[By Pranjal Kinjawadekar & Gunjan Hariramani ]
The authors are students of Maharashtra National Law University Mumbai.
Introduction
The significant component in any commercial contract is the pricing clause which states the pricing mechanisms which the parties would follow to complete the deal. A pricing mechanism is an important factor as it determines the amount of consideration to be paid by one party to another. In order to determine the purchase price of the target company, the parties involved in the transaction need to arrive at the value of the company. The value of the company is called the ‘base purchase price’ or ‘initial purchase price’ defined in the stock purchase agreement. In the past few decades, the widely used pricing models in mergers and acquisitions (“M&A”) transactions are the locked-box mechanism and the closing accounts adjustment management.
In this article, the authors have attempted to analyse the concept of the locked-box pricing mechanism used in private M&A deals in India. Further, an analysis of the order against Bharti Airtel Limited wherein the Competition Commission of India had imposed penalties on the acquirer for gun jumping due to the use of locked-box mechanism, has been provided.
Locked-Box Mechanism and Closing Accounts Adjustments Mechanism
The locked-box mechanism is defined as a pricing mechanism used by the parties in commercial contracts where they freeze the purchase price of a target company based on a historical balance sheet date. In this pricing mechanism, there are three important dates, first, the locked-box date, second, the signing date of the sale and purchase agreement (“SPA”) and third, the closing date. At the date of SPA signing, the parties agree to a fixed equity value of the target company. The historic balance sheet is used to calculate the equity value of the target company that is fixed at the locked-box date. Further, in the locked-box mechanism, the parties identify and agree to various factors like working capital, cash, and debt of the target company that could change the value of the company in the future. However, once the price has been fixed at the SPA signing date, the parties cannot adjust anything between the SPA signing date and the closing date. Additionally, the target company cannot take dividends, management fees, assets at an under-valued price, and bonuses out of its business. During this interim period, the target company is only allowed to make payments in its ordinary course of business. This approach is gaining popularity in M&A transactions as it enables both the buyer and seller to determine the price of the target company early at the signing stage, thereby reducing the risk of post-completion price adjustments.
On the other hand, the closing accounts mechanism is considered a traditional approach for determining the purchase price of a target company in a commercial contract. In this mechanism, the parties at the signing stage agree on a tentative purchase price by calculating the actual value of the target company’s assets and liabilities as of the date of closing the transaction. This means that the purchase price is adjusted and determined after the closing date of the transaction based on the actual financial performance of the target company. This approach is known as a buyer-friendly approach because the target company is responsible for all the economic risks till the closing date. The buyer undertakes all the risks and liabilities after the closing date. The closing accounts mechanism is considered a time-consuming, expensive, and complex process because it involves negotiations between the parties.
Why Locked-Box Mechanism should be preferred?
The locked-box mechanism serves the buyers and sellers with huge benefits in commercial contracts. One of the primary benefits of this mechanism is that it provides price certainty. By establishing a purchase price based on a historical balance sheet date of the target company, the buyer and seller can avoid the uncertainty and risk associated with post-completion price adjustments. This approach could be used to tackle times like COVID-19, where the sellers’ faced a downturn in business. For buyers, this mechanism is generally used as a stopgap measure in M&A transactions, in order to avoid value leakage and to prevent the seller from extracting value from the target company after the locked-box date. This mechanism makes the pricing process simpler by reducing the need for complex calculations and negotiations that often occur in the traditional M&A deals. Further, it allows the seller to continue to keep the benefit of the company’s control and management until the purchaser acquires the target company. In a traditional M&A transaction, the seller is supposed to prepare an up-to-date completion balance sheet, which would include the company’s cash flows up to the completion date. However, in the locked-box mechanism, the seller is not supposed to provide an up-to-date completion balance sheet, and the buyer is assumed to take the risk and benefit of the company’s cash flows from the historical balance sheet date. Additionally, the locked-box mechanism can help to speed up the negotiation process and reduce the cost of transaction. By agreeing on a price early in the negotiation process, the parties can focus on other key deal terms, such as representations, warranties and closing conditions. Therefore, it can be inferred that this process helps to reduce the time and costs associated with negotiating these other terms.
When should it be preferred?
There are several key considerations when opting for a locked-box mechanism in M&A transactions. It is commonly preferred when the parties involved in the transaction can agree on a fixed acquisition price based on past financial records, given the target company has steady and consistent cash flows. Additionally, as the locked-box mechanism gives them assurance and lowers the possibility of post-closing adjustments, it is frequently preferred by sellers. This type of mechanism works best when the buyer has completed thorough due diligence before signing the agreement and is satisfied with the accuracy of all the financial statements that have been furnished by the seller.
However, alternate mechanisms should be preferred if, from a functional or accounting standpoint, the company that is being offered for sale is not isolated from the seller’s other businesses. Interdependence and common assets among the seller’s functions can have a major impact on the economic health and financial standing of the seller in such instances. It is difficult to isolate the firm being sold and precisely establish its standalone financials when it is intricately linked to the seller’s other businesses.
When the target company’s cash flows are highly erratic or unclear, the locked-box approach might not be the best choice because it might not be acceptable to base the valuation on past financial statements. The implementation of this approach can also be hampered by disagreements over the locked-box date. Alternative pricing mechanisms, such as completion accounts or earn-outs, might be considered if there is a substantial possibility that the target company’s financial status will significantly change in the interim period that exists between the locked-box date and the closing date. Deal arrangements that are complex or constantly changing, like contingent payments or terms of service, may also call for the employment of more dynamic pricing techniques.
The choice to employ the locked-box mechanism ultimately depends on the unique circumstances of the transaction and the interests of the parties involved, and each agreement necessitates an in-depth evaluation of the risks and advantages involved. The choice of whether to implement the locked-box mechanism ultimately relies on the details of the transaction, the level of risk that the enterprise is prepared to accept and their goals. Several factors should be carefully taken into account, including the stability of the cash flow, potential value changes, and the degree of trust between the buyer and seller.
It is pertinent to note that there are no specific regulations in India which regulate transactions employing the locked-box mechanism. However, ancillary issues arising from such valuation mechanisms of transactions could be regulated. Contractual obligations which emerge from this mechanism and affect the competition dynamics could attract the scrutiny of the Competition Commission of India (“CCI”).
Analysis of the order against Bharti Airtel Limited
Recently, the CCI issued an order under Section 43A of the Competition Act, 2002 against Bharti Airtel Limited (acquirer) for gun jumping due to the use of locked-box mechanism in the transaction. In this 15 page order, the term “locked-box” has not been referred to anywhere, however, upon reading the order it can be inferred that the parties had agreed upon this pricing mechanism to safeguard the business value and avoid value leakage.
After receiving a notice by Bharti Airtel Limited under Section 6(2) of the Competition Act, 2002 for its proposed acquisition of Tata Teleservices Limited and Tata Teleservices (Maharashtra) Limited, the CCI reviewed the Combination and the acquisition agreement. The Regulator asserted that an Economic Responsibility (“ER”) clause present in the acquisition agreement permitted the acquirer to expressly undertake “economic responsibility” for the operations of the target prior to a “notional date”, before the CCI’s approval thereby violating standstill obligations. According to the CCI, this would mean that a portion of the intended combination would already be consummated before the CCI’s approval and would minimise the target’s incentives for competing with the acquirer prior to the transaction’s completion. The Commission also rejected the acquirer’s argument that the ER Clause was just a notional date, in the form of a contractual commitment aimed to safeguard the business valuation and it would become effective only when the CCI approved the combination, and thus did not amount to consummation. The CCI while imposing a penalty of INR 1,000,000 held that the clause obstructs the ordinary course business activities of the target and “cannot be considered as inherent and proportionate to the objective of preserving the business valuation”.
It is evident from the Bharti Airtel-Tata deal that the CCI is meticulously examining transactions and other filings to determine if any instances of gun jumping have occurred. While the parties must strike a delicate balance between retaining the intrinsic value of the target and its future business operations, it is necessary that the regulator now acknowledges the increased use of locked-box mechanism in M&A transactions and not over-regulate pre-agreed deals.
Conclusion
In India, there has been an increase in the use of locked-box mechanism in M&A transactions over the years and the same has been noted by Khaitan & Co in its latest study wherein “one-fifth (about 18%) of the deals it advised on in the last 18 months” opted for this mechanism. The increase can be attributed to the benefits the mechanism provides to the buyers who want to ensure that the seller has maximised the value of the business up to the locked-box date.
Nonetheless, the recent intervention of CCI in the Bharti Airtel -Tata Deal, might have an adverse impact on deal making especially if the CCI continues to regulate with a stringent approach. Incentive to compete is an important factor for maintaining a healthy competitive environment however, restraining the parties from undertaking any predetermined transaction solely based on this factor could hamper private M&A transactions.