The Reserve Bank of India must review its position on put options or risk driving foreign investors away

Put options provide a customary and useful exit mechanism to foreign financial investors such as private equity funds and venture capital funds which invest in Indian companies. Such investments are made with the expectation of an exit through an initial public offering (IPO) of an Indian portfolio company. However, if an IPO does not materialize – a possibility that is entirely real given current market conditions – investors are likely to rely on put options to exit a company by compelling the Indian promoters to acquire their stake. Legally speaking, a put option is the right or entitlement, but not obligation, of an investor to sell its shares in a company to the grantor of the option.

Although put options are a well-accepted right in any financial investment, their validity as a matter of Indian law is fraught with difficulties. Their enforceability is subject to grave risks posed by a mixture of complex domestic regulations.

First, since an option usually restricts transferability of the underlying shares, the ability of the shareholders of a company to self-impose restrictions is not free from doubt in the context of the Companies Act, 1956. This position has been obscured further by diverse approaches adopted by the Indian courts.

Second, regulators have questioned the validity of put options on shares of Indian companies, saying that they violate the Securities Contracts (Regulation) Act, 1956, and applicable regulations.

Third, the Reserve Bank of India (RBI) has adopted a regulatory stance that disallows options in securities in favour of foreign investors, saying that it violates the Foreign Exchange Management Act, 1999 (FEMA), and relevant regulations issued by the RBI.

While the first two questions regarding the enforceability of put options universally affect all investors, the third involving FEMA applies only to put options granted in favour of foreign investors. Given the breadth of legal issues involved, this article is confined to the specific question of enforceability raised by the RBI in the case of foreign investors.

Curiously enough, the RBI did not prohibit foreign investors from options using its formal rule-making process. It adopted this position after reviewing proposals for the investment or sale of Indian securities in transactions that were accompanied by, or were the result of, the exercise of put options.

The RBI’s stance is premised on two broad counts. One is that the existence of a put option amounts to a guaranteed return in favour of the foreign investor who therefore takes no equity risk in a company. Consequently, the argument goes, any equity investment accompanied by a put option will automatically become debt in the form of an external commercial borrowing (ECB) that requires compliance with detailed (and more onerous) regulations governing ECBs.

The other is that only foreign institutional investors (FIIs) registered with the Securities and Exchange Board of India (SEBI) may invest in exchange-traded derivatives, and that no other class of investors is allowed to enter into equity derivatives of an Indian company.

The goal of this article is to establish that the RBI’s concerns are unfounded, and that put options that are customary in foreign investment transactions should be permitted. This can be accomplished without any threat to India’s foreign exchange reserves, and without circumventing any laws pertaining to foreign investment.

Can equity become debt?

The RBI considers that the mere existence of a put option to a foreign investor holding equity shares in an Indian company will convert the nature of such equity into one of debt. In such cases, an investment in equity shares must comply with strict ECB regulations promulgated by the RBI that carry restrictions such as the tenure of the investment, a cap on costs and even limitations on the end-use of funds. This amounts to regulatory recharacterization of an investment, which is done without considering the inherent nature of the option granted.

That brings us to the possible variations in the nature of options granted to foreign investors. One type of put option allows a foreign investor to sell its shares to an Indian promoter at a predetermined price so that the foreign investor receives a guaranteed rate of return. In this case, the foreign investor obtains a fixed return without assuming any equity risk. It is entirely understandable that such put options would result in a foreign investor enjoying the same rights as a creditor, and should therefore be curbed by the RBI. In fact, it appears that the possible use of such options in certain transactions may have triggered the RBI’s suspicious outlook on put options more generally.

The more popular type of put options involve those where a foreign investor has the right, if a contingency occurs, to sell the shares to an Indian promoter either at the prevailing price or at any other predetermined price (so long as that is permissible under the RBI’s foreign exchange regulations). In 2010, the RBI streamlined the pricing mechanism for the transfer of shares between foreign investors and Indian residents, so that the benchmark price in a listed company relates to the historical market price (determined by applying a formula prescribed by SEBI). In an unlisted company, the pricing mechanism is related to the price determined by a chartered accountant or merchant banker using the discounted cash flow method. As the pricing of a transfer of shares is stipulated by the RBI, any transfer of shares (whether pursuant to the exercise of a put option or otherwise) must adhere to this pricing.

This has significant implications on whether investments in shares accompanied by put options should be treated as equity or debt. First, when the RBI’s pricing mechanism ensures that transfers occur at a price relatable to the then prevailing value of the company, there is no question of guaranteeing returns to foreign investors through a put option. A foreign investor effectively enjoys the reward and bears the risk of price movements. If the price of an Indian company’s shares rise during the period of investment, that benefit flows to a foreign investor as it is able to sell the shares at a beneficial price.

On the contrary, if the price falls during this period of investment, the foreign investor will be able to sell its shares at a disadvantageous price, thereby incurring a loss. The RBI’s pricing guidelines ensure that there is no loss of foreign exchange. In these circumstances, the RBI’s concern that the existence of the put option makes the investment akin to debt is unwarranted and altogether misguided.

Second, if a transfer of shares between a foreign investor and an Indian resident is permitted at the stipulated price, there is no reason to outlaw such a transfer merely because it is the result of a put option being exercised. If the transfer is legitimate, there is no reason to proscribe a trigger to the transfer, which is the existence and consequent exercise of the option.

The type of option must be carefully considered. While guaranteed options are akin to debt, customary options that allow for transfers at a prevailing price (in consonance with the RBI’s regulations) can only be treated as equity. The current approach by the RBI of outlawing all put options is a classic case of using a sledgehammer to crack a nut. While it is important to consider that put options may be misused to obtain guaranteed returns in exceptional cases, a “one-size-fits-all” approach runs the risk of outlawing put options entered into on reasonable terms that comply with foreign exchange regulations.

Regulatory uncertainty and inconsistency

India’s regulation of foreign investment is divided across two regulatory domains. While the central government, acting through the Ministry of Finance, lays down the broad foreign investment policy, the RBI, as the country’s foreign exchange regulator, oversees actual policy implementation. The regulation of put options indicates inconsistency between the two regulators resulting in regulatory uncertainty and investor confusion. This is magnified by an episode that played out in late 2011.

Out of options: The RBI continues to adhere to its rigid stance of outlawing all options despite the contrary diktat from the government.
Out of options: The RBI continues to adhere to its rigid stance of outlawing all options despite the contrary diktat from the government.

While the RBI’s stance to outlaw options was unstated and informal, the central government formalized this in its policy on foreign direct investment (FDI). In its Consolidated FDI Policy effective from 1 October 2011, the government stated that any foreign investment in equity shares would be treated as an ECB if it carried “built-in options” or was “supported by options sold by third parties”. Therefore, any foreign investment with a put option would be recharacterized as debt. Industry representatives and observers criticized the policy as being excessive and a retrograde step in the evolution of India’s foreign investment policy.

However, these concerns were assuaged by a clarification from the central government on 31 October 2011 that deletes the clause which outlaws options in securities in favour of foreign investors. This pronouncement was unequivocal, and the remarkable alacrity with which the government acted suggests that it was keen to pacify foreign investors.

Given this clarity in the government’s position, one could assume that the RBI as the implementing authority would adopt a similar approach and permit options that are within the sphere of the foreign exchange regulations as discussed earlier. However, that was not to be. Press reports indicate that the RBI continues to adhere to its rigid stance of outlawing all options despite the contrary diktat from the government. The sense of formality handed down by the government is clouded by the RBI’s continued informal stance. This does not augur well to policymaking in the country and adds to investor dilemmas.

Overextending the concept of derivatives

Apart from recharacterizing equity as debt, the RBI assumes that put options are derivatives, with investments into them permissible only in specific circumstances under the notification issued by the RBI under FEMA in 2000, updated through master circulars on an annual basis. The current master circular issued by the RBI states that only SEBI-registered FIIs are permitted to invest in exchange-traded derivatives. However, put options are not exchange-traded; they are created bilaterally through negotiations as over-the-counter (OTC) derivatives.

Hence, the limitation that only SEBI-registered FIIs can invest does not apply to put options entered into on an OTC basis. The RBI’s other argument is that no other type of derivative investment is permitted on a capital account basis. Here, an in-depth analysis of the nature of put options on equity shares suggests that the RBI’s stance overextends the concept of derivatives trading, and this is so for a number of reasons.

Put options are entered into as an integral part of the foreign equity investment, and are not separately tradable as security instruments. No separate consideration is paid or discharged for entering into such options, which is internalized in the equity investment itself. These are physically settled options as opposed to cash-settled options (that are contracts for differences), which necessarily result in the sale and purchase of the underlying equity shares, entirely permissible under the RBI’s regulations so long as the transfer is made at the prevailing price.

A physically settled put option of this kind involves only the creation of an option, which is settled through a transfer of shares. There is no question of any trading in derivatives, which is a concern that the RBI seeks to address by limiting such trading to FIIs and that too only on the stock exchange. If a transfer of shares is permissible, there is no reason why an option that is superimposed on such shares should not be permitted. This fine jurisprudential distinction appears to have been muddled by the resounding regulatory rhetoric against derivatives and exotic instruments generally.

Need for reconsideration

In conclusion, the RBI must substantially reexamine its position on options (whether they amount to guarantees or not) when they are granted in favour of foreign investors. The current position appears to be excessive as it affects customary protective provisions reasonably sought by investors in Indian companies. Moreover, the lack of coherence in the RBI and government’s approach creates substantial uncertainty in the regulatory regime, which needs to be addressed. The time is opportune for such a review considering the huge outflows of foreign exchange from India, attributable partly to the policy paralysis afflicting the Indian economy.

Without a progressive resolution of this stalemate, foreign investors (particularly financial investors) will encounter difficulties in exercising rights that are available to protect their investments. They will be left with no effective mechanisms to exit their investments. The lack of exit avenues through put options will have a chilling effect on foreign investments into India, and thereby adversely affect the capital-raising activity of Indian companies. (For more on put options, see our correspondents’ views on page 61.)

Umakanth Varottil is an assistant professor in the Faculty of Law at the National University of Singapore. Before his foray into academia, he practised law in India and was a partner at Amarchand Mangaldas.