Reverse Merger

Merger is a legal consolidation of two entities into one as a result of which the ownership, risk, assets, liabilities and functions are also consolidated. The term Merger is not defined in any Act.

A merger usually takes place when a smaller company folds into a larger one through exchange of shares or cash. But when the acquiring company is weaker or smaller than the one being acquired, this is termed a reverse merger. Typically, reverse mergers take place through a parent company merging into a subsidiary, or a profit-making firm merging into a loss-making one.

A Reverse Merger by way of Reverse IPO is process of acquisition of a public company by a private company. A large Private company may undergo reverse merge with a smaller listed entity and go public without an IPO. The Private company’s shareholders exchange their shares for shares of the public company thereby making the private company a publicly traded company without undergoing process of IPO and making it time and cost effective. The Private Company changes its status from Private to public

Reverse mergers are also known as Reverse Take overs (RTO) which are quite common in the US, but are few in India examples of reverse merger are when ICICI group merged with its arm ICICI bank in 2002 to create a universal bank that would lend to both industry and retail borrowers and the new entity after merger was named as ICICI bank. When Godrej soaps-profitable with a turnover of Rs. 437 crore- did a reverse merger with a loss-making Gujarat Godrej Innovative chemical Limited with turnover of Rs. 60 crore, the resulting Company was named as Godrej soaps Limited.

Cross border Reverse merger occurs when an unlisted public company in one country tries to get listed on a foreign stock exchange by merging with a public listed company in that foreign country. This trend is mostly common in rapidly emerging china market where Chinese companies get listed on US stock exchange. Few examples of significant cross border reverse mergers in India in recent years are: –

33. In 2018, Videocon d2h ltd. sold 33.5% of its equity shares to American blank check company silver Eagle acquisition corporation’
34. On December 19^th, 2016, Yatra Online Inc. a prominent Indian online travel company announced in merger with US based Terrapin acquisition corporation, a special purpose acquisition company formed for this purpose.

Brief process:

The procedure begins with entering into a “Share Exchange Agreement” between the healthy company and shell company. The terms of merger to be undertaken has to be set forth in the agreement. After the completion of the merger, the shell company may be the surviving entity. The business that once belonged to the healthy company becomes  a part of the shell company and takes on a new identity. Other essential elements of Reverse merger are Reverse Stock split and name changes.

The Reverse stock split is to be undertaken for the shell company to achieve the percentage ownership and upon closing, the healthy company’s management would change its name.

All the procedure requirement for merger as may be prescribed under various laws needs to be complied, wherever applicable.

Features of Reverse Mergers:

The following tests have to be satisfied before an arrangement can be termed as a reverse merger:

• The value of the assets of the large company must exceed the value of the assets of the small company.

• The net profits (after deducting all charges except taxation and excluding extraordinary items) attributable to the assets of the large company must exceed those of the small company.
• The equity capital to be issued as consideration for the acquisition must exceed the amount of the equity share capital of small company prior to the acquisition.
• Objectives of reverse merger be well defined before entering into the transaction.
• Fair value of purchase consideration must be arrived.
• After reverse Merger, the small company shall continue the operations of the large company and the large company ceases to exist.
• Merger must be in public interest
• Ensure that the transaction should result in obtaining the tax benefits under the income Tax Act,1961.

Reverse Merger benefits from Tax Perspective:

The Income Tax Act, 1961 seeks to encourage reverse merger by granting such entities tax incentives.

After Insertion of Section 72A, the entity created as a result of amalgamation of the sick company can benefit from the accumulated loss and allowance for depreciation accrued to sick company.

Any Amalgamation scheme involving merger of a sick company with a healthy and profitable company can take advantage of carry forward losses under section 72A. The provisions of section 72A clearly contemplates the amalgamation or merger of a financially sound company with another company. Thus, the objective of Section 72A is to facilitate revival of sick industrial undertaking by merging with healthier industrial companies by providing incentives in the form of tax savings. This can ensure increased employment avenues and generation of revenue in the interest of the public.

 Prerequisites for benefiting under Section 72A:

Section 72A uses the term amalgamation and not merger. Hence, the merger between the healthy unit and sick unit, must fall within the definition of amalgamation given in the Act. This requires merger to be in such a way that:

• All the Assets and Liabilities of the amalgamating company becomes the assets and liabilities of the amalgamated company by virtue of this amalgamation.
• Shareholders holding not less than 90% in value of the shares in the amalgamating company by virtue of this amalgamation, become shareholders of the amalgamated company.

Challenges of Reverse Merger:

• Shareholder’s risks: International experience shows that public company’s shareholders often sell off their stocks with malafide intentions. These may include intentional non-disclosure of huge liabilities such as pending lawsuits, fraudulent corporate governance. Additional due diligence is required to safeguard.

• Inadequate Public disclosure: In case of reverse takeovers complying with these disclosure requirements could reduce management flexibility and may harm the company by leaking the valuable information to competitors, suppliers, customers and business partners.
• Difficulties associated with organisation restructuring: Management of unlisted company may have little or no experience of managing the affairs of listed company. Hence, new internal and external challenges will be faced post-merger.

Advantages of Reverse Merger:

• A Simplified Process: Reverse mergers allow a private company to become public without raising capital, which considerably simplifies the process. While conventional IPOs can take months to materialize, reverse mergers take only a few weeks to complete. This saves a lot of time and energy of management.
• Minimizes risk: Undergoing the conventional IPO process does not guarantee that the company will ultimately go public. Managers can spend hundreds of hours planning for a traditional IPO but if the Stock market conditions become unfavourable to the proposed offering, the IPO may have to be called off. Pursuing reverse merger minimizes the risk.
• Less Dependent on Market Conditions: As the Reverse merger is solely a mechanism to merge a private company into a public entity or vice-versa, the process is less dependent on market conditions.

Disadvantages of a Reverse Merger:

• Due Diligence required: Reasonable due diligence will have to be conducted on the acquiring company, its management, investors, operations, financials, and possible pending liabilities (i.e., litigation, environmental problems, safety hazards, and labour issues.)
• Regulatory and compliance burden: The reverse merger may impose additional regulatory and compliance requirements on managers of the acquired entity who may be inexperienced and this burden can prove significant and the initial effort to comply with additional regulations can result in a underperforming company if managers devote much more time for administrative concerns rather than for running the business.

Recent Trends:

There are numerous reverse mergers taking place in India and abroad. However, a reverse merger only comes to the limelight when the interest of the general public or a listed entity is involved.

• Hardcastle Restaurants private limited(“HRPL”), a master franchisee which operates the McDonald’s branded restaurants in western and southern India and which also became the direct subsidiary of Westlife Development Limited(“WDL”), a BSE- listed company, by way of a composite scheme of arrangement and Amalgamation under a reverse merger in the year 2013.
• The Jindal (April 2003) – The Sajjan Jindal -Controlled Jindal Iron and Steel company and its subsidiary, Jindal Vijayanagar steel merged their business through reverse merger to create a rupees 4000 crores plus entity. They merged in an effective share swap ratio of 1:1 after reorganization of Jindal Vijayanagar steel’s capital.
• IBP Reverse merger with Indian oil (May 04, 2007) – IBP Co. Limited, the Stand-alone petroleum marketing subsidiary of Indian Oil corporation Limited with exclusive business groups for Explosives and Cryogenics, was Merged with the parent company with effect from 2^nd May, 2007. This was a step towards achieving smooth and seamless integration of business to integrate the various business segments of erstwhile IBP with similar business segments of the respective divisions of Indian oil at the earliest.

• India bulls (April, 2012) – India bulls completed the reverse merger of India bulls’ Financial services with India bulls Housing Finance. The share swap ratio among the stakeholders in the two companies was fixed at 1:1. This move enabled efficient utilization of India bulls Financials’ capital, consolidating it into the housing finance company, which accounts for most of the incremental mortgage business.

AN ANALYSIS OF THE REGULATORY FRAMEWORK IN INDIA COVERING COMPANIES ACT, 2013 AND SEBI REGULATIONS

The Companies Act 1956 (“CA 1956”) did not impose any prohibitions on Reverse Merger and hence they were treated at par with ordinary mergers. However, Section 232 (h) of the Companies Act 2013 (“CA 2013”) expressly states that in case of amalgamation between a listed company and an unlisted company, the resultant entity will be treated as an unlisted company.

Therefore, CA 2013 seeks to indirectly prohibit RTOs by placing restrictions on listing by specifically disallowing backdoor IPOs (which is the main driver behind RTOs). In essence, CA 2013 aims to stop private unlisted companies from reaping the benefits of a public listed company by going public through the backdoor. Another significant change in the regulatory landscape of RTOs are the enhanced SEBI regulations.

Under the provisions of CA 2013; listed companies undergoing mergers only required Court approval and in principle approval from stock exchanges. However, vide SEBI’s 2013 Circular dated February 4, 2013; listed companies undergoing mergers need to obtain mandatory approval from SEBI. Further, vide Circular dated May 21, 2013, SEBI has been vested with the powers to regulate schemes which are to the detriment of public/ minority shareholders due to inadequate disclosures and exaggerated valuations. The impugned Circulars impose stringent requirements for listed companies undergoing mergers. Therefore, any scheme of merger or amalgamation (including RTO) between a private unlisted company and a public listed company will be open to SEBI’s scrutiny.

SEBI has also raised objections on all such schemes, where, it has observed that, shares of listed public company are issued in a manner that it skewed in favour of promoters of unlisted private company. Therefore, currently although RTOs are not prohibited, they are stringently regulated by the new Companies Act as well as the SEBI circulars.

Conclusion:

Reverse merger could be one of the best way of going public without making an initial public offer (IPO) and going through the cumbersome requirements of a public issue thereby paving a way for unlisted entities (by a merger with listed entity) to obtain access to capital markets. Subject to certain conditions, taxation benefits may also be availed by a transferee entity, in terms of section 72A of Income Tax act,1961.

India having a good corporate governance structure helps companies to go public by way of reverse mergers while at the same time it keeps a check that no fraud is committed. Sometimes, reverse mergers may be good for the groups initiating them, but for shareholders they could well put returns into reverse gear.

As a precautionary measure, companies are advised that before entering into any such reverse mergers, a thorough research to be conducted of the transferee entity, and to go through all the pros and cons that may be associated with such reverse merger, to avoid any difficulties  issues and contingent liabilities that may arise in future.

Other Relevant Post related to Articles are:

Fast Track Merger-Companies Act 2013-https://www.rna-cs.com/fast-track-merger-companies-act-2013

Joint Ventures, Mergers, Amalgamations and Acquisitions-https://www.rna-cs.com/whatweoffer/specialised-services/joint-ventures-mergers-amalgamations-and-acquisitions

Mergers & Amalgamations (perspective)-Comparison between Companies Act 1956 and Companies Act 2013-https://www.rna-cs.com/mergers-amalgamations-perspective-comparison-between-companies-act-1956-and-companies-act-2013

Merger / Amalgamation / Acquisition and Demerger-https://www.rna-cs.com/whatweoffer/specialised-services/merger-amalgamation-acqusition-and-demerger