Those in the private equity industry may be aware that the RBI, in the recent past, had been issuing show cause notices to investors seeking to exercise their put option exit right against the promoters of their respective portfolio companies. The rationale for RBI issuing such notices is that in the RBI?s view the existence and exercise of a put option ? which in turn is dependent on the investment providing a guaranteed internal rate of return (IRR) ? makes the investment lose its equity character, and the RBI therefore looks at the associated investment as a debt ? thereby requiring a host of other compliance and restrictions as provided under the ECB policy.
Thus far, such a view (although more limited) seemed to be one resting only within the portals of the RBI. This understanding, although debatable and certainly not free from doubt, appears to have found favour by the DIPP as well, the apex body regulating FDI policy in India. The DIPP, through the new Consolidated FDI Policy (Circular 2 of 2011), effective from October 1, 2011 has in fact gone one step ahead and mandated that, all ?equity instruments (including compulsory convertible debentures and preference shares ? emphasis added) issued/transferred to non-residents having in-built options or supported by options sold by third parties would lose their equity character and such instruments would have to comply with the extant ECB guidelines.?
This amendment to the FDI policy has sent shockwaves through the investor community at large, and justifiably so. With this change, not only has the DIPP affirmed the view of the RBI vis-?-vis put option exits, but it has in fact brought about a complete demise of ?all options in sundry?. A typical example could be a case involving one of the joint venture partners seeking to enforce a call option on the shares held by the other partner in the event of an exit by the other partner ? irrespective of any built in IRR in their joint venture agreement. In such a case the options that now seem available include a voluntary sale to the other partner or initiation of a winding up.
In light of this recent policy shift, pending further clarity, existing and future foreign investors should be cautious while inserting routine put/call options clauses in their respective shareholders?/ investment agreements. Further, the policy is also not free from doubtful interpretation, as the ?in-built? options are always exercisable against ?promoters? and not the ?company? itself. So a question that naturally arises is that in the event of a put option exit, who would be treated as the eligible borrower under the extant ECB policy, the promoter or the target company?
With the DIPP spelling the demise of all ?in-built options? in securities, the risk associated with foreign investments, especially private equity transactions, will stand significantly increased – which in all probability will have a deterrent effect on FDI in the country; and it would be helpful if the RBI or the DIPP could clarify exactly what kind of ?in-built options? are intended to be killed by the extant policy change.
Sidharrth and Aashit are partners and Vatsal is an associate with J Sagar Associates. Views of the authors are personal.