Pursuant to Circular No. 86 A.P. (DIR Series) on 9 January 2014 (“Circular“), the Reserve Bank of India (“RBI“) has permitted foreign investors to be granted put options with respect to equity shares and compulsorily convertible instruments issued in accordance with the foreign direct investment (“FDI“) policy. The Circular as also prescribed the conditions, including applicable pricing, under which put options may be granted to, and exercised by foreign investors.
Regulatory Resistance to Options
Legality of options has always been surrounded by uncertainties in India on a number of fronts. There have been various challenges to the legality of call options on the basis that call options: (a) over shares of private companies, if not incorporated under the articles of association of private companies are void under company law; (b) over shares of public companies are contrary to the principle of free transferability stipulated under company law. Both call and put options have also been challenged under securities law on the ground that privately negotiated options are outside the scope of derivative contracts that are permitted under India’s restrictive derivative securities regime. Conflicting views taken by courts over time, and the view taken by the Securities and Exchange Board of India until recently on legality of options, only added to the uncertainty under statutes created by drafting ambiguities to begin with.
Against this backdrop, an altogether different challenge against put options was raised by the RBI, from a foreign exchange control perspective. FDI is permitted in India only through equity shares and other securities that are compulsorily convertible to equity shares. While optionally convertible and redeemable securities were earlier permitted for FDI purposes, this was changed in 2007 on the principle that from an exchange control standpoint, such securities bear more resemblance to debt securities than securities bearing equity risk. Indian exchange control regulations governing foreign debt have traditionally been significantly more restrictive than FDI regulations, with a number of restrictions on source of funding, interest/coupon rate caps, end-use restrictions, etc. RBI felt that optionally convertible and redeemable securities were being used for foreign funding transactions that were ostensibly posing as FDI, yet due to the redeemable nature of these instruments, the commercial effect of such transactions were similar to debt funding, and were being exploited to circumvent the restrictions applicable to foreign debt.
RBI’s previous opposition to put options in foreign equity transactions was based on the same principle. It was argued that put options available to foreign investors against Indian residents over equity instruments, especially where the option price was determined on the basis of a pre-agreed IRR, rendered a foreign equity transaction more similar to debt, yet foreign investors enjoyed the relative regulatory ease associated with foreign equity transactions.
FDI Policy Circular (2 of 2011)
To address this apparent regulatory gap, a provision was incorporated by the Department of Industrial Policy and Promotion (“DIPP“) in the Consolidated FDI Policy Circular (2 of 2011) in September 2011 to the effect that equity instruments backed by put options would be treated as foreign debt, and restrictions applicable to foreign debt such as end-use restrictions, cap of returns, etc., will apply to such equity instruments. While the intention behind introducing such a provision may have had been based on sound regulatory concerns, the rather broad sweep of the provision meant that a legitimate and important exit option that was available to foreign investors, especially venture capital and private equity investors, was taken away. Due to widespread objections from the industry, this provision was deleted a month later.
The Circular is the most recent attempt at addressing the apparent regulatory gap, while bearing in mind the industry’s legitimate concern regarding availability of put options as a genuine exit mechanism for foreign equity investors. The Circular now permits put options for equity shares and compulsorily convertible securities issued to foreign investors, subject to the following conditions:
(a) the securities will be subject to sectoral minimum lock-in requirements applicable to FDI, if any, i.e., the put option may be exercised only after expiry of any lock-in period stipulated for FDI investments – for instance, the 3 year lock-in period presently applicable to FDI in defence and construction development sectors; and
(b) the put option must not result in “any assured return” for the foreign investor.
For the purposes of ensuring that the foreign investor is not entitled to “any assured return“, the RBI has prescribed the following pricing norms for the price payable to the foreign investor for sale of equity securities pursuant to exercise of the put option:
(a) in the case of equity shares of listed companies, the price payable must be “the market price prevailing at recognized stock exchanges“;
(b) in the case of equity shares of unlisted companies, the price payable must not exceed the price arrived at the on the basis of return on equity (RoE) as per the latest audited balance sheet of the company; and
(c) in the case of compulsorily convertible debentures and preference shares, the price payable must be determined on the basis of any prevailing internationally accepted pricing methodology, which must be certified by a chartered accountant or a SEBI registered merchant banker. While there seems to be a certain degree of choice in the pricing methodology that may be adopted for convertible securities, this is still subject to the overarching principle that the foreign investor should not be entitled to any “assured exit price“.
Lack of Clarity and Unintended Consequences
The intent of the RBI may be noble in so far as to address an apparent regulatory gap without taking away a legitimate exit option available to foreign equity investors. However, its implementation through the Circular is not without concerns and uncertainties, both at a conceptual and textual level:
(a) Although it is not clear from the Circular, it is arguable that the pricing norms prescribed in relation to put options, are still subject to pricing caps prescribed for other transfers of equity shares by non-residents to residents. Transfer of equity shares pursuant to exercise of a put option is still a subset of the larger universe of transfer of equity shares by non-residents to residents, and there is arguably no reason why pricing for transfers pursuant to exercise of put options should operate independently of regular pricing caps. Prior to RBI frowning down on IRR based put options, the IRR based price payable to foreign investors for transfer of shares pursuant to exercise of put options were still subject to pricing caps. Such reasoning aside, this is not clear from the language used in the Circular, particularly in the context of put options over equity shares of listed companies, discussed in paragraph (b) below.
(b) In the case of exercise of a put option for equity shares of listed companies, the price applicable is the market price prevailing at recognized stock exchanges. However, the price payable for a regular non-resident to resident transfer of listed shares is capped at the higher of the average of the weekly high and low of the closing prices of such shares over the 26 or 2 weeks period preceding the date of transfer. If the prevailing market price is higher than the 26/2 weeks weekly high-low closing average price, based on the reasoning in paragraph (a) above, it is not clear if the foreign investor would indeed be entitled to this higher exit price. In any event, utility of put options for shares for listed companies that is capped at the then prevailing market price is questionable since (at least theoretically) the foreign investor could have secured a similar exit through a market transaction on the stock exchange, though for larger volumes, there is the benefit of a ready buyer to purchase through a synchronized trade.
(c) Similarly, even if the likelihood of such a scenario is relatively low, if the put option price based on the prescribed RoE valuation is higher than the price cap based on DCF valuation, applicable to other non-resident to resident transfers of unlisted equity shares, it is not clear if the foreign investor is entitled to the higher RoE based exit price. More problematically, unlike the language in the Circular used for pricing of listed equity shares, in the case of unlisted shares, the put option price payable clearly operates as a cap. If the RoE based price is lower than the DCF valuation (which is highly likely for start-up ventures, cyclical industries, and sectors with longer break-even periods), it is unclear if the foreign investor would be bound by the lower RoE based price cap for all future transfers of shares to the option counterparty, merely because the investor had secured a put option at the time of investment. To illustrate, if a private equity investor should have a put option against the promoters of an Indian company, and if the RoE based price cap turns out to be lower than the DCF valuation, is it permissible for the private equity investor to not exercise the put option, but separately negotiate an exit with the promoters at a price higher than the RoE valuation but within the DCF valuation? This is unclear, however, if the intention behind the Circular is indeed to restrict such an alternative exit at a higher price merely because the foreign investor happened to have secured a put option at the time of investment, it is contrary to the very essence of an option, which by definition includes the freedom to not exercise the option. In any event, RoE valuation cap notwithstanding, a put option is still useful in the case of unlisted companies if there is no buyer for the shares held by the investor other than the option counterparty.
(d) It is not clear how the RoE based valuation is practically useful in the case of companies with losses in the financial year immediately preceding the exit, or with a negative net worth. Both these are highly likely scenarios for start-up ventures and industries with longer break-even periods. Incidentally, such companies are the ones that are most in need of risk capital from venture capital and private equity investors, who in turn, commensurate to the equity risk taken, require alternatives to public market exits through means such as put options.
(e) Clearly, the RBI’s intent behind the Circular is to prevent complete de-allocation of equity risk for the foreign investor in an equity transaction, which is exactly what IRR based put options do in equity transactions, thereby lending them the flavour of debt financing. Preventing such complete de-allocation of risk, while at the same time preserving put options as a means of exit is the conceptual distinction that has completely missed both RBI and DIPP in the past. However, by prescribing an RoE based valuation cap, the RBI may have, perhaps unintentionally, allocated more risk to foreign equity investors than is required for securing both these objectives. In addition to the points discussed in the paragraphs above, RoE based valuation is historical in nature and is linked to performance of the investee company in a single financial year. At the time of investment, foreign investors are subject to a floor valuation based on DCF, which other than in the most atypical cases, provides a higher valuation for start-up ventures and industries with longer break-even periods. Yet, a pre-agreed exit mechanism for the same foreign investors who assumed significant equity risk and provided much needed risk capital to the Indian company is subject to price cap that is highly likely to be lower than a prospective valuation methodology such as DCF valuation. While complete de-allocation of risk for an equity investor is not desirable, can it be said that the foreign investor does not assume equity risk merely by virtue of availability of a put option based on prospective valuation. In any event, since DCF valuation methodology is anyway used as the threshold for entry valuation, how significant, if any, is the de-allocation of risk for the foreign investor if the same methodology is used as the basis of a pre-agreed exit mechanism (despite, arguably, the malleability of DCF valuation in practice)?
(f) RoE pricing methodology for put options may introduce an unwarranted bias in the choice of investment instrument in favour of compulsorily convertible debentures as opposed to compulsorily convertible preference shares, as the latter will add to the net worth of the investee company, thereby lowering RoE exit valuation.
(g) RoE based valuation for put options may unfairly prejudice foreign investors in investee companies that reinvested earnings in its business, thereby increasing net worth and lowering exit valuation through put options, as opposed to foreign investors in companies that made frequent dividend distributions during the investment period. The former class of investors not only does not receive dividend benefits, but is also subjected to a lower valuation for a pre-agreed exit, whereas the latter benefits from higher dividend payout as well as exit valuation. At a macro level, ceteris paribus, if investment choices are influenced by this parameter, this may result in a bias against allocation of risk capital to sectors where growth is dependant on prudent reinvestment of earnings.
Permissibility vs. Utility
Based on the above, one is left to wonder whether the so called permissibility of put options introduced pursuant to the Circular is helpful to either: (a) foreign investors as a means of exit, from the perspective of both regulatory clarity and commercial utility; or (b) Indian industries as a whole from the perspective of attracting risk capital and prudently allocating such capital across industries. The RBI may have had a sound conceptual basis for its resistance to put options. However, yet again, as Indian regulatory environment has proved itself in the recent past, the new solution is unclear, may prove to be unhelpful and as damaging as the problem.
G. T. Thomas Phillippe [email@example.com]