Modification of Pricing Guidelines for FDI Instruments with Optionality clause

For non-resident holders of equity shares, compulsorily convertible preference shares(‘CCPSs’)/ compulsorily convertible debentures (‘CCDs’), an exit option is now given to them by way of buy-back as per the price prevailing or value determined at the time of exercising such option. Therefore, at the time of making the investment, the non-resident investor will not be guaranteed any assured exit price. The investor can exit the investment only at the value determined at the time of exit, as per the prescribed guidelines of RBI. The clarification has been made by RBI vide RBI/2013 14/436, A.P. (DIR Series) Circular No. 86 dated January 9th, 2014.

The provision of optionality clause is made subject to the following conditions:

1. Minimum lock in period of one year or minimum lock in period prescribed under FDI regulations, whichever is higher. Lock in period will be effective from the date of allotment of such securities.
2. After the completion of lock in period, non- resident investor may exit at the following price:
• In case of listed companies:
  at the market price of such security, prevailing at recognized stock exchange
• In case of unlisted companies:
  for exit from investment in equity shares, at a price not exceeding the price determined on the basis of Return on Equity (‘ROE’) as per the latest audited balance sheet.
  ROE = Profit After Tax / Net Worth.
  Net worth will include all free reserves and paid up capital.
• For exit from investment in CCDs and CCPSs:
  at a price determined as per internationally accepted pricing methodology. The price so determined, is required to be certified by a chartered accountant or a merchant banker registered with SEBI.

3. It must be noted that these guidelines are applicable to all the existing contracts that must comply with the prescribed conditions in order to be in compliance with FDI guidelines.

Our Analysis:

Through this notification, RBI has legitimized the optionality clause in the FDI instruments issued to the foreign investors. The optionality clause in the FDI instruments has always been a grey area though on the one hand the share holders agreements/ investment agreements included standard option clauses and on the other hand, RBI appeared reluctant to give its approval or disapproval to such cases.

With the liberalization of optionality clauses, the RBI has also modified its pricing guideline. The RBI had rather indirectly governed the pricing of such exit cases through its general pricing guidelines. As per the general pricing guidelines, the shares can be transferred by a person resident outside India to a resident at a price which shall not be more than the minimum price at which the transfer of shares can be made from a resident to a non-resident. Therefore, in the case of listed companies, the price should not be more than price determined on the basis of SEBI guidelines and in case of unlisted companies, the price should not be more than fair value of shares as per the Discounted Free Cash Flow Method (DCF) as determined by a SEBI registered Merchant Banker or a Chartered Accountant.

However, the RBI notification has validated a new mechanism for valuation for cases where such shares were issued with optionality clause. It is important to note, since the notification also covers existing contracts, such existing contracts must be modified accordingly to comply with the prescribed conditions. Therefore, this notification has the potential to impact a number of foreign private equity investors who may now need to modify their existing contracts as per the new pricing norms for optionality contracts.

The new pricing norms also have the potential to encourage foreign private equity investors to bring their investments through CCPSs and CCDs as the pricing norms appear to be more liberal on these instruments. The RBI has allowed usage of any internationally accepted pricing methodology to determine the exit price of the CCPSs and CCDs, which provides more flexibility and discretion to the foreign investors to maximize returns on their investments.