RBI raises issues on Put option as an exit mode Conversation with Gautam Saha

With RBI taking a very strict stand on put option or pre- agreed buy-back of shares as a mode of exit, PE investors or foreign investors will now have to consider other alternate modes of exit. RBI has taken a view that such exit arrangements are not legally valid.

With RBI taking a very strict stand on put option or pre- agreed buy-back of shares as a mode of exit, PE investors or foreign investors will now have to consider other alternate modes of exit. RBI has taken a view that such exit arrangements are not legally valid.

Put option on promoters is the most widely adopted mode of exit used by investors. Typically, such an option is part of shareholders’/investment agreement when investors put money in unlisted entities. Most foreign direct investments, particularly in unlisted firms, are against special rights given to foreign investors who can exercise such rights under certain conditions. An exit via this route involves a put option right with the private equity investors on shares of the promoters of the company. The promoter buys back the investors’ share at a pre-determined price at a particular date in future. The parties must also ensure that a transfer of shares consequent to exercise of put option is in conformity with the pricing guidelines of RBI.

For a long time, when the market conditions were good, many PE investors successfully executed initial public offering (IPO) exit from the companies with a huge return on investments. The IPO of the company has been the primary and most preferred mode of exit. However, since lately the market has been very volatile and as current market conditions are not favourable for an IPO, the promoters buy back the shares to protect the investors’ interest.

RBI has recently started raising questions on many such deals where the foreign investors have tried to exercise the put option. RBI has been sending notices to such companies as it thinks such inflows are foreign 'loans' and not 'equity'. This issue raised by RBI is creating lot of confusion in the market especially among foreign investors.

RBI feels that a sellback right, or a put option, to foreign investors amounts to one-to-one derivative deals.

According to LiveMint, an RBI spokesperson said that under the Foreign Exchange Management Act (FEMA), notification 20 (regulations 3, 4 and 5), only Sebi-registered foreign institutional investors and non-resident Indians are allowed to invest in exchange-traded derivative contracts where the underlying securities are equity shares of an Indian firm. "No other class of foreign investor is allowed to enter into any derivative contract where the underlying security is an equity share of an Indian company."

Private equity investors, at the time of entry, must be very clear about their exit options. Profits accruing to private equity investors depend on their terms of exit and therefore the investors want to be prepared right at the outset. Therefore, looking at the view that RBI is taking the enforcement of put option as a mode of exit looks uncertain creating doubts in the minds of foreign investors.

Bar & Bench spoke to Gautam Saha Partner at AZB & Partners

Bar & Bench: With RBI taking a very strict stand on put option as an exit mode, what will be the impact on foreign investments given that most of the agreements that PE investors enter into have a put option?

Gautam Saha: Most investors are going to start thinking about this issue, as put option is one of the preferred exit options for investors. Just because there is a put option, it doesn’t mean that there is a debt or it becomes a debt instrument because ultimately the exercise of the put option is subject to various other guidelines including the pricing guidelines. Even if I have a put option at a particular price or based on a particular mechanism, at the time of exercise of put option, the price has to comply with the pricing guidelines, so in a sense it is no different from a share purchase agreement. The put option has to be viewed separate from the underlying security in itself. A debt instrument for example FCCB bond, that itself carries a redemption right so the bond holder can ask the company to redeem the instrument, so that is what makes it a debt instrument. In a put option,the company has no obligations. Whena put option is being classified as a debt, a question arises as to who is the “borrower”.When the investor invests, the money does to the company.  However, the put option is against the promoter. Therefore, who is the borrower because the company which receives the money doesn’t have to pay back the money, it is the promoter.

Rather than looking at it as purely an issue which only affects the foreign investors, I think it has to be looked at in a slightly larger context. Today, in many transactions there is an option (put or call) in favour of Indian promoters where Indian promoters either have a put option or call option. Ultimately it has to be viewed in the context of exit right for a financial investor. Financial investor could be Indian party or a foreign party.

Bar & Bench: In view of the RBI’s position on put option, what other alternate exit routes are you advising to clients?

Gautam Saha: In view of the RBI position, I think right now it’s a bit too early to say thatput options are completely ruled out. Though RBI has taken the positionbut I think it’s still an evolving position. I expect that the cases where RBI has issued notices, the parties concerned will argue out the position with RBI and then we have to wait to see what the final situation. Thereis nothing expressly stated in the foreign exchange regulations against such kind of exit options. It is likely that this issue will finally be determined by the court.

I don’t think so far we are telling people that put options are completely out of the question but in terms of other exit options, right now there is a significant level of uncertainty.This does not help any of the parties.

Bar & Bench: RBI while raising concerns over deals where foreign investors have a right to sell back shares to Indian promoters if certain conditions are not fulfilled, has taken the view that such deals are foreign ‘loans’ and not ‘equity’. Your views on the same.

Gautam Saha: Any sale of shares by a non resident to a resident requires compliance with pricing guidelines.The pricing guidelines say that at the time of the transfer you need to do a fair valuation of the company based on the discounted free cash flow method. Today if I invest in equity and later the  company is not doing very well and is in losses and the state of the company is not very good, the fair value  of the company is going to come as very low. Even if I have a put option at a very high price, I will not be able to exercise the put option because I can get back only what isthe fairvalue of the company so I am taking an equity risk. Only if the company does welland the fair value of the company justifies the put option price only then I will be able to exercisethe put option and get an exit.