OYO’s Dispute With Zo Rooms and its Potential Impact on the IPO
A few years ago when asked about how the name OYO Rooms came to be, the founder Ritesh Agarwal explained how the full-form “On Your Own” rooms sounded interesting as something a teenager might take up.
The 19-year-old teenage college dropout who founded the company in 2013 now looks forward to the ambitious $1.1bn-valued IPO of the company. However, the host of challenges the company has encountered in the past continues to take the shine off of the IPO news as Mr. Agarwal seems to battle them largely on his own.
One such challenge has resurfaced recently as Zostel (Zo Rooms or Zo), the popular backpacker hostels chain, resumed its three-year-long legal battle with OYO. The dispute dates back to 2015 after the merger talks between the companies broke down.
But it’s not as straightforward as it sounds.
Let’s try and understand the nuances of the case and make out whether OYO, the eight-year-old Indian startup and a popular name across college campuses and budget hotel markets, has managed to steer away from chaos and towards clarity enough to pull off a successful IPO.
The Dispute
On December 17th 2015, it was widely reported (including in the annual report of SoftBank, OYO’s largest investor) that OYO is set to acquire Zo Rooms in an all-stock deal. The purchase was an indication of OYO’s rising dominance in the budget hotel aggregator segment considering that Zo, with a network of 11,000 rooms in 1,000 hotels across 50 cities in India, was its biggest rival.
The deal was structured as an asset sale in which Zo’s founders and investors (including Tiger Global) would be given a combined 7% stake in Oravel Stays Pvt. Ltd., OYO’s parent company. OYO would also absorb nearly 40% of Zo’s employees. The deal was designed to resolve Zo’s cash crunch and OYO’s goal of an industry-wide consolidation.
But alas, the merger talks fell through within a year (November 2016).
Zo claims that it held up its end of the deal and transferred the business but OYO failed to transfer the 7% stake to its shareholders which it was contractually entitled to.
OYO, on the other hand, says that the deal never took place. It claims to have backed off from the talks citing several irregularities in the due-diligence process like Zo’s outstanding liabilities, unpaid dues as well as contingent liabilities that were undisclosed during the initial talks.
The Terms In a Bind
The chief discrepancy between the claims of both parties lies in whether a particular “term sheet” in question was legally binding or not.
Just a quick refresher. A term sheet is a letter of intent that contains declarations by both parties on whether a successful exchange of business has taken place. But there is enough legal jurisprudence (both from British and Indian courts) which says that “the intention to create legal relations is quite different from the enforcement of the relations”.
Think of it this way. A letter from A to B stating A will buy mangoes from B is a letter of intent but it is not an order for purchase which would enforce A’s intent to buy B’s mangoes. Thus, the letter as such (like a term sheet) is not legally enforceable.
The Supreme Court has held in past cases that a letter of intent should NOT be binding on parties as it is not fundamental to the contract to buy or sell.
Going by this reasoning, the term sheet dated November 25th 2015 between OYO and Zo would have been non-binding, contrary to Zo’s claims. However, the arbitrator’s award brought a surprising twist in the tale when it ruled that the term sheet in question was enforceable.
For the record, this was in spite of the fact that the term sheet executed on November 25th 2015 specifically mentioned in its preamble that it will not be binding.
Why Then?
This is where the nuance of the case comes into picture.
According to the arbitrator, despite the express non-binding nature of the agreement, a particular element under contract law called “specific performance” becomes relevant to this case. Specific performance is essentially a contractual remedy that enables one party to claim damages against the other if a part of the terms under the contract has been performed.
The arbitrator says that Zo “did everything within its control to complete the obligations” under the deal, including the transfer of its assets. In contrast, OYO failed to transfer the 7% stake that it was obliged to do under the same deal. The theory of specific performance dictates that even if there is no intent to pursue a contractual relationship, the performance of certain acts to the effect of starting a contractual relationship (like Zo’s asset sale) could be construed as an agreement.
The obligations under the term sheet were consented, executed and performed by Zo which shows “definite intention” to enter into a contract. Therefore, the arbitrator considered the deal to be binding, valid and enforceable.
But is it the most suitable interpretation? If a unilateral pursuit of contractual obligation is given legal recognition then it would question the whole consensus-based approach that contracts are based on.
To top it off, the term sheet, both in definition and practice, is quite different from a real contract which comes with more clarity on the rights and obligations of parties. If term sheets were binding in general then all such exploratory measures employed by companies before pursuing mergers or acquisition deals would be called into question. A mere interest for purchase is not a definitive agreement to do so.
Legal Cobwebs Still Around
The award, however, hasn’t been enforced yet. It doesn’t offer any monetary relief to the parties either. The petition filed in the Delhi High Court is thus an attempt by Zo to follow-up on the arbitration and bag a conclusive verdict in its favour. Meanwhile, OYO has announced it will pursue further legal action to overturn it.
As per SEBI’s listing regulations, “an issuer shall not be eligible to make an initial public offer if there are any outstanding convertible securities or any other right which would entitle any person with any option to receive equity shares of the issuer”.
This means that until the issue of Zo’s contentious 7% stake in OYO’s parent company is resolved, OYO would be restrained from filing its prospectus with SEBI and face significant financial setbacks in the process. OYO’s latest valuation stood at $9.6bn and accordingly, a 7% stake in it would be valued at $672m. That is a sizable amount for Zo to pursue at the expense of such a long-drawn contractual battle.
OYO, on the other hand, has been trying hard to revive its revenue generation and cut back on loss-making operations for quite some time. With pandemic’s scaled impact on hotel businesses and other ambitious partnerships of OYO in the fray (like Microsoft’s $5m investment), a lot is at stake for the company vis-a-vis the 7% stake of Zo in dispute.
(Originally published October 1st 2021 in transfin.in)
