[By Pranay Agarwal]
The author is a student at the Gujarat National Law University.
Introduction
The process of merger and acquisition is not consolidated in India and still remains a practical aspect influenced more by the business practices and the consensus between the entities. One of the important aspects of this process is the Share Purchase Agreements (SPAs) where the shares of the seller are legally transferred to the buyer to give effective control to the buyer over the target. Though the practice of drafting an SPA before any takeover is common in the country, the threat of gun jumping always prevails due to the exercise of control over the target before the transaction is complete.
The threat of gun jumping becomes even larger from the inclusion of pre-closing covenants in the SPAs in which the buyer entity has decisive control over the various aspects of the operations of the target entity in the ordinary course of business before the merger transaction is completed. However, at the same time, such pre-closing covenants ensure fair competition in the market balancing the rights of both the target and the buyer.
In this article, the pre-closing covenants are given a legal explanation in light of the existing competition laws of the country and it is tried to separate them from the gun jumping and necessitates the need to understand the fine line between them to safeguard the interests of the entities and ensure healthy competition in the market.
What are Pre-closing Covenants?
Pre-closing covenants are signed during the time period ranging from the execution of the SPA to the actual transfer of the shares or closing of the takeover transaction in order to confer some control to the buyer over the actions and conduct of the target entity. In other words, the pre-closing covenants set out those actions which the seller entity is permitted to carry out in the ordinary course of business.
The ordinary course of business, in this case, should be ascertained from the commercial perspective and not from a general perspective. Therefore, it is pertinent to look into the objects clause of the Memorandum of Association of the entity to get a clear picture of the activities conducted by the entity in the ordinary course of business. However, the Memorandum of Association should not only be the criteria to decide such activities and the term should be given a purposive construction depending on the policy or transactions of the entity with related parties.
Nevertheless, due to the prevailing business practices on the pre-closing covenants, buyers are given rights on fixing the actions which can be freely carried on by the target entity, and such control is even extended to capping the monetary value of the transactions of the target. While this may seem to be giving effective control to the buyer over the conduct of the target before the actual takeover, the pre-closing covenants are included with the sole purpose of ensuring the position or image of the target entity in the market in the interim period does not differ from that at the time of the agreement in order to prevent unjust losses to the buyer due to conduct of the target meanwhile.
Decisive influence in Pre-closing covenants
The apprehension of gun jumping due to the pre-closing covenants is majorly influenced by the excessive control that it gives to the buyer over the conduct of the target. If seen from one perspective, the pre-closing covenants through conferring extensive control to the buyer over the target, at times transcend its boundaries to significantly influence the actions of the target entity before the closing of a merger or takeover transaction.
‘Decisive influence’ in this context has to be construed in the light of the gun jumping laws of the country. The test of ‘decisive influence’ was given in Hindustan Colas v. CCI, where the Competition Commission of India (CCI) held that the decisive influence by the buyer over the target constitutes the implementation of the combination, violative of section 43A of the Competition Act, 2002 (the Act).
While the decisive influence test as was also reiterated in the Etihad Airways case properly defines the practice of gun jumping, the test has to be seen more from the perspective of ‘effective control’ than the decisive influence to practically fulfill the test. The term has been given a proper definition from the mergers and acquisitions perspective in Regulation 2(1)(c) of the SEBI Regulations, 1997 where the control has been given a broad definition of not only relating to the voting of the directors but also management or policy decisions of the entity.
The definition though gives an enlarged view of the control of the company, it is possible that the pre-closing covenants are misused under the guise of preservation of the value of the target to exercise excessive control and thus, decisively influence the actions of the target; thus effecting the combination before the completion of stipulated time and procedure. Nonetheless, such presumption may do more harm than good by damaging the sacrosanct line between gun jumping and pre-closing covenants, making it necessary to clearly distinguish between them.
The Dissonance between Gun Jumping and Pre-closing Covenants
Gun jumping has been a major concern during the merger process. While the term has got its origins in the European competition laws, the CCI in Ultratech Cement case tried to give an indigenous view on the same. The important factor which has to be taken into account is the conduct of the parties to the combination which results in the consummation of the combination before the orders of CCI under section 31 of the Act or when the standstill obligation is still in force.
The pre-closing covenants inherently confer powers to the buyer to exercise some control over the seller’s conduct, thus hinting toward the high chances of gun jumping in such agreements. However, the incidences of gun jumping have to be recognized in matters of pre-closing covenants on a case-to-case basis by the Indian watchdog in order to uphold the principles of natural justice and the very object of the competition laws. In this regard, the jurisprudence given by European Commission (EC) in Altice/PT Portugal case is significant.
The court in the case propounded the ‘value preservation’ test and upheld that the clauses of such agreements are only valid if they are “strictly limited to what is necessary to ensure that the value of the target is maintained”. The test although has to be applied on a case to case basis and is dependent on two important factors – the value of the target entity and necessary steps which are reasonably required to be taken by the buyer to safeguard the value of the target, it balances the interests and fears of both the buyer and the target.
Moreover, in Ernst & Young, the ‘control test’ given by EC and the principle and conditions which are required to be fulfilled to constitute gun jumping also maintain the balance maintained by the court in Altice judgment. Thus, the jurisprudence given by the European courts gives important insights into the problem and its solution which may come in the future.
Conclusion
Pre-closing covenants are a part of the SPAs and are normally governed by provisions of the Indian Contract Act. While it gives the acquirer some rights to control the conduct and actions of the target so that the market value of the target is preserved during the interim period, the target is conferred with business management and control rights necessary to conduct its activities in the ordinary course of business. Therefore, they are included with a mutual-understanding and mutual benefit of both the parties to the combination.
It cannot be denied that the apprehensions of gun jumping and the decisive influence of the buyer are irrelevant. However, a fine balance has to be made between decisive influence and value preservation in order to separate gun jumping from the pre-closing covenants. Unnecessary imposition of the provisions of gun jumping on the pre-closing covenants will not only lead to damaging the sacrament balance but also will hurt the interests of the acquirer, affecting the competition.
The need, therefore, is for providing the legal framework and the principles that need to be devised for defining the boundaries of gun jumping with respect to the pre-closing covenants. In India, where the gun jumping laws are still in their nascent stage, assistance can be taken from the ’value preservation’ test and the ‘control’ test given by the European Commission in broadening the ambit of the ‘decisive influence’ test which the CCI majorly follows in respect to the pre-closing covenants and gun jumping.
However, the tests and principles being highly vague and having high scope of judicial discretion have been criticized at various points. The vagueness in the tests is attributable to the principles like value preservation, commercial integrity, and ordinary course of business, which form the conditions of the test. Notably, it is pertinent that such principles have to be defined in the Indian context to suit the indigenous laws and markets. While there have been attempts to define the terms like ‘ordinary course of business’, the same has been done with respect to the specific law in issue and the facts of the case before the court. It can therefore only be hoped that the Indian watchdog gives some clarity over the same in its subsequent decisions and prevent any future damage caused by the legal void.