RBI Reforms on Investment Instruments and Pricing

The Reserve Bank of India (RBI) has recently brought
about two sets of related reforms that introduce much greater flexibility to
foreign investors in investing in Indian companies that gets rid of some of the
rigidity that hitherto existed. In terms of investment instruments, the RBI has
permitted investment in partly paid shares and warrants. Additionally, it has
also relaxed the pricing requirements for entry and exit for foreign investors.


Under the pre-existing regime, foreign investment was
permitted under the usual route only for investment in fully paid shares and
convertible instruments (such as debentures and preference shares) that were
fully and mandatorily convertible. These could contain optionality clauses but
without any right to exit at an assured price. This was to ensure that the
investments under the foreign direct investment (FDI) policy came as close to
equity shares as possible. Party-paid shares were virtually shunned, and
warrants were permissible only under the Government approval route with not
much clarity on what type of instruments or terms would be viewed favourably.
This substantially limited the structuring options for investment instruments
as far as foreign investors are concerned.

Through a notification
issued yesterday, the RBI has brought both partly paid shares as well as
warrants within the scope of the FDI policy thereby offering these instruments
for investment by foreign residents. These instruments are now available for
investment under the foreign portfolio investment (FPI) scheme as well. For
both partly paid shares as well as warrants, a minimum of 25% of the total
consideration amount is required to be brought in up front. For partly paid
shares, the remaining amount must be paid within 12 months (except where the
issue size exceeds Rs. 500 crores (Rs. 5 billion) in which case the period can
be longer. In case of warrants, the remaining consideration must be brought
within 18 months.

As regards pricing, for partly paid shares it must be
determined up front. The usual pricing guidelines for equity shares would
apply. For warrants, there is some additional flexibility. The notification
states that the “price at the time of conversion should not in any case be
lower than the fair value worked out, at the time of issuance of such warrants,
in accordance with extant FEMA Regulations and pricing guidelines stipulated by
RBI from time to time”.

Other requirements under the foreign investment
policy such as sectoral caps must be complied with on the assumption that the
partly paid shares or warrants are converted into fully paid shares.

These reforms are beneficial to the investors as well
as Indian companies who wish to raise foreign capital on attractive terms.
While it confers investors with some flexibility to make deferred payments, the
stringent terms and conditions such as the maximum conversion period and
pricing would ensure that the mechanism is not subject to abuse. Hence, the
approach appears quite balanced.

Pricing Norms

For several years now, the RBI, as India’s foreign
exchange regulator, has been controlling the price at which foreign investors
may enter and exit India. RBI’s primary concern relates to the flow of foreign
exchange that accompanies such entry and exit. Consistent with this rationale,
it has been imposing minimum price (floor) at which foreign investors may
invest in Indian companies and a maximum price (cap) at which they may exit
from their investments. This philosophy continues to operate. However, what has
been the subject of change in the method to determine the floor and the cap.
Until 2010, the primary determinant was a formula set out by the erstwhile
Controller of Capital Issues (CCI), which formula had outlived its utility.
This was then replaced by the discounted cash flow (DCF) method. There has been
a lot of debate about the relevance of each of these methods and how they fare
against each other.

In the latest round of reforms, the RBI has done away
with the prescription of any specific method altogether, and has decided to set
forth some general principles for determination of the price. In an amendment
to the FEMA Regulations, the floor and the cap are now set at a price:

… arrived at as per any
internationally accepted pricing methodology for valuation of shares on arm’s
length basis, duly certified by a Chartered Accountant or a SEBI registered
Merchant Banker. The guiding principle would be that the non-resident investor
is not guaranteed any assured exit price at the time of making such
investment/agreements and shall exit at the price prevailing at the time of
exit, subject to lock-in period requirement.

This represents an important shift wherein RBI has
ceases to prescribe the specific method, and has instead decided to defer to
the expertise of intermediaries such as chartered accountants and investment
banks. It has prescribed general principles such as “internationally accepted
pricing methodology” and “arm’s length basis”. It places the onus on the
intermediary to devise the most appropriate methodology in a given set of facts
and circumstances. This is somewhat similar to the approach followed by courts
in the case of share exchange ratio and valuation to be arrived at in the case
of mergers, demergers and restructuring where they are generally willing to
defer to the expertise of the valuers. Courts tend to interfere only when there
is a fundamental flaw in the process or a patent error.

This is a welcome move from a foreign investment
perspective as it provides the necessary flexibility to investors who are no
longer bound by a rigid rule that may not uniformly apply to every single case.
At the same time, it imposes the onus on the companies and intermediaries to
comply with internationally accepted methodologies and value on an arm’s length
basis. The regulator seems to have left some room to interfere in case there
has been an aberration from these guidelines. 
In that sense, while the broad philosophy of maintaining a pricing floor
for investments and a cap for exits continues abated, there is liberalization
on the actual methodology for determining those prices.

The discussion in this post is based on an initial
analysis of the relevant notifications. Greater details and issues may emerge
going forward, which we will attempt to discuss in future posts.

For a detailed discussion on these issues, please see
this discussion
on The Firm – Corporate Law in India.

(I would like to thank our reader Shashank
Bijapur for sharing some of the relevant gazetted RBI notifications)

Update – July 16, 2015: The revised pricing guidelines issued by
the RBI on July 15, 2014 are now available here.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

1 comment

  • A very fundamental of all fundamental genuine doubts any such reported development of its kind, taking place almost perennially, on a day-in-day-out basis, likely to arise in anyone's mind is THIS > Why any such idea or attendant step being conceived of and brought about by any authority, requiring to be followed, especially in exercise of its regulatory or semi-regulatory powers, can rightly or virtuously be regarded and named 'REFORM'? In short, is there not need for allowing at least 'breathing time' between one and the immediately succeeding one , so as to get to know and apprise, more so, expect to have the first one , firstly to be reached and percolate, secondly but not lastly to yield any result, as desired ?

    Pithily stated, the point for an incisive consideration is . – will not , any action resorted to by scrupulously sticking / hanging on to the concept of 'updating' turn out to be meaningless, in that the intended objective might never happen to be accomplished ?

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