Indemnity in cross-border M&As: Creative structuring is key to deal completion

Indemnity obligations are par for the course in most M&A transactions, domestic or cross border. In India, indemnity obligations are recognized under contract laws and are enforceable in general. However, a cross border indemnity attracts a layer of complexity with exchange control laws coming into play. Indemnity obligations under exchange control laws have not been tested in Indian courts and its enforceability was always a subject matter of differing opinions, especially in cases where a resident (seller) had agreed to indemnify a non-resident (buyer). Some felt that at the time of payment of such an indemnity claim, one would need approval from the Reserve Bank of India (RBI). Others opined that with a Court order that permitted payment, the concerned remitting bank should categorise the remittance as a business payment and allow payment without government approvals. The real enforceability of a cross border indemnity obligation was always debatable. Views differed primarily due to the lack of clarity in being able to classify an indemnity as a current account or capital account transaction. The exact distinction between current account and capital account transactions could itself be the subject matter of another article. However, the entire debate underwent a significant shift when the Government of India (GoI) introduced amendments on 20 May 2016 to the exchange control laws (in-bound foreign investment), providing express language with respect to indemnity obligations. The amendments cleared the air with respect to the regulatory position on indemnities, but not without introducing a new set of challenges. This article will specifically examine the challenges faced in a cross-border transaction involving a resident seller and a non-resident buyer.

In its attempt to provide a more liberal regime, the GoI formulated regulations to permit indemnity arrangements with escrows and holdbacks. The amendment permitted contracting parties to agree upto 25% of the consideration amount as part of indemnity obligations in an escrow / hold back arrangement. However, this liberalising regime went a couple of steps ahead in its zeal to reform. The amendment became overtly prescriptive, creating more confusion than liberalisation. A summary of the indemnity / holdback related provision as amended under exchange control is as follows:

  • It applies to any share purchase transaction between a resident and non-resident;
  • The buyer can retain up to 25% of the transaction consideration as an indemnity holdback;
  • The indemnity obligation cannot extend beyond 18 months from the date of the ‘agreement’;
  • If the buyer pays full consideration, the indemnity obligation furnished by seller cannot exceed 25% of the consideration. Such unfunded indemnity will also be valid only for 18 months from the date of payment of complete consideration;
  • In no situation can the net amount received by the seller be in violation of pricing guidelines. (The pricing guidelines prescribe that, for sale of shares, a non-resident seller cannot receive consideration higher than fair market value and a resident seller cannot receive consideration lower than fair market value.)

In recent interactions with various market participants, it appears that there is still no consensus on the actual impact of the amendment. But, before we attempt to understand the impact of the amendment on M&A transactions, we should be mindful of a basic legal principle:

— Under Indian law, an obligation in an agreement which is against an express provision of the law is not valid or enforceable!

Applying the above principle:

  • Any indemnity in a cross-border share purchase transaction more than 25% by way of hold back or otherwise would not be enforceable!
  • Prior to the 20 May 2016 amendment, indemnity obligations could be contracted for differing periods for different subject heads; tax matters (four to seven years), environmental liabilities (seven years), financial liabilities (two years). From 20 May 2016, any indemnity obligation beyond 18 months from the date of the agreement / payment of consideration would not be enforceable!
  • By mandating that the seller of shares should eventually receive consideration in accordance with pricing guidelines, the notification presupposes that share consideration being paid to a resident seller (who cannot receive consideration lower than fair market value) will in all cases exceed the fair market valuation. If the original price does not exceed the fair market value, for the indemnity to be enforceable, should the claim giving rise to the indemnity reduce the valuation of the shares? How else does one give effect to an indemnity payment yet pay fair market value? As any practitioner knows, valuation is not an exact science and chances are the cause of action in an indemnity related claim may not always alter the fundamentals of the valuation. Alternatively, contracting parties will need to agree upon a price in excess of the fair market value to account for indemnity payments.

It seems that some market participants proceed on the belief that an indemnity that does not conform with the provisions of the amendment can be cleared by obtaining approval, at a later date, from the RBI. This view proceeds on the assumption that the indemnity payer will cooperate at the time of payment. In India, it is common knowledge that for a person to recover even their rightful dues from another person is an uphill task. In this backdrop; the simplest defence for any person liable to make good an indemnity obligation would be to challenge the indemnity obligation as an unenforceable agreement, being in contravention of the indemnity provisions under exchange control laws. Contractual protections are conceptualised to offer the contracting parties comfort in the event of a dispute. The ‘post transaction approval’ approach does not achieve this basic purpose. An alternative would be to obtain approval from the RBI, prior to completion of the transaction, for any indemnity arrangement not in consonance with the exchange control regime. There are residual provisions under the relevant exchange control regulations for such prior approval. However, this may not be a practical approach in most transactions.

Deal lawyers and participants need to work around and structure through the new challenges to the indemnity regime. In this context, one can never overstate the importance of a thorough pre-transaction due diligence. Rather than relying solely on a contractual indemnity, buyers may explore certain valuation adjustments for identified potential liabilities. Some other options to consider could be:

  • Using a buyer / seller indemnity insurance with costs of premium to be borne by the seller. Once charges are paid the seller has less of an incentive to challenge any legitimate indemnity payments;
  • Getting the resident seller to re-invest part of the sale proceeds into the target company as optionally convertible and redeemable instruments with built in repayments on completion of indemnity timelines. If money is locked in, a seller would avoid frivolous litigation where he has a rightful liability to pay;
  • Placing obligations on the seller to compensate potential business losses to the target company;
  • Without creating a double dipping claim for similar losses, provide that an indemnity will not be the sole remedy for recovering claims. It needs to be a priority in the ‘payment waterfall’ followed by damages for inaccurate contractual warranties;
  • Utilising the 25% limit in a ‘payment waterfall’ towards specific indemnities, since these are usually identified potential liabilities;
  • Adopting post-transaction audit measures to spot early indemnity-related claims within the 18-month period.

In conclusion, creative structuring and solutions as opposed to ‘creative’ interpretations should be the preferred approach to transaction completion. If a workable indemnity structure cannot be negotiated, buyers need to factor in the risk of not being able to enforce an indemnity exceeding 25% of the consideration and beyond 18 months.

Ajay Joseph

Partner, Veyrah Law

This article was first published in Vccircle. Views expressed above are for information purposes only and should not be considered as a formal legal opinion or advice on any subject matter therein.


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