31 May, 2016
The Early Years
With the creation of the Securities and Exchange Board of India (SEBI) in 1992, the existence of the Controller of Capital Issues (CCI) which was overseeing Indian capital markets was rendered redundant. However, the pricing guidelines issued by the CCI (PG) assumed greater importance despite CCI’s redundancy, given India’s intent to attract foreign direct investment (FDI). This was especially as most FDI transactions were in the unlisted entity space whereas SEBI was regulating listed entities. As such, the PG formulated by the CCI became the guiding principle for various investments into India. As per Reserve Bank of India (RBI) stipulations, the fair value of shares (FV) to be issued/ transferred to non residents (NRs) was to be determined by a chartered accountant (CA), in accordance the PG formula laid down by the CCI.
The rationale behind these stipulations was to garner maximum value and forex for Indian shares and was resultant of the 1991 crisis on balance of payments faced by India. Principles laid down in Press Notes 18/ 1998[1] and 1/2005[2] were also aimed at strengthening Indian promoters. In so far as outgo of currency was concerned, regulatory supervision was exercised to ensure that such outflow would be heavily regulated and minimised. This mindset continued to operate in the new millennium even as substantial liberalisation of sectors took place (in the context of FDI) and even when the context changed from regulation of forex to maintenance thereof.
Methodology Before the Global Financial Crisis
Whilst 2006-2007 saw record FDI inflows resulting in substantial relaxations of the forex outflow regime and tightening of norms to regulate inflows by way of convertible instruments, the ensuing world financial crisis in 2008 effected the move towards fuller capital convertibility. By 2010, most sectors stood liberalised from an FDI standpoint. During this period, the ‘indirect’ foreign investment regime (Press Notes 2[3], 3[4] & 4[5]/2009) and control issues were at the fore. Isolated cases of NRs paying a much higher value than the FV for Indian shares had started to surface, including on accounts of control premium or to ensure economic power, beyond the equity percentage caps.
It was in this background that the pricing regime was reviewed in 2010[6]. The chief argument for such review in the context of the PG was that the PG were inadequate to address valuation of certain non- ‘traditional’ corporates (for instance, IT based enterprises, insurance companies, etc). The change made in 2010 was to enable valuation to be determined by a SEBI registered merchant banker or a CA as per the discounted free cash flow method (DCFM).
The one-size-fits-all approach of DCFM had its own set of problems
A Change in Perspective
While initially welcomed, the straitjacket prescription of the DCFM was questioned on account of its one–size-fits-all approach. Simultaneously, transactions triggered by “put” or “call” options (Options) came up before the RBI. To address this, the internationally accepted pricing methodology duly certified by a CA or a SEBI registered merchant banker (IAPM) was prescribed. When the position regarding the Options was finally cleared by SEBI, pricing guidelines under FEMA were announced by RBI in January 2014[7] to include transactions arising out of such Options, subject to further stipulations. However, the exit of the NR from the equity shares was differentially linked to a price not exceeding that arrived at on the basis of the return on equity as per the latest audited balance sheet.
This differential treatment between equity and convertibles did not go down well with the market and in July 2014[8], the methodology for determining the FV for equity and convertibles was determined to be any IAPM. Further, transactions involving Options were required to have a lock-in of one year or as stipulated in the FDI policy and there was to be no assured return. FEMA also mandated transparency by requiring details of valuation, the pricing methodology followed and details of the certifying agency, to be provided in the balance sheet.
What Lies Ahead
Over the years, the pricing guidelines have thus evolved and have become more liberal and accepted. However some areas of concern items subsist:
Differential treatment for transactions involving purchase by a NR (price to be not less than the FV) and the transaction
involving purchase by a resident (price to be not exceeding the FV). One suggestion could be that this differential be made uniform or at a 1% variation, either way.
Differential pricing from R to NR and NR to R transfers pose challenges when indirect foreign investment transactions are to be priced – the RBI regulations are currently silent on this.
Whilst transparency in pricing and valuation is welcome, apart from the RBI circular of July 2014 to authorised dealers, there is no mention under extant and relevant/ applicable regulations regarding this (e.g. FEMA, company law, etc).
The statement of the Governor of RBI in the 6th Bi-monthly Monetary Policy Statement of February 2015[9] indicates that in the context of FDI in various sectors, the aim is to “to introduce greater flexibility in the pricing of instruments/securities including an assured return at an appropriate discount over the sovereign yield curve through an embedded optionality clause or in any other manner.”
As such, whilst there does appear to a possibility of some legislative concession on this matter, the move towards allowing assured returns at a discount to the sovereign yield curve, for foreign investors appears to be currently fanciful. There are cases currently in arbitration on this topic where a downside protection to equity risk is being sought to be defended. Perhaps the outcome of this case would impact any future approaches. Prima facie, any assurance (including downside protection) may have the effect of conversion of the instrument into a hybrid instrument. With the implementation of the Indian Accounting Standards which are at par with IFRS, “assured returns” may impact the balance sheet, as well. As such, it will be interesting to note how the investor community receives this.
[1] http://dipp.nic.in/english/acts_rules/Press_Notes/press18.htm
[2] http://dipp.nic.in/english/acts_rules/Press_Notes/pn1_2005.pdf
[3] http://dipp.nic.in/English/policy/changes/pn2_2009.pdf
[4] http://dipp.nic.in/english/acts_rules/Press_Notes/pn3_2009.pdf
[5] http://dipp.nic.in/English/policy/changes/pn4_2009.pdf
[6] A.P. (DIR Series) Circular No. 49 dated May 04, 2010
[7] A.P. (DIR Series) Circular No. 86 dated January 9, 2014
[8] A.P. (DIR Series) Circular No. 4 dated July 15, 2014
[9] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=33144
For further information, please contact:
Cyril Shroff, Managing Partner, Cyril Amarchand Mangaldas
cyril.shroff@cyrilshroff.com
