Red signals on put options turned yellow, soon green?

By Vidyut Gulati and Kushal Sinha, Shardul Amarchand Mangaldas & Co
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Not long ago, the validity and enforceability of put options on equity shares and compulsorily convertible debentures and preference shares held by foreign investors, being one of the preferred exit routes, was the biggest bone of contention between the proponents of foreign direct investment (FDI) and India’s securities and foreign exchange regulators. The Reserve Bank of India (RBI) on 3 February this year has announced its intention to allow investors an assured return at an appropriate discount over the sovereign yield curve through an embedded optionality clause or otherwise. The recent and rapid liberalization of the regulatory regime on this issue is briefly traced below.

Regulatory clampdown

The Securities and Exchange Board of India (SEBI), through its notification dated 1 March 2000, prohibited contracts for sale or purchase of securities, other than by spot delivery or such other contracts as expressly permitted. As per SEBI, private contractual arrangements granting options were forward contracts and hence transgressed the Securities Contracts (Regulation) Act, 1956, which permits certain specified forward contracts entered on stock exchanges.

Vidyut Gulati
Vidyut Gulati

The RBI, on the other hand, frowned on FDI instruments with options and assured returns from promoters, as being akin to external commercial borrowings (ECBs) and not equity and hence a mode of circumventing the stringent regulatory regime governing ECBs. In a circular dated 8 June 2007, the RBI stated that instruments which are redeemable or optionally redeemable qualify as ECBs and cannot fall within the purview of the FDI regime.

The RBI’s stance was expressed on a case-to-case basis until the Department of Industrial Policy and Promotion (DIPP) introduced a prohibition on options in the consolidated FDI policy of 1 October 2011. However, in light of severe criticism from the industry, the provision was deleted within a month of its publication.

The winds of change

The withdrawal of the DIPP’s notification may have signalled the realization by policy makers that the controversy around options was exacerbating the country’s already gloomy investment climate. On 3 October 2013, SEBI rescinded its notification of 1 March 2000 and permitted contracts with put and call options as well as other pre-emption rights such as right of first refusal and drag along rights.

The RBI followed, on 9 January 2014, by legitimizing foreign investments through instruments containing optionality clauses, albeit with conditions. Optionality clauses were allowed in equity shares and compulsorily convertible preference shares and debentures, provided that the obligatory buyback of such securities from the investor occurred at a price not exceeding the fair value at the time of exit, so as to preclude any assured return. Additionally, a minimum lock-in of one year (or more if prescribed under the FDI policy) was imposed on such investments and the guidelines for exit prices were expressly set out.

Kushal Sinha
Kushal Sinha

For a listed company exit was allowed at the market prices on stock exchanges. For an unlisted company the exit price for investments through compulsorily convertible debentures and preference shares was to be determined independently as per any internationally accepted pricing methodology, while the exit price for equity shares was linked to return on equity (RoE being profit after tax divided by net worth, i.e. paid-up capital and all free reserves) as per the latest audited balance sheet of the investee company.

The linkage to RoE appeared odd, since exit for convertible instruments was liberally left open to any internationally accepted pricing methodology. This anomaly was subsequently corrected and exit at a value determined as per any internationally accepted pricing methodology is now permitted for unlisted equity shares as well as convertibles.

Better days ahead?

While the above changes clearly reflect pragmatism from the regulators, their approach to issues has often differed in practice and theory. According to recent reports, when the Tata group approached the RBI for permission to buy out their joint venture partner NTT DoCoMo at a pre-agreed price (which was higher than the independently determined fair value), the RBI appeared ready to ease the pricing requirements to allow the exit, but left the final decision with the Ministry of Finance. According to media reports on 25 March, the RBI finally rejected the proposal after receiving negative feedback from the ministry.

This may be the latest instance of confusing signals being sent out by the Indian regulators and policy makers to foreign investors, who often see lack of clarity in the regulatory regime as the biggest impediment in India. Options, being an accepted accessory to investments worldwide, merit a clear and unambiguous stance, from both the government and the RBI. The existing ambiguity has led to domestic promoters reneging on contractual commitments to investors, and diluting India’s bid to become the regional hub for foreign investments.

Vidyut Gulati is a partner and Kushal Sinha is an associate at Shardul Amarchand Mangaldas & Co. The views expressed in this article are those of the authors and do not reflect the position of the firm.

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