This Article has been authored by the Suman Kumar Jha (Founder & Managing Partner), Afnaan Siddiqui (Co-founder & Partner), Visakha Raghuram (Associate) and Vikramaditya Das
Introduction
In the world of corporate restructuring, mergers and acquisitions (M&A) play a crucial role in shaping the business landscape. However, not all merger applications reach their intended conclusion. The recent news of merger fall-out between Zee Entertainment Enterprises Limited and Culver Max Entertainment Private Limited (formerly, Sony Pictures Networks India Private Limited) because of termination of merger deal by Sony has put the spotlight on the process of withdrawal from a merger transaction. The withdrawal of a merger application is a complex process with far-reaching consequences for the companies involved, their stakeholders, and the broader market. This article delves into the intricacies of withdrawing a merger application, exploring the process, reasons, and potential outcomes.
THE MERGER APPLICATION PROCESS
Before discussing withdrawal, it’s essential to understand the merger application process. When two companies decide to merge, they typically go through the following steps:
- Negotiation and agreement on terms;
- Due diligence;
- Drafting and signing of the merger agreement;
- Filing of the merger application with regulatory bodies (e.g., NCLT, ROC, SEBI etc);
- Obtaining necessary approvals from shareholders, creditors, and regulatory authorities; and
- Implementation of the merger.
The NCLT is the ultimate authority in considering the application and giving its sanction or refusing to do so in situations where it feels the scheme is not in the public interest. Likewise, if two companies reach a mutual decision to withdraw a merger application, they must submit a request for withdrawal under Rule 11 of the NCLT Rules, 2016. Before filing for withdrawal, the companies must pass a board resolution officially approving the withdrawal.
REASONS FOR A DEAL FALL-OUT
In certain instances, a merger deal may be terminated unilaterally before the approval stage or post-approval of the Tribunal, by a party to the transaction. This could happen either during the discussions of the term sheet or during the due diligence, negotiation of the definitive documents or before consummation of the deal. Some of the primary reasons for this include:
Industry-Specific Regulatory issues
In India, the process of mergers and acquisitions (M&A) involves the need to obtain several regulatory approvals to ensure compliance with various laws and regulations. These include approvals from the National Company Law Tribunal (NCLT), the Competition Commission of India, the Securities and Exchange Board of India (SEBI), and the Foreign Investment Promotion Board under the Foreign Exchange Management Act (FEMA). Further industry-specific compliance is also required such as approval of Insurance Regulatory and Development Authority of India (IRDAI) for Insurance Companies, Telecom Regulatory Authority of India (TRAI) for Telecom Companies and Reserve Bank of India (RBI) for Banking companies. Without adhering to these approvals and sector-specific compliances, the progress of a merger deal may be impeded.
The HDFC Life and Max Life merger is an example of this. The merger was supposed to take place through a three-step process: first, Max Life would merge with its parent company Max Financial Services, and then the life insurance business would be demerged from Max Financial and merged into HDFC Life. This transaction would have resulted in HDFC Life being automatically listed through a reverse merger process.
However, IRDAI denied permission for the proposed merger, citing violation of Section 35 of the Insurance Act, 1938, which prohibits the merger of an insurance company with a non-insurance firm.
Material Adverse Change
The Material Adverse Clause encompasses any event, change, occurrence, formation, circumstance, or consequence that, either individually or collectively, results in and is expected to cause a substantial change in the EBITDA, revenue, assets, rights, duties, obligations, or financial condition of an entity. These changes directly impact the current state or position of the entity.
The collapse of the high-profile merger between Zee TV and Sony’s Indian media assets is an example of this. Sony cited the debarment of Zee CEO Puneet Goenka by SEBI and the repeated investigations of alleged fraudulent transactions as a material change that affected the merger deal.
Breach of Representations and Warranties
Representations are statements of past and/ or existing facts surrounding the target, while warranties are promises that existing and/ or future facts are, or will be, true. In M&A transactions in India, representations and warranties (R&W) are commonly used and are typically backed by indemnities. These R&W help allocate risks between the acquirer and the seller or target entity. They are meant to induce the parties into a transaction, and any inaccuracies could lead to legal relief. Generally, the preferred remedy for inaccurate R&W is an indemnity, but relief in the form of damages or specific performance may also be available. If there is a misrepresentation, the innocent party may have the option to rescind the contract, while a breach of warranty would typically result in damages. It’s also worth noting that some contracts allow the acquirer to terminate the contract before completion of any R&W is found to be untrue. Additionally, in certain cases, the contract may allow rescission even after the transaction has taken place.
The importance of accurate representations was underscored by the Supreme Court in the case of Laxmi Devi v. Manas Muni Merchants Pvt. Ltd., where deliberate misrepresentation was considered grounds for contract rescission.
Breach of Closing Covenants
In the definitive agreements, the parties involved (buyer and seller) agree to certain closing obligations such as non-compete clauses, non-solicitation agreements, confidentiality requirements, and promises not to interfere with customer or supplier relationships. These obligations may remain in effect even after the deal has closed, and in some cases, even after the agreement has been terminated. Closing covenants may also impose restrictions on how the seller can use the investment funds. Additionally, the seller may be required to address any minor non-compliances or breaches identified during the due diligence process, as well as obtain any pending approvals. Furthermore, the buyer may need to provide similar employee benefits for a specified period as those provided by the seller, as well as indemnification for outgoing directors or officers of the target company.
In a recent development, the much-anticipated merger between Zee and Sony collapsed as Sony terminated the merger deal, citing Zee’s failure to meet the “closing conditions” relating to the specified financial thresholds that were required for the deal to go through.
Merger Scheme opposed to public Interest
Public interest, as per Black’s Law Dictionary, is defined as something wherein the public and community have pecuniary or any interest by which the legal rights and liabilities of communities are affected. The definition provides for a broader aspect of the meaning of public interest. As per Companies Act 2013, the term public interest has been recognised in provisions 62(4), 129, 210, 221, 233(5) and 237 in the Act. Under company law, public interest shall be given precedence even though the approval of the management and stakeholders is provided for the scheme of amalgamation/merger.
In the case of Wiki Kids Ltd v. Regional Director, South East Region – the NCLAT held that the tribunal must act in the Public Interest, it needs to see if it is in interest of all the shareholders and the company.
Similarly in a recent case of merger application between Hologram Holdings Pvt. Ltd., Swen Holdings Pvt. Ltd and Sulphur Securities Pvt ltd, the NCLT denied sanction citing it to be against the public interest as the proposed amalgamation was intended to legitimise suspicious transactions, avoid tax and launder money.
CONSEQUENCES OF A MERGER WITHDRAWAL
In the event that merger or acquisition falls through, the consequences can be severe. This includes the possibility of large-scale layoffs, significant damage to the company’s reputation, a decline in customer loyalty, a loss of revenue, heightened operational expenses, and, in extreme cases, the permanent shutdown of the business.
Compensation as Break Fee/ Termination Fee
A break fee, also known as a termination fee, is a contractual provision in merger and acquisition (M&A) transactions where one party agrees to pay a predetermined amount to the other party if the deal fails to consummate under specific circumstances. Typically, it is an amount payable by the seller or target company to the buyer or vice versa, for pre-specified and contractually agreed events occurring between the signing and closing of the deal, leading to its termination.
Break fees generally range from 1% to 3% of the total transaction value and are calculated based on the time, resources, and costs incurred by the parties involved. This provision is usually included in the letter of intent (LOI) and aims to safeguard the interests of the parties, by ensuring deal certainty and compensating for potential losses if the transaction falls through.
For example, after termination of the merger deal between Zee and Sony, Zee demanded a termination fee of 90 million dollars from Sony for calling off the merger deal.
POSSIBLE SOLUTIONS
Forced Merger: an option?
In the banking sector, there’s a provision for compulsory merger of private sector banking companies by the RBI. Under Section 45 of the Banking Regulation Act 1949, RBI has the power to apply to the Central Government of India for the suspension of businesses by a company that is in banking to prepare a reconstruction scheme or an amalgamation scheme. It is to provide a compulsory amalgamation of the bank with any other bank without the vote of their members or creditors. A period of moratorium has to be declared by the RBI for the interest of the various shareholders and to get a proper managing committee of the bank that will prepare the scheme of merger or amalgamation. It also provides that the various schemes finalised by the RBI have to be filed before the Central Government of India which has the power to sanction the scheme either with modifications or without changes.
Given the RBI’s compulsory merger powers in maintaining stability in the banking sector, it’s worth considering whether a similar mechanism could be implemented for other sectors. Could the NCLT be granted powers to enforce mergers in non-banking sectors when it’s deemed necessary to prevent significant economic disruption or protect stakeholder interests? In the case of Zee and Sony, Zee approached the NCLT to enforce the merger scheme given the fact that NCLT had already approved the scheme before Sony decided to terminate the same.
While break fees serve as a financial deterrent to merger withdrawal, a forced merger option could act as a regulatory backstop in cases where the economic consequences of a failed merger are deemed too severe. This could potentially reduce the need for excessively high break fees, as the threat of forced completion might serve as an additional incentive for parties to honour their merger agreements.
In 2016 the Union Ministry ordered the compulsory amalgamation of National Spot Exchange Ltd (NSEL) with its parent company Financial Technologies India Ltd (later name changed as 63 Moons Tech Ltd) under section 396 of the Companies Act 1956 (section 237 in CA, 2013). However, the decision was set aside by the Supreme Court citing it to be against public interest.
Modifications in the Scheme
Modifications in the scheme are another way to ensure the success of the scheme. In the recent case of merger between Viacomm-18 of Reliance and Disney, the NCLT gave its sanction after the two companies gave assurance of voluntary modifications of the scheme to comply with the concerns raised by the CCI. Further, the NCLT also has the power to amend the scheme but these modifications must be minor and cannot tamper with the scheme’s essence. This has been enshrined by the Supreme Court as the Basic Fabric Doctrine in the case of Reliance Natural Resources Ltd. v. Reliance Industries Limited. The doctrine serves as a safeguard against substantial post-approval changes that could potentially alter the nature of the deal that the shareholders originally ratified.
In conclusion, the withdrawal of a merger application is a complex and consequential process if consent of both parties is not involved. The recent breakdown of the Zee-Sony deal underscores the substantial risks and complexities inherent in unilateral termination of mergers and acquisitions. Companies must carefully navigate through regulatory approvals, material changes, and contractual obligations, any of which can derail a transaction and inflict significant damage.
The consequences of a failed merger can be severe, from financial penalties to reputational harm. To mitigate these risks, companies must approach the merger process with meticulous planning, thorough due diligence, and a willingness to consider solutions like scheme modifications or even compulsory mergers enforced by regulators.