Korea had the strongest and most active M&A market in 2014 during the past five years with a 47% increase in announced deal volume from USD 64.8 billion in 2013 to USD 95 billion in 2014 (based on Bloomberg statistics), and Kim & Chang had the privilege of advising on transactions accounting for approximately USD 38 billion, amounting to 40%, of such total for 2014. Inbound investments into Korea were particularly active as offshore private equity funds sought to capitalize on the buyout opportunities arising from the Korean government’s efforts to restructure and ease the debt burden of selected, highly leveraged Korean conglomerates (chaebol in Korean), which resulted in many assets and businesses, including core businesses, of such conglomerates being divested and sold in 2014. The market also witnessed increased voluntary restructuring efforts by financially sound conglomerates to strengthen and focus on their core businesses (e.g., proposed sales of non-core businesses by POSCO and KT Corporation, and the recently announced Samsung-Hanwha deal), and we expect such financial restructuring and voluntary restructuring efforts by Korean conglomerates, combined with upcoming exits of maturing private equity investments, small to mid-cap cash-out transactions by controlling shareholders and private equity or venture minority investments, to continue to support a healthy and dynamic Korean M&A market in 2015. Another key recent trend is the rising competition and sophistication of domestic private equity funds, which are contributing to the vigor and enthusiasm for Korean assets as investment commitment in such domestic funds exceeded KRW 50 trillion (approximately USD 46 billion) for the first time in history in 2014, and the domestic funds are now actively searching and competing for investment opportunities in Korea alongside traditional offshore private equity heavyweights.
To briefly recap the past year and to stay abreast of key issues of interest in Korean M&A, we share below our observations on some of the material recent developments and issues widely discussed in Korean M&A circles.
M&A Regulatory Landscape. Understanding the value and contribution of healthy M&A activities to the overall economy, the Korean government continued its efforts in 2014 to promote an M&A friendly regulatory environment. In particular, the Korean government sought to alleviate regulatory hurdles restricting investments and the growth of private equity by proposing numerous deregulatory legislations, including the following which are now subject to the deliberation and vote of the National Assembly:
- Amendment of the Korean Commercial Code to permit and facilitate previously prohibited transaction structures, including triangular spin-off and triangular share exchange, and allow the board of directors of companies to definitively approve certain business and asset transfers without shareholder approval;
- amendment of the Financial Investment Services and Capital Markets Act to abolish the prior approval requirement for establishing local private equity funds thereunder and adopt an after-the-fact notice scheme to allow such funds to promptly commence operations upon establishment, and expand the scope of permitted investment targets and structures of such local private equity funds; and
- amendment of the Monopoly Regulation and Fair Trade Law to exempt establishments of such local private equity funds and special purpose vehicles and certain other corporate events from merger filing requirements.
The Korean government appears to be committed to its deregulation efforts, and we expect the improved legal infrastructure to facilitate and support the continued growth of M&A, and particularly private equity investments, in Korea. Nonetheless, navigating the regulatory requirements to consummate an M&A transaction in Korea is often a complex and delicate task, particularly in regulated or nationally sensitive industries, and potential investors are well advised to undertake a comprehensive analysis of potential regulatory obstacles early in their review of proposed investments in Korea.
Withholding Tax on Capital Gains. Korean tax on Korean source income, particularly capital gains, earned by offshore funds has been a consistent topic of interest for offshore funds and the Korean tax authorities in 2014. The issue of whether the Korean tax authorities would look through the offshore funds towards the ultimate investors of the funds in applying tax treaties to, and assessing tax on, Korean source capital gains remains unresolved as there remains a conflict between two positions respectively supported by statutory law and a line of Korean Supreme Court decisions. First, the so-called Overseas Investment Vehicle (OIV) regime, which became effective as of July 1, 2012 for Korean source passive income (e.g., dividend, interest and royalty income) and as of January 1, 2014 for Korean source capital gains, supports looking through the offshore funds, typically limited partnerships, towards the limited partners of such funds as the beneficial owners of the Korean source capital gains and affording to such limited partners the benefit of any tax treaty in effect between Korea and their resident country. This regime is consistent with the past practice of the Korean tax authorities, as well as the OECD’s position on taxation of offshore funds. On the other hand, the Korean Supreme Court, in a series of decisions since 2012, have found offshore funds themselves to have distinct business purposes and be the beneficial owners of Korean source capital gains in relation to transactions consummated prior to the effective date of the OIV regime. Currently, a request for authoritative ruling remains pending before the Ministry of Strategy and Finance, the Korean governmental body responsible for the interpretation of tax laws and treaties, to resolve this apparent inconsistency, and the Ministry is soon expected to provide official guidance on the operations of the OIV regime against the backdrop of the recent line of Korean Supreme Court decisions.
Acquisition Financing. On January 22, 2015, the Seoul Central District Court rendered a notable decision regarding the alleged breach of fiduciary duty in connection with a leveraged buyout (LBO) transaction in the Hi-Mart case. The lower court in Hi-Mart, with distinct factual circumstances under review, held that the directors of the target company should not be held criminally liable for breach of fiduciary duty in a “merger type” LBO (a structure whereby the acquirer would incorporate an SPC which would borrow funds for the acquisition, and thereafter merge the SPC with the target, thereby giving the creditor a direct recourse to the assets of the target) underscoring, among others, the financial soundness of the SPC, the assets of the target not being encumbered to secure the acquisition financing obligations of the SPC, and the merger being consummated in accordance with applicable laws. The lower court’s reasoning and decision in Hi-Mart may provide meaningful guidance on structuring of future LBO transactions. However, caution is still warranted to potential legal risks when structuring an LBO transaction of this type given that the Korean courts view the legality of an LBO transaction on a case-by-case basis and have, in fact, held LBO transactions in criminal violation of the directors’ fiduciary duty in many cases (again, the subject lower court’s holding in Hi-Mart was rendered upon detailed review of distinct set of facts) and Hi-Mart may still be appealed to the appellate court and potentially to the Supreme Court.
General Partner Liability. Many private equity fund personnel have frequently inquired on the scope of fiduciary duties and liabilities of a director serving on the board of directors of a Korean portfolio company. Underscoring the need for private equity funds to exercise caution in managing their Korean portfolio companies, a Korean court recently allowed creditors of a Korean company to provisionally seize the management fees and carried interest owed by a private equity fund to its general partner in connection with a damage claim brought against the general partner. According to news reports, the creditors are claiming that the directors of the company breached their duties of loyalty and care and the private equity fund is liable as a controlling shareholder who actively participated in the management of its Korean portfolio company. Although it remains to be seen whether the court will ultimately find the directors and the general partner to be liable, this development serves as a prominent reminder of the importance of understanding the scope of fiduciary duties of directors of Korean companies and the potential liability for not only the private equity fund personnel serving as directors but also the general partner of the private equity fund.
Compliance. The current Korean administration has emphasized its commitment to address the potentially corrupt ties between the government and the private sector in various industries. In July 2014, Korean government agencies jointly formed the Anti-Corruption Task Force, which investigated nearly 500 cases of corruption linked to government institutions within two months of its establishment, implicating over 1,700 individuals. Further, the most significant new anti-corruption legislation to-date, namely the “Act on Prevention of Improper Solicitation and Provision/Receipt of Money and Valuables”, which is more commonly known as the “Kim Young-ran Law”, is expected to be passed and voted into law by the National Assembly in February 2015. If passed in the current form, the new law would, among others, (i) criminalize receipt of an amount or benefit of over KRW 1 million (approximately USD 920), even if not connected to the duties of the relevant public official, (ii) criminalize bribery of smaller amounts, if the aggregate value of benefits provided/received in a one-year period exceeds KRW 3 million (approximately USD 2,800), and (iii) expand the scope of the subject public officials to include individuals “deemed to perform a public function in society”, such as teachers at private schools and news reporters. Given the heightened interest by the Korean government to eradicate corrupt practices and the impending new legislation, investors in Korean corporations are strongly urged to strengthen compliance due diligence, particularly in industries with higher risks of corruption.
Employment and Labor. Employment and labor have long been a due diligence area of focus in Korean M&A due to the strong employment rights and protections provided under Korean law to the Korean workforce. While a number of such issues may arise in any given Korean M&A transaction based on the particular facts and circumstances, below are three of such issues frequently encountered in recent transactions.
- Ordinary Wage. In 2014, contingent liabilities of Korean companies arising from potential unpaid wage to their employees due to a retroactive and prospective increase in “ordinary wage” (a Korean labor term describing the base wage of an employee and used as a basis for calculating additional wage for statutory allowances, such as overtime and holiday work allowances) were extensively diligenced, and negotiated between transaction parties to allocate risks in numerous Korean M&A transactions. The landmark Korean Supreme Court decision addressing this issue (rendered in December 2013), continues to heavily influence how parties analyze and assess risks as to unpaid wage arising from ordinary wage. In short, the Korean Supreme Court held that certain allowances and bonuses customarily excluded in calculating the ordinary wage of employees must be included and added if paid on a “regular”, “uniformed” and “fixed” basis unless certain conditions (among others, where the payment of such unpaid wage would result in an excessive financial burden on the relevant company) justify barring employees’ unpaid wage claim arising therefrom based on the principle of good faith and trust. Since the Supreme Court decision, numerous claims for unpaid wage based on the ordinary wage issue have been filed by employees (frequently led by labor unions), and lower courts have issued at times conflicting decisions in interpreting whether a certain allowance or bonus satisfies the requirement to qualify as ordinary wage or whether the requirements for the good faith and trust exception have been satisfied. We expect this issue to remain hotly contested in Korea in 2015.
- Additional Allowance for Holiday Work. Another unpaid wage issue that has received much attention in 2014 is whether employers are required to pay overtime work allowance, in addition to holiday work allowance (each of which would provide employees with an additional payment of 50% of ordinary wage), to their employees for hours worked during holidays. Until recently, based on administrative guidelines previously issued by the Ministry of Employment and Labor, most Korean companies only paid holiday work allowance, in addition to ordinary wage, to employees for less than eight hours worked on any given holiday. Employees recently started to bring lawsuits claiming entitlement to overtime work allowance in addition to holiday work allowance for such hours worked during holidays, and a majority of the lower courts have held in favor of employees and ruled that employees are entitled to receive an additional payment of a total of 100% of ordinary wage for each hour worked during a holiday. The Korean Supreme Court is expected to weigh in on this issue soon, and practitioners and commentators expect the majority lower court decisions to be upheld.
- Labor Unions. In addition to being a key diligence concern, labor unions of Korean companies have at times delayed or even derailed Korean M&A transactions by making excessive demands for employment guarantee, incentive payments (often referred to as M&A bonus) and other concessions in cases of change of control transactions. Accordingly, investors should consider preparing a game plan at the initial outset of a Korean M&A transaction to understand the characteristics and concerns of the relevant labor union.
We hope you find our discussion above helpful as you consider Korean investment opportunities. Please feel free to reach out to us if you have any Korea related issue of interest, and we would be happy to discuss and provide our input.
Executive Summary: While most merger transactions have been passed by the Competition Commission of India (“CCI”) without conducting a detailed investigation, the CCI has escalated recent combinations to such greater review. This article examines the procedure of the CCI in relation to so-called Phase II inquiries in proposed combinations and highlights some of the teething issues that may be associated with such inquiries.
Since the operationalization of the merger control rules in June 2011, the Competition Commission of India (‘CCI’) has reviewed close to 200 transactions (referred to as ‘combinations’) without conducting a detailed investigation, or Phase II inquiry, of a proposed combination. By and large CCI has approved most proposed combinations within 4 to 8 weeks of the receipt of notification by the parties. Notably, CCI took significantly longer – 168 days – to review and issue an approval order in respect of Etihad’s proposal to acquire a 24% stake in Jet1. Nonetheless, CCI did not see the need to subject a proposed combination to the detailed scrutiny of a Phase II inquiry.
In the last three months though, CCI has in quick succession, escalated two proposed combinations to Phase II review. In September 2014, CCI formally announced the opening of a Phase II inquiry of the proposed combination between Sun Pharmaceutical Industries Limited (‘Sun’) and Ranbaxy Laboratories Limited (‘Ranbaxy’) (‘Sun-Ranbaxy Transaction’). On December 5, 2014 CCI approved the Sun-Ranbaxy Transaction, ending the first ever Phase II review initiated by it. CCI followed this up with commencing a Phase II inquiry of the combination between Holcim Limited (‘Holcim’) and Lafarge S.A. (‘Lafarge’) (‘Holcim-Lafarge Transaction’) in November 2014. Undoubtedly, CCI has done an excellent job in streamlining the merger control regulations and approving transactions well within the 210 days statutory outer limit prescribed under the Competition Act, 2002 (‘Competition Act’) for approving transactions, however, the procedure on Phase II inquiries though remains a little unclear.
In light of CCI concurrently conducting 2 detailed Phase II inquiries, this article seeks to provide an overview of the procedure followed by CCI in Phase II inquiries and highlights some of the teething issues that may be associated with Phase II inquiries.
General CCI processes regarding combination inquiries
As a general rule, CCI is required to issue a prima facie opinion on whether a proposed combination causes or is likely to cause an appreciable adverse effect on competition (‘AAEC’) in India within 30 calendar days of receipt of a notice. The time taken by the parties to the combination to respond to CCI’s requests for additional information is not counted towards the 30 day period. If CCI reaches the prima facie opinion that a proposed combination does not (or is not likely to) cause an AAEC in India, it issues a formal order approving the proposed combination. Otherwise, CCI issues a notice under Section 29 of the Competition Act (‘Section 29 Notice’) seeking the parties’ view on why a detailed investigation to examine the competitive effects of the proposed combination should not be carried out. If the relevant parties successfully address CCI’s concerns, including by way of offering structural remedies or behavioral commitments, CCI does not initiate a formal inquiry and approves the transaction. Conversely, if the CCI is not satisfied by the responses offered by relevant parties, then CCI initiates a formal Phase II inquiry.
The Phase II process
Upon receipt of a response to the Section 29 Notice, CCI may, at its discretion, request its investigative arm, the Director General (‘DG’), to conduct an investigation and submit a report in respect of the proposed combination. Simultaneously and within 7 days of receipt of the report from the DG, or the parties’ response to the Section 29 Notice, CCI is required to direct the parties to publish the details of the proposed combination (‘Publication Direction’), which must be complied with, within 10 working days of such a direction. The publication entails providing details of the proposed combination in the format prescribed under the merger control regulations (known as a Form IV). The parties are required to upload a completed Form IV on their respective websites and also publish it in 2 national dailies. CCI also posts the Form IV on its website within 10 days of issuance of the Publication Direction (‘Public Disclosure’).
Pursuant to the Public Disclosure, CCI may invite written objections to the combination from any person affected or likely to be affected due to the proposed combination coming into effect (‘Public Objections’). The Public Objections must be filed within 15 days of the Public Disclosure. Subsequent to the receipt of Public Objections, CCI must within 15 working days seek additional information, if it wishes to, from the parties. Again, the parties are offered a 15 day window to submit such additional information to CCI.
After the receipt of additional information requested by CCI from the parties, CCI is required to issue an order either (i) approving the transaction, (ii) disallowing the transaction, or (iii) proposing modifications to the transaction (‘Remedies’). If CCI proposes Remedies, the parties have the flexibility to propose modifications to CCI’s proposed Remedies. CCI may either accept the modification proposed by the parties or compel the parties to accept the Remedies initially identified by it if CCI is not satisfied with the parties’ proposed modification.
The parties are required to carry out the modifications within such time as CCI may prescribe and upon completion of the modifications, the parties need to file a compliance report with CCI.
Indian Experience with Phase II investigations
On December 5, 2014 CCI approved the Sun-Ranbaxy Transaction but ordered the divestment of all tamsulosin and tolterodine products of Sun and six other products marketed by Ranbaxy. The combined market share of Sun and Ranbaxy for the products to be divested are in the range of 90-95%, CCI. The high combined market shares in these eight products appear to be the key reason for the CCI’s decision to require their divestiture.
CCI has stated that the transaction shall not be given effect until the divestments have been entered made, in accordance with the orders of CCI.
The Holcim-Lafarge Transaction is still at the Public Disclosure stage. While CCI did not escalate its inquiry to Phase II investigation, on at least on 2 occasions, CCI has required parties to transactions in the pharmaceutical sector to modify the terms of their non-compete agreements.
Contributed by: Masakazu Iwakura, Nishimura & Asahi (Tokyo)
- During 2013, M&A deals in which at least one party was a Japanese company grew by approximately 10.8% from the previous year, the second consecutive year of growth in M&A deal volume.
- Several large-scale and cross-border deals were completed, including (i) the combination of Applied Materials, Inc. and Tokyo Electron Limited to create a new company valued at approximately US$29bn (¥2.8 trillion), (ii) the acquisition of Sprint Nextel Corporation by SoftBank Corp for approximately US$21.6bn (¥1.8 trillion) in the telecom industry; (iii) the acquisition of Bank of Ayudhya Public Company Limited by the Bank of Tokyo-Mitsubishi UFJ, Ltd. for approximately Bt170.6bn (¥536.0bn) in the bank business, and (iv) the acquisition of Beam Inc. by Suntory Holdings Limited for approximately US$16bn in the liquor industry.
- It was generally reported that in 2013 the economic environment in Japan was much improved under the series of the economic policies adopted by the Abe LDP Administration, called “Abenomics.” It is expected that cross-border transactions will likely continue to increase due to the shrinking of the Japanese market.
- New legal developments, such as the pending revisions of the Companies Act and revisions to insider trading regulations, and new court decisions are expected to impact M&A practice in Japan.
In 2013, M&A transactions in Japan significantly increased, and several large-scale and cross-border deals were completed. While it is not clear how the economic environment in Japan will proceed in 2014, it is expected that cross-border transactions will likely continue to increase due to the shrinking of the Japanese market. There have also been many legal developments, such as submission of the amendment bill of the Companies Act to the Diet and new court decisions that are expected to impact M&A practice in Japan.
According to the data published by Recof, an M&A advisory boutique firm in Japan, during 2013 there were 2,048 M&A deals in which at least one party was a Japanese company. This number grew by approximately 10.8% from the previous year, which marks the second consecutive year in which M&A deals increased.
The number of inbound M&A deals, in which Japanese companies are acquired by foreign companies, grew by approximately 33.0% and domestic M&A deals grew by approximately 14.7% in each case from the previous year. On the other hand, the number of outbound M&A deals, in which foreign companies are acquired by Japanese companies, slightly decreased by approximately 3.1%. However, the number of outbound M&A deal has remained at a high level in recent years and the geographic locations of the acquired companies were quite broad, ranging from North America and Europe to China and Southeast Asia.
It was generally reported that in 2013 the economic environment in Japan was much improved than in 2012 under the series of the economic policies adopted by the Abe LDP Administration, which are called “Abenomics.” One example, which shows the favourable economic environment in 2013 in Japan, is that during 2013 the Nikkei Stock Average recovered to the level it achieved before the Lehman Brothers Collapse in 2008. Many consider the recovery to be one of the reasons for the increase in M&A transactions in Japan in 2013. On the other hand, since the beginning of 2014, the Nikkei Stock Average has fallen. In addition, the consumption tax rate will be scheduled to rise from 5% to 8% in April 2014. Therefore, it is unclear how the economic environment and trends in M&A activity in Japan will proceed in 2014.
Notable M&A deals in 2013
In 2013, several large-scale and cross-border deals were completed. For example, the business integration between Applied Materials, Inc. and Tokyo Electron Limited, both of which are among the largest companies in the world in the semiconductor and display manufacturing technology industry, attracted broad attention due to the deal size, which values the new combined company at approximately US$29bn (¥2.8 trillion), and the novel structure in which the holding company for both parties after the business integration was incorporated in the Netherlands. Other examples of large-scale and cross-border deals include (i) the acquisition of Sprint Nextel Corporation by SoftBank Corp for approximately US$21.6bn (¥1.8 trillion) in the telecom industry; (ii) the acquisition of Bank of Ayudhya Public Company Limited by the Bank of Tokyo-Mitsubishi UFJ, Ltd. for approximately Bt170.6bn (¥536.0bn) in the bank business; and (iii) the acquisition of Beam Inc. by Suntory Holdings Limited for approximately US$16bn in the liquor industry.
It is expected that the number of Japanese companies seeking to conduct business on a wider and more global scale through outbound M&A transactions continues to increase from now on because of social and economic conditions in Japan, mainly due to the shrinking of the market and the decline in the birth rate.
With respect to M&A deals in which both parties are Japanese companies, integrations between or among companies in the same industry or business continued to increase in 2013. Examples of these transactions include (i) the acquisition of the Peacock Store and the Daiei Inc. by AEON Co., Ltd. and the acquisition of the Nissen Holdings Co., Ltd. by Seven & i Holdings Co., Ltd. in the retail industry; (ii) the integration of system LSI businesses between Panasonic Corporation and Fujitu Limited in the electronics industry; and (iii) the acquisition of the Honda Elesys Co., Ltd. by NIDEC Corporation in the electronic control units for automobiles industry.
In Japan, it is said that since there is oversaturation of companies in the same industry or business area, many companies are competing despite the shrinking size of the market. It is expected that in order to survive in the highly competitive market situation these companies will need to strengthen their business bases through mergers between or among companies in the same business areas. Therefore, it is expected that the number of such M&A deals will continue to increase in the future.
In addition, much attention has been given to the proposed acquisition of Japanese companies by foreign entities. One example is the proposal of acquisition provided by the Wuthelam group, a major paint maker in Singapore, to Nippon Paint Co., Ltd. Another example is the business proposal by Third Point LLC to Sony Corporation to spin-off and list the entertainment business of Sony Corporation. Both cases did not result in unsolicited or hostile take-over attempts.
However, the possibility that these transactions may increase in the future cannot be ruled out and in some of them unsolicited or hostile take-overs may be attempted because foreign companies, which are attracted to the brand, advanced technology and sophisticated expertise of Japanese companies, may aim to acquire Japanese companies with such resources.
Revisions of the Companies Act
An amendment bill of the Companies Act was submitted to the Diet on November 29, 2013. The amendment bill is under Diet deliberations now, and is expected to be adopted in this regular Diet session. The effective date of the revised Companies Act is not clear yet, but is expected to be April or May in 2015.
The amendment is composed mainly of revisions to the corporate governance system, but also includes the following important revisions that have the potential to impact M&A practice in Japan.
Revising the rules on third-party allotment of new shares. Under the current Companies Act, third-party allotments of new shares are required to be approved only by a resolution of the board of directors, but not by a resolution of the shareholders’ meeting unless the amount to be paid for the subscribed shares is particularly favourable to the subscribers.
As to this point, some cases in which large-scale third-party allotments of new shares were made to new shareholders and the largest shareholder was altered without a resolution of a shareholders’ meeting have faced severe criticism from cross-border institutional investors as unfair issuances of new shares.
Therefore, under the revised Companies Act, a third-party allotment of new shares that results in the replacement of the controlling shareholder is expected to be subject to a resolution of a shareholders’ meeting under certain conditions. To be more precise, a company willing to conduct such a third-party allotment of new shares shall provide a notice to shareholders or public notice. If shareholders who hold 10% or more voting rights of the company notify the company that they are opposed to the third-party allotment of new shares within two weeks from the date of such notice to shareholders or public notice provided by the company, the third-party allotment of new shares is required to be approved by a resolution of a shareholders’ meeting.
Revising the rules on transfer of the shares of a subsidiary. Under the current Companies Act, the transfer of the shares of a subsidiary is not required to be approved by a resolution of the shareholders’ meeting, but the assignment of a significant part of the business must be approved by a special resolution of a shareholders’ meeting.
In order to resolve this imbalance under the current Companies Act, under the revised Companies Act, the transfer of the shares of a subsidiary will be required to be approved by a special resolution of a shareholders’ meeting if the book value of such shares is more than 20% of the total asset value of the transferring company or if, following the transfer, the transferring company will not be the parent company of a company of which shares are transferred.
Revising the rules on cash squeeze-outs and introducing a new cash-out method. Although under the current Companies Act, a company is able to conduct a squeeze-out of minority shareholders with cash using a particular class of shares, the procedures for doing so are complex and time-consuming. For example, the special resolution of a shareholders’ meeting is required for revisions of the articles of incorporation.
Under the revised Companies Act, special controlling shareholders, who have 90% or more voting rights of the target company, will have rights to purchase the remaining shares from other shareholders. This procedure will require the resolution of the board of directors, but not a resolution of a shareholders’ meeting of the target company.
Therefore, it is expected that the amendment will simplify the procedures for cash squeeze-outs.
It is worth noting that the other shareholders, who object to the sale price proposed by the special controlling shareholder, may file a petition to the court for a determination of a fair sale price.
Revising the rules on company splits. Many professors of the Companies Act have stated that the current rules on company splits are not sufficient to protect the rights and benefits of the creditors of the splitting company. In addition, many lawsuits and important court precedents related to this issue have arisen in recent years.
The creditors of the splitting company may not exercise their credit upon successor companies after the company splits if the credits are not included in the splitting assets under the current Companies Act.
Under the revised Companies Act, the rights and benefits of the creditors of the splitting company will be better protected. To be more precise, if the splitting company conducts the company split with the knowledge that the split is harmful to the creditors of the company, the creditors may exercise their credit upon the successor companies.
Revisions to insider trading regulations
In 2013, there were two important revisions to insider trading regulations concerning M&A transactions.
Scope of regulations in M&A transactions. Firstly, a revision was implemented concerning the scope of application of the regulations to the transfer of shares in M&A transactions.
Under the past regulations, the transfer of shares in a merger or corporate split was not subject to the insider trading regulations, while share transfers in a business transfer were subject to such regulations.
Under the revised regulations, the transfer of shares in a merger or corporate split, as well as in a business transfer, is subject to the insider trading regulations. On the other hand, transactions in which there may be little potential for insider trading are exempt from insider trading regulation regardless of the methods of such transactions.
In short, the revised regulations allows businesses to be more neutral in selecting the method or type of the transaction in light of the insider trading regulations.
Insider trading regulations concerning Tender Offers. Secondly, insider trading regulations concerning Tender Offers were revised. The two main points of this revision, which was published in June 2013 and will be enforced beginning on April 1, 2014, are as follows:
- Extension of the range of “Person Concerned with Tender Offeror”: In recent years, the frequency of insider trading by officers and employees of a company which is the target of a tender offer, or persons who receive insider information from them, has increased.
Under the new regulations, if officers or employees of the target company come to know the relevant fact in the course of their work or business, they become a “Person Concerned with Tender Offeror” to whom insider trading regulations are applied. In addition, persons who receive insider information from officers or employees of the target company are also subject to insider trading regulations.
- Exemption applied to persons who receive insider information from a Person Concerned with Tender Offeror: Under the past regulations, if an entity (X) which makes a decision to launch a tender offer tells another entity (Y), a possible tender offeror, any information or fact concerning the launch of the tender offer by X before publication, then Y is subject to insider trading regulations and unable to launch a tender offer for the same company. The regulations effectively limit unreasonably competitive tender offers.
Under the revised regulations, Y may not be subject to the regulations and could launch a tender offer in the following two cases: (i) when Y publicises such information or fact concerning X’s launch of a tender offer by a Tender Offer Notification or (ii) six months after Y receives the information or fact from X.
However, the exemption shall apply to only to information or a fact concerning other entity’s launch of a tender offer. Therefore, an entity that receives insider information concerning the business or other matters of a target company from an entity that makes a decision to launch a tender offer, shall not launch its own tender offer for such target company.
In 2013, there were several important court decisions which are expected to affect M&A practice in Japan.
Court decisions concerning representation and warranty clauses are particularly important. In the past, it was not necessarily usual for a party to an M&A transaction in Japan to file a suit against the other party for indemnity due to a breach of a representation and warranty clause. However, in recent years, the number of lawsuits concerning M&A transactions has been increasing.
Court decisions in cases where a buyer knows or is able to know of any breach of representation and warranty by sellers are divided into two types. Some court decisions have said that there is no need to give a remedy to such a buyer and dismissed such buyer’s claim for indemnification. Other court decisions have said that a seller who made representations and warranties shall take on risk of liability for breach even if the buyer knows of a breach of one of the seller’s representation and warranty clauses and have allowed the buyer’s claim for indemnities.
Although it is still not clear how court decisions will proceed in the future, it is necessary to monitor the future development of court decisions with regard to representation and warranty clauses. Furthermore, it is important to pay attention to the risk that a buyer’s claim for indemnity will not be allowed in Japan in accordance with the wording of the agreement if a buyer knows or should know of the seller’s breach of a representation and warranty clause.
- A recent notification of the Securities and Exchange Board of India expressly permitted put and call options in relation to shares of public limited companies, both listed and unlisted.
- The Reserve Bank of India has clarified that foreign investors can have “optionality” attached to Equity Securities (defined below) so long as such option / right does not assure them of a fixed exit price, provided that other conditions described below are met.
- With regard to equity shares, such option / right may be exercised: (i) in case of a listed company, at a price not more than the prevailing market price; and (ii) in case of unlisted companies, at a price not exceeding that arrived on the basis of Return on Equity (“RoE”) as per the latest audited balance sheet. The shift of the exit price from a discounted free cash flow method of valuation to a return on equity based valuation could have a negative impact on foreign investors.
- In case of compulsorily convertible preference shares and compulsorily convertible debentures, the pricing for an exit by way of a put option can be arrived at as per any internationally accepted pricing methods as certified by a chartered accountant or SEBI registered merchant banker.
The use of put and call options are commonplace in investment transactions and are one of the means for achieving a potential exit from an investment. Until recently, the Securities Contracts (Regulation) Act,1956, did not permit the use of put and call options in investment transactions involving public limited companies. This was because private contracts with put and call options were in the nature of derivative contracts which were not in compliance with the SCRA.
The Reserve Bank of India (‘RBI’), India’s apex bank, was also not in favour of the use of put and call options in investment transactions. From an RBI perspective, though not expressly prohibited under the foreign exchange regulations, RBI viewed “put” option rights in favour of non residents with a guaranteed exit price as debt masquerading as equity and thought that they should therefore be viewed and treated as external commercial borrowings.
Liberalisation by SEBI
On October 3, 2013, the Securities and Exchange Board of India, (‘SEBI’), India’s capital markets regulator, had issued a notification which inter alia expressly permitted put and call options in relation to shares of public limited companies (both listed and unlisted). This SEBI notification is a good step forward in clarifying SEBI’s position on put and call option contracts, given the uncertainties created previously.
The SEBI notification, however, has some riders attached to it. It has been stipulated that the selling party of a put option must hold the title and ownership of the underlying securities for a minimum of 1 year from the date of entering into the contract. SEBI has also required that the consideration paid on the exercise of any option must be in compliance with the relevant guidelines for pricing as are stipulated by SEBI and RBI, and the contract must also compulsorily be settled by way of actual delivery. Effectively, the pricing of the “put” option (for transfer from foreign investors to Indian residents) for unlisted companies was linked to the RBI prescribed price, which price was a ceiling calculated in accordance with the discounted free cash flow method of valuation (‘DCF’). For listed companies, the price was capped at the preferential allotment price calculated in accordance with the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2013, which is essentially the higher of the average weekly high and low closing prices quoted on the stock exchange during the preceding 26 weeks or 2 weeks.
While SEBI took steps to remove some of the uncertainties around “put” / “call” options on securities of public limited companies, the position of RBI still remained unclear in relation to foreign investors. Recently, RBI has released its notification dated November 12, 2013 published in the Official Gazette on December 30, 2013 and circular dated January 9, 2014 on this subject matter (collectively, ‘RBI Circulars’).
RBI’s stand under the RBI Circulars
The RBI Circulars do not consider any equity shares, convertible preference shares or convertible debentures (‘Equity Securities’) carrying “optionality” rights and which assure returns, as eligible instruments in the hands of a foreign investor from a foreign direct investment standpoint. Thus, any foreign investment made in any Equity Security cannot carry “optionality” and assured returns. Equity Securities carrying “optionality” but no assured returns are valid and eligible but transfer of such instruments are subject to certain conditions set out in the RBI Circulars.
What is meant by “optionality”?
The term “optionality” is not defined under the RBI Circulars. What kind of rights under the shareholders agreement constitutes “optionality” is a matter of interpretation. Based on previous concerns raised by RBI in the context of “put” options, one may infer that “optionality” should include only those rights which grants the foreign investor a right to cause the company or the other shareholders to purchase (or cause the purchase) of Equity Securities held by such foreign investor. In other words an optionality clause should be one which obliges the buyback or purchase of Equity Securities from the foreign investors.
“Options” which are “disallowed”
The RBI Circulars have provided that Equity Securities which: (a) contain an optionality clause; and (b) which provides a foreign investor with a right to exit at an assured price, will not be regarded as an eligible security and cannot be subscribed to by foreign investors. The guiding principle that RBI has set forth, is that foreign investors should not be guaranteed any assured exit price at the time of making the investment.
What is meant by “assured return”?
The term “assured return” is also not defined under the RBI Circulars. It is not clear whether put options with an agreed return that are subject to, and capped at the price arrived at based on applicable pricing guidelines, particularly where there are no agreed mechanisms to ensure that the agreed price is effectively safeguarded, will constitute “assured return” within the meaning of the RBI Circulars. Arguably, a “price assured” which is, subject to it being in compliance with the pricing requirements under the law ought to be treated as a return which is contingent, rather than assured. However, RBI will perhaps need to be convinced with respect to this aspect.
“Options” which are “allowed”
RBI has clarified that foreign investors can have “optionality” attached to Equity Securities so long as such option / right does not assure them of a fixed exit price. In other words, “put” options are possible going forward, so long as such “put” right does not result in an Indian resident providing an assured return to foreign investors. This is however, subject to the following conditions:
i. Such Equity Securities will be locked in for a minimum period of one year, unless a higher lock-in is prescribed by the exchange control regulations (e.g. certain sectors such as defence and construction development have a minimum lock-in requirement of three years); and
ii. Such exit will be subject to pricing guidelines discussed below.
Pricing of equity shares at the time of exit
In terms of the RBI Circulars, such option / right may be exercised: (i) in case of a listed company, at a price not more than the prevailing market price; and (ii) in case of unlisted companies, at a price not exceeding that arrived on the basis of Return on Equity (“RoE”) as per the latest audited balance sheet. RoE has been defined to mean profit after tax divided by the net worth, and net worth includes free reserves and paid up capital.
It should be noted that this RoE based valuation will apply only for exit by exercising the “optionality” clause.
The shift of the exit price from DCF to RoE based valuation could have a negative impact on foreign investors. The minimum price at which a foreign direct investment can currently be made in unlisted equity shares is determined on the basis of DCF valuation of the equity shares. The DCF valuation takes into account the future performance of the company based on specified variables. A RoE valuation is an indicator of the financial performance of a company during a specified period, and may not convey the actual fair value of the equity shares of the company. While RBI had in its recently issued FAQs on ‘Foreign Investments in India’ clarified that the foreign investor can exit at a price which gives an annualized return equal to or less than the RoE as per the latest audited balance sheet, it remains to be seen how the foreign investors will get their return under the RoE based valuation in sectors with a long gestation period like insurance, infrastructure, real estate, etc., or where at the time of exit, the company is a loss making company.
Arguably, the RoE based valuation should not apply in the context of events of default by a resident pursuant to which a non-resident has the right to exit the company, and requires the resident to buy its shares. However, further clarity is awaited on this.
Pricing of compulsorily convertible preference shares and compulsorily convertible debentures at the time of exit
In case of compulsorily convertible preference shares and compulsorily convertible debentures, the pricing for an exit by way of a put option can be arrived at as per any internationally accepted pricing methods as certified by a chartered accountant or SEBI registered merchant banker. The underlying rationale for making this distinction is also unclear since a convertible instrument derives its value from the underlying security i.e. the equity share of a company, the transfer of which (as per the RBI Circulars) needs to comply with a valuation based on RoE method.
What happens to existing contracts?
RBI has further stipulated that all existing contracts will have to comply with the above lock in and pricing conditions to qualify as compliant with exchange control laws. Accordingly, it will need to be assessed whether existing contracts need to be amended or not in order for these contracts to be enforceable. Further, it needs to be assessed if any “put” options with an assured return (issued before the date of the RBI Circulars) can be regarded as eligible securities under the exchange control regulations. In this context determination of what will tantamount to “assured return” is important.
While recognition of options by the SEBI and RBI is a welcome move for foreign investors, there are several areas that will need careful consideration, particularly in the context of the pricing regime proposed for exits that will occur pursuant to exercise of option rights by the foreign investor.
 As per Section 18A of the Securities Contracts (Regulation) Act, 1956, derivate contracts are permissible only if entered into on stock exchanges and settled on the clearing house of the recognized stock exchange.
 The Department of Industrial Policy and Promotion (“DIPP”), on September 30, 2011, had announced that all investments in securities with ‘in-built’ options will be considered as external commercial borrowings. However, industry uproar resulted in reversing of this position.
 The lock-in will apply from the date of allotment of such Equity Securities and accordingly, in case of multi-tranche investments, each tranche of investment would be locked in from the date of its respective allotment.
 FAQs on Foreign Investments in India issued by RBI as updated till January 28, 2014.
CHINESE UPDATE – People’s Bank of China Announced Financial Support Polices on Shanghai Pilot Free Trade Zone
Highlights: On December 2, 2013, the People’s Bank of China (“PBOC”) released its Opinions on the Financial Support of the Development of the China (Shanghai) Pilot Free Trade Zone (the “FTZ”) (the “Opinions”). The Opinions committed to the promotion of reforms and pilots in the FTZ in the sectors of cross-border RMB usage, RMB capital account convertibility, interest rate liberalization and foreign exchange administration. The Opinions give a roadmap of financial reforms in terms of cross-border RMB usage and RMB capital account relaxation on one hand, but on the other hand lay out to some extent the boundary of financial reforms to be launched in the FTZ.
PBOC Announced Financial Support Polices on Shanghai Pilot Free Trade Zone
On December 2, 2013, the People’s Bank of China released its Opinions on the Financial Support of the Development of the China (Shanghai) Pilot Free Trade Zone. The Opinions committed to the promotion of reforms and pilots in the FTZ in the sectors of cross-border RMB usage, RMB capital account convertibility, interest rate liberalization and foreign exchange administration.
The Opinions did not offer a timetable for issuance of detailed implementing rules. On the second day after the Opinions were released, PBOC Shanghai branch informally gave a preliminary schedule to media: (1) most of the upcoming policy initiatives are expected to be implemented within the next three months; (2) those implementing rules would be subject to test and exploration for about half a year to gain experience, and; (3) if the experiments work, the authorities expect to establish, within one year, a financial administration model that is may be duplicated and extended to other regions of China.
Summary of Policy Initiatives in the Opinion
We touch on a few of the significant policy initiatives in the Opinions below:
Free Trade Accounts
At the heart of the Opinions, PBOC establishes a specially tagged bank accounts system for use of such special accounts by companies and individuals in the FTZ in relation to those financial innovation activities allowed in the Opinion.
- Residents in the FTZ will be allowed to open Free Trade Accounts for Residents (“Residents FTA”), while non-residents will be allowed to open Free Trade Accounts for Non-residents (“Non-residents FTA”). Free fund transfers are only permitted for those between Residents FTAs and offshore accounts, non-residents’ onshore accounts, Non-residents FTAs and other Residents FTAs, while the fund transfers between Residents FTAs and other on-shore accounts are still subject to the current cross-border fund transfer restrictions. All commercial banks in the Shanghai area can open Free Trade Accounts for its FTZ qualified clients by way of setting up a unit using a separate account management system.
Cross-border Investments and Financing
The most significant changes PBOC laid out are those that concern cross-border investment. In this area, the Opinions echo the “Specific Measures Supporting and Promoting the Development of the Pilot Free Trade Zone” released by the China Securities Regulatory Committee (“CSRC”) on September 29. However, various qualifiers and terms used in the Opinions are still short on specifics, and need to be fleshed out by PBOC in the implementing rules. It remains to be seen to what extent PBOC will lift its sharp limits on funds entering and leaving China for securities investments.
- “Qualified” Chinese individuals who are “working in” the FTZ will be allowed, in accordance with “relevant rules”, to invest in overseas securities market and transfer their after-tax income earned within the FTZ to offshore accounts. Similarly, “qualified” foreign individuals who are “working in” the FTZ can open non-resident individual domestic investment account to, in accordance with “relevant rules”, make investment in China including securities investment.
- Financial institutions and companies in the FTZ will be allowed to invest in Shanghai’s securities market in accordance with “relevant rules”.
“Qualified” companies in the FTZ will be allowed to directly invest in overseas capital markets including the derivative markets in accordance with “relevant rules”.
RMB Cross-Border Usage
- Commercial banks in the Shanghai area can directly process cross-border RMB settlement related to current accounts (as opposed to capital accounts) and direct investment transactions upon customers’ instructions, on the basis of “know your customer”; “know your business” and “due diligence review” principles, unless the instructing entity is on the “export trading RMB settlement entities watch list”. This reform aims to promote the usage of cross-border RMB in both investment and trade settlement by adopting a macro supervision system.
- PBOC permits financial institutions and companies in the FTZ to borrow RMB funds from offshore markets, but meanwhile, re-emphasizes that those funds cannot be invested in securities or derivatives, nor be used for trust loans.
Living Monitoring of Fund Flow
- PBOC will establish a living monitoring mechanism towards fund flow in the FTZ. PBOC may, at its discretion, put forth stronger supervision of short-term speculative fund flows in the FTZ, and even take temporary control measure against such fund flow.
The list of reforms unveiled by PBOC addresses in more detail the previous scope of reforms in the blueprint of FTZ issued by the State Council on September 27. The Opinions give a roadmap of financial reforms in terms of cross-border RMB usage and RMB capital account relaxation on one hand, but on the other hand lay out to some extent the boundary of financial reforms to be launched in the FTZ.
In relaxing some controls, PBOC also made clear that it would not allow FTZ become a back door to circumvent long standing capital control. PBOC will continue to closely monitor the fund flows between the FTZ and the rest of China.