Highlights:

• A recent notification of the Securities and Exchange Board of India expressly permitted put and call options in relation to shares of public limited companies, both listed and unlisted.
• The Reserve Bank of India has clarified that foreign investors can have “optionality” attached to Equity Securities (defined below) so long as such option / right does not assure them of a fixed exit price, provided that other conditions described below are met.
• With regard to equity shares, such option / right may be exercised: (i) in case of a listed company, at a price not more than the prevailing market price; and (ii) in case of unlisted companies, at a price not exceeding that arrived on the basis of Return on Equity (“RoE”) as per the latest au­dited balance sheet.  The shift of the exit price from a discounted free cash flow method of valuation to a return on equity based valuation could have a negative impact on foreign investors.
• In case of compulsorily convertible preference shares and compulsorily convertible debentures, the pricing for an exit by way of a put option can be arrived at as per any internationally accepted pricing methods as certified by a chartered accountant or SEBI registered merchant banker.

Main Article:

Introduction

The use of put and call options are commonplace in investment transactions and are one of the means for achieving a potential exit from an investment. Until recently, the Securities Contracts (Regulation) Act,1956[1], did not permit the use of put and call options in investment trans­actions involving public limited companies. This was because private contracts with put and call options were in the nature of derivative contracts which were not in compliance with the SCRA.

The Reserve Bank of India (‘RBI’), India’s apex bank, was also not in favour of the use of put and call options in investment transactions. From an RBI perspective[2], though not expressly prohibited under the foreign exchange regulations, RBI viewed “put” option rights in favour of non residents with a guaranteed exit price as debt masquerading as equity and thought that they should therefore be viewed and treated as external commercial borrowings.

Liberalisation by SEBI

On October 3, 2013, the Securities and Exchange Board of India, (‘SEBI’), India’s capital markets regulator, had issued a notification which inter alia expressly permitted put and call options in relation to shares of public limited companies (both listed and unlisted). This SEBI notification is a good step forward in clarifying SEBI’s position on put and call option contracts, given the uncertainties created previously.

The SEBI notification, however, has some riders attached to it. It has been stipulated that the selling party of a put option must hold the title and ownership of the underlying securities for a minimum of 1 year from the date of entering into the contract. SEBI has also required that the consideration paid on the exercise of any option must be in compliance with the relevant guidelines for pricing as are stipulated by SEBI and RBI, and the contract must also compulso­rily be settled by way of actual delivery. Effectively, the pricing of the “put” option (for transfer from foreign investors to Indian residents) for unlisted companies was linked to the RBI pre­scribed price, which price was a ceiling calculated in accordance with the discounted free cash flow method of valuation (‘DCF’). For listed companies, the price was capped at the preferential allotment price calculated in accordance with the SEBI (Issue of Capital and Disclosure Require­ments) Regulations, 2013, which is essentially the higher of the average weekly high and low clos­ing prices quoted on the stock exchange during the preceding 26 weeks or 2 weeks.

While SEBI took steps to remove some of the uncertainties around “put” / “call” options on securities of public limited companies, the position of RBI still remained unclear in relation to foreign investors. Recently, RBI has released its notification dated November 12, 2013 published in the Official Gazette on December 30, 2013 and circular dated January 9, 2014 on this subject matter (collectively, ‘RBI Circulars’).

RBI’s stand under the RBI Circulars

The RBI Circulars do not consider any equity shares, convertible preference shares or convertible debentures (‘Equity Securities’) carrying “optionality” rights and which assure returns, as eli­gible instruments in the hands of a foreign investor from a foreign direct investment standpoint. Thus, any foreign investment made in any Equity Security cannot carry “optionality” and as­sured returns. Equity Securities carrying “optionality” but no assured returns are valid and eligi­ble but transfer of such instruments are subject to certain conditions set out in the RBI Circulars.

What is meant by “optionality”?

The term “optionality” is not defined under the RBI Circulars. What kind of rights under the shareholders agreement constitutes “optionality” is a matter of interpretation. Based on pre­vious concerns raised by RBI in the context of “put” options, one may infer that “optionality” should include only those rights which grants the foreign investor a right to cause the company or the other shareholders to purchase (or cause the purchase) of Equity Securities held by such foreign investor. In other words an optionality clause should be one which obliges the buyback or purchase of Equity Securities from the foreign investors.

 “Options” which are “disallowed”

The RBI Circulars have provided that Equity Securities which: (a) contain an optionality clause; and (b) which provides a foreign investor with a right to exit at an assured price, will not be regarded as an eligible security and cannot be subscribed to by foreign investors. The guiding principle that RBI has set forth, is that foreign investors should not be guaranteed any assured exit price at the time of making the investment.

What is meant by “assured return”?

The term “assured return” is also not defined under the RBI Circulars. It is not clear whether put options with an agreed return that are subject to, and capped at the price arrived at based on applicable pricing guidelines, particularly where there are no agreed mechanisms to ensure that the agreed price is effectively safeguarded, will constitute “assured return” within the mean­ing of the RBI Circulars. Arguably, a “price assured” which is, subject to it being in compliance with the pricing requirements under the law ought to be treated as a return which is contingent, rather than assured. However, RBI will perhaps need to be convinced with respect to this aspect.

“Options” which are “allowed”

RBI has clarified that foreign investors can have “optionality” attached to Equity Securities so long as such option / right does not assure them of a fixed exit price. In other words, “put” options are possible going forward, so long as such “put” right does not result in an Indian resident pro­viding an assured return to foreign investors. This is however, subject to the following conditions:

i.    Such Equity Securities will be locked in for a minimum period of one year, unless a higher lock-in is prescribed by the exchange control regulations (e.g. certain sectors such as defence and construction development have a minimum lock-in requirement of three years)[3]; and

ii.   Such exit will be subject to pricing guidelines discussed below.

Pricing of equity shares at the time of exit

In terms of the RBI Circulars, such option / right may be exercised: (i) in case of a listed company, at a price not more than the prevailing market price; and (ii) in case of unlisted companies, at a price not exceeding that arrived on the basis of Return on Equity (“RoE”) as per the latest au­dited balance sheet. RoE has been defined to mean profit after tax divided by the net worth, and net worth includes free reserves and paid up capital.

It should be noted that this RoE based valuation will apply only for exit by exercising the “op­tionality” clause.

The shift of the exit price from DCF to RoE based valuation could have a negative impact on foreign investors. The minimum price at which a foreign direct investment can currently be made in unlisted equity shares is determined on the basis of DCF valuation of the equity shares. The DCF valuation takes into account the future performance of the company based on specified variables. A RoE valuation is an indicator of the financial performance of a company during a specified period, and may not convey the actual fair value of the equity shares of the com­pany. While RBI had in its recently issued FAQs on ‘Foreign Investments in India’[4] clarified that the foreign investor can exit at a price which gives an annualized return equal to or less than the RoE as per the latest audited balance sheet, it remains to be seen how the foreign investors will get their return under the RoE based valuation in sectors with a long gestation period like insurance, infrastructure, real estate, etc., or where at the time of exit, the company is a loss making company.

Arguably, the RoE based valuation should not apply in the context of events of default by a resident pursuant to which a non-resident has the right to exit the company, and requires the resident to buy its shares. However, further clarity is awaited on this.

Pricing of compulsorily convertible preference shares and compulsorily convertible debentures at the time of exit

In case of compulsorily convertible preference shares and compulsorily convertible debentures, the pricing for an exit by way of a put option can be arrived at as per any internationally accepted pricing methods as certified by a chartered accountant or SEBI registered merchant banker. The underlying rationale for making this distinction is also unclear since a convertible instrument derives its value from the underlying security i.e. the equity share of a company, the transfer of which (as per the RBI Circulars) needs to comply with a valuation based on RoE method.

What happens to existing contracts?

RBI has further stipulated that all existing contracts will have to comply with the above lock in and pricing conditions to qualify as compliant with exchange control laws. Accordingly, it will need to be assessed whether existing contracts need to be amended or not in order for these contracts to be enforceable. Further, it needs to be assessed if any “put” options with an assured return (issued before the date of the RBI Circulars) can be regarded as eligible securities under the exchange control regulations. In this context determination of what will tantamount to “as­sured return” is important.

 Conclusion

While recognition of options by the SEBI and RBI is a welcome move for foreign investors, there are several areas that will need careful consideration, particularly in the context of the pricing regime proposed for exits that will occur pursuant to exercise of option rights by the foreign investor.

[1] As per Section 18A of the Securities Contracts (Regulation) Act, 1956, derivate contracts are permissible only if entered into on stock exchanges and settled on the clearing house of the recognized stock exchange.

[2] The Department of Industrial Policy and Promotion (“DIPP”), on September 30, 2011, had announced that all investments in securities with ‘in-built’ options will be considered as external commercial borrowings. However, industry uproar resulted in reversing of this position.

[3] The lock-in will apply from the date of allotment of such Equity Securities and accordingly, in case of multi-tranche investments, each tranche of investment would be locked in from the date of its respective allotment.

[4] FAQs on Foreign Investments in India issued by RBI as updated till January 28, 2014.