‘Put Options’ in favour of a non-resident requiring an Indian resident to purchase the shares held by the non-resident under the foreign direct investment (“FDI”) regime were hitherto considered as violative of the FDI Policy by the Reserve Bank of India (“RBI”). The RBI has now legitimized option arrangements through its recent amendment (“Amendment”) to the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 (“TISPRO”), notified through its circular1 dated January 09, 2013 (the “Circularâ � ). TISPRO now recognizes that equity shares, fully and mandatorily convertible preference shares and debentures (“FDI Instruments”) containing an optionality clause can be issued as eligible instruments to foreign investors. However, the Circular specifies that such an option / right when exercised should not entitle the non-resident investor to exit at an assured return.
The validity and enforceability of put options has always been a bone of contention from an Indian securities law and exchange control perspective.
In the past, Securities and Exchange Board of India (“SEBI”) had taken a stand, in context of public companies, that option arrangements are akin to forward contracts, hence restricted. SEBI relaxed its position through a notification2 in October, 2013. The SEBI notification granted validity to contracts containing clauses related to preemptive rights, right of first offer, tag-along right, drag-along right, and call and put options.
From an RBI perspective, the issue was more from an external commercial borrowings (“ECB”) perspective. RBI had issued a notification on June 8, 2007 vide Circular 73, setting out that non-residents could only subscribe to FDI Instruments, and any instrument that may be redeemable or optionally redeemable will qualify as ECB. Interpreting that Circular, the RBI regarded put options in favour of non-residents as redeemable instruments, not permitted under the FDI regime. That interpretation was even extended to situations where the put option was not on the company, but the promoters of the company.
On a separate count, taking a cue from SEBI, the RBI also took a view that a put option provision in an investment agreement would qualify as a ‘option’ or an over the counter derivative, which is not permitted under the FDI route. That view was taken despite the fact that no separate price was paid for the optionality, and the optionality could not be traded independent of the FDI Instrument.
Having said that, there was no clear written policy that restricted put options, and RBI’s approach was seen to be on a case-to-case basis, typically in cases where the promoters (not willing to honor the put) approached the RBI themselves. However, the aggressiveness with which the RBI implements such an unwritten policy was remarkable. The risk of having a put was not just limited to it being not enforceable, RBI in fact regarded the mere existence of put in a contract as a violation of the FDI Policy and initiated proceedings against the parties for having provided for such options in their investment contracts.
In fact, the Department of Industrial Policy and Promotion (DIPP) had brought in a written prohibition on options in the Consolidated FDI Policy dated October 01, 2011, but deleted that provision within 30 days of it in light of industry wide criticism. However, notwithstanding the deletion of prohibition of options, RBI continued with its approach that put options in favour of non-residents were violative of the FDI policy. Please refer to our hotline discussing the change in regulatory policy here and here.
The Amendment, for the first time, provides for a written policy on put options, and in doing that sets out the following conditions for exercise of options by a non-resident:
Shares/debentures with an optionality clause can be issued to foreign investors, provided that they do not contain an option/right to exit at an assured price;
Such instruments shall be subject to a minimum lock-in period of one year;
The exit price should be as follows:
In case of listed company, at the market price determined on the floor of the recognized stock exchanges;
In case of unlisted equity shares, at a price not exceeding that arrived on the basis of Return on Equity (“RoE”) as per latest audited balance sheet. RoE is defined as the Profit after Tax divided by the net worth (defined to include all free reserves and paid up capital)
In case of preference shares or debe ntures, at a price determined by a Chartered Accountant or a SEBI registered Merchant Banker per any internationally accepted methodology.
In a market where IPOs are almost non-existent, put options give tremendous comfort to offshore private equity funds, should a trade sale not materialize within their exit horizons. Put options become even more important for certain asset classes like real estate or other stabilized yield generating assets where secondary sales and IPOs are not very common in the Indian context. The Amendment is a positive development for such players as commercial justifications behind inclusion of options into investment agreements have been recognized, and Indian companies and their founders can no longer treat such rights/options as mere paper rights.
A detailed analysis of the Amendment, its ambiguities and practical challenges are set out herein below.
1. Lock in
2. Will DCF pricing cap still apply, if the exit price for options is higher than DCF
3. Exit price for equity shares
4. Determination of price of convertibles securities
5. Status of existing option arrangements
6. Impact on joint ventures and M&A deals
The Amendment is a welcome development as it gives predictability and commercial flexibility to foreign investors, in relation to contractual provisions, which are fairly standard in the international investment context. However, pegging the exit price for equity to RoE (and not a multiple of RoE that brings the exit price closer to FMV) is likely to be a cause of major concern for investors. While preference shares may be preferred from an exit pricing perspective, Companies Act 2013, which denies the flexibility of voting on as-if-converted basis may galvanize the investors to invest in common equity. The need to amend existing contracts to bring them in line with the Amendment may be a challenging task, especially for most offshore private equity players that would be hesitant to revisit investment agreements if they are close to their exit horizons. What will also be interesting is to see how the term ‘exercise’ is interpreted and whether RBI will require exit pricing as set out f or options to be applicable even when the shares are transferred to the Indian resident granting the option voluntarily, and not in exercise of the option/right.
(Aditya Shukla, Shreya Rao & Ruchir Sinha work with research-based international law firm with offices in Mumbai, Bangalore, Silicon Valley, Singapore, Mumbai and New Delhi.)
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