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Column: Validating options

Jan 13 2014, 03:26 IST
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SummaryRBI's new rules on investments by non-residents in shares and convertible debentures is a leap forward

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 clear—that 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 partner’s 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 RBI’s 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 development—townships and housing. This looks to be an acceptable condition which will ensure that exits aren’t possible before the end of lock-in period. This may

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