Column: Validating options

Written by Lalit Kumar | Updated: Jan 13 2014, 08:56am hrs
A recent Reserve Bank of India (RBI) notification amending foreign exchange regulations for investments by non-residents in shares and convertible debentures carrying an option/right to exit is yet another leap, ensuring clarity on the validity of such options. Last year, the Securities and Exchange Board of India (Sebi) had validated such options from securities laws perspective; however, ambiguity persisted as far as foreign exchange regulations were concerned. With this notification, RBI has put the ambiguity to rest, although with certain riders.

Loads of conditions have to be satisfied before an option is considered valid. The reason for these stringent conditions is clearthat RBI only wants genuine options to be valid and not those which are designed to earn quick and assured returns to foreign investors.

For instance, a foreign joint venture partners right to put its shares in favour of the Indian partner in the event of a breach or a termination of their venture will be valid as it appears to be a genuine one, but even in that case the foreign partner would not be allowed to repatriate in excess of the exit price prescribed in the notification. That should be a concern for the foreign partner. Stringent conditions imposed will address RBIs concern of debt disguised as equity flowing in India without complying guidelines applicable for raising debt.

A foreign investor can now hold shares or convertible debentures with an optionality clause, i.e. with call and put option rights or other rights which can provide an exit, provided such option/right does not guarantee any assured price on exit. For instance, while a foreign private equity investor could now have shares or convertible debentures with a put option right, but no internal rate of return (IRR) can be guaranteed at the time of investment. This may place a foreign private equity investor at a disadvantageous position as compared to its Indian counterparts.

Another condition laid to ensure that an option is genuine and not a short-selling arrangement to earn quick profit is the minimum lock-in period of 1 year before securities acquired with options could be sold or transferred. This limit could be higher in cases where the FDI policy for a sector prescribes a higher lock-in period; for example, 3 years in the case of construction developmenttownships and housing. This looks to be an acceptable condition which will ensure that exits arent possible before the end of lock-in period. This may not have any major impact as typically exits are not made within a year of investment.

Perhaps the most stringent condition is the maximum cap on the exit price. Currently, a foreign investor in an unlisted company can transfer shares to a person in India and can repatriate up to a maximum price of share arrived on the basis of discounted cash flow method (DCF) of valuation. This method takes into account the future cash flow projections as well. The RBI notification now provides that the maximum exit price will be based on return on equity as per the latest audited balance sheet. Return on equity means profit after tax divided by net worth based on the latest audited balance sheet at the time of exit. By determining valuation on historic figure of latest balance sheet, the exit price will completely ignore the valuation based on future earnings of the company at the time of exit. This could deprive an investor with an upside in valuation if the future earnings are promising at the time of exit. Ideally, the exit price could have been capped at discounted cash flow (DCF) valuation and not return on equity. Similarly, in case of a listed company, the exit price now cannot exceed the market price prevailing at the time of exit.

At present, for transfer of shares in case of listed companies, RBI relies on Sebi pricing. In fact, Sebi pricing does not take the prevailing market price as the only benchmark, instead it prescribes price based on average over a period of time, which is a more accurate method to determine the price of a listed share, which this notification completely ignores. There shouldnt have been so much of discrimination on pricing just because the foreign investor has an option to exit.

The notification further provides that all existing contracts will have to comply with the conditions of this notification. Consequently, now all executed agreements will have to be reopened to test if they meet the conditions; this could force parties to renegotiate their arrangements and cause great inconvenience.

It now appears that this amendment is only applicable to investments made through the FDI route and not through other routes such as the foreign venture capital investor (FVCI) route. For instance, if a PE investor invests under the FVCI route and not the FDI route, then it need not comply with the conditions of this notification.

The author is partner, J Sagar Associates. Views are personal