(Shubham Sharma, Student at Chanakya National Law University)
Due diligence (DD) forms the backbone and perhaps the most critical aspect of any Mergers & Acquisitions (M&A) transaction. The purpose of DD in M&A is to uncover possible risks in the transaction such as financial, legal and tax risk. A robust DD ensures that parties have a clear picture of the transaction in front of them which they can use to effectively negotiate and make informed decisions about the deal. Legal DD involves in-depth review of the legal compliances, legal structure and material agreements of the businesses involved in the transaction.
Recently, the Supreme Court of India (Apex Court) in Jaiprakash Associates Pvt Ltd v. Delhi Development Authority (Jaiprakash Associates) held that any merger or amalgamation of two companies resulting in transfer of a property may lead to payment to the lessor of an unearned increase in the value of the assets being leased. It serves as a critical consideration for legal DD in M&A in India.
In this post, the author will provide an overview of unearned increase clauses, discuss and analyse the implications of the Jaiprakash Associates ruling to M&A transactions.
A Brief on Unearned Increase Clauses
In India, it is very common for businesses to buy/lease freehold land from development authorities as they are encumbrance-free and charge low rental. In these allotment/lease agreements, there is a provision for ‘unearned increase’ to be paid to these development authorities. “Unearned increase” refers to the differential value accrued to a property over time due to factors external to the owner’s efforts or investments. Simply stated, it is the difference between the original consideration paid by the allottee/lessee of the property and the market value of the property in subsequent point of time. These clauses require that whenever a property which is purchased/leased from development authority is transferred or sold to another person, the allottee/lessee will be first required to take the consent of the development authority. If the development authority grants such consent, then it will be entitled to a share in the unearned increase received in the hands of the former allottee/lease on transfer of such property. These clauses are very broadly defined to cover every kind of change in the ownership of the property.
For better understanding, the unearned increase clause of the case in discussion is reproduced hereunder:
“II. The Lessee for himself, his heirs, executors, administrators and assigns covenants with the Lessor in the manner following that is to say: -
.. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. ..
(4) (a) The lessee shall not sell, transfer, assign or otherwise part with the possession of the whole or any part of the commercial plot except with the previous consent in writing of the lessor which he shall be entitled to refuse in his absolute discretion.
Provided that such consent shall not be given for a period of ten years from the commencement of this Lease unless in the opinion of the Lessor, exceptional circumstances exist for the grant of such consent.
Provided further that in the event of the consent being given the Lessor may impose such terms and conditions as he thinks fit and the Lessor shall be entitled to claim and recover a portion of the unearned increase in the value (i.e. the difference between the premium paid and the market value) of the plot at the time of sale, transfer, assignment, or parting with the possession, the amount to be recovered being fifty percent of the unearned increased and the decision of the Lessor in respect of the market value shall be final and binding.
Provided further that the Lessor shall have the pre-emptive right to purchase the property after deducting fifty per cent of the unearned increase as aforesaid.”
Facts of the Case
The facts of the case were that on 12 August 1983, vide four separate perpetual lease deeds, the President of India leased certain plots in favour of Jaiprakash Associates Pvt Ltd. Thereafter, in July 1986, Jaiprakash Associates Pvt Ltd and Jaypee Rewa Cement Ltd made a joint application before the Allahabad High Court for amalgamation of Jaiprakash Associates Pvt Ltd with Jaypee Rewa Cement Ltd wherein the said plots were included in the Schedule of the properties to the scheme of amalgamation. By the order dated 30 July 1986 (“sanction order”), the said High Court sanctioned the scheme of amalgamation with a direction that the properties in Parts I, II and III of Schedule II of the scheme of amalgamation shall stand vested in the transferee company i.e. Jaypee Rewa Cement Ltd. Later, the name of the transferee company was changed to Jaiprakash Associates Ltd (Appellant).
Subsequently, the Appellant made an application to Delhi Development Authority (Respondent) seeking its permission to mortgage the said plots in favour of IDFCI. The Respondent however, demanded an unearned increase value of Rs.2,13,59,511.20 for the same. Being aggrieved by the said demand, the Appellant made several representations before the Respondent which were rejected by them. Consequently, the Appellant filed a writ petition before a Single Judge bench of the Delhi High Court which was rejected by order dated 30 January 2003. The Appellant’s subsequent appeal before the Division Bench of the same Court as well failed (impugned judgment), aggrieved by which the Appellant approached the Supreme Court.
The Case Before the Supreme Court
The issue that ultimately arose for consideration before the Apex Court in this matter was whether amalgamation of the companies will amount to transfer of the said plots for which the Respondent can claim unearned increase in value.
It was the case of the Appellant that the unearned increase clause in the lease deed is applicable only upon the sale, transfer or assignment of the said plots. It was contended that the amalgamation of the lessee with another company under the orders of the Company Court will not be covered under the above scenario. It was also contended that amalgamation or merger of the two companies does not involve any transfer within the meaning of the Transfer of Property Act, 1882 (TPA). It was urged that the vesting of assets and liabilities with the Appellant in this case was in view of the operation of law i.e. through section 394 of the Companies Act, 1956, which is different from transfer in general sense, in that there was no element of sale consideration or consideration for transfer.
On the other hand, the Respondent referred to the sanction order where it was stated under clause (1) that the transferor company’s properties, rights and powers in respect of the property described in the first, second and third parts of Schedule II shall be transferred without any further act or deed to the transferee company. In view of this order, the Respondent contended that the demand for unearned increase was lawful.
Ruling of the Court
The Apex Court began its discussion by drawing reference to its earlier ruling in Delhi Development Authority v. Nalwa Sons Investment Ltd (Nalwa Sons). The said ruling concerned a demerger, where the plot was transferred to another company pursuant to order of the Company Court. In Nalwa Sons as well, the lease deed contained unearned increase clause similar to that in the present case. The Court had ruled that the policy determining unearned income was applicable in the case of transfer due to demerger. On similar lines, the Apex Court held that in the instant case of amalgamation of companies, the same principles will apply, and an unearned increase will be payable. It was observed that the unearned increase clause is very wide and it not only covers transfers as canvassed under Section 5 of TPA but also parting with possession and involuntary transfers. The Court referred to the provision of Section 5 which provides for exclusion of the applicability of the provision from laws governing the transfer of property to or by companies. Accordingly, the Apex Court ruled that there is nothing illegal about the impugned judgment.
Implications of the Jaiprakash Associates Ruling
Firstly, it can be seen that in the present case as well in Nalwa Sons, the Apex Court gave a wider interpretation to the term “transfer” in the unearned increase clause under the lease agreement, encompassing not only voluntary transfers such as sale but also corporate restructuring activities like amalgamations and demergers. This means that any change in ownership of the property through M&A activities could trigger the payment of unearned increase to the development authority. However, the judgment shies away from answering as to which party will have to bear the liability for payment of unearned increase. In restructuring transactions like business transfer, things become further complicated as it is unclear whether the liability to pay the unearned increase will fall on the purchaser or the seller of the business undertaking.
Secondly, it will now be imperative for parties contemplating M&A deals involving leasehold properties to conduct thorough due diligence to identify potential unearned increase liabilities. This will include examining lease agreements for unearned increase liability clauses. For companies on the buy side, this could involve negotiation with sellers to incorporate a clause necessitating payment of unearned increase to the development authorities as a ‘Condition Precedent’ to the closing of the transaction for specific indemnification against potential claims for unearned increase claims from the development authorities.
Thirdly, in M&A transactions involving transfer of large parcels of land, potential unearned increase liability would be significant which would be required to be factored into the valuation of the target company during M&A negotiations. The buyers may be required to adjust their offer price to account for this additional cost.
Way Forward
Having discussed and analysed the implications of Jaiprakash Associates, it is clear that unearned increase will remain an enduring factor in influencing M&A negotiations, particularly in land-intensive sectors. It is worrying to see that government’s levy on the unearned increase can be anywhere between 50-60% depending upon the nature and purpose of transfer of land, which is an enormous financial burden. In the past, there have been instances ,where the general public had expressed its discontent about the exorbitant charges levied on unearned increases before the Apex Court. Consequently, the government on orders from the Apex Court formed a Committee which recommended reducing the unearned increase to 25% or 20%. However, the amount still remains very high. The author is of the view that to further stimulate domestic M&A, policymakers should consider reducing the exorbitant unearned increase charges alongside other FDI liberalisation policies.
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