VENTURE CAPITAL FUNDING IN INDIA

VENTURE CAPITAL FUNDING IN INDIA

Venture Capital Fund

Venture Capital Fund (VCF) is a privately pooled investment vehicle. It can be established or incorporated in the form of a trust, a company, a limited liability partnership, or a body corporate which collects funds from investors, for investing in accordance with a defined investment policy for the benefit of its investors.

Current scenario in India

As per the report of Bain and Company[1] “India Private Equity Report 2018”; 2017 was a good year for private equity in India as the country witnessed the highest investment of Private Equity (PE) /Venture Capital (VC) ever, i.e. an investment of around $26 billion.

Securities and Exchange Board of India (SEBI) regulates both domestic and offshore funds by the virtue of various regulations. Domestic VC funds are regulated under SEBI (Alternate Investment Fund) Regulations and offshore VC funds are regulated under SEBI (FVCI) Regulations, 2000.

Instruments

Some of the preferred instruments for a VC fund outside equity are (a) compulsorily convertible preference shares are one such type of instrument as they carry a preferential right over dividend and gives investors a preferential right to recover investment in case the company is wound-up; (b) compulsorily convertible debentures are another, investment instrument that may be considered. It is a debt instrument compulsorily convertible into equity after a specified time period; (c) convertible notes[2] as an investment option is permitted for startup companies with effect from January 10, 2017. A foreign investor is permitted to invest in convertible notes up to twenty five lakh rupees or more in a single tranche.[3]

Documentation

Typically, a VC fund enters into various documents in connection with its investment which includes (a) term sheet: capital financing is initially captured by a term sheet. It covers various important aspects such as valuation of the company, the constitution of the board, the right to veto, exit rights, future funding, right to financial information etc.; (b) Share subscription agreement: it provides for the issue of shares to the investor for subscription money, determined as per the valuation of the company. It provides the purpose for which the money may be used, representations and warranties by the founder pertaining to the startup, provides a safeguard against any liability which the investor may face due to legal, regulatory or tax related liabilities of the startup etc.; (c) Shareholders’ agreement: it provides for the structure of the board of directors, the appointment of the investor’s directors on the board, liability of the founder to provide investor with financial reports from time to time, pre-emptive right, right of first refusal,  the exit route available to the investors etc.

Exit Options/Routes available to the investors are as set out below:

One of the key aspects for a VC fund in connection with its investment is the right to exit the portfolio company. Typically the exit options include (a) initial public offering, (b) buyback of shares, (c) redemption of fully paid-up preference shares / debentures, (d) registration rights: a right of investor to register its securities for sale in case the company lists its securities on a foreign stock exchange, (e) tag along rights: investor can sell its share on the same terms and conditions as the shareholders exiting the company to a third party, (f) drag along rights: investor can compel the other shareholders  to sell their shares on the same terms and conditions as the investor to a third party, (g) put option :investor can sell shares back to the other shareholders at a predetermined price/terms and conditions (h) call option: investor can purchase the shares of another shareholder at a predetermined price/terms and conditions as specified under the shareholders agreement.

Judicial pronouncements

The Indian Courts with recent judicial pronouncements are likely to instil more confidence amongst the investor, creating a favourable climate for investments. The Delhi High Court in a recent judgment upheld an international arbitral award passed in favour of foreign investor, and against the promoters, of an India company for having concealed information about proceedings against them by American food and drug department while selling their shares. In another judgment of NTT Docomo v.Tata Sons Limited[4] the court by upheld the arbitral award in favour of Docomo. The court by this decision clearly brought out the need to create a favourable environment for foreign investment by holding the Indian parties liable to their commitments under the contracts disabling them to take defence of the Foreign Exchange laws.

Conclusion

Economic growth in any country depends upon the consistent growth of business and an environment which nurtures investor confidence. Investor confidence can be ensured when investors are able to exit the companies after accruing profits and without suffering any loss due to wilful default or misrepresentation of the other shareholders or promoters. With laudable judicial precedents and liberal laws India is likely to achieve high investment and business growth in the coming years.

[1]https://www.bain.com/insights/india-private-equity-report-2018/; last seen 21.08.2018

[2] Convertible Note’ means an instrument issued by a startup company evidencing receipt of money initially as debt, which is repayable at the option of the holder, or which is convertible into such number of equity shares of such startup company, within a period not exceeding five years from the date of issue of the convertible note, upon occurrence of specified events as per the other terms and conditions agreed to and indicated in the instrument.

[3] https://rbi.org.in/scripts/FS_Notification.aspx?Id=11253&fn=5&Mode=0

[4] (2017) 241 DLT 65

FUNDING OF INDIAN SUBSIDIARIES

FUNDING OF INDIAN SUBSIDIARIES

Liberalisation in India has resulted in significant inbound foreign investment. As Indian operations of foreign businesses grow, foreign shareholders grapple with the best ways to finance these operations and repatriate some of the profits – partly due to the Indian regulatory system, which strictly regulates capital account transactions. This article examines some key ways of financing Indian operations of foreign shareholders. But it will depend on the specific circumstances in each case to determine which option is best suited for a particular Indian subsidiary.

Investment through shares and convertible instruments. Foreign companies can finance their subsidiary’s operations through investment in shares and convertible instruments. The law allows investment through equity shares, compulsory convertible preference shares, compulsory convertible debentures and warrants.

The investment in the aforesaid instruments is treated as capital investment by the foreign investment law of India, but such capital investment is subject to certain conditions including: (1) Restrictions on the level of capital investment in specified sectors, e.g. permissible capital investment in multi-brand retail is up to 50%; (2) the need to specify the manner of pricing the instrument to ensure that the instrument is not issued/transferred at a lower price than its fair market value (pricing compliance); (3) a specified time for the allotment of such instruments; (4) reporting such capital investment within a specified timeline.

For example, when a foreign shareholder wants to fund its subsidiary for working capital needs, the foreign shareholder may want to evaluate, prior to the capital investment, the pricing compliance. Considering the pricing compliance mandates that the instrument be not issued at a price lower than its fair market value, the foreign shareholder will need to evaluate whether such pricing compliance will result in the capital investment being much more than what is needed.

However, there are some exceptions to the pricing compliance for a private company or a public unlisted company, e.g. issuing the instrument through a rights issue. Instruments issued through a rights issue can be issued at a price similar to the price offered to an Indian shareholder. For wholly owned subsidiary of a foreign shareholder, however, this exception may need to be examined given that the subsidiary may not have an Indian shareholder.

Considering the above, capital investments may not always be the optimum method for funding as foreign shareholders may not want to lock in huge capital for inordinately long periods. Further, repatriation of profits from such subsidiaries has certain restrictions under applicable law and is coupled with attendant tax leakages.

External commercial borrowings. A foreign shareholder can also fund through debt. However, third party loans are costly in India compared to borrowing overseas and are not easily available. But there are some viable debt alternatives which foreign parents can explore to finance their Indian subsidiaries, earn some interest and recover the money in due course.

Under the applicable law, an Indian subsidiary can raise debt from its foreign shareholder by way of external commercial borrowings (ECBs). In this context, a direct foreign equity holder with minimum 25% direct equity holding in the Indian subsidiary, an indirect equity holder with minimum indirect equity holding of 51% in the Indian subsidiary, or a group company with a common overseas parent, is permitted to provide an ECB to its Indian affiliate. The borrowings may fall under any of the three categories – either with or without approval of the central bank (RBI) – depending on the business of the Indian subsidiary, the end use of the ECB proceeds, the currency of borrowing and the average tenure of the ECB. Further, the applicable law stipulates that the Indian subsidiary is to maintain a debt equity ratio of 7:1. However, this ratio is not applicable if the total of all ECBs raised by an Indian entity is up to US$5 million or equivalent.

While the applicable law requires RBI approval for ECBs not satisfying certain conditions set out under the relevant regulation, such approval may be time consuming and may not meet the immediate needs of the Indian subsidiary.

Masala bonds. In September 2015, RBI permitted Indian corporates to issue rupee-denominated bonds (nicknamed as Masala bonds) under the ECB regime. The Masala bonds regime is more liberal than the ECB one. The pool of lenders is increased and any person from a Financial Action Task Force compliant jurisdiction can subscribe to such bonds. The requirement of holding a minimum equity percentage as per the ECB guidelines for foreign equity holders is not applicable, and an equity holder with less than 25% equity in the Indian company would also be eligible to subscribe to such bonds.

Non-convertible debentures. Another avenue available is the corporate debt market. A group company of a foreign shareholder can register as a foreign portfolio investor (FPI) under the Securities and Exchange Board of India’s prescribed regulations. The registration process is straightforward and typically an FPI registration can be completed within a few weeks. An FPI is permitted to invest in listed or unlisted non-convertible debentures (NCDs). The minimum residual maturity of such NCD’s should be 1-year subject to certain conditions set out under the applicable law. The NCDs can be secured or unsecured. The issuer has considerable flexibility on how to use the proceeds and the amount of interest or redemption premium to be paid on such instruments.

This route has been used amply, especially by foreign funds, to finance Indian portfolio companies. This option provides more flexibility than the ECB option in raising funds from foreign shareholders. However, there would be certain disclosure requirements that need to be considered.

By way of business arrangements. Today a good number of Indian subsidiaries, commonly in the IT sector, have been set up to provide services only to its foreign shareholder based in a jurisdiction outside India. These Indian subsidiaries enter into service arrangements with its foreign shareholder and receive funds as part of their business income for providing services to such shareholder. The applicable law does not stipulate a cap on funds received from a foreign shareholder as part of a service contract between the Indian subsidiary and the foreign shareholder. Therefore a foreign shareholder can raise funds for his subsidiary through such an option. However, certain tax implications, such as transfer pricing, may need to be examined.

KEY CONSIDERATIONS IN FOUNDERS’AGREEMENT

KEY CONSIDERATIONS IN FOUNDERS’AGREEMENT

 

A founders’ agreement (“Agreement”) is contract that is executed between all the co-founders of a company. The Agreement sets forth the ownership, rights, responsibilities, dispute resolution and other terms to be executed between the founders and the company.

Key Terms of the Agreement

  1.  Equity ownership

One of the most important terms of the Agreement is determining the proportion of equity ownership of each of the co-founders of the company. The equity ownership of the co-founders of the company is determined taking into consideration multiple factors such as the monetary investment, experience, existing intellectual property, know-how and network in the industry. Also, the equity ownership is pertinent to ascertain the voting rights that the co-founder may exercise.

Significant Questions:

How much money is being invested and at what stage in the life cycle of the company? Is the founder also bringing other intangibles along with the money, such as experience, industry connects and credibility?

  1. Vesting

One of the important considerations to be taken note of while drafting the Agreement is providing a mechanism to deal with a situation where any of the co-founders exits or is ousted from the company. For this purpose, a vesting structure shall be incorporated in the Agreement detailing the manner in which the shares shall be taken up by the founders.

The vesting of the shares may done in the following manner:

  • Time Based Vesting

Under time based vesting, the shares owned by the founder shall be vested in proportion to the time spent by the founder in the company. In the event, the founder decides to quit from the company before the expiry of his term, the remaining shares of such founder shall be returned to the company. The Agreement shall state a time period post which the vesting of shares shall begin, say, 6 (six) months or 1 (one) year (“Cliff Period”). One potential problem with the time-based method of vesting is that performance of the founder is not taken into consideration.

  • Milestone Vesting

 The vesting of shares in milestone vesting takes place when the milestones set out in the Agreement are achieved by the company. This type of vesting rewards performance of the business as a whole. In the event, the founder leaves the company before the milestones are achieved, the shares earmarked for such founder does not vest in him.

Significant Questions:

Whether the vesting of the shares shall be time based or milestones based? What happens if one of the co-founders decides to leave before the expiry of the term of the Agreement?

  1. Demarcation of the roles and responsibilities

The Agreement should clearly demarcate the roles and responsibilities of each of the co-founders of the company. Broadly, the roles and responsibilities of the co-founders can be divided as operations, marketing, administration and finance.

Significant Questions:

What are the different roles and responsibilities that each of the co-founders will perform? How will be the accountability fixed?

  1. Restriction on transfer of shares

 Another important aspect to be taken into consideration in the Agreement is the rights and restrictions of the founders to transfer their shares in the company. The Agreement may provide for a lock-in clause prescribing the number of years before the expiry of which the co-founder is not permitted to transfer the shares owned by him in the company. The Agreement shall provide for a mechanism to deal with a situation where the co-founder wants to exit the company before the expiry of the lock-in-period. It is pertinent to ascertain the method of valuation of the shares and the anti-dilution rights attached to the shares.

One of the ways to ensure that the equity of the company is not transferred to outsiders is by providing the right of first refusal to the shareholders. The right of first refusal will require the founders to transfer their shares to outsiders only once the same has been refused to be taken up by the other shareholders of the company.

The High Court of Judicature at Bombay in Bajaj Auto Ltd v. Western Maharashtra Development Corporation Limited (CDJ2015 BHC 1305) held that in the event there is an agreement inter se the shareholders containing restrictions on transfer of shares of the company, then even if such a company is a public company the restrictions on transfer of shares will be enforceable.

Significant Questions:

What kind of restriction on transfer of shares may be imposed by the company? What shall be the lock-in period of the shares?

  1. Intellectual property assignment

In general business practice, the ideas, inventions and other intellectual property developed by a person remains the property of that person. While drafting the Agreement it must be taken care that the intellectual property rights of the co-founders are assigned to the company and the same do not remain the property of an individual. It is not uncommon for companies to obtain trademarks, patents and domain names in the name of one or more of the co-founders initially which later may be transferred in the name of the company. The valuation of the company is affected by the intellectual property owned by it. Further, the Agreement shall contain a clause stating that the intellectual property developed by the co-founders in the course of their association with the company shall always be owned by the company. In specialized high technology sectors, the founder can consider sharing the intellectual property jointly with the company. However, this needs to be well thought out and documented properly.

Significant Questions:

Whether the intellectual property developed by the founder shall be fully transferred to the company or shall it be shared between the company and the founder? How will the valuation of the intellectual property to be transferred done?

  1. Value additions by the founders

The co-founders may make value additions in the form of bringing in intellectual property rights, technical know-how, marketing rights or similar value additions in the company. It is important that there is a clear understanding between the co-founders with respect to the nature of such value additions, the monetary value of such value additions, time periods at which such value additions would be made and the compensation to be paid to the co-founders for bringing in such value additions. At times, the co-founders are issued shares against the value additions made by them. The Agreement should clearly lay down the number of shares to be issued, percentage shareholding and the method of valuation of such shares, so that there is no ambiguity pertaining to the same.

Significant Questions:

How many shares are to be issued against the value additions? How shall the value of the shares be determined?

  1. Non-compete

The co-founders of the company are expected to maintain strict confidentiality of the business activities of the company and shall refrain from engaging in any business that conflicts with the business of the company. There should be a clear agreement between the co-founders prohibiting them from engaging in activities that are in conflict with the objectives of the company during their association and for a period of a certain number of years after the termination of the Agreement.

It is pertinent to note that section 27 of the Indian Contract Act, 1872 (Contract Act) provides that every agreement by which anyone is restrained from exercising a lawful profession, trade or business of any kind, is to that extent void. The courts in India have taken varied views in enforcing such a clause. It can be inferred that while dealing with disputes relating to non-compete clause under an employment agreement, the Indian courts have considered the pre-termination period of the employment distinct from the post termination period of the employment. Whilst the courts have been tolerant about the application of the non-compete clause, they have walked an extra mile to ensure that such a clause does not have an effect after the cessation of employment and have held that such a clause would fall within the mischief of section 27 of the Contract Act.

In Taprogge Gesellschaft MBH v. IAEC India Ltd (AIR 1988 Bom 157), the Bombay High Court held that a restraint operating after termination of the contract to secure freedom from competition from a person, who no longer worked within the contract, was void. The court refused to enforce the negative covenant and held that, even if such a covenant was valid under German law, it could not be enforced in India.

In Gujarat Bottling Company Ltd and Ors. v. Coca Cola Co. and Ors. [1995 (5) SCC 545 it has been held that “There is a growing trend to regulate the distribution of goods and services through franchise agreements providing for the grant of franchise by the franchiser on certain terms and conditions to the franchisee. Such agreements often incorporate a condition that the franchisee shall not deal with competing goods. Such a condition restricting the right of the franchisee to deal with competing goods is for facilitating the distribution of the goods of the franchiser and it cannot be regarded as in restraint of trade.”.

Significant Questions:

What constitutes a competing business? What shall be the period of non-compete so that it is not considered as unreasonable?

  1. Confidentiality

The founders by the very nature of their association with the company have knowledge of a lot of confidential information about the company some of which may constitute trade secrets. The founders should be contractually restricted from disclosing any confidential information obtained by such co-founder during the course of his/her association with the company as the same may cause irreparable harm to the business of the company.

Significant Questions:

Whether the company shall sign a separate non-disclosure agreement with the founders? What constitutes the confidential information of the company? What shall be the duration for which the confidentiality obligations will subsist post the expiry of the Agreement?

In Fairfest Media Ltd. v. ITE Group PLC (2015 (2) CHN 704), the Petitioner, an organizer of travel trade shows entered into a non-disclosure agreement with the respondent for a period of 6 (six) months in anticipation of entering into a joint venture agreement with the respondent on a later date. As per the terms of the non-disclosure agreement, the respondent was restrained from disclosing the confidential information for a period of 2 (two) years from the date of the termination of the non-disclosure agreement. The nature of information for which the petitioner was seeking protection related to marketing strategy, customer base, costing and profitability of organizing travel trade shows. Subsequently, when the parties failed to conclude the negotiations, the petitioner prayed for an order of injunction from the court to prevent the respondent from utilizing the confidential information for a period of 2 (two) years from the date of termination of the non-disclosure agreement. The High Court of Kolkata held that business information such as cost and pricing, projected capital investments, inventory, marketing strategies and customer lists may qualify as trade secrets and passed an order of injunction restraining the respondent from sharing any information concerning the marketing strategy and customer base received from the petitioner for a period of 2 (two) years from the date of termination of the non-disclosure agreement thereby enforcing the non-disclosure agreement post termination. In enforcing the non-disclosure agreement post termination, the court also relied on the principle that a person who has obtained confidential information cannot use it as a springboard for activities detrimental to the person who has made the confidential information. Further, in determining what shall constitute confidential information the court relied on the rule laid down in an English case Saltmen Engineering Co. v. Campbell Engineering Co. Ltd. [1963 (3) All ER 413] which states that an information can only be said to be confidential information when it has been made by the maker who has applied his brain and produced a result which cannot be produced by another without going through the same process.

  1. Employment

Generally, the co-founders are required to be in whole time employment of the company. There must be a clear understanding amongst the co-founders with respect to their terms of employment, designation, compensation and benefits to be paid to each of them. The Agreement may contain general understanding between the co-founders pertaining to the same and a separate employment contract shall be entered into providing the detailed terms of employment of the co-founders including the benefits to be provided to each of the co-founders. The employment contract of the co-founder shall contain a non-compete clause that prohibits the co-founder to solicit clients or employees of the company to other entities post his departure from the company.

Significant Questions:

What shall be the designation, roles and responsibilities of the founder? How much compensation and other benefits shall be provided to the founder? What shall be the mechanism for termination of the employment contract?

  1. Future financing

The Agreement should clearly contain the detailed provisions for contribution of additional finances by the co-founders for the growth of the company, i.e., whether the additional finances shall be contributed by the founders as equity or as debt, the method of valuation of equity in case the financing is through equity and the rate of interest to be paid by the company in case the financing is a debt financing.

Significant Questions:

Whether the additional finances shall be contributed by the founders as equity or as debt? What shall be the method of valuation of equity in case the financing is done through equity and the rate of interest to be paid by the company in case the financing is a debt financing?

  1. Decision making

In the day-to-day functioning of the business, the company may be required to take complex decisions. The Agreement shall clearly state the manner of exercise of simple as well as the substantial decisions. Further, the structure of the board of directors of the company shall be determined. The day-to-day decision making is allocated to the chief executive officer who is appointed by the board of directors of the company. The Agreement is also required to prescribe the procedure which is to be adopted by the company in the event that there is a deadlock in decision making.

Significant Questions:

What shall be structure of the board of directors? How will the simple and complex decisions be made? What will be the mechanism adopted in case there is a deadlock in decision making?

  1. Termination and dispute resolution

The Agreement shall lay down the rights of the company as well the co-founders to terminate the Agreement. The Agreement may be terminated upon occurrence of a particular event, i.e., for cause or without any cause by a party or by mutual consent of the parties. Further, the Agreement shall provide a clear mechanism for resolution of disputes between the company and the co-founders with respect to any matter stated in the Agreement, i.e., mediation, conciliation and arbitration. The parties shall agree on the governing law of the Agreement and the exclusive jurisdiction of the courts to which the disputes under the Agreement may be referred to.

Significant Questions:

Under what circumstances shall the Agreement be terminated? How will the dispute between the parties be resolved? Which court shall have the exclusive jurisdiction to try any dispute arising n connection with the Agreement.

FOREX MANAGEMENT IN CROSS-BORDER MERGERS

FOREX MANAGEMENT IN CROSS-BORDER MERGERS

The Indian companies law currently allows Indian companies to merge with foreign companies and vica- versa (Cross Border Mergers/Merger). Further, on March 20th, 2018, the government notified the Foreign Exchange Management (Cross Border Merger) Regulations, 2018 (Merger Regulation) which attempt to provide clarity regarding Cross Border Mergers from a foreign exchange law perspective. In this background this article examines the key aspects of the Merger Regulation and its implications.

 

For-EX management in Cross-border Mergers

INBOUND MERGERS

Inbound Merger means when an Indian company (IC) acquires assets and liabilities of a foreign company consequent to a Cross Border Merger. In this regard, the Merger Regulations are allowing transfer of securities to a foreign shareholder, subject to compliances applicable to a foreign investor under the foreign direct investment regulations (FDI Regs). This effectively means that such Cross Border Mergers cannot result in any contravention of any restriction applicable to foreign direct investment into India, per the FDI Regs. Illustratively, an IC cannot issue shares, as result of a Cross Border Merger, to a person resident outside India if such IC is engaged in a sector prohibited for investment under the FDI Regs.  Similarly, the Merger Regulations have stated that a Cross Border Merger resulting in transfer of securities of a joint venture (JV) or a wholly owned subsidiary (WS) of an IC, situated in a foreign jurisdiction, shall be subject to compliances such as pricing of shares in a specified manner, any outstanding’s owed to the IC being clear prior to such transfer, etc.  set out under the Foreign Exchange Management (Transfer or issue of any foreign security) Regulations, 2004) (ODI Regulation). Further, the Merger Regulations mandates that if the Cross Border Merger results in acquisition of a stepdown subsidiary (situated in a foreign jurisdiction) of the JV/WOS, by an IC, then certain additional conditions laid down in the ODI Regulations will need to be complied with. One such conditions requires inter-alia the IC to (a) be regulated by a financial sector regulator (b) have earned net profit during the preceding three financial years from the financial services activities; if such stepdown subsidiary (situated in a foreign jurisdiction) is engaged in the financial sector.

The Merger Regulation has also stipulated certain compliances for the IC, on overseas borrowings, to be acquired by the IC, in connection with such Cross Border Merger. One such compliance requires the IC to ensure that the overseas borrowings of the foreign company, proposed to be taken over by it, are compliant with the provisions of the overseas borrowing regulations under Indian law (Overseas Borrowing Regs) within a period of 2 years from the date of sanction of the scheme pertaining to such Cross Border Merger by the relevant authority. However, the IC cannot remit any moneys from India for repayment of such overseas borrowings, as part of ensuring compliances with Overseas Borrowing Regs, during such 2-year period. Further, it is to be noted that the Overseas Borrowing Regs inter-alia stipulate specified interest rates, maturity, end use restrictions, on borrowings, from overseas, by an Indian company (however, end use restrictions are not applicable to an IC per the Merger Regulations).

While the intent is to ensure smooth transition, it may possibly bring the relevant parties to the drawing board as the interest rates and maturity etc. stipulated in the Overseas Borrowing Regs may not tie in with the commercial intent of such borrowings. Secondly, the restriction on repayment of such overseas borrowings during the 2 year period may create hurdles for the Cross Border Merger.

OUTBOUND MERGERS

Outbound Merger is exactly the opposite of an Inbound Merger i.e. a foreign company (FC) acquiring assets and liabilities of an IC. While it is assumed that the law applicable in the jurisdiction where the FC is situated will regulate such Cross Border Merger, the Merger Regulations also stipulate certain conditions such as guarantees or outstanding borrowings of the IC which shall, as a result of such Cross Border Merger, become guarantees or borrowings of the FC. This however is subject to the FC not acquiring any such guarantee or outstanding borrowing, in rupees payable to Indian lenders, non-compliant with the relevant foreign exchange law in India (Applicable Law). Considering rupee borrowings by Indian entities from Indian lenders may not always be compliant with Applicable Law, such a restriction will need to be examined by the FC from a balance sheet perspective.

CONCLUSION

This notification will enable companies to consolidate and re-structure their business in the most efficient and business friendly manner. However, the challenges discussed above may need to be ironed out by the relevant regulators.

LEGAL DUE DILIGENCE IN REAL ESTATE TRANSACTIONS

LEGAL DUE DILIGENCE IN REAL ESTATE TRANSACTIONS

Introduction

Legal Due Diligence in a real estate transaction is an investigation of real estate property records and anything else deemed relevant to the sale, purchase, lease or mortgage of the property. In other words, it refers to the reasonable measures which every individual shall adapt before executing an agreement in relation to the real estate/ immoveable property. This is for the purpose of making them aware of the risks involved in the transaction and minimizing them in consonance with the parties’ requirements.

In the current scenario, legal due diligence is an important component of a transaction involving sale, purchase or mortgaging the immoveable property to any Financing Institutions (“FI’s”). However, in India, the procedure of property acquisition and land due diligence is extremely time consuming and complicated, due to the involvement of various regulatory authorities, State specific laws and judicial precedents. It is pertinent to analyze certain issues in relation to the real estate property such as ownership title, legality of development & construction, permitted use, easements and encumbrances which have the potential to influence the essential attributes of the real estate property and its suitability to the transaction.

The process of legal due diligence involves preparing a checklist in accordance with various state jurisdictions and legislations, scrutinizing litigations pending against the immovable property, encumbrances/ charges, easements and registrations/ authorizations with the competent government authorities. This due diligence exercise is to be categorically conducted to procure a crystal clear vision on the preceding title of ownerships of the real estate property with all permitted uses, encumbrances/ charges, compliance of statutory requirements, restrictions vested in the property and modus operandi to overcome obstructions, if any.

The Legal Due Diligence of a real estate property can be performed in two ways i.e. Full Search or Limited Search. Both methods furnish a comprehensive and complete search of all components of a real estate property such as the chain of preceding title ownerships, encumbrances/ charges (mortgage or lien), statutory compliance or authorizations, easement rights, pending judicial proceedings, if any, and the course of action to resolve such disputes. The only variation between the two searches is the tenure of search carried out in Full Search is usually between 30 (thirty) years to 99 (ninety nine) years or as prescribed by the FI’s. In contrast, the tenure of search for Limited Search is restricted to 15 (fifteen) years.

Key components of Legal Due Diligence

The due diligence normally involves tracing of the title verification of the present and preceding owners, any encumbrance/ charges and state specific legislations impacting the transfer of the real estate property. For accomplishing this purpose, the following components are required to be examined in conjunction with the real estate property requirements-

  1. Derivation of Ownership: The title ownership of a real estate property can be derived in the following manner:

1.1 If the title of ownership of real estate property is obtained by virtue of sale or purchase, the beneficiary shall verify the registered sale deeds and the title documents of the preceding title ownership holders. Further, all the vested rights over the real estate property shall be alienated to the beneficiary.

1.2  If the title of ownership of a real estate property is obtained by virtue of gift, one shall scrutinize the registered gift deed or any other relevant document to give effect to the transferability of the real estate property.

1.3  If the title of ownership of a real estate property is obtained by virtue of a will or inheritance, the executors shall examine the will document as its conditions doesn’t violate the statutory law in any manner and the order of a competent court authorizing legality of the will.

1.4  If the title of ownership of a real estate property is obtained by virtue of lease, the transferee shall examine the lease deed, parties’ rights and compliance of all the obligations in regard to transferability of such property.

  1. Authority to transfer the title of real estate property – It is incumbent upon the vendor to examine the flow of rights or authority in the executed instrument to legally transfer the title of property to the beneficiary or new owner. For this purpose, one has to examine the link documents, mutation and jamabandi records or khatiyan as the case may be. Further, the transferor shall be legally capable (not minor or unsound mind) to execute a binding contract in regard to sale or purchase of the property.
  2. Charges or Encumbrances over the real estate property – It is necessary to inspect the encumbrances/ charges (mortgage or lien), over the property to any bank or FI’s from the office of the Registrar of Charges of that particular jurisdiction by procuring an encumbrance or non-encumbrance certificate as the case may be, providing details of all the registered charges, depending upon the transaction. Further, if any charge over property is created by company, CHG-1 form filed with Registrar of Companies shall be inspected and encumbrance certificate shall be procured accordingly.

In case of equitable mortgage or mortgage by deposit of title deeds, the FI’s requires delivery (actual or constructive) of sale deed or conveyance deed. This is to verify the authenticity of the original title deeds and to safeguard FI’s interest by assuring non-existence of such unregistered mortgage.

  1. Transfer within a particular category – In some States by virtue of their local state legislations, if the real estate property belongs to the ST’s, SC’s or other backward classes, it shall be transferred only to the similar tribes and not to general class. Additionally, while conducting due diligence exercise, the preceding title records of the property shall be examined in this regard and if any preceding title owner is found to be SC, ST or of other backward class, that real estate property shall be transferred to the Government at the very first instance.
  2. Sub-lease for a specific purpose – In India, the Government provides the property to the lease holders specifically for agricultural purposes which can further be sub leased specifically for agriculture purpose. While performing due diligence exercise of the agriculture land, it is pertinent to verify the sub leases made in the transaction are not for any other commercial or residential purposes.
  3. Development/ Construction over the property – While conducting the due diligence process, it is necessary to verify the legality of the construction/ development of the property in accordance with the state specific laws in their particular jurisdiction and the development agreement shall be executed. Further, the nature of property shall also be examined i.e. (agricultural or non-agricultural) and if the property is agricultural land, the Change of Land Use is required by that particular State Government.
  4. Government approvals and authorizations – While performing due diligence process, it is pertinent to inspect and verify that all the approvals and authorization in relation to the transaction have been procured by the competent government authorities for building & industrial approvals, insurance policies, taxes, environment compliance etc.
  5. Acquisition process – In India, the law of Land Acquisition restricts the alienation rights of the original owner. While conducting due diligence, it is pertinent to ensure that the real estate property is not under any acquisition process because if any transaction is executed on the property which has been acquired by the government, the transaction shall be treated as void ab initio and cannot be enforced legally.
  6. Publication – To be on the safer side and to prevent himself from any unregistered transactions, the beneficiary may publish a notice in atleast two local newspapers, which will endorse the beneficiary’s bonafide title ownership, if any dispute is raised later.
Conclusion

In view of the above, Legal Due Diligence plays a significant role for an individual as well as the FI’s in any transaction related to real estate property for its sale, purchase, lease or mortgage. It is obligatory to probe and evaluate every such record or information about the real estate property which affects the nature and transactions of such property. Further, it is advisable before entering into any such transaction of a property, to determine and ensure that all chain deeds, title documents, encumbrance certificate, insurance policies and government authorizations are in accordance with the statutory requirements.