QUESTION- 18

INTRODUCTION

Liquidation preference has been employed as a mechanism to hedge the investment risk in any
of the Private Equity (“PE”) transaction. With the contours of the worldwide economic
landscape experiencing relentless change the investors tend to minimize the risk and try to
protect its value of investment through the mode of inclusion of liquidation preference right
clause (“Clause”) under the contractual agreement more-particularly under the investment
agreement. The clause triggers when a liquidation event occurs. However, their do exist a
distinction between the two terms used more often while discussion: -

Pay-out on liquidation

Liquidity Event- date on which
company commences operation
or any other event taking place.
Liquidity Prefernce-
Advantage/preference investor
gets in case company is
undergoing bankruptcy,
liquidation or winding or other
insolvency proceedings under
IBC.

Liquidation Preference Arrangement: Role of the Clause: -

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The construct of this clause shades light on the risk management and involves a protection
mechanism for investor as the payment investment along with the agreed rate of return to the
investor is provided along with priority over the other shareholders.

Under the Shareholder Agreement the investor gets two categories of rights:

 Governance Right
 Internal Control Right

These are those rights which provides investor a say in right to appoint board representative,
quorum right (meeting will be held incomplete unless the representative of investor is present in
the meeting), affirmative voting right (these rights are required while changing the name of
company1 via special resolution) and information right (including but not limited to financial
information, inspection right. Also, Anti-Dilution (during further round of investment the right
will be diluted down) thus, affirmative voting right protects the interest and via anti-dilution if
rights diluted down then investor gets fresh shares. In a nutshell, the liquidation preference
arrangement sets a motion in case liquidation event gets trigger when insolvency, winding up,
sale of assets, change of control, a merger or other even occurs. 2 Liquidation preferences can be
classified as non-participating, participating and hybrid, dependent on whether the investor has
been accorded with right to participate in the liquidation proceeding.

However, the aforementioned rights throw a shadow of ‘control’ provided to investor in

management and decision-making authority. The analysis over ‘control’ was provided in the
case of Subhkam Ventures v. Securities and Exchange Board of India, 3 the Security Appellate
Tribunal if an investor has board right, affirmative voting right and quorum right then it doesn’t
amount to control as these rights are accorded to provide investment protection. However, the
Apex Court4 upheld the order and denied the precedential value while keeping the question of

1
Feroz Bhasania v. United Breweries, (1971) ILR 1 (Cal.) 367 (India).
2
Swaraj Singh Dhanjal, Venture Capitalists Add Tough Riders to Fund-Raising Pacts, LIVEMINT (Nov. 17,
2015), https://www.livemint.com/Companies/ZdXnzJzgvmZ09EJsPTo1SN/Venture-capitalists-add-toughriders-to-
fundraising-pacts.html last accessed on 22nd May, 2022 5:00 AM.
3
Securities Appellate Tribunal Order (Jan. 15, 2010) (India)
http://www.sebi.gov.in/satorders/subhkamventures.pdf).
4
Securities and Exchange Board of India v. Subhkam Ventures (I) Private Limited MANU/SC/1587/2011

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control open-ended. In Kamat Hotels vs. Clearwater'5 case SEBI ruled that rights provided to
investors are protective rights for the value of investment.

Preferred payout on liquidation: Exit Right

A generic liquidity event encompasses several actions. However, this right/clause in the
agreement coverts the equity shares subscribed by the PE into preference share, as preference
shares receives priority over equity shareholders.6 The order of priority is well settled in the
Insolvency and Bankruptcy Code of India (“Code”) and the governing provision is defined in
the section 53 of the Code.

ORDER OF PRIORITY UNDER IBC

o Section 53(1) provides for the priority of payment: The WATERFALL

MECHANISM

The clause starts with a non-obstante clause “Notwithstanding anything to the contrary
contained in any law enacted by the Parliament or any State Legislature for the time being in
force, the proceeds from the sale of the liquidation assets shall be distributed in the following
order of priority”7 as prescribed below: -

5
SEC. & EXCH. BD. INDIA Order in the matter of Kamat Hotels (India) Ltd.,
WTM/GM/EFD/DRAIII/20/MAR/2017 (Mar. 31, 2017),
https://www.sebi.gov.in/sebi_data/attachdocs/1491380833690.pdf.
6
Charles R. Korsmo, Venture Capital and Preferred Stock, 78 Brook. L. Rev. 1163 (2013). 43.
7
The Indian Insolvency and Bankruptcy Code, 2016, No. 31, Acts of Parliament, 2016 (India), sec. 53 (1).

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 Insolvency Resolution Process Cost and liquidation cost in full

workman dues for 24 months prior to the commencement of liquidation and dues of secured
creditor if relinquished interest under section 52.

Dues of other employees upto 12 months other than worksmen

Financial Debt owed to unsecured creditor

Government dues/Statutory dues (upto 2 years) residual debts of secured creditor

Remaining debts

Preference Shareholders

Equity Shareholder
8

For the private limited companies, the battle of priority between preference and equity
shareholder can be resolved via the exemption provided to the companies by Ministry of
Corporate Affairs on 5th June 20159, the exemption excludes the applicability of section 4310 and
section 47 of Companies Act, 2013 via alteration in MOA and AOA. As with the alteration a
different class of equity shares can be created, which takes precedes over the preference shares
during winding up. Otherwise, it becomes difficult and challenging for the investor who is
equity shares to enforce its preference right during liquidation.11

8
Rule 4 of the Companies (Share Capital and Debenture) Rules 2014
9
Notification No. G.S.R 464 (E) dated June 5, 2015.
10
ICA 2013, sec. 43
11
ICA 1956, sec. 511 provides that “Subject to the provisions of this Act as to preferential payments, the assets of a
company shall, on its winding up, be applied in satisfaction of its liabilities pari passu and, subject to such
application, shall, unless the articles otherwise provide, be distributed among the members according to their rights
and interests in the company”

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The voluntary liquidation is provided in Chapter V of the IBC under Section 59(6) of the IBC,
which states that payments must be made in the same order of priority as provided for
compulsory liquidation.12 However, the enforceability of the liquidation preference arrangement
is still questionable in the light of Code.

o Enforceability of Liquidation Preference Arrangement: Analysis of Section 53 (2)13

As the for the process of liquidation, the liquidator is appointed within the contours of IBC,
thus, the statutory provision of Code doesn’t bound the liquidator to take into consideration the
liquidation preference arrangement provided in the Agreement. If clause says that in case of
liquidation or insolvency/bankruptcy, investor will be paid off first then such arrangement is
unceremoniously defenestrated, in other words will not be taken into consideration. As per the
provisions of IBC any contractual provision which disrupts or go beyond the contours of
order to priority provided under the Code shall be disregarded or not to be considered by the
liquidator. Thus, preferred pay-out on liquidation stands unenforceable under the umbrella
of IBC.

ANALYSIS

In the light of above backdrop of discussion its worthwhile to state that section 238 of the IBC
provides overriding effect of legislation on other laws and liquidation is a subject-matter which
comes under the provision of IBC hence, any contractual provision which is otherwise
enforceable under Companies Act, 2013 or under Indian Contract Act, 1872 wouldn’t hold
water.

Thus, the investment agreement executed between Targaryen Pvt. Ltd. and Dothraki Ryders
Venture Fund, containing the liquidation preference clause will not be taken into consideration
by the liquidator in case Targaryen Pvt. Ltd. undergoes a liquidation. In our opinion, Iron
Bank will not have any adverse effect on the ability to recover the money from Targaryen Pvt.
Ltd. Also, IBC suggests that “at each stage of the distribution of proceeds in respect of a class
of recipients that rank equally, each of the debts will either be paid in full, or will be paid in
12
Insolvency and Bankruptcy Board of India (Voluntary Liquidation Process) Regulations, 2017
13
The Indian Insolvency and Bankruptcy Code, 2016, No. 31, Acts of Parliament, 2016 (India), sec. 53 (2).

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equal proportion within the same class of recipients, if the proceeds are insufficient to meet
the debts in full.14 Furthermore, taking into account that Dothraki Ryders Venture Fund is a
PE in Essos i.e., outside India, comes under the umbrella of foreign investor and liquidation
preference clause of the Agreement offers an assured/minimum guaranteed to Dothraki
Ryders Venture Fund flouts the regulation set forth by the Reserve Bank of India, as its
against the pricing guidelines.

DUE DILIGENCE OR FURTHER CONSIDERATION ON THE FOLLOWING CASES

SHALL BE TAKEN INTO ACCOUNT BY IRON BANK

Case 1: - If Targaryen Pvt. Ltd. amends the MOA or AOA to avail the exemption provided by
Ministry of Corporate Affairs on 5 June 201515, which excludes the application of section 43
and section 47 of Companies Act 2013 and creates a differential class of equity shares (Dothraki
Ryders Venture Fund) then that would take precedence over the preference share. In such a
scenario the order of priority will change which may have some adverse effect during
liquidation.

Case 2: - Targaryen Pvt. Ltd. and its promoter if any, would be contractually bound by the
liquidation preference clause thus, it may give Dothraki Ryders Venture Fund cause of action
against Targaryen Pvt. Ltd. and its promoter if any requiring due performance of such
liquidation preference clause and in that case order of priority might get affected.

Case 3: - If the investment agreement clause is amended by Targaryen Pvt. Ltd. and Dothraki
Ryders Venture Fund which requires the promoter of Targaryen Pvt. Ltd. to compensate
Dothraki Ryders Venture Fund for any deficit in the liquidation proceeds then it may affect the
order of priority however it depends on the liquidator. On the other hand, the promoters of
Targaryen Pvt. Ltd. will have tax implication if they have to make the payment to Dothraki
Ryders Venture Fund.

14
The Indian Insolvency and Bankruptcy Code, 2016, No. 31, Acts of Parliament, 2016 (India), sec. 53
explanation.
15
Notification No. G.S.R 464 (E) dated June 5, 2015.

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Case 4: - Analysis/study of other clauses such as put options, drag and tag along rights, etc.
over and above the liquidation preference clause shall be done by Iron Bank.

CONCLUSION: -

In a nutshell, it is opined that such liquidation preference clause will not be having any adverse
effect on Iron Bank, as liquidation is governed by the provision of IBC law and not by the
provision of Indian Contract Act, 1872 and Companies Act, 2013. Moreover, the language of
section 53 (1) of IBC clearly sets out the order of priority in case of liquidation and liquidator
under the provisions of 53 (2) is not bound by the provisions of investment agreement liquidity
preference clause executed between Targaryen Pvt. Ltd. and Dothraki Ryders Venture Fund.

However, the aforementioned opinion is solely applicable on the facts provided by Iron Bank
till date, a due consideration to the aforementioned CASE 1, CASE 2, and CASE 3 shall be
given as this might change the scenario and priority of claims.

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