kshatriya is an associate at Bharucha & Partners