RBI’s Restrictions On

Deferred Consideration:
Ready For Covid-19
Second Wave?
ExclusivesRBI’s Restrictions On Deferred
Consideration: Ready For Covid-19 Second Wave?

A move hailed as radical in 2016, may today

be considered archaic and impractical.
Reserve Bank Of India RBI seal at entrance gate.
(Source: PTI)

In cross-border transactions, deferred consideration is

one of the most useful means of resolving differences in
the valuation of companies between buyers and sellers. It
means only a part of the consideration for shares is paid
at the closing of a transaction, with the rest being paid
later, perhaps based on future performance. However,
foreign investment into India is constrained by various
limitations in respect of deferred consideration. This is
due to the FEMA (Non Debt Instruments) Rules, 2019,
and the Consolidated FDI Policy of 2020, which stipulate
that only 25% of the total consideration may be deferred,
for a maximum period of 18 months, termed the ‘18-25’
limit.

This is further exacerbated by the Reserve Bank of

India’s requirement that an externally certified fair value
be agreed on upfront and paid to an Indian seller,
whereas globally, a price agreed between a willing buyer
and a willing seller constitutes fair value in and of itself.
Correspondingly, the adjustability against price gets tied
to this number and becomes inflexible towards the
negative. Such restrictions are absent in most developed
jurisdictions and represent the RBI’s efforts to monitor
the inflow and outflow of foreign exchange and to ensure
that Indian parties get the full value of their equity
without undue delay.
Deferred consideration was completely prohibited except
through RBI approval until 2011. In 2016, the RBI
amended the FEMA (Transfer or issue of security by a
person resident outside India) Rules, 2000, and brought
about the ‘18-25’ limit in operation currently.

This move, hailed as radical in 2016, may today be

considered archaic and impractical, especially in
light of the changing landscape of private equity
and M&A.

This necessitates a critical evaluation of the ‘18-25’

limit, which has been attempted here. While these limits
may be exceeded with the RBI’s approval, and though
the RBI has improved its responsiveness, the approval
process does cause undue and unpredictable delays.

The Impact Of Covid-19

Undoubtedly, the pandemic has caused an unprecedented
jolt to the global economy. Not only have business
revenues and the values of acquisition deals deteriorated,
but there has also been a significant impact on deal
structuring. The uncertainty and slowdown caused by the
pandemic create greater scope for disagreements on
valuation, especially in complex cross-border deals.
While sellers would vie for pre-Covid valuations of their
company and remain confident about future
performance, buyers would naturally require mitigation
of risk, both in terms of the present and future
performance of the company. In such situations, deferred
consideration structures can significantly alleviate the
concerns of both parties and enable the seller to get the
maximum valuation possible, while also leaving
reasonable recourse to the buyer.

Whenever there is significant uncertainty in the business

climate, deferred consideration structures assume
importance. For example, the 2008 recession led to a
tremendous increase in the use of earn-outs in the
developed world.

Now, with the second wave of the pandemic, there will be

an increased prevalence of deferred consideration
structures in acquisition transactions as unavoidable
slowdowns take place in the conduct of business.

It is widely opined that these trends will persist even in

the aftermath of the pandemic.

Liberalising ‘18-25’ Limit: Making

The Case For A 3-Year Limit
Viewed in the global context, where deferred
consideration is being used in an increasing number of
deals, the RBI’s restrictions significantly affect the ability
of Indian parties to structure their transactions and obtain
the best value for their companies.

18 months is simply too short and 25% of the purchase

consideration, too less. Naturally, it would affect the
value of foreign investment into Indian companies since
beyond the 18-month period, investors can neither
structure higher prices in installments nor on the basis of
future earnings of the company. Moreover, there does
exist a possibility that sellers attempt to inflate the value
of the company prior to an acquisition or a funding
round. Due diligence prior to transactions, while helpful,
may not always present a complete or accurate picture
for the simple reason that most of the information being
relied upon is supplied by the seller.

The 18-month limit in most cases would only

afford the buyer one audit cycle to evaluate the
actual state of the company after the transaction,
and thus, even if any ‘creative accounting’ is
discovered subsequently, there will not be any
direct recourse to the purchase consideration itself.

Further, the time limit of 18 months commences from the

date of execution of the transaction documents and not
closing, which is when the share transfer actually
becomes operational, the consideration is paid, and the
new owners/investors begin to assume control. Hence, in
cross-border transactions, where often a significant
period of time elapses between the date of execution and
closing, buyers have an extremely shortened window to
evaluate the affairs of the company, and vary the
consideration on that basis.

Impact On Indemnities
In terms of the ‘18-25’ rule applying to indemnity
holdbacks or escrows, the full consideration must be paid
and only 25% of the same may be held back or placed in
escrow for indemnities, for up to a period of 18 months.
This leads to certain anomalies in the context of
contractual indemnities in India.

First, the statutory period of limitation for contractual

indemnity claims is 3 years, with the ‘18-25’ rule
effectively halving the ‘secured’ time available to a
buyer.

Second, the nature of representations and warranties

usually determine the extent of indemnification. For
example, indemnification on fundamental breaches, title
of shares, or the capacity of parties to transact, is usually
uncapped and may extend to the entire amount of
consideration.

In such extreme situations, the recourse available is quite

apparently insufficient. Moreover, it is common for
investors to rely on specific indemnities, which often
pertain to the full consideration amount, and are used as a
tool to resolve gating issues that may prevent or
significantly delay closing.

Conclusion
In order to remedy these issues, we believe that the time
limit for deferred consideration must be extended to a
period of at least 3 years, with an extension where a
dispute is initiated. This would ensure at least two audit
cycles before the final consideration is due, and thus
afford buyers sufficient time to evaluate the company
without the effects of any padding of valuation that may
have taken place, while at the same time remedying the
contrast with statutory limitation.

Additionally, if the threshold of 25% is made flexible, it

would sufficiently address the issue of parties being
severely restricted from structuring their transactions
effectively, as well as render the Indian position on par
with global standards. The monetary threshold also needs
to be adjustable negatively within the fair value
determined for the purposes of the RBI’s pricing
guidelines as reasons for adjustment do actually represent
negative factors determined post facto.

With the second wave of Covid-19 underway, it is hoped

that the government and the RBI are alive to the
shortcomings in this policy, and are prepared to do the
needful at the earliest.

Arjun Rajgopal is Partner, Abhilasha Gupta and

Abhiroop Saha are Associates - M&A and Private
Equity, L&L Partners, New Delhi.

The views expressed here are those of the authors, and do

not necessarily represent the views of BloombergQuint or
its editorial team.

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