A pause for Mumbai

Real Value Through Acquisitions of Troubled US Companies

“Meltdown in the world financial markets has thrown open new opportunities for Indian firms to buy out under-valued overseas assets that fit well into their gameplan for achieving global ambitions, India Inc's top CEOs say.” Press Trust of India, October 5, 2008

Given the current state of the US economy, corporate India and other foreign buyers are recognizing that this is a critical time to consider the acquisition of undervalued US companies, including through the US bankruptcy process. Though a purchase of a troubled company is more complicated than the stock or asset purchase of a healthy US company, tremendous value can now be achieved through the purchase of low-priced US assets.

In response to the current economic environment in the US, we have put together an experienced team of corporate transactional, restructuring and bankruptcy lawyers to assist foreign buyers of US companies. We also operate in a cost-effective way that is all but impossible to match by larger law firms.

Not much more than a glance at financial headlines yields a very prominent example of the purchase by a foreign company of the assets of a US company through a Section 363 sale under the US Bankruptcy Code - Barclays’ purchase of certain assets of Lehman Brothers. On Sunday, September 14, Barclays had been negotiating with Lehman for the purchase of certain of its assets. The next day, Lehmans filed for bankruptcy protection. On Tuesday, September 16, Barclays was then bidding through a Section 363 sale process for the very assets it had sought, reportedly for several hundred million dollars less than the September 14 price. The sale would also result in the purchase of such assets virtually clear and free of any liens, encumbrances and liabilities. While the headlines blared the bankruptcy of Lehman, the story is also about a savvy foreign company making a play for cheap US assets through the US bankruptcy process.

What About an Asset Sale Outside of Bankruptcy Process – Better to Buy Before a Bankruptcy Filing? A conventional asset sale pursuant to an asset purchase agreement may be possible if the target company has not yet filed for bankruptcy - such as was pursued by Barclays prior to Lehman’s bankruptcy filing. However, while such a sale avoids the expense and procedural requirements of a bankruptcy sale, shareholders and creditors of the selling company may later seek to reverse the sale by claiming that the sale was a fraudulent transfer. For example, the US Bankruptcy Code permits the reversal of a sale as a fraudulent transfer if the company receives less than reasonably equivalent value for its sold assets and the company was insolvent at the time of the sale.

A Bankruptcy Sale Under Section 363 - Real Value for Foreign Buyers. This section of the US Bankruptcy Code allows a purchase of the assets of a company free and clear of liens and claims. This sale process under Chapter 11 of the US Bankruptcy Code involves an offer from an acquiring company (referred to as a “stalking horse”) to purchase the assets of the bankrupt company (the role played by Barclays in the Lehman transaction). The bankrupt company is then required to solicit competing bids and to conduct an auction to determine the highest and best bid. Even if the “stalking horse” loses the bid, it can be entitled to compensation for its time and expenses through a break-up fee and/or expense reimbursement that is approved in advance by the bankruptcy court.

• Advantages to the First Bidder (the "Stalking Horse"). If other competing bids can beat the initial bidder as the “stalking horse,” why not wait for someone else to act as the stalking horse if you may lose the bid even if you gain a break-up fee? The stalking horse has some real advantages: (1) it is able to negotiate its own deal terms - other prospective purchasers must accept the stalking horse’s asset purchase agreement terms with few changes, (2) it is able to perform greater due diligence than a latecomer, and (3) other prospective purchasers must make bids that exceed the stalking horse’s bid by at least a specified minimum amount, plus the amount of any break-up fee.

• A Deal Cleansed of Liabilities. The end result, unlike in a conventional asset purchase sale mentioned above, is that the terms of the Section 363 sale are approved by the bankruptcy court and offer the buyer some degree of certainty that it is getting the kind of assets it wants without the kind of liabilities it seeks to avoid. We have recently discussed ways in which Indian companies may be underestimating the legal risks of US acquisitions - click here for this discussion. Here is a way to gain great value and limit such risks.
  

• Asset Agreement and Diligence Process is Otherwise Similar. Though the asset sale agreement is subject to bankruptcy court approval, the process of negotiating and documenting the asset purchase agreement is no different from that of a conventional asset purchase sale. The parties enter into the same kind of confidentiality agreement and there is a due diligence process as in a conventional sale.

• Such Bankruptcy Sales are on the Rise. The numbers of these Section 363 transactions are increasing, with a greater share being pursued by foreign companies. As overall numbers, 32 Section 363 sales, worth $1.6 billion, were announced in the first quarter of 2008 as compared with 21 such sales, worth $888 million, in the first quarter of 2007. While an Indian buyer may be less familiar with the US bankruptcy process and may not move as quickly as an experienced US buyer, good US legal advice can help steer a transaction to conclusion. For example, in a recent sale of the assets of a US manufacturing company, an Indian buyer won the Section 363 auction process, and was able to navigate the compressed timing of the bankruptcy sale, even though it entered the bidding at a late stage.

Other options are also open to a company acquiring the assets of a troubled company, including the following:

Sale Under a Chapter 11 Plan. This avoids the competitive bidding process under Section 363 and requires the investor to co-sponsor the target’s Chapter 11 plan of reorganization. The Chapter 11 plan is then voted on by the target’s creditors.

Secured Creditor Foreclosure/Sale of Assets. Such an arrangement takes the form of a negotiated package with a secured creditor whereby the creditor would foreclose on a loan to obtain the assets and at the same time sell the assets to a foreign buyer.

Acquisition of Debt or Extension of Loan. A foreign investor could either extend a loan to a target company or acquire the debt of a target company, and then either exert some degree of control over the target through loan covenants or even exchange the debt for the target’s equity.

Foreign Subsidiaries - Set-Up Tips to Avoid Later Problems - Part 1

Our clients often enter new markets by contract or investment -- what are some of the legal issues in establishing a new foreign company or investment that will have an important impact on operating the company and possibly later selling it? This is Part 1 of our two-part observations on this subject.

Taking India as an example, these observations are meant as a follow-up to our articles in the last several months on acquiring and investing in Indian companies. Though our focus here is on choices that can help US companies better operate and later sell their Indian companies, the lessons can be applied in other international markets.

These comments were inspired by our recent work on the sale of a US company’s Indian subsidiary and are also relevant to the many US companies in the process of restructuring their foreign operations, whether due to the changing economics of manufacturing in China or business process outsourcing in India, and recent examples of “on shoring” back to the US or moving production to a third country.

Though India is Now More Open to Foreign Investment, Set Realistic Time and Budget Expectations. Our earlier articles emphasized the current relatively open Indian approach to foreign investment, whether through acquisition or otherwise. However, in establishing, operating and later selling an Indian company, US companies can find Indian procedural formalities to be frustrating. This is also true for companies operating in other developing economies, though the procedural formalities may be less daunting in China and substantially improved in countries such as Korea which have graduated from the “developing” roster over the past several years.

The Indian Companies Act of 1956 and its regulations govern the incorporation, operation and winding-up of companies in India. Procedures for director identification numbers (DINs), recording new or resigning directors, making changes in share capital, issuing notices of meetings and for properly conducting meetings and recording minutes - all can challenge company management. Outside of the incorporation and ongoing corporate requirements, an Indian company will need several regulatory licenses and registrations, such as a possible “shops and establishment license,” value added tax registration, tax account numbers, import and export licenses if these activities will be engaged in, and industrial approvals based on national and local requirements. Some - not much different from the most developed economies. Others – somewhat more daunting and time-consuming.

A China consultant recently told me that he assumed that our work with US companies in India must be relatively easy as compared with China given this UK-based system and use of the English language. While India indeed has these advantages, this can cause US companies to greatly underestimate the timing and level of detail for doing business in India. While in some sense the legal framework continues to be more open to interpretation in China, the great attention to legal and procedural formalities in India within a system that is less precise than many assume creates a different type of challenge.

Appointing Directors - Take Into Account Practicalities and Local Rules. An Indian private company is required to appoint two or more directors. They do not need not be Indian nationals or residents, and meetings can be held outside of India.

So far, so good. A US company may make the assumption that two US-based directors are sufficient, though it is advisable to appoint at least one India-based director to be able to sign forms and take India-based actions. Some may then opt for at least one director based in the US and one in India, with a quorum of 2 directors.

Yet, to smoothly operate the company, it is important to have a quorum of directors available in the same place in order to conduct board actions. The Indian Companies Act does not allow meetings through teleconferencing or videoconferencing. In order to constitute a valid quorum for a meeting, at least two directors are required to attend a meeting in person, though the meetings can be in either India or elsewhere. What happens if a quorum in either India or the US is not available and a board action is needed? There are ways around this problem (involving resignations, reappointments and carefully-described minutes), but it is best avoided up front.

So You Want to Sell Your Indian Subsidiary? A Few Stock Transfer Issues. Indian government approvals or reporting of share transfers are generally not required for a transfer from one foreigner to another (such as the sale by a US parent to another US parent), yet additional steps are required for the transfer from an Indian resident shareholder to a non-resident.

An Indian private company must have at least two shareholders -- a US parent company can be one shareholder and another subsidiary can be the second. If a minimum single share is held by an Indian resident with the remainder held by the US parent company, complications may result if the Indian resident must then transfer the single share to a non-resident. For example, Reserve Bank of India rules require that a local bank certify that filings have been made and money received for the share transfer. For such a sale from a resident to a non-resident, a valuation of shares is generally also required as a measure of fair market value. (Can these issues be avoided through an asset transfer? Perhaps, though asset as opposed to stock sales are uncommon in India due to high asset transfer stamp duties.)

Is Holding the Indian Company Through an Offshore Holding Company Really Worth Considering? In our February 2008 article, we noted the advantages of acquiring an Indian company through a Mauritius holding company. US companies may believe that this sounds a little exotic and unnecessary and may prefer a more straightforward holding of the Indian company directly by the parent or a US-based special purpose subsidiary.

Let's say that despite your best expectations, its time to sell that Indian company sooner rather than later. For example, many US companies have found that their India-based costs have increased due to an increase in labor costs and also an increased value of the Rupee. If the company is sold after 1-year as part of a stock sale, a long-term capital gains tax of more than 20% will be imposed as a withholding tax that must be paid by the buyer. Holdings of less than 1-year would increase the tax to over 40%. Allocations of the purchase price between the sale of the stock and license fees may be possible, but not easy, and a US foreign tax credit may apply, but cannot always be used. (By the way, if the buyer is to hold part of the purchase price in escrow until certain conditions are met, the escrow amount is also subject to the withholding tax since the transfer takes place upon the transfer of the ownership of the stock, not a transfer of the consideration.)

Hiring Employees – Hope for the Best, But Set Realistic Termination and Non-Compete Expectations. In India as in any country, adjustments to contract language can help limit the chances of a dispute with an employee, particularly post-termination, as well as help protect confidential information accessed by the employee. In addition, some countries (as well as some US States) do not allow a non-compete to extend beyond the period of employment. This is the case for India - post-employment non-competes are not enforceable, though are routinely included in employment agreements.

Also, US companies understandably feel more comfortable with the law of their home state and local courts, though such a dispute resolution clause for a non-US employee would require a US company to first obtain a US judgment and then enforce it in another country – which can be a very uncertain process. We often prefer local arbitration which gives the US company the ability to seek an injunction in local courts pending the outcome of the arbitration.

If the time comes for a downsizing or termination of employees, also keep in mind mandatory employment laws in India that apply to non-managerial workers and those who earn less than defined amounts. These laws impose additional compensation, employment terms and termination requirements.

Part 2 of these observations follow (click here)

Things you wish you had thought of when you established, invested in or acquired your foreign subsidiary - Part 2

This is a continuation of our prior comments, using India as an example. Our clients often enter new markets by contract or investment -- what are some of the legal issues in establishing a new foreign company or investment that will have an important impact on operating the company and possibly later selling it?

Following the Letter of the Law vs. Local Practices - How to Strike a Balance? In entering into a lease, other contracts or in gaining operating approvals, there is often a local way of getting things done and the “overly theoretical and cautious approach taken by foreign companies that do not really understand how business is done in my country.” We are not necessary speaking of questionable payments here, but the kind of approvals and arrangements that may not be in full compliance with the law but are followed by many if not most local companies. An example is in entering into a lease or a “leave and license” agreement (a form of non-leasehold lease) in fast-growth Indian municipalities with landlords that may not have full approval for the development of their sites and buildings.

Perhaps more need not be said about deals that depend upon the right officials looking the other way and would be harmed by a change in policy, landlords that may agree to take care of any future contingency through indemnity or otherwise and a later buyer of your subsidiary that may not be quite as understanding in inheriting a business built on questionable arrangements. Local (and national) officials don’t last forever, and (as a general principal of international business and not meant to single-out India) enforcement against visible foreign companies can serve as a convenient example to others.

Forming the Right US-India Legal Team. What is the right mix of in-house counsel, US-based counsel and in-country foreign local counsel? A team lead by India-experienced US counsel can help to minimize the day-to-day details that can distract US management yet also be familiar with the bigger-picture structuring issues that can save real dollars and rupees.

In today’s information-soaked environment, a little Googling will allow a sharp high school student to locate many well-regarded foreign local counsel for just about any country. No list of names or membership in yet another “world lawyers network” is a substitute for a track record of cross-border experience and more than a few good working relationships built with local counsel in more than a few local firms. And we mean experience by the lawyer in charge of your project and not the kind of fragmented “collective experience” within many of today’s large law firms that may be found by sifting through the transaction lists of a disparate group of colleagues in a disparate number of offices.

India is blessed with many fine lawyers, and the fact that India remains one of the few world commercial centers with a flat prohibition on foreign law firms (Korea is another) does not really impact the ability of experienced US lawyers to efficiently execute the vast majority of cross-border projects with the input of local counsel. (Apart from a smaller segment of mega-deals and special cases that may benefit from an integrated bricks-and-mortar multi-country law firm, most of the world’s cross-border projects are executed by a few lawyers in one market working with a few lawyers in the world’s independent law firms another market). We have found that some of the better local Indian accountants and consultants can also be a good practical supplement to local Indian lawyers

Indian Company Acquisitions in the US - 2008 Trends Thus Far

We have been avidly following outbound Indian company acquisitions, and the 2008 numbers thus far are below 2007's strong pace. However, the decrease has not been as dramatic as the media has tended to report.

Grant Thornton's excellent statistics and detailed breakdown of cross-border Indian acquisitions shows that, taking into account all destinations, there were 112 total outbound Indian acquisitions for the first half of 2008 with a value of US$8.5 billion, as compared with 119 total for the first half of 2007 with a value of nearly US$28 billion. While there were only 7 fewer outbound deals in the first half of 2008, the volume dropped by 70%, which Grant Thornton explains was due in part to some very large deals that took place in the first few months of 2007.

We have noted that a large percentage of Indian deals headed to the US are relatively small. While the total numbers of deals have been more constant, the total dollar or rupee volume of deals can be greatly skewed depending on whether a few large deals were closed during the period in question. For the first half of 2008, while the total volume has decreased in the range of 30%, the total numbers have declined by a more modest range of 15%.

In the first half of 2008, Virtus Global Partners reported a total of 34 US-bound acquisitions from India, a drop of 15% as compared with the 40 US deals Virtus reported for the first half of 2007. In the same period, Virtus reports the total volume was US$5.1 billion, a 30% decline from the first half of 2007.

The precise numbers may differ depending on who is compiling the statistics - Grant Thornton reported an added 7 acquisitions for the first half of 2008, for a total of 41 US-bound acquisitions. However, the overall point remains that the number of U.S.-bound deals remains healthy, and while the UK appears to be the country with the largest deal volume, the US leads the way as the top destination for Indian companies when measured by the number of companies acquired.

Many have pointed-out that the relative size of Indian deals is small by global standards. For example, of the 83 US-bound deals from India reported by Virtus in 2007, 76% of the deals were for less than US$25 million.

In Handling US Legal Matters, What Mistakes and Misperceptions Are We Seeing Among Indian Companies?

As described in our related blog entry, Indian acquisitions of United States companies may not be matching the pace of 2007, though the numbers are still significant. In managing the legal aspects of their US acquisitions, here are some of the challenges facing Indian companies:

Under-appreciation of US Acquisition Legal Risk. This can lead Indian companies to make harmful assumptions, such as by favoring stock purchases over asset purchases, and also by underestimating the importance of good legal input. For example, as we discussed in our February, 2008 article on Indian acquisitions by US companies (posted elsewhere in this blog), though an asset purchase in India would result in very high stamp duties and other consequences, an asset purchase is often considered in the US for tax reasons and to limit the liabilities that would be transferred as part of the business in a stock purchase.

Also due to the complex legal risk environment in the United States, stock as well as asset purchase agreements have evolved into a careful interplay of promises made by the seller regarding the condition of the business (representations and warranties), disclosures which make exception to these promises (as part of disclosure schedules attached to the agreement) indemnification provisions which set the terms for how any breaches of the promises will be paid for, and possible escrow amounts which are reserved to pay for the breaches.

An informed buyer needs to carefully decide what due diligence information is required from the US seller and be willing to take a careful look at the legal due diligence materials provided by the seller- not just cross this off the “to do” list once a seller provides initial information that may be inadequate. The seller’s representations and warranties then need to make meaningful statements that really reflect the underlying business, not just heavily-qualified and general statements that give the Indian buyer little ability to hold the US seller to its word.

These aspects of the agreement operate as a form of insurance policy which protects the buyer in the event the condition of the business is different than what was expected. Litigation from suppliers or employees, product liability claims from customers and other risks can undermine an attractive purchase price and lead to a drain in time and resources that the Indian buyer needs to use in integrating and running its US business.

The underestimation of such legal risk issues in the United States is natural for investors from countries that do not carry a similar level of risk at home – this is not unique to India and we have seen similar issues faced by investors from countries such as Korea (from the early 1990s) and Japan (from the mid-1980s) in their earlier stages of cross-border acquisitions. However, though also not unique to India, we are concerned over the longer-term fall-out from corporate India’s strong emphasis on cost as the primary factor in working with US lawyers.

Evaluation of US Counsel Based on Price Only. US legal costs can be intimidating for Indian companies. The process of performing US legal due diligence and documenting a US acquisition is a time-intensive process that can lead to significant cost savings through the containment of US legal risks. In part due to this increased legal risk component in the US, the documentation and due diligence process is a more intensive process as compared with acquisitions in India, and US legal costs are more expensive that legal costs in India.

Many Indian companies understandably try to contain these legal costs, though we have found a tendency to search for the lowest priced lawyers, preferably those that will offer a fixed overall cost. This limits the pool of experienced merger and acquisition lawyers who are at the lower end of the cost spectrum. Those with the lowest cost will not likely have the right mix of acquisitions experience, cross-border legal sensitivity and experience in India as well as the US which offers a perspective on the Indian company’s priorities and needs. The legal costs of deals between parties in two countries are also inevitably higher due to time zone and other reasons, one of the many factors that may not be taken into account by law firms without significant cross-border experience.

Will a firm willing to handle an acquisitions project for a very small fixed amount be able to devote its experienced team members to the project and enough effort to the details that require input? Most will say yes, but how realistic is this?

Limited Information Offered to US Counsel Submitting a Proposal. Since some Indian companies may view acquisition legal input as something of a fixed-price commodity service, companies may have limited sensitivity to the information that goes into the preparation of a meaningful proposal to handle the legal issues of an acquisition. A meaningful proposal will tell the Indian company what it will actually be receiving - for example, what level of due diligence and participation in document drafting and review? Indian companies should be more open to discussing their priorities and needs with US counsel to enable such counsel to provide a realistic proposal. If the proposal is not fixed but carries some level of assumptions, this may be more a mark of experience than an attempt to be vague and evasive.

The Good News - A Less Cumbersome US Regulatory Environment. We have also worked with US companies in India and recently assisted a US company with the sale of its Indian subsidiary. Indian companies are very familiar with the web of Indian rules that require at least two shareholders, demand physical board meetings (not teleconferences) and involve numerous filings, such as to obtain director identification numbers for new directors. At least for privately held companies, the legal process for creating and operating US companies is simpler and less expensive.

In-Bound Acquisitions of US Companies - Private Equity Losing Deals to Foreign Strategic Buyers?

Here is an example of how Apollo lost a deal to buy a GE unit - to foreign buyers. The video clip offers a flavor for how foreign buyers can afford to pay more, of course in part due to the weak dollar. The legendary dealmakers Bruce Wasserstein and Martin Lipton make a minor contribution to Leon Black's comments.

Foreign Direct Investment Slows in China, Grows in Other Parts of Asia

Note this interesting graphic from the June 17, 2008 New York Times. On the one hand, the chart shows that in 2007 foreign direct investment (FDI) grew by 14% in China but a whopping 136% in Vietnam and 36% in India.

More dramatically, the chart shows the continued enormous disparity in China's share of FDI compared with India and Vietnam - while China's FDI in 2007 was $80 billion, FDI was under $20 billion in each of India and Vietnam. Interestingly too, note that Vietnam's FDI is at similar levels to India, a much larger country.

If US States Were Countries - By GDP

Take a look at this map of the United States as you may have never seen it - the US state names have been replaced by countries with a similar level of GDP.

I credit this to Professor Christian Broda of the University of Chicago.

Investment in India - Further Evidence of Liberalization

As further evidence of India's quick market liberalization pace for acquisitions and overall foreign investment - a point made in our India articles noted elsewhere in this blog - the March 28 edition of India's The Economic Times reported that foreign investors in Indian real estate may soon be allowed expanded exit opportunities.

Though up to a 100% foreign equity interest is currently permitted in real estate as well as hotels and tourism, foreign investors are now subject to a three-year lock-in during which the investor cannot sell the equity stake without the approval of India's Foreign Investment Promotion Board (FIPB). Indian authorities have proposed a waiver of this three-year lock-in as well as the lifting of a minimum investment requirement of US$5 million for joint ventures or $10 million for wholly-owned ventures.

Get ready to pick-up your dream apartment overlooking the ocean on Marine Drive in Mumbai along with that land for your manufacturing facilities.

Midddle Market Growth in Uncertain World Markets - A Fine Conference

I had the pleasure of co-chairing a fine international conference yesterday –sponsored by the Association for Corporate Growth’s Chicago chapter– a group that brings together our very active community of private equity firms, investment banks, accountants, lawyers and other dealmakers. Many in this 1,000-member organization share a growing passion for international opportunities, and about 200 proved to be active enough to register for our event.

The focus was on mid-market companies expanding internationally in uncertain times. The overall message from our several panels of speakers: yes, capital and debt markets in the coming months will present some major challenges, but expanding companies and dealmakers that are not relying on high levels of debt are likely to find an excellent hedge against the US economy in growth markets elsewhere (as well as from non-US investors attracted by a weak dollar and more reasonable US valuations). You all know the markets – whether India or other BRIC countries, Central Europe, Dubai, Vietnam and elsewhere.

Our feedback was strongly positive, fueled by an excellent keynote presentation by Robert Reich (who happens to have a great sense of humor, including on a personal level around the lunch table), a breakfast keynote moderated by Fortune Magazine’s Global Editor, Stephanie Mehta (a rising journalism star of South Asian decent who happens to be from Chicago), and 5 panels of speakers from companies such as Boeing, Abbott Laboratories, Zebra and Littlefuse, private equity firms such as The Jordan Company, Baird, 3i and Audax, investment banks such as Brown Gibbons Lang, consultants such as A. T. Kearney and Visthar and other publications such as Business Week.

Can you guess InternationalCounsel’s professional interest in contributing to such an event? Our longstanding focus has been on internationally-expanding mid-market companies attracted by our cost-effective international legal team model - just the sort of audience who found their way to the Sheraton for yesterday’s event.

Acquisitions of Indian Companies - Our Recent Article

Prior to my recent India trip, the General Counsel of a Chicago-area company and I published an article on acquisitions of Indian companies by US companies.

As part of our cross-border legal advisory services, we work with US companies investing and doing business in India (and also with Indian companies doing business in the US).

Here is a copy of the article, as a follow up to my February, 2007 update on foreign equity investment in Indian companies - published in the Association for Corporate Growth's Cross-Border Transactions Bulletin.

We are active with the international activities of this mid-market-focused dealmakers' association, and I am co-chairing our 2008 international conference on March 18. Click on the images below to enlarge.

India Updates

I have just returned from Mumbai, Bangalore and Delhi (with stops in Pune and Mysore). We are seeing a good deal of acquisition and other activity with India. Stay tuned for updates.

The photo is of Marine Drive, Mumbai, otherwise known as the great city of Bombay - photo credit to Rakesh Krishna Kumar.