4 August, 2015
It has been estimated that India must spend approximately US$100bn every year to meet the energy demands of its rapidly growing economy.1 In this article, we highlight some issues for potential investors to watch out for, based on our experience of advising foreign investors in major projects in India’s energy sector.
The energy challenge
According to the World Bank, India’s economy has recorded an average growth rate of over seven per cent each year
in the past decade, despite the global economic downturn. This trend is expected to continue, with the country’s economy expected to grow by approximately 5.5 per cent each year in the period between 2015 and 2035. On this basis, India is set to become the world’s third largest economy by 2035.2
However, there are obstacles to overcome if India is to achieve its economic potential. Key among these is its national energy shortage. As the country’s economy has grown, so too has its energy needs. National energy shortages, combined with an inadequate domestic energy infrastructure, threaten India’s ability to sustain its pace of economic growth.
India as an investment destination
To tackle the challenges posed by its energy demands, India needs major investment into its energy sector. In the words of Fatih Birol, the Director and Chief Economist of Global Energy Economics at the International Energy Agency: “India needs three things for its energy sector: investment, investment and investment”.3
The Modi Government is aware of the threat the energy challenge poses to national prosperity, and recognises the need to attract international investment into the energy sector. As befits a prime minister who has been described as “the most pro- business, pro-investment political leader in the world today”,4 under Prime Minister Modi’s tenure, the Indian Government has announced significant legislative and policy changes aimed at liberalising the country’s Energy market and attracting foreign investment into the energy sector. However, notwithstanding the improving investment environment, India remains a challenging destination for foreign investors. There are many reasons for this, and below we highlight six issues – or lessons learned – which investors should be aware of and factor into any investment plan.
Lesson one: government-affiliated companies may be inflexible but they may also have significant political clout Investing alongside Indian Government Companies (GOCs) presents significant advantages for foreign investors into the country’s highly regulated energy sector. Indian GOCs, with their strong links to central government, are generally better equipped to lobby government to address the specific concerns of foreign investors in relation to relevant Indian public policy and legislation; a recent example of this being the Indian Government’s willingness to address concerns regarding India’s civil nuclear liability regime raised by foreign investors into the country’s nuclear sector.
However, with those benefits come certain challenges, since Indian GOCs can be inflexible about certain issues. For example, Indian GOCs will typically only agree to a dispute resolution process which is based in India; this is often difficult for foreign investors to accept due to the perceived limitations of the Indian court process. Similarly, long-term supply or offtake contracts (for feedstock or refined products) are rare given that committing to a certain price for the long term is perceived as difficult by Indian GOCs. Nonetheless, some investors have been able to secure long-term supply contracts and non-Indian arbitration clauses. In our experience, there is typically a greater chance of reaching a suitable compromise where both parties engage in dialogue and aim to find creative solutions to ensure that an investment takes place.
Lesson two: be pragmatic about due diligence.
The due diligence concept is well established in India. However, Indian companies, and particularly Indian GOCs, are not always able or willing to disclose to potential investors the level of information which investors would normally require for a thorough due diligence exercise, due to internally imposed restrictions and the regulatory regime.
India’s corporate culture has a significant bearing on the practicalities of conducting due diligence in the country. For example, Indian GOCs may be reluctant to use virtual data rooms for all relevant documents due to concerns over information flow. Instead, the use by Indian GOCs of physical data rooms with no or limited copying rights is still a relatively common feature of due diligence, even in large-scale transactions.
There may also be a debate about whether more sensitive information, such as relevant pricing information, will be made available at all.
In our experience, continuous dialogue with the relevant Indian counterparty regarding the benefits of disclosing information, and describing how the use of efficient virtual data rooms and the grant of printing rights can be beneficial to both parties, can make the due diligence process faster and more efficient.
For foreign investors considering an investment into major energy projects involving Indian-listed companies, there are also regulatory restrictions to factor in.
India’s current insider trading regulations, issued by the Securities and Exchange Board of India, restrict or limit the information which may be disclosed during a due diligence process. Broadly, Indian-listed companies wishing to disclose price- sensitive information may only do so if they also disclose such information to the market – which, unsurprisingly, they are often reluctant to do. This is, of course, often the information which a potential investor would wish to review as part of its due diligence. Again, continuous dialogue with the relevant Indian counterparty regarding the benefits of disclosure and the strategic timing of any necessary public disclosures (in accordance with the relevant regulations) may allow for a greater degree of overall disclosure.
Finally, a number of important public records (for example, those relating to land rights, bankruptcy, civil litigation and criminal prosecutions) are not available online. Where online public records are available (for example, certain intellectual property registers or filings with the registrar of companies), these may only cover fairly recent filings. This all makes the process of checking and obtaining public records time-consuming, which needs to be factored into the due diligence process early on.
In many cases, the obstacles to a comprehensive due diligence exercise may be overcome by engaging closely with the relevant parties to ensure that expectations are aligned in relation to expected outcomes and timing. The due diligence process will likely impact on transaction timelines, and it is important to factor this in when timetabling transactions in order to allow sufficient time for the work to be done properly.
Lesson three: under Indian law, indemnities may afford less protection than a foreign investor expects. Under English law, the inclusion of well- drafted indemnities in favour of an investor in the relevant transaction documents is a well-recognised and reliable way of allocating risk. Broadly, if an indemnity is triggered, an investor would expect to recover its loss on a dollar-for-dollar basis. However, under Indian law, indemnities may not operate in the same way and may afford an investor less certainty of outcome.
There is a risk under Indian law that the general contractual principles obliging a claiming party to mitigate its loss also apply to indemnities. Accordingly, any indemnities should be drafted to expressly exclude the obligation of the indemnified party to mitigate any loss which forms the subject of an indemnity claim.
Under Indian law, an indemnity claim will only be upheld by a court or arbitral tribunal if it is deemed to constitute an “absolute obligation” on the indemnifying party. There is no established principle under Indian law to determine whether an indemnity amounts to an “absolute obligation”, and this question is instead determined by the court or arbitral tribunal on a case-by-case basis. To ensure that the court or arbitral tribunal uphold the indemnity claim as intended, the drafting needs to make clear the absolute nature of the indemnity obligation and should be as tight and as clear as possible.
Finally, in the event of a dispute between the indemnified party and the indemnifying party as to the nature or extent of any liabilities and losses suffered by the indemnified party, an Indian court or arbitral tribunal may only consider that loss which is deemed to be reasonable and direct and may exclude indirect or remote loss. So, a dollar-for-dollar recovery may not be available in the same way as under English law, and any claim may instead be subject to the tests of reasonableness and directness of loss. Applying these tests to an indemnity may significantly reduce the scope of loss for which an indemnified investor could recover (for example, it may restrict any ability to recover for losses relating to financing arrangements which an investor has entered into in connection with an investment), and this may run counter to a foreign investor’s intention behind seeking an indemnity in the first place.
The uncertainty around the use of indemnities under Indian law introduces an element of enforcement risk and may increase overall transaction risk for a foreign investor. Where possible, it may therefore be preferable for a foreign investor to protect itself against any specific transaction issues by dealing with them before deal completion. Typically, this could be achieved by the use of specific conditions precedent in the relevant transaction documents requiring (as a condition to completion of the deal) that the specific issues are removed or resolved. Clearly, however, the use of conditions precedent will not be appropriate for all identified issues, either because such issues cannot practically be resolved in advance or because the length of time they will take to resolve precludes their resolution prior to deal completion.
Where specific issues cannot be removed or restricted in advance of deal completion, investors will need to address them through the use of contractual mitigants in the transaction documents. Clearly, indemnities will still form an important part of the suite of contractual mitigants. However, if contracting under Indian law, investors should be aware of the uncertainties around the enforcement of indemnities and should ensure that any indemnities are drafted as precisely as possible to clarify the absolute nature of the obligation and the basis for recovery, and to reduce (to the extent possible) any opportunities for the indemnifying party to make a successful challenge.
Lesson four: watch out for restrictions on repatriating money awarded pursuant to a contractual claim Irrespective of the governing law of
the transaction documents, all foreign investors must obtain the approval of the Reserve Bank of India (RBI) before they can repatriate out of India any amount awarded to them under a contractual claim. This restriction applies regardless of whether the claim has been mutually settled and agreed between the parties, or awarded to an investor pursuant to a court order or arbitral judgment.
There are no formal principles or guidelines which apply when the RBI considers a repatriation request from a foreign investor. Instead, each repatriation request is treated on a case-by-case basis. However, in practice, the RBI does usually permit repatriation of any amounts awarded to foreign investors pursuant to a court order or arbitral judgment. There is less certainty where a settlement has been reached, and to be sure of being able to repatriate the relevant funds, it may be necessary to obtain a court order or arbitral judgment (even where the relevant claim is not disputed by the contractual counterparties).
There are no fixed timelines for the process of obtaining RBI approval. In addition, the pursuit of a contractual claim through arbitration or before the Indian courts can be a lengthy process. Therefore, in terms of assessing enforcement risk, it is important to factor in a long time period from initiating a claim to actual receipt of any funds, if successful.
Given the uncertainty around obtaining RBI consent for repatriation, as well as the timing issues, one option is to look at structuring a transaction to avoid the requirement for RBI approval altogether, and many foreign investors opt to structure their transactions accordingly. Options include structuring the transaction so that any investment is made by an “onshore” Indian entity, or so that an “offshore” entity of an Indian counterparty provides the relevant contractual assurances. In either case, the aim is to ensure that no funds will be flowing out of India, so there will be no requirement for RBI approval.
Lesson five: do not underestimate the time it takes to satisfy conditions precedent Similarly to the due diligence process, the process of satisfying conditions precedent can take a relatively long time in India. Accordingly, it is important to build into the transaction timeline (and the transaction documents) sufficient time for the satisfaction of conditions precedent. This issue is particularly pertinent in the context of any third party consents which are required to be obtained (for example, any regulatory consents). One potential method of shortening the period of time required for the satisfaction of conditions precedent is to consider whether the investor can assist the Indian counterparty in dealing with the relevant conditions precedent. For example, if one of the conditions precedent requires the entry into of long-term offtake agreements, the investor may wish to consider whether it can assist in concluding such agreements, either by offtaking the relevant product itself or by assisting in identifying a third party who is willing to enter into such an agreement.
Lesson six: regulatory restrictions may limit the effectiveness of put/call options and deferred consideration mechanisms
Under India’s foreign exchange laws, any sale of shares by or to a person not resident in India must be at a price which represents the “fair value” for the shares.
This means that any share transfer provisions in transaction documents (such as, for example, any put or call options relating to an event of default under a shareholders’ agreement) must not purport to transfer shares at less than “fair value”. Accordingly, a foreign investor will not be able to rely on mechanisms for the transfer of shares at a discount as a means of discouraging or penalising contractual non- compliance by an Indian counterparty.
It is also worth noting that India’s foreign exchange laws do not permit the withholding of all or any of the share purchase price by foreign investors.
Instead, full consideration for the share purchase price must be paid by foreign investors at the point of deal completion and deferred consideration mechanisms for share purchases, linked to post- completion performance milestones, are not permissible under Indian law.
Conclusion
India has huge energy requirements and investment needs but foreign investors face certain challenges. In particular, the distinctive character of India’s corporate culture and the applicable foreign investment laws may require foreign investors to adjust their investment mindset.
Foreign investors considering an investment into India’s energy sector need to look at an early stage at the full range of transaction structuring options available, including the use of “onshore” and “offshore” entities and the relevant transaction governing law, in order to maximise certainty of outcome and mitigate transaction risk. Clearly, using local expertise is also essential in order to manage potential investment pitfalls.
The existence of a challenging market for foreign investors is not a feature which is unique to India – all markets (whether developed or emerging) have their own complexities. However, what India does possess, which many markets currently lack, is a great wealth of potential investment opportunities and an increasingly hospitable environment for foreign investors. Those investors who acknowledge and respond appropriately to the challenges and issues associated with investment in India’s energy sector are most likely to secure the best outcomes.
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1 The Economic Times (India), 13 April 2015.
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2 BP Energy Outlook 2035, February 2015.
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3 As footnote 1.
4 Forbes (2014, speech by CLSA’s Asian market strategist Chris Wood), 6 March 2015.
ben.rollason@ashurst.com
