Contractual Share Swaps Flavour of the Season

In terms of the Companies Act, 2013, issuance of shares of an unlisted company for consideration other than cash, i.e., a share swap, is permitted so long as it is authorised by its Articles of Association, a special resolution of the shareholders and justified by the valuation report of a registered valuer.

Companies across sectors seek expansion of their market share, access to improved technologies and efficiencies, diversification of their offerings and increase of shareholder value. Inorganic growth through mergers, acquisitions and joint ventures helps achieve such objectives. However, when the entity is not cash rich, it is difficult to smoothly execute such inorganic transactions. Acquisition of targets, technology, or other assets for consideration other than cash – especially shares of the acquiring entity, is a viable alternative in such situations. Whilst amalgamation of the acquirer and target is one of the quintessentially tried and tested methods for such non-cash transactions, a plain vanilla share swap (without the trappings of a court process) is also gaining ground.

Several recent acquisition transactions have opted for this method. The board of directors of Maruti Suzuki India Limited (“MSIL”) approved a share swap transaction for acquisition of shares of Suzuki Motor Gujarat Private Limited (“SMG”). MSIL will issue its equity shares on preferential allotment basis to Suzuki Motor Corporation (“SMC”), a Japanese multinational company, as consideration for the acquisition of 100% stake of SMC in SMG. In another instance, the DLI Group will be selling its interest in Distribution Logistics Infrastructure Private Limited (“DLI”) to Pristine Malwa Logistics Park Private Limited (“Pristine”) for shares and cash, whereby Distribution and Logistics Infrastructure India, Mauritius, which owns 99.99% interest in DLI, will receive, in consideration for selling its entire shareholding in DLI, a cash payment and up to 33% of Pristine’s issued share capital. Another example is that of RHI Magnesita which entered into a share swap agreement with Dalmia Bharat Refractories, to acquire all outstanding shares in Dalmia OCL Limited in exchange for new shares in RHI Magnesita India.

This article examines contractual share swap arrangements in acquisition transactions, including cross-border transactions.

A share swap is an arrangement where shares of the acquirer are used as currency (instead of cash) to buy the shares of the target company. This typically occur in the following scenarios:

• Scenario 1 - Indian Company A buys shares of Indian Company B from resident / non-resident shareholders by issuing them Company A shares (instead of paying cash);

• Scenario 2- Indian Company A buys shares of Foreign Company B from resident / non-resident shareholders by issuing them Company A shares (instead of paying cash);

• Scenario 3 - Shareholders of Indian Company B sell their shares in the Company to Foreign Company A, in exchange for shares of Foreign Company A.

Under Indian law, Scenarios 1 and 2 are possible. Scenario 3 is not permitted.

In terms of the Companies Act, 2013, issuance of shares of an unlisted company for consideration other than cash, i.e., a share swap, is permitted so long as it is authorised by its articles of association, a special resolution of the shareholders and justified by the valuation report of a registered valuer.¹ Listed companies are required to comply with the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 and are required to submit a valuation report by an independent registered valuer to the stock exchange(s) where the equity shares of the issuer are listed.²

For cross border share swaps under Scenario 1, the FDI Policy, 2020 permitted FDI through swap of shares without government approval in automatic sector where the valuation of the shares is undertaken by a merchant banker registered with SEBI or an investment banker outside India registered with the appropriate regulatory authority in the host country (“FDI Pricing Guidelines”). Under the FEMA (Non-debt Instruments) Rules, 2019 (“NDI Rules”), an Indian company may issue equity instruments to a person resident outside India against swap of equity instruments, if the Indian investee company is engaged in an automatic route sector³. Further, the NDI Rules specify that the FDI Pricing Guidelines will apply where equity instruments of an Indian company are transferred by a person resident outside India to a person resident in India through a swap of equity instruments⁴

In terms of FEMA(Overseas Investment) Rules, 2022, FEMA (Overseas Investment) Regulations, 2022 and FEMA (Overseas Investment) Directions, 2022 (“ODI Framework”), a person resident in India may make ODI by way of swap of securities, subject to conditions prescribed therein. Further, the ODI Directions prescribe that in case of swap of securities, ‘both the legs of transaction shall comply with FEMA provisions, as applicable.’

Thus, under Scenario 2, where an Indian investor, engaged in automatic sector, undertakes ODI by subscribing to/ acquiring shares of a foreign company (“ODI Leg”), and issues its own shares to the non-resident shareholders of the foreign company, as consideration for its ODI (“FDI Leg”), such transaction will be required to comply with the provisions of both the ODI Framework and the NDI Rules. That entails that the pricing guidelines under the ODI Framework apply to the ODI Leg and the FDI Pricing Guidelines apply to the FDI Leg. The parties will also be required to undertake necessary reporting with the RBI for both the ODI Leg and the FDI Leg.

However, no specific rules are prescribed for secondary share swaps making Scenario 3 not doable under Indian law. It will require RBI approval and there are not many precedents of Indian sellers receiving such approval. In our view, a facilitative amendment to the NDI Rules whereby swap of secondary shares of an Indian company for the shares of a foreign company is permitted will open doors for new investment structures and also enable smoother exits for Indian promoters.

Contractual share swap structures face the following key concerns:

(i) Valuation: The swap ratio is fixed as on a certain date. This is a lock box approach, not leaving much room for any subsequent change in valuation or working capital related adjustments. This may result in deal difficulties if the time period between signing and closing of the deal is long.

(ii) Non-cash transaction: It may not be an ideal structure where the target is looking to raise funds for its operations, or the promoters are looking for a cash exit.

(iii) Dilution: In a share swap, which involves issuance of fresh shares, the promoters of the acquirer entity should be prepared for dilution of stake and if the share consideration is substantial, entering into suitable governance related arrangements with the target’s shareholders.

(iv) ODI-FDI anomaly: Specifically, for cross-border swaps, there seems to be an anomaly between the extant regulations governing FDI and ODI. Under the ODI Framework, it is permissible for an Indian investor to issue its own shares for subscribing to/ acquiring shares of a foreign target. However, the reverse does not seem permissible under the NDI Rules.

(v) Compliance burden for cross-border swaps: Where the share swap transaction results in an ODI-FDI structure, compliance with pricing and reporting guidelines needs to be undertaken for both the legs under their respective framework.

Disclaimer – The views expressed in this article are the personal views of the authors and are purely informative