By Sidharrth Shankar and Vatsal Gaur

The second quarter of the last year witnessed the RBI introducing the discounted free cash flow (DCF) method of valuing shares of private companies and closely held (unlisted) public companies. This mode of valuation was made applicable for transfer of shares of such companies between a resident and a non-resident and vice versa. To be precise, whereas the valuation arrived at through the DCF method would be reckoned as the base price in cases of transfers made by a resident to a non-resident; the same would comprise the upper threshold for all reverse transfers, i.e. transfers made by a non-resident to a resident.

Though the DCF method of valuation continues to remain controversial and has its own set of uncertainties around its methodology, with a recent change in policy notified by the RBI by way of a circular issued on November 4, 2011, the question plaguing the minds of most practitioners and professionals is: has DCF been watered down? – The answer, unfortunately, seems to be a No!

By way of background, the Indian exchange control laws provide that any transaction of transfer of shares between a resident and a non-resident not meeting the pricing guidelines stipulated by the RBI (in the case of unlisted companies- the DCF method of valuation), requires prior RBI approval. Additionally, prior RBI approval is also required in certain other cases, viz. where the transfer of shares would require prior approval of the FIPB; where the transfer would fall under the ambit of the SEBI takeover regulations; or where the company whose shares were being transferred was engaged in the financial services sector.

With a view to liberalise the FDI regime governing transfer of shares between residents and non-residents, and to do away with the requirement of seeking multiple nods from different regulators for the same transaction of transfer (as was the case formally), the RBI has recently amended the erstwhile requirement of seeking prior RBI approval for the aforementioned classes of share transfers, subject to otherwise complying with FDI policy and the caps and conditionalities imposed therein. Though this is a move abundantly welcome by the investment community and other market participants, the recent policy change (much like most policy changes) is beset with potential quagmires and misinterpretations, foremost amongst which is whether and to what extent has the RBI done away with the DCF method of valuation applicable to transfer of shares?

And here’s where the catch is! Although a plain reading of the circular may tempt one to believe that a non-resident would now be able to make a sale of shares to a resident without being under an obligation to adhere to the DCF method of valuation (so far as shares of an unlisted company are concerned), it is suggested that non-resident shareholders contemplating a favourable exit under this (unlikely) interpretation should hold their horses!

The RBI has usually been very conservative in its approach of managing the country’s balance of payments, and more so with respect to the amount and extent of foreign exchange leaving Indian shores. Moreover, the circular does not unequivocally state that the DCF regime has been partially superseded/ repealed (readers may be aware that when the DCF regime had originally been introduced, the erstwhile CCI guidelines of valuation had expressly been repealed).

A purposive interpretation of the RBI circular would only mean that as long as the pricing of the transaction is compliant with the specific SEBI pricing guidelines (pertaining to IPOs, block deals, delisting, exits, open offers, and buy-backs) as applicable to listed companies falling within the jurisdiction of the SEBI, such transactions would henceforth not call for additional scrutiny by the RBI.  

With respect to transfer of shares being effected by a resident in favour of a non-resident, an interpretation of the RBI circular may lead one to believe that as long as the activities of the investee company (i.e. the company whose shares are being transferred) fall under the automatic route of the FDI Policy, no prior approval of the RBI would be required; even in those cases where the negotiated price of the transferred shares falls short of the base value arrived at through the DCF method of valuation. Here again, this misreading of the RBI circular could be suicidal. The RBI has sought to only provide a carve out to those companies which albeit meeting with the prescribed SEBI guidelines, were forced to knock on the RBI’s doors and justify their due compliance.

In this highly convoluted FDI regime, temptation should always give way to prudent realism; sometimes even pessimism!

Sidharrth Shankar is a Partner and Vatsal Gaur is an Associate with J. Sagar Associates. Views of the authors are personal.

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