RBI notification recognizes importance of exit options but the riders have created some confusion – AZB Partner Gautam Saha

The Reserve Bank of India (RBI), pursuant to a notification dated December 30, 2013 and its circular dated January 9, 2014 has finally allowed foreign investors to include ‘options’ in structuring their investments. The notification brings some long-pending clarity on the issue..This move by the RBI comes three months after the Securities and Exchange Board of India (SEBI) permitted the use of ‘put and call’ options in investment agreements by amending the Securities Contracts (Regulation) Act, 1956..The SEBI, had recently allowed put and call options in M&A deals in listed companies, removing the uncertainty concerning the validity of contracts containing optionality clauses..However, foreign investors and private equity funds were still concerned about the position of the RBI on the issue as the RBI had earlier taken a very strict stand on put option or pre- agreed buy-back of shares as a mode of exit. RBI had taken a view that such exit arrangements are not legally valid..The RBI has now amended the Foreign Exchange Management Regulations to allow optionality clauses in equity shares and compulsorily and mandatorily convertible preference shares/debentures to be issued to a person resident outside India under the Foreign Direct Investment (FDI) Scheme..The RBI notification says.“Shares or convertible debentures containing an optionality clause but without any option/right to exit at an assured price shall be reckoned as eligible instruments to be issued to a person resident outside India by an Indian company …….”.As expected, the RBI has prescribed a minimum lock-in period of one year to allow the exercise of these options. Also, the RBI has allowed use of put options without any right to exit at an assured price..Further, the RBI has provided pricing norms that must be followed in relation to the exercise of options at the time of exit:.– Listed company – at the market price determined on the floor of the recognised stock exchanges;.– Equity shares of unlisted company – at a price not exceeding that arrived on the basis of Return on Equity (RoE) as per latest audited balance sheet..– Preference shares and debentures – the price for exit is required to be determined as per an internationally acceptable pricing methodology at the time of exit..Bar & Bench speaks with AZB & Partners Partner Gautam Saha for his views on the RBI notification.B&B: The RBI has finally brought some clarity on the long pending issue allowing the use of put and call options by foreign investors in structuring their investments. Thoughts?.Gautam Saha: This notification does address some issues, in the sense that it recognizes that exit options are an important part of an investment decision. Unfortunately, the riders have resulted in creating further issues, some of which could have been easily avoided. On a related note, the notification and the RBI position needs to be viewed in the context of basically put/exit options. Call Options in favour of non-residents are not really the focus here as those are not exit rights – they involve additional investment by the foreign investor..B&B: The RBI has allowed these exit options subject to certain riders. Do you think the conditions are strict? What is the reason for imposing these riders, specifically not allowing assured return at the time of exit? .Gautam: RBI’s stance against exit options providing an assured return is well understood and there is no issue with that. Their position is that as an equity shareholder, the foreign shareholder should take an equity risk and providing a guaranteed rate of return is inconsistent with this basic principle. However, where there seems to be a disconnect is where the notification goes way beyond restricting assured return instruments..Conceptually, even prior to this notification, there could never be an assured return for the foreign investor as any exit in favour of a resident was subject to the pricing guidelines. Therefore, even if the foreign investor had a put option at, say 20% IRR, the put price could not have been higher than the DCF value at the time of exercise of the put. Therefore, there was no question of any ‘assured return’..The RBI should have reiterated this position and clarified (even though this was always the case) that any exit option that allowed a foreign investor to receive a price higher than the fair value of the shares would not be permissible. This would ensure that the foreign investor took an equity risk..It is important to understand that in most transactions, the stated IRR return actually operated as an effective cap for the benefit of the Indian promoter/company. This is because the foreign investor was anyway capped at fair market value (due to the RBI pricing guidelines). So when the contract provided that the put price should provide, say a 12% IRR to the investor, what it actually did was to cap the price at a 12% return for the investor in cases where the fair market value may have yielded higher returns..B&B: The RBI has prescribed rules to arrive at an exit price. In case of an unlisted company, the exit price should be less than the return on equity as per latest audited balance sheet. What does this mean for Indian unlisted companies and foreign investors? .Gautam: The new pricing guidelines in relation to unlisted equity shares (where the exit is through a put) are not clear. The return on equity formula is not a generally accepted valuation methodology. It is primarily an evaluation tool (pretty much like a debt- equity ratio), which shows how efficiently a company is using the funds of its shareholder. Using the return on equity of the latest year as an exclusive tool for valuation does not appear to be appropriate..The rationale for these additional pricing conditions is not clear. RBI had already prescribed the DCF pricing norms, which proceeded on the basis, that any non-resident selling to an Indian resident could only receive the fair market value of the shares. That ensured an equity risk for the non-resident, which seems to be the key concern, which RBI has been trying to address.