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How strong are investor rights in Indian private equity? All you need to know

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  • Sudish Sharma and Anantha Desikan S

  • Private Equity (“PE”) investments are primarily made by PE firms, venture capital firms, foreign institutional investors (FII) etc. Typically, a PE investor invests in minority shareholding of a company in the range of 10% to 25% of the equity share capital by way of subscribing to (i) equity share capital of the company or (ii) compulsorily

    convertible instruments of the company. In such a case, the individual promoters of the company hold the majority shareholding and control in the company. The PE investor may also acquire majority control in a company.

    The rights and obligations of the PE investor in a company is determined under the shareholders’ agreements. A PE investor seeks to obtain the following rights under the shareholders’ agreement:

    (a) Appointment of nominee director on the board of directors of the company (“Board”): PE investors usually have 1 or more nominees on the Board depending on the shareholding in the company which is supported by deadlock provisions whereby the presence of nominee director of PE investor will be mandatory for the purposes of satisfying quorum requirements for meetings at (i) Board level, (ii) shareholders’ level and (iii) committee level of the Board. In certain cases, the PE investor also appoint a Board observer to track the progress of the business instead of appointment of a nominee director.

    (b) Rights in relation to affirmative voting: In general parlance, affirmative voting rights are akin to veto rights of PE investor whereby the company is required to obtain prior written consent of PE investor to undertake certain actions at meetings at (i) Board level, (ii) shareholders’ level and (iii) committee level of the Board;

    (c) Anti-dilution protection: The PE investor seek anti-dilution protection to prevent dilution in the shareholding interest of the PE investor;

    (d) Information and inspection rights: The common information and inspection rights include the rights to receive or examine certain financial data or other types of information in the company apart from the information rights received as a member of the Board;

    (e) Transfer restrictions on securities: The PE investors are not in charge of the company’s operations and management and accordingly, PE impose lock-in obligations on the promoters. The most common forms of securities transfer restrictions in SHA are lock-in period obligations, right of first refusal or right of first offer, drag along rights and tag along rights; and

    (f) Exit mechanism: A PE investor tries to negotiate and obtain any 1 or more of the following exit mechanisms, namely, (i) call option, (ii) put option, (iii) buyback of securities by company, (iv) strategic sale of securities to third party and (v) IPO etc.

    Under the Companies Act, 2013, a company is bound by the constitutional documents i.e. memorandum of association (MOA) and articles of association (AOA). Therefore, (i) the company is also made party to the shareholders’ agreements so as to make the provisions binding on the company and (ii) provisions of the shareholders’ agreement are included in the AOA for enforcement of PE investor’s rights.

    The enforceability issues in PE transactions generally occurs at the exit stage of the PE investor. Before investing, a PE investor should ensure that they have a well-defined exit policy. The exit policy laid should account for (i) exiting a non-performing investment; (ii) ending a business that is not upbringing profits; or (iii) exiting the investment after obtaining the desired amount of profits.

    In terms of extant exchange control laws of India an assured return cannot be guaranteed to a PE investor and the price of securities issued to a person resident outside India is subject to pricing guidelines. Under the extant exchange control laws of India, put options and call options are allowed but not at a pre- determined price.

    The prohibition on having an assured return as part of a put option came into scrutiny in two recent judgments. In Cruz City 1 Mauritius Holdings vs. Unitech Limited, the parties and their subsidiaries had entered into various agreements for investment in real estate projects in India. Due to delay on the part of the company in completing the project, the investor exercised its put option which required Unitech’s subsidiaries to purchase its shares. The Delhi High Court held that the put option was enforceable. The contention that the assured return provisions in a contract are not enforceable was rejected by the Court on the ground that the assured return was not absolute and unconditional. The Court also distinguished assured return as prescribed by RBI and damages for a breach of contract and held that the investor was entitled to its remedies which included damages.

    Similarly, in NTT Docomo Inc vs. Tata Sons Limited, the transaction documents entered between parties specified that if the targets agreed mutually between the parties were not achieved within the stipulated timeframe, then the investor had the option to exit from company, at a price which was not less than fair market value of the shares of the company or half of the amount invested by investor, whichever is higher. The investor decided to exit the joint venture as the stipulated targets were not achieved by the company. The company failed to honour the exit option given to investors by claiming that the exit clause would violate the extant exchange control laws of India. Hence, the parties invoked the arbitration clause in order to amicably settle their dispute. The arbitration award was given by the London Court of International Arbitration was in favour of the investor. When the award was to be enforced in India, the Delhi High Court ordered that the award was not violative of any provisions of the Indian law or public policy and allowed the LCIA award to be enforced in India on the grounds that the award to the investor were

    damages for breach of the transaction documents and not the assured return on the purchase price of the shares.

    The Indian laws seek to create a business environment that revolves around accountability, transparency and trust for the benefits of the investors. The PE investors rights are adequately protected in India and the same is evident from the approach taken by the Indian judiciary in dealing with cases seeking the protection of investors’ rights. It is also important that at the time of drafting and negotiating transaction documents, the rights of the PE investor are clearly identified with no ambiguity and bearing in the mind the legal enforceability of provisions of the transaction documents.

    By- Sudish Sharma is Executive Partner & Anantha Desikan S is Senior Associate, Lakshmikumaran & Sridharan Attorneys. Views are the authors' own.