Closing Loopholes Assessing Evasion Risks in Fast-Track Mergers

Introduction

In a progressive decision to expand the scope of Fast Track Mergers (‘FTMs’), the Ministry of Corporate Affairs (‘MCA’) has amended the Companies (Compromises, Arrangements, and Amalgamations) Rules, 2016 (‘CAA Rules’). FTM derives its definition from Section 233 of the Companies Act 2013, and Rule 25 of the CAA Rules, which refers to a streamlined process of merger or amalgamation for a particular class without the actual need for any approval from the National Company Law Tribunal (‘NCLT’). The usual merger route involves a lengthier process of taking approval from the NCLT. The entire process takes an approximate time of 9 to 12 months. During this period, there might be a change in the financial conditions on which the deal depends. This delay can lead to unfavourable conditions that might be a mismatch for the parties involved, thus defeating the whole purpose of amalgamation.

To address this concern, FTMs were introduced in 2016, where certain classes of combinations were allowed to merge without undergoing the tedious process of regulatory approval. Since then, the MCA has been working towards an FTM intrinsic environment, which means it has aimed its amendment towards a more efficient and time-effective mechanism. For example, in 2021, the scope of Section 233 of the Companies Act was expanded to allow FTMs between start-up companies. Additionally, in 2023, the MCA introduced a time-bound approval mechanism to reduce delays and increase efficiency in the fast-track route.

Under the current framework, FTMs apply to specific classes of companies, which include two or more small companies, a holding company and its wholly owned subsidiary, two or more start-ups, or a combination of start-ups and small companies. With the expansion, the fast-track route can now be opted by:

• Two or more unlisted companies, if they meet specific criteria of total borrowing through their loans, debentures, or deposits,
• a holding company and its subsidiary, provided that the transferor company is not listed on the stock exchange, and
• Two or more subsidiaries of the same holding company, excluding the scenario where the transferor company is listed on a stock exchange.

Section 233 replaces strict judicial scrutiny for a certain class of mergers on the premise of ease of doing business. The FTM route works on the assumption that smaller classes of companies pose lower risk in the regulatory landscape, and therefore, the NCLT scrutiny can be relaxed for promoting efficiency in the restructuring route. The potential for regulatory evasion under the amended route, which is explained in further parts, highlights an issue that goes against this assumption. This article critiques the recent amendment by analysing it through the lens of Vedanta’s demerger scheme. Additionally, it recommends a continuous debt disclosure mechanism along with a legislative clarification to bridge the gap in the current lacuna.

Evasion Risks Under the New Fast-Track Route

The new sub-clause (iii) of Rule 25(1) of the CAA rules allows unlisted companies to take the fast-track route for merger or demerger, with the condition that these companies do not go over certain financial thresholds. Under this provision, the companies must ensure that their outstanding loans, debentures, or deposits do not exceed INR 200 crore for thirty days prior to issuing the notice of reorganisation, and on the date of filing the merger scheme. The newly added clause remains unclear regarding a breach between the two specified periods. For instance, if a company satisfies the 200-crore loan threshold for thirty days prior to issuing notice for the same but takes a subsequent loan before filing the merger scheme, it will technically violate the cap set by the new clause. However, the provision does not specify any consequence for such an interim breach, and whether the company will still be eligible for the FTM route on subsequent correction of compliance remains an issue that is open to interpretation.

This clause goes against the compliance assumption of the FTM route. Due to the absence of the possibility of an interim breach, the FTM process worked on the principle of continuous compliance. This essentially meant that the FTM route assumed companies remained compliant throughout the merger process, as the issue of a subsequent breach did not arise. However, Rule 25(1)(iii) defies this assumption. It gives rise to the issue of an interim breach, which is not accommodated by the fast-track route. This concern goes against the idea of a quick merger route that seeks to promote ease of doing business, rather than functioning as a gap for regulatory bypass.

Additionally, this rule raises a significant concern regarding the potential for corporations to misrepresent their loan positions. Such manipulation enables companies to circumvent the regulatory scrutiny of NCLT, thereby creating a loophole that allows them to bypass merger regulations. The companies might create a clean-up window in which they can quickly repay their loan right before the thirty-day window and then avail themselves of the loan again, either after issuing the notice of merger or after obtaining the auditor’s certificate for compliance and filing for the merger. On paper, this portrays that they are financially sound, and with the help of the new amendment, they can restructure under the FTM route, which has less scrutiny than the normal route, where NCLT approval is required.

Since the FTM process does not require mandatory approval from the NCLT, companies are only subjected to administrative scrutiny from the Registrar of Companies (‘RoC’) and Official Liquidator (‘OL’). The role of RoC and OL is limited to the evaluation of procedural compliance, solvency declaration, statutory compliance, and fairness in terms of creditors and shareholder’s interest. Importantly, the check performed by RoC and OL happens before the registration of FTM takes place. As explained above, prior to issuing the notice of merger, companies can easily create a clean-up window to show a clean record and take a subsequent loan after the evaluation is complete. Therefore, non-compliance with debt limits post-administrative verification is not contemplated or addressed in the FTM route. Additionally, the assessment of overall fairness, which may have accommodated the interim breach issue, is limited to the role of NCLT. Since the NCLT scrutiny is not attracted here, the recently amended route provides a much safer shell to sidestep hefty regulatory scrutiny and bypass merger regulations.

Misrepresentation of Financial Position: A Challenge for the Fast-Track Mechanism

The new sub-clause (iii) of Rule 25(1) of the CAA rules allows unlisted companies to take the fast-track route for merger or demerger, with the condition that these companies do not go over certain financial thresholds. Under this provision, the companies must ensure that their outstanding loans, debentures, or deposits do not exceed INR 200 crore for thirty days prior to issuing the notice of reorganisation, and on the date of filing the merger scheme. The newly added clause remains unclear regarding a breach between the two specified periods. For instance, if a company satisfies the 200-crore loan threshold for thirty days prior to issuing notice for the same but takes a subsequent loan before filing the merger scheme, it will technically violate the cap set by the new clause. However, the provision does not specify any consequence for such an interim breach, and whether the company will still be eligible for the FTM route on subsequent correction of compliance remains an issue that is open to interpretation.

This clause goes against the compliance assumption of the FTM route. Due to the absence of the possibility of an interim breach, the FTM process worked on the principle of continuous compliance. This essentially meant that the FTM route assumed companies remained compliant throughout the merger process, as the issue of a subsequent breach did not arise. However, Rule 25(1)(iii) defies this assumption. It gives rise to the issue of an interim breach, which is not accommodated by the fast-track route. This concern goes against the idea of a quick merger route that seeks to promote ease of doing business, rather than functioning as a gap for regulatory bypass.

Additionally, this rule raises a significant concern regarding the potential for corporations to misrepresent their loan positions. Such manipulation enables companies to circumvent the regulatory scrutiny of NCLT, thereby creating a loophole that allows them to bypass merger regulations. The companies might create a clean-up window in which they can quickly repay their loan right before the thirty-day window and then avail themselves of the loan again, either after issuing the notice of merger or after obtaining the auditor’s certificate for compliance and filing for the merger. On paper, this portrays that they are financially sound, and with the help of the new amendment, they can restructure under the FTM route, which has less scrutiny than the normal route, where NCLT approval is required.

Since the FTM process does not require mandatory approval from the NCLT, companies are only subjected to administrative scrutiny from the Registrar of Companies (‘RoC’) and Official Liquidator (‘OL’). The role of RoC and OL is limited to the evaluation of procedural compliance, solvency declaration, statutory compliance, and fairness in terms of creditors and shareholder’s interest. Importantly, the check performed by RoC and OL happens before the registration of FTM takes place. As explained above, prior to issuing the notice of merger, companies can easily create a clean-up window to show a clean record and take a subsequent loan after the evaluation is complete. Therefore, non-compliance with debt limits post-administrative verification is not contemplated or addressed in the FTM route. Additionally, the assessment of overall fairness, which may have accommodated the interim breach issue, is limited to the role of NCLT. Since the NCLT scrutiny is not attracted here, the recently amended route provides a much safer shell to sidestep hefty regulatory scrutiny and bypass merger regulations.

The Way Forward

The FTM route lacks the required level of oversight in the restructuring landscape. As the quick route keeps expanding to include different categories of entities under its purview, the risk of evasion also increases. The numerical threshold assessment at a specific point would not be enough to prevent the possible evasion through the fast-track route. A mechanism which accommodates the interim breach issue is required to prevent the possible evasion.

Strengthening FTMs Through A Continuous Debt Disclosure Model

In order to tackle the issue highlighted above, a continuous debt reporting mechanism can be laid down. India can take inspiration from the filing model of the US Securities and Exchange Commission (‘SEC’) for this purpose. This model mandates entities (mostly public) registered with the SEC to constantly report on their economic position throughout the year. The disclosure includes a variety of information, including the records on the debt position. Through its Form 10-K and 10-Q, the SEC ensures routine disclosure on a yearly and quarterly basis, respectively. The multiple entity verification system of this model further ensures timely and impartial disclosure of the companies’ financial standings. MCA can take insights from this mechanism and mandate continuous financial reporting for the unlisted companies that opt for the fast-track route. The compulsory debt disclosure, especially during the time gap between filing the merger scheme and issuing the notice for reorganisation, reduces the possibility of an interim breach.

Even though the SEC model does not relate to the FTM process in the US, it highlights how a continuous debt disclosure mechanism helps to prevent regulatory sidesteps. The mention of the model is restricted to the principle of continuous financial verification and not the application of professional disclosure policies to unlisted entities. Therefore, the comparison stands appropriate as it only works to promote the idea of a periodic debt disclosure.

Extending The Role Of RoC And OL

Even though the debt disclosure model ensures that companies routinely disclose their loan position during the FTM process, an issue remains unresolved. The current framework governing the independence of financial auditors ensures that auditors have no personal or economic ties with the companies they audit; however, a risk of susceptibility remains intact. Long-term auditor tenures can make the financial assessors vulnerable to subtle pressure. The formation of a separate panel for the random selection of auditors could be a possible solution. However, this goes against the idea of ease of doing business with hefty financial and procedural requirements.

In order to tackle this problem, the simple solution lies in extending the function of RoC and OL. RoC and OL should be given the authority to verify the reports of debt disclosure in the interim period, where the potential of breach is significantly high. This verification can happen at any random point in the window between the issuance of notice and filing of the merger. Importantly, this random check will significantly keep the companies at a risk of getting caught, which will reduce the possibility of the potential sidestep. However, this authority to verify the debt disclosure should be limited to two or three times during the FTM process to maintain the ease of doing business.

This extension protects the fundamental idea of the fast-track process, which works on the principle of non-judicial intervention. Extending the role of RoC and OL ensures that the regulatory oversight remains in the hands of the administration. Additionally, limited random verification of debt position only during the potential breach period further ensures efficiency and time management in the FTM route.

In addition to the recommendation suggested above, a legislative clarification will completely seal the gap in the amended FTM route. The MCA must explicitly clarify the consequences of failing to comply with the thirty-day window. Since the grey area over interim breach will be appropriately addressed, the FTM framework will remain an efficient route with adequate safeguards.

Conclusion

The expansion of the fast-track route is a commendable step towards procedural efficiency. However, the ambiguity surrounding the interim breaches poses a grave threat to the merger mechanism. The explicit gap in the current legislation can be abused as a legal loophole. The absence of clear consequences for compliance with the thirty-day window defies the assumption of continuous compliance throughout the FTM process. The illustration viewed through the lens of Vedanta’s recent demerger, appropriately highlights the risk associated with the current framework. Therefore, a legislative amendment/clarification becomes imperative to strike a balance between efficiency and accountability. A continuous debt disclosure model, along with the extension of RoC and OL’s function, will further ensure a robust merger mechanism. This reform will preserve the non-judicial character of the FTM route while providing adequate safeguards to prevent regulatory bypass.

*Ashar Nezami and Mohd. Arslaan are second year students at Dr. Ram Manohar Lohiya National Law University, Lucknow