The Reserve Bank of India (RBI), by a notification dated 20 May, eased restrictions on certain deal structuring tools, i.e. payment of consideration on a deferred basis, escrow and indemnity. To facilitate cross-border M&A, the notification amends the Foreign Exchange Management (Transfer or issue of security by a person resident outside India) Regulations, 2000, to allow deferred consideration, escrow and indemnity arrangements under the automatic route in certain scenarios.
Historically, escrow arrangements in cross-border transactions between a resident and a non-resident, being in the nature of deposits, were not permitted unless specially approved by the RBI. Then, in 2011, the RBI permitted authorized dealer banks to open non-interest-bearing escrow accounts (in Indian rupees) for a maximum of six months, solely to facilitate implementation of foreign direct investment (FDI) transactions.
Escrow beyond six months still required prior RBI approval. Similarly, payment of consideration on a deferred basis in FDI transactions and indemnity payments required prior approval of the RBI. The grant of approvals was discretionary and dependent on specific factual matrices. The notification prescribes that so long as certain specific parameters in respect of such arrangements are met, they would not require specific approval of the RBI.
For transfer of shares of an Indian company between residents and non-residents, the notification permits that up to 25% of the total consideration can be paid by the buyer on a deferred basis, within 18 months from the date of the share purchase agreement. However, the total consideration finally paid must comply with the pricing guidelines.
Before the notification, deferring payment of part of the consideration required RBI approval and the RBI generally required that in FDI transactions payment to be made upfront on closing should be in compliance with pricing norms (i.e. above fair value). The notification allows that the upfront payment on closing and the deferred component, together, have to be in compliance with the pricing guidelines.
As for escrow for indemnity claims in share purchase deals between residents and non-residents, if the total consideration is paid by the buyer to the seller, the notification allows the seller to furnish an indemnity of up to 25% of the total consideration, for a period not exceeding 18 months from the date of payment of full consideration. Again, the total consideration finally paid must be in compliance with the applicable pricing guidelines.
An analysis of the notification would suggest that since the payment by a non-resident buyer to a resident seller has to be above fair value, commercially, the parties would place in the indemnity escrow only that fraction of the total consideration which is above fair value (subject to it being up to 25% of the total consideration). Where the seller is a non-resident, up to 25% of the total consideration can be kept in indemnity escrow, as the total consideration has to be fair value or below.
Under the notification, which deals with arrangements permissible under automatic route, up to 25% of the total consideration can be placed in an indemnity escrow. If the parties require the indemnity escrow to be for more than 25% of the consideration, or for longer than 18 months from the payment of consideration, this is not prohibited but would require a specific prior approval of the RBI based on requisite justifications.
While in a deferred consideration arrangement, the time period of 18 months discussed in the notification triggers from the date of the transfer agreement, in case of indemnity escrows, the 18 months commence from the date of the payment of the full consideration. This distinction may in some cases restrict the parties from enjoying the full benefit under the notification.
The gap between execution of the share purchase agreement and closing of the transaction may span several months, particularly where approvals from multiple regulators are required. In such cases, the effective time available for deferment of some portion of the consideration might be less than 18 months. The RBI could have allowed 18 months from closing for payment of consideration on a deferred basis as well, which could have been more beneficial for the parties.
Still, the notification brings about necessary clarity in crucial aspects of deferred consideration and indemnity. The RBI has taken due cognizance of increasing investor maturity and the new dynamics involved in cross-border deals, and has made the regulatory environment more investor friendly.
Luthra & Luthra is a full-service law firm with offices in New Delhi, Mumbai, Bengaluru and Hyderabad. Saurabh Tiwari is a partner and Saurav Bhaumik is an associate at the firm. This article is intended for general informational purposes only and is not a substitute for legal advice.