The Importance of Early Considerations and Exit Strategies in Structuring an International Joint Venture in India

Contributed by Shahana Basu Kanodia, Edwards Angell Palmer & Dodge LLP, and Rashi Mittal, Law Clerk to the Massachusetts Superior Court Justices.
Much has been written about establishing an international joint venture ("IJV") in India. This article explicitly focuses on early considerations and exit strategies that are often neglected. With an increase in the deregulation of foreign direct investment ("FDI") in India, a larger proportion of foreign firms entering the Indian market have no prior business experience in India. Under such circumstances, partnering with a domestic firm and forming an IJV could be a good strategic move. Partnering gives foreign companies an insight into the local consumer and business conditions and access to the Indian partner's pre-established market and distribution channels. It also brings together complementary skills, know-how and resources of two or more parent firms to accomplish specific objectives. To avoid the pitfalls of forming an IJV, however, foreign firms need to pay attention to some early considerations outlined below. Early Considerations A. Foreign Direct Investment An IJV is treated as a domestic company in India. A threshold issue in forming an IJV for a foreign firm is to be aware of the complex and continuously changing FDI regime in India. The FDI rules are sector specific and dictate the level of ownership of foreign firms in an IJV in India. While the FDI rules have been substantially liberalized since the early 1990s, some sectors such as telecommunications, insurance and defense manufacturing still have FDI caps and necessitate a formation of an IJV through either "automatic" or "governmental approval" route. Under the automatic route, to invest in an IJV, an investor does not require any approval either from the Foreign Investment Promotion Board ("FIPB") or the Reserve
© 2010 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P in the Vol. 3, No. 3 edition of the Bloomberg Law Reports – Asia Pacific Law. Reprinted with permission. The views expressed herein are those of the authors and do not represent those of Bloomberg Finance L.P. Bloomberg Law Reports® is a registered trademark and service mark of Bloomberg Finance L.P. The discussions set forth in this report are for informational purposes only. They do not take into account the qualifications, exceptions and other considerations that may be relevant to particular situations. These discussions should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Any tax information contained in this report is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. The opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content contained in this report and do not make any representation or warranty as to its completeness or accuracy.

Bank of India ("RBI"). FDI in joint ventures not covered under the automatic route require prior government approval and the parties have to apply to the FIPB for approval. 1 B. Choosing a Suitable Partner The first step to forming a successful IJV is choosing a suitable local partner in India and assessing its capabilities and track record. It is critical that from the outset, the investors be cognizant of the significant cultural differences and expectations and utilizes their time to select a partner who will be the right "fit". The Indian decision-making process is often hierarchical, and foreign firms must identify the ultimate decision makers in the Indian company and involve them in the process during the early stages of negotiations to avoid wasting time and resources. Additionally, in order to succeed, foreign firms should spend time to become acquainted with their IJV partners and build a strong and cooperative relationship. Building informal relationships with the key people at the local firm, which in India usually are the owners of the business and their families, is of paramount importance to understanding the core values and levels of professionalization of the local Indian firm. Essentially, rather than jumping at the first opportunity they see, foreign firms should always remember that misaligned expectations and objectives often suggest that the parties are not ideally suited for each other and the IJV is reasonably likely to fail in the future. C. Due Diligence Foreign firms should insist on a formal due diligence process to identify the expectations and limitations of the IJV partners, to test the validity of the partners' business operations, to assess the legality of the documents produced by the potential partners, and to evaluate any risk factors associated with the potential partners. To conduct due diligence, foreign firms should employ a team of independent legal counsel, technical consultants, and auditors who can conduct a detailed investigation and identify if the potential Indian partners have concealed facts and figures; if they have failed to comply with regulations or have conducted adventurous interpretations of contracts, legal provisions, accounting principles, policies or standards; if they have any contingent liabilities; and, if they have failed to report any outstanding legal proceedings against them. The due diligence team should also obtain a declaration or certificate from the potential
© 2010 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P in the Vol. 3, No. 3 edition of the Bloomberg Law Reports – Asia Pacific Law. Reprinted with permission. The views expressed herein are those of the authors and do not represent those of Bloomberg Finance L.P. Bloomberg Law Reports® is a registered trademark and service mark of Bloomberg Finance L.P. The discussions set forth in this report are for informational purposes only. They do not take into account the qualifications, exceptions and other considerations that may be relevant to particular situations. These discussions should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Any tax information contained in this report is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. The opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content contained in this report and do not make any representation or warranty as to its completeness or accuracy.

Indian partner confirming the completeness of the disclosed information and documents, and that no material data has been withheld. D. Drafting a Detailed IJV Agreement At the outset of an IJV's formation, the parties must also identify clear and common objectives, as well as the structure and the form of the IJV. Indian parties often believe that as circumstances change, the legal contract can easily be amended. Moreover, Indian parties often prefer contractual provisions which delay difficult decision-making by allowing the parties to negotiate in good faith at the time of occurrence of a foreseeable event. To avoid blowing up the deal, foreign firms often agree to such provisions. They are keen to start the IJV relationship as soon as possible and often put thorny issues on a delayed time fuse in the hope that better relations in the future will help resolve these issues in a more amicable manner. To avoid this "ongoing" nature of negotiations, it is important that the IJV documentation addresses all foreseeable issues and leaves little to chance. If matters are not agreed upon at the negotiation stage, it is likely that the parties will never agree on those issues, and a dispute will arise in the future. The IJV agreement should include among other things, the purpose of the IJV; the governing law and jurisdiction; ownership interests; the board structure; issues pertaining to management control; exit strategy; and dispute resolution mechanisms for when disputes arise. E. Management Control The level of equity participation inevitably influences the level of management control the firms have in the decision-making process. In India, certain major decisions have to be approved by a special majority of 75 percent or 90 percent of the shareholders by value. While cooperative decision-making where all the shareholders agree is optimum, majority ownership often allows for quick decision-making and thus avoids costly compromises or deadlocks. It is important to note that at least 75 percent of the shareholders must approve a matter before it is passed as a special resolution. Such matters include capital increases, alteration in the memorandum and articles of the company, changing the registered office address of the company from one state to another, change in the name of the company, buy-back of shares, proposed mergers and liquidation. Therefore, a minority shareholder with more than 25 percent voting rights would have the ability to block special resolutions.
© 2010 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P in the Vol. 3, No. 3 edition of the Bloomberg Law Reports – Asia Pacific Law. Reprinted with permission. The views expressed herein are those of the authors and do not represent those of Bloomberg Finance L.P. Bloomberg Law Reports® is a registered trademark and service mark of Bloomberg Finance L.P. The discussions set forth in this report are for informational purposes only. They do not take into account the qualifications, exceptions and other considerations that may be relevant to particular situations. These discussions should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Any tax information contained in this report is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. The opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content contained in this report and do not make any representation or warranty as to its completeness or accuracy.

Accordingly, foreign firms have to think strategically when determining their equity ownership in the IJV. Foreign firms should be mindful, however, that equity ownership is only one part of the puzzle; the composition of the IJV board, the presence of local directors in India who keep an eye on the operations of the company of on behalf of the foreign firm, contractual veto rights, and possession of core technology are some other important factors that determine who actually controls the management. F. Tax Considerations Foreign firms should seek tax advice even at the initial stages of evaluating an Indian investment. India has a very low threshold for creating a taxable presence. The proceeds of a sale of shares in an Indian company are usually taxed in India as capital gains, even if the seller is not a resident of India. India taxes such capital gains at high, variable rates of taxation ranging from zero to around 30 percent.2 Hence, foreign partners are generally advised to invest via an offshore jurisdiction which has a favorable double taxation agreement with India. India has favorable tax treaties with Mauritius, Cypress, the UAE, Singapore, and the Netherlands. Mauritius, however, is by far the most commonly used jurisdiction for inbound investment into India for the following reasons: a.) The Double Taxation Avoidance Tax Treaty between India and Mauritius, (the "Treaty") provides that the foreign company does not have to pay any capital gains taxes to India or Mauritius when the Mauritius company sells the shares of an Indian company. b.) The Treaty also affords protection against the double taxation of dividends. Under ordinary circumstances, India imposes a 19.5 percent dividend distribution tax on an Indian company that distributes dividends. However, this dividend distribution tax is reduced to 5 percent if the Mauritius company holds more than ten percent of the shares of the Indian company.3 In setting up an intermediate holding company in Mauritius, foreign firms need to ensure that the control and management of the Mauritius holding company is not wholly situated in India. G. Conflict Resolution
© 2010 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P in the Vol. 3, No. 3 edition of the Bloomberg Law Reports – Asia Pacific Law. Reprinted with permission. The views expressed herein are those of the authors and do not represent those of Bloomberg Finance L.P. Bloomberg Law Reports® is a registered trademark and service mark of Bloomberg Finance L.P. The discussions set forth in this report are for informational purposes only. They do not take into account the qualifications, exceptions and other considerations that may be relevant to particular situations. These discussions should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Any tax information contained in this report is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. The opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content contained in this report and do not make any representation or warranty as to its completeness or accuracy.

Conflict is an inevitable part of a partnership and cultural differences are often responsible for deadlocks between foreign and Indian firms in an IJV. Accordingly, the parties must establish an appropriate mechanism for the resolution of such deadlocks. Often, mediation can assist with deadlocks associated with smaller day to day issues and prevent an early failure of an IJV. Moreover, due to a large backlog of cases, litigation in India is slow, making it essential that foreign investors incorporate a well thought out arbitration or alternative dispute resolution clause in their IJV agreement. The IJV agreement should clearly address when the arbitration clause would be triggered, the arbitration situs, the applicable law, the number of arbitrators, and the procedures to be followed by the arbitrators. Given the potential for conflict inherent in an IJV, foreign firms must focus on formulating their exit strategies at the time of their initial negotiations with the potential Indian partner. Exit Strategies IJVs are generally structured to have a finite lifespan, and foreign firms should take the length of such a lifespan seriously. IJVs often fail because the local partners are unable to invest enough resources to expand the business as quickly as the foreign company had hoped for or because the local partners have a knowledge advantage in terms of the local conditions of doing business and have divergent interests from the foreign firms. To avoid this situation, foreign firms should consider entering into an IJV for a short, finite period. During this period, the foreign firms should establish a local presence, understand the local consumers and business conditions, develop relationships with clients and contacts in the local industry, and assist with monitoring the supply chain and the IJV partners. Even though it might be counter intuitive, it is absolutely necessary to determine the plan and timing of the exit from the IJV at the outset. An exit strategy is a mechanism by which one or both partners may either withdraw from the venture or push the other partner out of the venture upon a deadlock between the partners or upon the occurrence of certain predetermined events. Things to consider when formulating an exit strategy includes determining what will trigger dissolution, for example, changes in business conditions and/or parties, and what would happen if the goals and objectives of the partners change with time or if one of the IJV partners is acquired or gets into financial trouble.
© 2010 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P in the Vol. 3, No. 3 edition of the Bloomberg Law Reports – Asia Pacific Law. Reprinted with permission. The views expressed herein are those of the authors and do not represent those of Bloomberg Finance L.P. Bloomberg Law Reports® is a registered trademark and service mark of Bloomberg Finance L.P. The discussions set forth in this report are for informational purposes only. They do not take into account the qualifications, exceptions and other considerations that may be relevant to particular situations. These discussions should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Any tax information contained in this report is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. The opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content contained in this report and do not make any representation or warranty as to its completeness or accuracy.

The common exit options are: buy-sell agreements, unilateral sale rights, and, put/call rights. Alternatively, the IJV agreement may also provide for the cessation of operations and the liquidation and dissolution of the venture. Any of those options can be used independently or in combination with each other. A. Buy-Sell Agreements In a buy-sell agreement, either IJV party will decide to purchase the interest of the other by sending a buy-sell trigger notice to the other party specifying a cash purchase price at which the offeror party is willing to buy the assets. If the offeror-party has a greater source of funds than the other, it might submit a buy-sell offer that is intentionally much lower than the fair market value of the assets knowing that the other party will not be able to buy the offeror-party's interest. To avoid this situation, it is important that the IJV agreement includes a provision about going to an independent and agreed upon appraiser to assess the fair market value of the assets when either party sends a buy-sell trigger notice. Because of the finality of the buy-sell agreement, the IJV agreement should also contain a provision about a lock-out period during which the buy-sell mechanism cannot be triggered. The lock-out period is necessary to ensure that the venture has the opportunity to succeed before the buy-sell is triggered. Further, if any major projects are under development, it may be in the interest of both parties to prohibit the exercise of buy-sell during that period. Of course, the lock-out provision should be well thought out because in circumstances where there are deadlocks or one party breaches the material terms of the IJV agreement, a lock-out may result in more harm than benefit to the company. Accordingly, the lock-out provisions should be narrowly tailored. The IJV agreement should also demarcate the rights and obligations of all the partners during the interim period between the initiation of the buy-sell and closing and how the major decisions will be made during the buy-sell period. These provisions are important because at a minimum, the parties would want the business to be operated in the ordinary course until the sale is finalized, and the buying partner would certainly not want the buysell agreement to negatively affect the company's operations and reputation. Additionally, the IJV agreement should also provide provisions that will enable the buying partner to have adequate time to procure the necessary outside financing.
© 2010 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P in the Vol. 3, No. 3 edition of the Bloomberg Law Reports – Asia Pacific Law. Reprinted with permission. The views expressed herein are those of the authors and do not represent those of Bloomberg Finance L.P. Bloomberg Law Reports® is a registered trademark and service mark of Bloomberg Finance L.P. The discussions set forth in this report are for informational purposes only. They do not take into account the qualifications, exceptions and other considerations that may be relevant to particular situations. These discussions should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Any tax information contained in this report is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. The opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content contained in this report and do not make any representation or warranty as to its completeness or accuracy.

B. Put/Call Rights Put/call rights are incorporated in an IJV agreement when one partner wants to liquidate as soon as possible, while the other partner wants to hold the venture assets long-term. A "call right" would give the foreign firm the right, but not the obligation to buy the IJV from the local partner at a certain time (triggering event) for a certain price. The seller is obligated to sell should the buyer so decide. Conversely, a "put right" would force the local partner to buy its interest when the foreign firm decides that it wants to liquidate. Determining the price is often difficult and a third-party appraiser should be used for this purpose. C. Unilateral Sale Rights Although unilateral sales rights are not so common, in some instances, one or both partners may have the unilateral right to sell their interest in the venture to a third party. Alternatively, the partners may decide to bring in a new investor who can provide the needed capital, expertise and direction. It is essential that the parties consider this option when drafting the IJV agreement and ensure that trigger points are included for such thirdparty assistance. D. Other Considerations At the heart of the various exit strategies are some common issues such as dealing with the valuation of the assets at the time of sale and whether such valuation properly accounts for the company's liabilities (including contingent liabilities), as well as the release of the exiting party from any guarantees and obligations. If these issues are not addressed in the IJV agreement, they can be difficult to resolve at the time of exit when parties are likely to be in the middle of a disagreement. Furthermore, post-exit non-compete, non-solicitation and confidentiality covenants are also crucial and should be negotiated while drafting the IJV agreement. The scope and terms of the non-compete agreements may significantly impact the exiting parties' interest. More importantly, India's Press Note 1 of 2005 ("PN1") 4 requires that foreign firms that have an existing collaboration with an Indian firm, receive approval from the Government of India before they set up their own operations or IJV with another firm in the same line of
© 2010 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P in the Vol. 3, No. 3 edition of the Bloomberg Law Reports – Asia Pacific Law. Reprinted with permission. The views expressed herein are those of the authors and do not represent those of Bloomberg Finance L.P. Bloomberg Law Reports® is a registered trademark and service mark of Bloomberg Finance L.P. The discussions set forth in this report are for informational purposes only. They do not take into account the qualifications, exceptions and other considerations that may be relevant to particular situations. These discussions should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Any tax information contained in this report is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. The opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content contained in this report and do not make any representation or warranty as to its completeness or accuracy.

business. PN1 advises the collaborators to consider, negotiate, and if agreed, to include a clause avoiding conflict of interest. While the Indian regulations are continuously changing and becoming more foreign investor friendly, it is important that foreign firms pay attention to any such regulations while planning their exit strategy. Conclusion While the benefits of entering into an IJV to expand business operations in India are enormous, it is essential that foreign firms are wary of the cultural nuances that are associated with doing business in India. To be successful, foreign firms should not only make an extra effort to understand the local market, culture, needs, and consumers, but should also do their due diligence in finding a suitable Indian partner and properly research and negotiate the terms of their IJV agreement. Shahana Basu Kanodia is a Partner in Edward Angell Palmer & Dodge's Business Law Department in Boston and Chair of the South Asia Practice Group. Edwards Angell Palmer & Dodge is a global law firm with 13 offices including offices in the US, UK and Hong Kong. Ms. Kanodia's practice areas include general corporate matters with a focus on cross border business transactions, including mergers and acquisitions, joint ventures, private equity and other strategic investments. Ms. Kanodia is a frequent speaker at domestic and international events on issues relating to foreign investment, cross border mergers and acquisitions, international transactions and international public law. Ms Kanodia received a BA (History) with First Class Honors from Delhi University, a Tripos in Social & Political Sciences with First Class Honors from Cambridge University, an MA (Sociology) with First Class Honors from the University of Chicago and a JD from Yale Law School. She currently serves on the Executive Board of the Yale Law School Association, the Board of the Children's Advocacy Center for Suffolk County and the Board of the Community Dispute Settlement Center and is an Overseer of the Peabody Essex Museum. Email: skanodia@eapdlaw.com Rashi Mittal is a Law Clerk to the Justices at the Massachusetts Superior Court, where she works extensively with Justices on trials, hearing and motion sessions, and prepares draft decisions and legal memoranda on a multitude of topics in civil and criminal law. In 2004, Ms. Mittal received a B.A. in both Public Policy and Economics from Stanford University, where she graduated with honors. During her time at Stanford, she studied abroad at Oxford University. In 2008, she received a J.D. from Boston University School of Law, where she served on the staff of the International Law Journal. She also worked as a legal intern for the Honorable Joseph L. Tauro of the Massachusetts District Court, Massachusetts State Senator Jack Hart, and at the Los Angeles office of the Federal Trade Commission. She
© 2010 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P in the Vol. 3, No. 3 edition of the Bloomberg Law Reports – Asia Pacific Law. Reprinted with permission. The views expressed herein are those of the authors and do not represent those of Bloomberg Finance L.P. Bloomberg Law Reports® is a registered trademark and service mark of Bloomberg Finance L.P. The discussions set forth in this report are for informational purposes only. They do not take into account the qualifications, exceptions and other considerations that may be relevant to particular situations. These discussions should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Any tax information contained in this report is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. The opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content contained in this report and do not make any representation or warranty as to its completeness or accuracy.

currently serves on the Board of the South Asian Bar Association of Greater Boston as Legal Relations Co-Chair. Email: rashimitt@gmail.com. The views expressed in this article are those of the authors and are not to be attributed to Bloomberg Finance L.P. and the Massachusetts Superior Court or any of its Justices.

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More detailed information about these routes can be found on the Department of Industrial Policy and Promotion website (see http://dipp.nic.in). See Section 10(38) and 88E of the Indian Income Tax Act, 1961. See Article 10(2) (a) of the India-Mauritius Tax Treaty. See http://siadipp.nic.in/policy/pressnotes_main.htm.

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© 2010 Bloomberg Finance L.P. All rights reserved. Originally published by Bloomberg Finance L.P in the Vol. 3, No. 3 edition of the Bloomberg Law Reports – Asia Pacific Law. Reprinted with permission. The views expressed herein are those of the authors and do not represent those of Bloomberg Finance L.P. Bloomberg Law Reports® is a registered trademark and service mark of Bloomberg Finance L.P. The discussions set forth in this report are for informational purposes only. They do not take into account the qualifications, exceptions and other considerations that may be relevant to particular situations. These discussions should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Any tax information contained in this report is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. The opinions expressed are those of the author. Bloomberg Finance L.P. and its affiliated entities do not take responsibility for the content contained in this report and do not make any representation or warranty as to its completeness or accuracy.

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