This article has been written by Shankarlal Raheja, pursuing the Diploma in M&A, Institutional Finance, and Investment Laws (PE and VC transactions) from LawSikho.
Table of Contents
Introduction
A swap ratio is the rate of a particular exchange agreed by the parties who will be acquiring or merging with another company. It is an important criterion as well as gives an overall perception of the M&A transaction between companies.
A swap ratio is a ratio at which an acquiring company will offer its own shares in exchange for the target company’s shares during a merger or acquisition. When two companies merge or when one company acquires another, the transaction does not have to be an outright purchase of the target company’s shares with cash. It can involve a stock conversion, which is basically an exchange rate, described through the swap ratio.
The swap ratio is determined through a variety of factors, such as debt levels, dividends paid, earnings per share, and profits. The swap ratio can also be applied to a debt/equity swap. The goal of the swap ratio is to ensure that shareholders are not negatively impacted by the merger and maintain the same value as before. This can be understood with an example such as Company A is the acquiring company and is offering 13 self-owned shares for every 11 shares of Company B. Company B is the target company and therefore the swap ratio of this M&A transaction will be 13:11. Swap ratios are important because they aim to ensure that the shareholders of the companies are not impacted by the merger or acquisition and that the shareholders maintain the same value as they did before, with the hopes of further growth through the synergies of a merged company.
Analysis
The companies involved in the M&A transaction will have to execute a number of calculations regarding their financial situation. The financial situation may be determined by book value, size of the companies involved, long-term debts of the target company, earnings per share, profits after tax, a dividend paid, or companies’ reasoning for the M&A transaction. The swap ratio represents the size and value of the companies involved. It also gives a conclusive idea of the impact of shareholders after the companies are merged and its board of directors. Any merger under such kinds of agreements is dealt with under Section 230 to 240 of the Companies Act, 2015 as well as Companies (Compromises, Arrangement, Amalgamations) Rules, 2016. This also needs authorization by the Board of Directors of both companies and approval by the National Company Law Tribunal.
To arrive at the appropriate swap ratio, companies analyze a variety of financial metrics, such as book value, earnings per share, dividends, and debt levels, as well as other factors, such as the reasons for the merger or acquisition. The swap ratio aims to be a purely financial metric but can waver away from a purely financial perspective through negotiations.
The acquiring company will establish a body of creditors. The creditors will determine the proposal, schedule meetings, calculate the value of debt and report this to the Transferor company in case of amalgamation. A draft of this agreement has to be prepared in the meeting of creditors and submitted to the NCLT. The target company will give all the details related to finances, net worth, debts, the book value of shares, earnings per share, etc. The target company will attend all the meetings organized by creditors and provide all the compliances before the SEBI, RBI, and the registrar of companies. After all this the parties are expected to reach a common point in the M&A transaction and decide the swap ratio.
Calculation of swap ratio
There is no standard or precise formula to calculate the swap ratio in every given situation. Although the determination of the swap ratio can be attained after several meetings and discussions. This process begins with an application under Section 230 of the Companies Act, 2013 before the NCLT by any of the parties under M&A transactions. The acquiring company will establish a body of creditors.
The Supreme Court has said that in deciding the compromise between parties, it will have no jurisdiction to question the procedure of determination of Swap Ratio if the dissenting voters have overcome the majority of the creditor’s decision.
If any objection is raised before the NCLT to swap ratio of shares, the investigation that the court has to make is whether it is contrary to any laws, valuation done was by an independent third party, or swap ratio is unfair.
The shareholders have the power to approve any scheme banking company. The Indian courts have also not expressed any view on the valuation of shares for calculating the swap ratios of shares.
The proper and fair valuation approach for determining the swap ratio is a combination of three methods such as asset value approach, market value approach, and the income approach. This had to be applied following the directions of the Supreme Court’s decision in the Hindustan Lever Employees Union v/s Hindustan Lever Ltd. & others.
Case laws
The Court accepts the Manageable Profit Method, Net Worth or Break up Method, and Market value provided the ratio is a fair exchange. In general, words, when the valuation has been decided by a reputed firm’s chartered accountants who are experts in their field of valuation, the court cannot revise such a swap ratio.
The jurisdiction of the Court in sanctioning a claim of the merger is not to ascertain mathematical accuracy if the determination satisfied the arithmetical test. A company court does not exercise appellate jurisdiction. It exercises a jurisdiction founded on fairness. It is not required to interfere only because the figure arrived at by the valuer was not as good as it would have been if another method had been adopted. What is imperative is that such determination should not have been contrary to law and that it was not unfair for the shareholders of the company which was being merged.
The Hon’ble Supreme Court held that the inner administration, business movement, or institutional activity of public bodies can be exposed to assessment by the court. To do as such is bumbling and ill-advised and, in this way, outside the allotted boundaries.
In the above case, the court acknowledged the proportion of 2:2:1 as Income, Market, and Asset Approach on which the valuation was based.
The Supreme Court in Duncans Industries Ltd. vs. the State of UP held that the subject of valuation is essentially an issue of truth and the Supreme Court is ordinarily hesitant to meddle with the finding on such an issue of reality on the off chance that it depends on significant material on record. The Court additionally saw that the authority depending upon the valuation needs to likewise apply its psyche while endorsing/tolerating the report of the supported valuer while fixing the holding cost.
In this case, it was ruled that the Court won’t meddle simply because the valuation embraced by the valuer may have been refined or had another technique been received. The Court is neither a valuer nor an appellate forum to appreciate the benefits of the valuation. What the court needs to guarantee is that the assurance ought not to be opposite the law or out of line to the investors of the organization which has been consolidated.
The Bombay High Court in German Remedies Ltd held that it’s anything but for the court to sit in a bid over the esteemed judges of the value investors who should be businessmen. Businessmen who know their normal advantage and interests hidden the proposed plot, with open eyes, have Okayed the trade proportion by a staggering larger part of 90% in numbers and 99 percent in the worth of the individuals present and casting a ballot. The restricted purview of the court is just to see whether the proportion isn’t right or the blunder is pretty much as gross as would make the plan outlandish or unfair or abusive to the minority of the individuals or any class of them.
In the matter of Brooke Bond Lipton India Ltd., the Calcutta High Court has held that in a plan of the blend, if the proportion of trade has been fixed by an accomplished and rumored firm of chartered accountants, then, at that point without any charge of extortion against them, the court will acknowledge such valuation and proportion of trade. A simple claim of extortion isn’t sufficient; it’s anything but a legitimate accusation of misrepresentation of full specifics. In the given case, there was no charge made or set up.
Conclusion
The swap ratio idealistically makes sure that the investors of the companies are moderately unaffected by the M&A transactions. The shareholders of the companies involved will be able to maintain their individual shares even after the merger. However, there is a dilution of new shares for the shareholders of the target company involving the amalgamation of both assets and liabilities of the company. Therefore, the swap ratio is the mathematical and quantitative approximate or financial background of the companies.
Reference
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