Stricter Compliance for Acquirers – SC Guideline for Better Governance in M&A Transaction

Introduction

Indian corporates are currently witnessing surge in M&A deals paving a path towards better growth and development. Amidst these corporate expansions, there is increased focus on conducting due diligence on target entities for identifying risks and assessing acquirer’s liabilities for the defaults under applicable laws committed prior to the closing date. For some time, the acquirer’s liability for the past defaults has been debated in various judicial decisions. However, the Hon’ble Supreme Court (the “SC”) in its recent judgment McLeod Russel India Limited vs. Reg. Provident Fund Commissioner¹ (“Mcleod”) settles the position on acquirer’s liability for non-payment of statutory contributions under social security laws. Mcleod judgment makes it clear that acquirer will be jointly and severally liable with transferor entity for outstanding dues under social legislations like Employees’ Provident Fund Act (“EPF Act”). The bulletin aims at analyzing the rationale for Mcleod judgment and makes an attempt to understand its impact on M&A deals in India.

1. Factual Background

Mcleod Russel India Limited (“MRIL”) took over the business of tea estate from Madhura Tea Estate owned by Saroda Tea Company Limited (“TCL”). Prior to the transfer, TCL had defaulted in paying employer’s statutory contribution under the EPF Act. In order to safeguard MRIL’s interests, the parties executed a memorandum of understanding (“MOU”) wherein any damages payable for default was the exclusive liability of TCL. Subsequently, the Regional Provident Fund Commissioner (“Commissioner”) imposed damages of INR 7,037,950 ($1,131,321.16 approx) under S. 14B on both parties, jointly and severally, with further direction for levying penal damages as stipulated under S. 7Q.² MRIL being aggrieved by the Commissioner’s order challenged it in the Calcutta High Court on grounds that imposing liability for default done prior to transfer was unjustifiable, especially in light of the express understanding in the MOU. The Single Judge upheld the argument and overruled the Commissioner’s order. Thereafter, the Division Bench in appeal reversed the decision of the Single Judge and upheld the Commissioner’s order imposing damages on MRIL. It is against this judgment that MRIL preferred an appeal before the SC.

2. Judgment

The key issue involved in Mcleod was whether an acquiring entity can be held liable as an “employer” under the EPF Act, after transfer of business, for outstanding dues towards PF statutory contribution. In order to determine the issue, SC analyzed the applicable provisions of EPF Act and various judicial decisions. Before analyzing the legal

principles relied on by the SC, it is essential to comprehend the applicable provisions under EPF Act. S. 2(e) defines employer to mean any person who has the ultimate control over the affairs of the establishment. For instance employer is occupier for a factory and managing director for a company. An employer is liable to make monthly contributions to schemes under the EPF Act for employee benefit. S. 14B provides that where default is made in payment of contributions to provident fund scheme, due amount can be recovered by way of damages, subject to aggregate of arrears. Further, S. 17B states that in cases of transfer of establishment (wholly or partly), the liability for contribution upto date of transfer shall be the joint and several liabilities of the proposed acquirer and the transferor. However, the extent of such liability for the acquirer is limited to the value of the asset acquired.

The principles for attributing liability for employer’s statutory dues under EPF Act were laid down in Dalgaon Agro Industries Ltd. vs. Union of India³ (the “Dalgaon”). It is provided that:

• liability for payment of due amount remains unaffected by transfer of establishment;
• transferee entity is jointly and severally liable for payment of such dues;
• outstanding due is first charge on the asset transferred;
• such due can be recovered as damages;
• acquirer’s liability is limited to the value of the asset transferred; and
• no personal liability attaches to the acquirer or any other asset of the acquirer.

Judicial interpretation of social security laws in India is based on pro-socialistic approach. Social security laws (such as EPF Act, ESI Act, Payment of Gratuity Act) are beneficent legislation which should be interpreted for promoting employee benefits rather than to facilitate evasion of employer’s responsibility to contribute.⁴ Recovery of due amount as damages are justified as it compensates employees for employer’s default, condemns ulterior motives and acts as deterrent factor.⁵ Consideration of mens rea on part of defaulting employer is relevant for determining the quantum of damages.⁶

It was contended by MRIL that non-compliance occurred prior to transfer and that it cannot be considered as employer for such default on part of TCL. Further, it was also contended that there was no mens rea involved on part of MRIL. The SC dismissed the arguments and relied on the Dalgaon principles to uphold the Commissioner’s order making MRIL liable for payment of statutory dues incurred prior to business transfer, irrespective of express agreement to the contrary in the MOU. It reaffirmed that social welfare laws must be construed for employee’s benefits, and implemented with rigor. Mcleod judgment clarifies that the liability does not become extinct with change of management, as the same continues to remain with the new management. The key responsibility of an employer to make contributions to social welfare funds continues even after change of structure, either wholly or in part.

3. Impact on M&A Deals

Mcleod judgment may have significant concerns for M&A deals in India. The ruling re-defines the framework for conducting M&A and spreads caution for entities proposing to acquire Indian businesses. More often than not, proposed buyer undertakes thorough due diligence to identify past breaches and lapses of laws such as taxation, intellectual property and labour laws. The objective is to identify the risk matrix involved in the underlying transaction. Thereafter, adequate contractual protection is included in transaction documents for safeguarding buyer’s interest. Generally, covenants are included to restrict liability which arises for events and occurrences prior to closing coupled with indemnification provisions. However, in light of Mcleod, agreements limiting liability for statutory dues solely on transferor is unenforceable.

This makes it imperative to identify specific breaches of social security legislations and negotiating crafty contractual terms to limit acquirer’s liability. The judgment also needs to be considered while determining the preferred structure of a deal – business or asset purchase.

Conclusion

Mcleod case accentuates the risk involved in acquisition of assets. It may be worthwhile for the acquirer to insist on payment of statutory dues under social security laws prior to closing. Further, in order to avoid ambiguity on the scope of liability, the acquirer may expressly restrict it to the value of the asset involved, carving out any liability of personal assets of acquirer. Additionally, general indemnity clauses may not solve the purpose and specific indemnity for making good the losses incurred due to past breaches of social security laws must be included. Last but not the least, it explains the increased emphasis on the necessity of conducting thorough due diligence and obtaining adequate disclosures from selling entity.

Authored by:
Rohini S. Kumar

1 AIR 2014 SC 2573
2 S 7Q states that defaulting employer is liable for payment of interest @ 12% on outstanding dues or such higher rate as may be provided under the EPF scheme
3 (2006) 1 CALLT32(HC)
4 Sayaji Mills Limited vs. Regional Provident Fund Commissioner 1984 (Supp) SC 610
5 Organo Chemical Industries and Antr. vs. Union of India and Ors AIR 1979 SC1803
6 Employee State Insurance Corporation vs. H.M.T Ltd. Antr. AIR 2008 SC 1322