Deal Aware

Keywords: Demerger, Companies Act 2013, Company Examples, Corporate restructuring

K

(Dhruv Thakur is a IV year, B.B.A.LL.B student at Gujarat National Law University, GNLU)

INTRODUCTION:

Companies have now figured out that a diversified business model under one listed entity fails to attract the required valuation. In the previous decade, India witnessed a trend where companies rambled diversification drives beyond their central businesses. However, in today’s era, there is a clear inclination towards value unlocking by demerging business units which indicates many of them have now realized that the diversified business model does not work well in terms of stock valuations and fundraising compared to companies which stayed focused on their core businesses. But the question is whether in the last few years demergers have created value for shareholders? Before diving into that it is important to get familiarized with the fundamental idea behind a demerger.

DEFINITION AND RATIONALE OF A DEMERGER:

A Demerger is essentially separation of one or more units of a company to either be liquidated or form a new company independent from the original one. Primarily, demergers are a form of corporate restructuring the objective behind which is to promote specialization. Sections 230 to 240 of Chapter XV of the Companies Act, 2013 (hereinafter ‘CA, 2013’) read with the Companies (Compromises, Arrangements and Amalgamations) Rules, 2016 are the applicable provisions in case of a demerger. The term ’demerger’ is not defined under the CA, 2013 per se but explanation to Section 230 (1) allows for division of shares of different classes as a route for the readjustment of share capital. Section 2 (19AA) of Income Tax Act, 1961 (hereinafter ‘IT Act’)defines a demerger as-

“Demerger”, in relation to companies, means the transfer, pursuant to a scheme of arrangement under sections 391 to 394 of the Companies Act, 1956 (1 of 1956, old act), by a demerged company of its one or more undertakings to any resulting company…”

However, it was held by the High Court of Delhi in the matter of Indo Rama Synthetics Ltd. that the definition under the IT Act was only for the mere purpose of making sure that the demerger was tax neutral, irrespective of whether it fulfills other conditions as regarded by the IT Act.

The rationale behind pursuing demergers is based on the many benefits if offers, which works as motives for a company to initiate the process. It allows a specific division or unit to grow as a separate and focused entity, thereby increasing its efficiency and effectiveness.

To illustrate better, Reliance Jio Infocom Ltd. (hereinafter ‘RJI’) which had three primary undertakings namely (a) digital services business, (b) optical fibre business, and (c) tower infrastructure business went for an NCLT approved demerger process in 2019. It transferred the optical fibre business to a newly formed company ‘Jio Fibre Pvt Ltd.’ and the tower infrastructure business to an existing company ‘Reliance Jio Infratel Pvt Ltd’. However,the digital services business was retained with the original company (RJI).

Each of the three undertakings do have a distinct strategy, separate industry specific risks and operate inter alia under differentiated market dynamics. Even the competition involved in each of the businesses is different from the other two. Hence, segregation of the company by a demerger will incorporate enhanced focus of each of the undertakings and help exploit varied opportunities in their respective fields. Here’s a link to RJI’s composite scheme of arrangement.

Further, in a few cases of family owned companies, demergers are also used to give effect to family partitions, for instance the division of Ambani Group in 2013 between Anil and Mukesh Ambani, splitting up Reliance Industries Ltd. into four distinct entities.

WAYS TO GIVE EFFECT TO A MERGER:

Agreement between the promoters

Under this case a company may hive off its undertaking to a new resulting company. ​ This new company formed due to the demerger issues shares of the resulting company to shareholders of the parent company as consideration. The assets and liabilities pertaining to the undertaking which has been demerged will be transferred to the new resulting company.

2. Demerger under the scheme of arrangement

Similar to the amalgamation process, in this case approval from the NCLT, under CA, 2013 is mandatory. Provisions governing this route are Sections 230-232 of the CA, 2013. However, this route is only permissible if the Memorandum of Association (hereinafter ‘MoA’) and Articles of Association (hereinafter ‘AoA’) of the company allow for such a process. If not, then the first step would be to amend the AOA of the company by passing a special resolution in the general meeting.

3. Demerger under voluntary winding up and the power of liquidator

After the split of the original company into various companies, the original company can go for voluntary winding up under Section 270 of the CA, 2013. Original company may transfer or sell its workings to the resulting companies.

DEMERGERS AND SHAREHOLDERS' VALUE:

Demergers benefit the shareholders of the company by providing them shares of the applicant company (which is going for the demerger) as well as the resulting company (company segregated from applicant company), which in turn divests better opportunities to participate in the management, decision making process, operations and profits.

But is shareholder value in practice enhanced by demergers and spin-offs? It depends and needs to be carefully examined, as with everything else in life. It is a well-known fact that one of the major objectives behind demergers is to increase the shareholder value. Disposal of any undertaking, will replace cash and/or securities for assets. The benefits to shareholders are mightily dependent on the reaction of the stock market. The typical situation is where the subsidiary is in a high rated sector (rated highly by the market) and the seller is outmoded. Then as an inevitable result demerger unlocks the hidden value for shareholders who receive a part in the demerged equity.

To give an example, in 2016 Crompton Greaves through a court approved process demerged its consumer product business into a separate listed company ‘Crompton Greaves Consumer Electrical’. Consequentially, shareholders of Crompton Greaves were issued shares in the resulting company, The result of the arrangement was a 57% combined return of both original and resulting undertaking since its record date on March 16, 2016.

CONCLUSION:

Well, ideally shareholders of the demerged undertakings do reap the benefits of higher focussed businesses with management accountability driving the intrinsic value of each company, propelling their respective share prices higher than had they remained a combined entity. And spin-offs are usually preferred over IPOs by investors due to their assets being better known and better positioning of incentives due to the parent company’s wish for the progeny to succeed. That being said, have spin-offs underachieved after being demerged?

A few definitely have. All things considered, one thing is for certain, be it Crompton Greeves 2016 demerger (57% combined return) or Reliance Jio Infocom’s 2019 demerger, the value generated for shareholders is positively reflected in the market price of the demerged and resulting corporate entities where the split in undertakings is well defined and better thought out.

Keywords: Covid-19, M&A, MAC, Cross-border

(Dhruv Thakur is a IV year, B.B.A.LL.B student at Gujarat National Law University, GNLU)

INTRODUCTION:

The world is facing the challenges transpired due to a global pandemic, and it has already manifested into an economic crisis as evinced by International Monetary Fund. This is surely expected to bring hard-hitting and drastic blows to the M&A scenario. As globalization faces the risk of an impending doom this can especially affect cross border transactions.

Material Adverse Change (MAC) clause is a protective measure which divests the right to either party to terminate the agreement in case of a material change of events or a development which adversely affects the feasibility of the transaction or the company. In these circumstances, as a resort to repudiate transactions, it wouldn’t be unlikely to see the invocation of MAC Clauses in Merger/Investment Agreements.

MAC is available as a recourse from the signing of the agreement to the completion of the transaction. This is usually one of the most rigorously negotiated clauses but is hardly enforced. With respect to ongoing transactions, the most significant aspect of MAC clauses is their specific wording which will determine if COVID-19 can be taken into consideration or not. Buyers/Investors like to keep the scope of MAC clauses broad whereas the sellers like it as narrow as possible.

CAN COVID-19 SET-OFF MAC? 

In scenarios where the signing of the agreement is complete, it is pertinent to note whether “acts of God” (force majeure) or “pandemics” “changes in financial/political/market conditions” are specifically excluded, in which case it would be difficult for the Investor to utilise the MAC clause. However, if not excluded, then to determine the materiality threshold, guidance needs to be taken from the specific wording of the MAC clause.

Usually, courts have deemed a high bar for the occurrence of a MAC event and interpreted MAC clauses narrowly, stating that MAC is any change or event which will render it impossible for any reasonable party to enter into such transactions. There is an evident lack of structured guidelines by the courts.

Indian laws also stipulate that anything that makes it impossible or prevents a prudent person from the fulfillment of their obligation due to turbulent circumstances can be deemed as MAC. Regulation 23(1) (c) of the SEBI Takeover Code, enunciates that the parties under a contract can withdraw from the obligations, if for reasons beyond the reasonable control of the parties it becomes impossible to meet the conditions stipulated therein. Further, courts have also stressed upon the direct correlation between materiality and duration period of the change. It essentially means the development should have durational significance which is a concept even US Court’s Judgements rely upon, which is the assessment of the long-term impact caused by the event.

CROSS BORDER IMPLICATIONS:

Further, most importantly Cross-border transactions are in a rocky boat due to the supply chain being hampered. To elucidate, a major challenge to cross border transactions is that governments across the world are using lockdowns as a countermeasure against COVID-19 which has hampered the cross-border supply chain for goods and services due to constraints on movement of labour and sealed borders. Cross border transaction agreements usually carry a MAC provision for risks and costs which includes a situation of a change in law, post entering the agreement.

In cross border transactions, generally the parties have a predetermined jurisdiction that they would be subjected to, essentially meaning that any relief would not be provided to the injured party, in case the change in law falls outside of such predetermined jurisdiction. Although, principally the restrictions are the same across all jurisdictions since the entire global economy is combating COVID-19.

Hence, attempt must be made to diligently scrutinize the MAC provision, placing the restrictions apropos the lockdown under its ambit. Consequently, it becomes imperative to carefully evaluate the MAC provision as there may be scenarios where a change in law in one particular jurisdiction is not contemplate a change in law in another one.

However, in case ambiguities still persist, the affected party can terminate the agreement for the cross-border transaction, the availability of which heavily rests upon on how the MAC clause under the agreement has been worded. Therefore, it is essential that the MAC provision is devised with utmost attention to detail and a precise materiality threshold in order to solicit the same to a COVID-19 like situation, and it can help steer clear of cumbersome & expensive litigation.

In cross border transactions where the agreement has not been executed yet, more than anything else, both parties must clearly define the risk allocations amongst themselves and resort to eloquent drafting of the provisions with regards to the COVID-19 pandemic, which successively may assist both the parties to mitigate the adverse effect of the pandemic.

CONTEMPORARY SCENARIO:

In India, even after nearly 100 days since the first positive case regrettably, Covid-19 still has a strong grasp over some major metropolitan cities (surely durational implications are expected) and even if pandemics are specifically excluded from MAC, the situation can still fall under events which have industry-wide implications, acts of god or events of nationwide economic impact. Further, now that the Indian Ministry of Finance has already issued an office memorandum declaring that COVID-19 can be treated as a natural calamity, it can thus constitute ‘act of god’. Even the Indian Supreme Court in a 2018 landmark judgment clarified constituents required for being declared force majeure as:

Hence, any impact due to COVID-19 has scope to be covered under the MCA as a force majeure event.

However, ultimately the burden of proof is on the one invoking it and instituting an MAC is an extremely subjective mechanism which all boils down to facts & circumstances of each case. What stays imperative in every scenario for triggering the MAC clause is a cautious & diligent evaluation of the specific wording of the MAC clause and lastly to take all possible measures to mitigate the impact of COVID-19 upon the ability to fulfill the obligations under a contract.

1. Preventive measures to be applicable before the open offer/bid comes into effect i.e. Pre-offer Defenses;
2. Reactionary measures applicable after the open offer / bid i.e. Post-offer Defenses.

1. PRE-OFFER DEFENCES

• Shark repellent / Embedded Defences

• Poison Pill

• Staggered Board Defense

• Brand Pills

Private Companies which are owned and controlled by the promoters own the Brands and/or Critical assets which are licensed or leased respectively to the listed companies.
The listed companies have made provisions in their Charter documents that automatically terminate those license/leasing agreements if the licensee/lessor i.e. the listed company ceases to be in control of the licensee entities. Moreover, an automatic termination of such agreements may not come under the ambit of restrictions imposed by Regulation 26 of the SEBI Takeover Code.

• Golden Parachute

• Buyback of shares at a huge premium

• Greenmailing

• Asset Restructuring

The Crown Jewels strategy entails disinvesting critical assets of the company in order to make the acquisition seem unappealing to the corporate raider. The targeted company also has the option of purchasing certain assets or undertakings which makes the acquisition undesirable for the bidder or may potentially pose anti-trust issues for it.
A more radical approach to the aforementioned strategy is the Scorched Earth approach which entails selling off most, if not all, properties of appreciable value. However, this would leave the major shareholders of the company in control of a non-appreciating enterprise.

• Pacman Defense

• White Knight Defense

• British American Tobacco (BAT)-controlled VST Industries employed this strategy by making ITC its white knight to combat a takeover attempt by Radhakishan Damani.
• The promoters of Oberoi group’s EIH employed this strategy by getting RIL as its white knight to quash ITC group’s attempt to make an open offer by increasing its stake in VST by acquiring a 14.8% shareholding.
• Kalindee Rail Nirman Ltd. employed a white knight strategy as Jupiter Metal attempted a hostile bid to acquire it. In order to fend off the takeover attempt, it approved a preferential allotment of equity shares (24.9% of equity) to Texmaco Rail & Engineering promoted by Saroj Poddar. Texmaco and Kalindee subsequently agreed to merge.
• Saroj Kumar Poddar of the Adventz Group also acted as a white knight for Vijay Mallya when Deepak Fertilizer attempted a hostile takeover of UB Group’s Mangalore Chemicals in the form of an unsolicited open offer.
• Mahindra Realty acted as a white knight to the Sheth family-controlled GESCO Corporation, when Abhishek Dalmia of the Renaissance Group tried to acquire it.

•  Regulatory Bottleneck / Litigation