Transaction Background
LU Ltd. (LU) was a company engaged in a business of manufacturing and sale of auto components based in Maharashtra. It was originally promoted by four entrepreneurs A, B, C and D. Subsequently, C and D exited LU and started a new venture named LA Ltd (LA) to carry on the similar business.
LU had borrowed from a Bank secured by the assets of LU and also by the personal guarantee of all the shareholders A, B C and D. Because of some operational issues LU turned into a loss-making a company and consequently it was unable to discharge the bank loan. Bank started recovery proceedings under Court and BIFR routes. Disturbed by the legal hassles and considering the inability of other shareholders (A, B and D) to discharge the loan obligation, C came up to settle the bank loan. C initiated One Time Settlement (OTS) with a bank. As against outstanding loan of around Rs.100 Crores (Principal – Rs 40 and outstanding interest Rs.60 crores), the OTS amount was decided at Rs.60 Crores. C proposed to bring the required fund by way of borrowing from relatives and/or friends.
Key Problems & Issues
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- Challenges associated with discharging the loan liability
- Structuring the said transaction
- Independent turnaround of LU may be difficult for C
- Funding operations of LU will be difficult as it will not be able to bear interest cost
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Strategic objectives
Structure the transaction such that C is able to take the maximum benefit out of the transaction at minimum transaction cost.
Options Analysed
The following options were analysed:
Option 1:
Infusion of fresh loan directly into LU to enable payment of OTS amount by it and consequently C acquires all equity shares from the existing shareholders of LU i.e. A,B and their family members at nominal value
PROS
- Lesser legal complexities and time involved
CONS
- In light of the provisions of Sec.79 of Income Tax Act, 1961 C won’t be able to take the benefit of carry forward and set off of the unabsorbed depreciation loss since at least 51% of the owners (at the time of incurrence of loss) does not remain owners now.
Option 2:
Infusion of fresh loan directly into LU to enable it for payment of OTS amount, however, C does not acquire any shares in LU and just remain as a mediator for debt swap by LU till all losses are set off
PROS
- Sec.79 is not get attracted
CONS
- Ensuring the repayment of fresh loan by LU to the third party may become difficult for C, being an outsider to LU
- Independent turnaround of LU may be difficult for C.
- Stand-alone it may take very long time to set off losses
Option 3:
LA takes over the business of LU along with assets and bank loan on “Slump Sale Basis”. Subsequently, C infuses funds into LA to enable LA to enter into OTS with a bank.
PROS
- Only the specified liabilities will be acquired by LA. So that any other hidden/contingent liability of LU does not devolve upon the LA.
- Lesser legal complexity and time involved
CONS
- LA will not be allowed to carry forward and set off the unabsorbed depreciation losses of LU
- Independent turnaround of LU may be difficult for C.
- Stamp duty liability on the transfer of assets to LA will be higher as it would be treated as a normal conveyance.
Option 4:
Purchase of all share of LU by LA from A and B (making LU a wholly owned subsidiary company of LA) and subsequent amalgamation of LU into LA. Combined entity will enter into OTS and discharge the same.
PROS
- Stamp duty liability would be minimal as special exemption in case of amalgamation of 100% subsidiary company is in force under the provision of Bombay Stamp Act
- Depreciation loss will be allowed to be set off
- Since both LU and LA are into similar line of business, the amalgamation will result in operation synergies that will increase the chances of early turnaround LU
- By way of infusion of fund into LA as equity by C through the borrowing in personal capacity, C can increase his stake in LA
CONS
- LA may not like to comply with some stringent conditions of Sec 72A
- All the hidden/contingent liability of LU may devolve upon the LA. However, the same can be taken care by providing for the same in Share Purchase Agreement (SPA)
Option 5:
Infusion of fund into LU by C and subsequent amalgamation of LA into LU. (Reverse merger) The name of LU can be changed to LA. Combined entity will enter into OTS and discharge the same.
PROS
- Since a profit making company is amalgamating into a loss-making company, provisions of Sec 72A are not attracted.
CONS
- Since the size of LA is much larger than LU the stamp duty liability will be substantially higher.
Our Recommendations :
Considering all the facts of the case and pros and cons of each alternative, Option 4 was found to be most suitable option for the following reasons:
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- It does not involve any cash outflow by way of stamp duty.
- It will also enable it to claim major part of loss which was by way of depreciation loss
- It was possible to make bankers agree and offer most possible favourable terms under One Time Settlement (OTS) as running a profitable company is taking over the business having enough cash flow to pay EMI , whether the business of LU is a turnaround or not.
- Further, it is favourable to LA as whole down payment was taken care by way of likely refund of advance tax already paid and savings in stamp duty
- It will be possible for the acquirer to generate enough cash flow to repay EMI without having any stress on its own cash flow and all its financial ratios.
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