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RBI Liberalizes Pricing Norms: Impact On FDI Structures?

Published on Tue, Jul 15,2014 | 08:55, Updated at Wed, Jul 16 at 18:37Source : CNBC-TV18 |   Watch Video :

First there was CCI, then there was DCF and this year brought RoE (Return on Equity). And now there is nothing! In a landmark change, the RBI no longer prescribes any one valuation method for the entry and exit of foreign investors. It permits the use of any internationally accepted pricing method. This is very good news for foreign investors and for the India investment story. For more on this we are joined by Abhijit Joshi of AZB and Ashwath Rau of Amarchand Mangaldas.

Doshi: Let us start first by talking about how this marks a landmark shift in Reserve Bank of India's (RBI) thinking process. We saw the first signs of this in January this year when they put out the Call and Put Option notification which was otherwise very adverse because they linked it for unlisted shares to RoE but when it came to compulsorily convertible debentures or preference shares, they had included the option of using any internationally accepted pricing methodology. That was the first sign that maybe RBI is looking to shift its decade old attitude of prescribing a valuation method. Then we saw further reference in the RBI governor's monetary policy statement in the months that followed and now we finally have this new policy. Big change in the way RBI looks at FDI entry and exit?

Joshi: Absolutely big change but at the same time, late change because prescribing valuations is a difficult task. Even courts have held in the schemes of mergers that they are no experts as to how value of shares can be worked out. I think the concept out here was a fair value concept and what the fair value should be whether it should be the Commodity Channel Index (CCI) pricing, whether it should be Discounted Cash Flow (DCF) was best left to the businesses and people who know valuation. So I think it is a great move, it is a move towards the right direction, it is not for any court or regulator to prescribe what would be fair value, it is for the valuers to prescribe and that is what the RBI has done. I think to that extent, it is a good move for rationalising things going forward on the subject.

Doshi: On this very show, in the past we have criticised RBI for using a very old fashioned approach to foreign investment especially when the country is so desperately needs it. You would say this is a contemporary new fashioned approach finally?

Rau: I would think so and it’s actually a move towards Capital Account Convertibility and a big one because for the first time you have looked at a pricing methodology for foreign investment, both entry and exit where earlier you had prescriptive norms, as he said CCI and then DCF, this is the first time where they have said that any internationally accepted pricing norm as long as done on arm’s length basis is acceptable. So, it’s actually a step away from basically saying parties can determine their own prices.

Doshi: So, when it comes to the entry of foreign investment into the country via the issue of shares to non-resident or foreign investor, that has to be done at a price which is more then the price arrived at via an internationally acceptable pricing method, those last four words used to be earlier replaced by DCF and before that CCI, now you don’t have that prescribed method.

RBI Liberalizes Foreign Entry/Exit
July 8 Notification

‘In case of equity shares, preference shares or debentures of unlisted company, at a price not exceeding that 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.’

When it comes to the transfer of shares to a non-resident by a resident, there is nothing in these notifications that prescribes what format to follow or how this should be done but the expectation broadly is that RBI will issue a circular that aligns that with these notifications.

RBI Liberalizes Foreign Entry/Exit
July 8 Notification

‘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.’

Rau: it already has been. So, effectively both these floor for investment for foreigners as well as the cap for exit by foreigners has effectively being fixed.

Doshi: What I mean is the transfer of shares to non-resident at the point of entry, is that clear?

Rau: That is.

Doshi: That is also clear?

Joshi: They have said that on the transfer section while they have amended schedule one; they have said that in the body of the regulation, they have said that it will be as prescribed by RBI from time to time. But, we are talking about something which is 2-4 hours old and if there is any issue in terms of drafting anomalies that have remained, that will be sorted out, the message is loud and clear.

Doshi: So you fully expect that even in entry of foreign investment via the transfer of shares from a resident to non-resident, the same methodology will apply which is at a price, which is more than a price determined by internationally accepted pricing method.

Joshi: I am quite certain about it because you have done that in ROE or rather the optionalities, they have done it for issuance, and there could also be interpretation that this is done for transfer but that’s the thought process.

Doshi: When it comes to the exit now of foreign investors which involves transfer of shares from a non-resident or a foreign investor to a resident, that has to be done as you put at a price less than the price arrived at via again internationally accepted pricing methodology. So, this is the simplified new regime for the entry and exit of foreign investors. Now, here they have said it has to be done at an arm’s length so the valuation of shares has to be in arm’s length duly certified by chartered accountant or a SEBI registered merchant banker, do you see any problems there at all because some of the experts I was talking to said, well arm’s length could be a grey area but I wasn’t sure whether they were just picking holes.

Rau: The basic objective here is they are saying as long as it’s a value that is sort of market related, a transaction which two unrelated parties would effectively do a transaction, it works. So, as long as the valuer can support his valuation on the basis of internationally accepted valuation norms, I don’t think there should be problem at all.

Doshi: Abhijit, do you see any problem in this perception?

Joshi: I don’t think so and also we have to realize that this valuation is in the context of deciding a floor or a cap, this is not a concept where they want to fix what is the value at which you should transact, its different.. then parties are free to transact so long as they are above or below. So, therefore, I think he is right to the extent that you have to read in context that so long as it’s done by a valuer as prescribed, the rest would be implicit.

Doshi: We also do have now fresh guidance on what the pricing methodology will be for warrants and partly paid shares?

Rau: That’s actually a big one. If you really look at it from a foreign investment structuring standpoint, we have had a lot of grey as far as warrants are concerned, it was under the approval route and we have had views taken by the government in the past which have been unhelpful. So, you had norms applicable to a listed company, lifted in toto and applied to an unlisted company and that just simply didn’t work because you didn’t have a market to determine pricing. So, this is a welcome move, it does give clarity that warrants are finally okay, partly paid-up shares would have been instruments that many investors would have used, they had welcomed that as well. I wouldn’t say it detracts from the change because the change does bring in clarity now. But, I think the one provision which one would have hoped to assume the case was apart from saying 25 percent, it needs to come in for both these instruments upfront. For warrants, the conversion period is limited to 18 months inline with listed companies, may not do the trick, for example, for venture capital investments or even private equity investments and 12 months for partly paid-up, there is an exemption for issue size in excess of Rs 500 crore but it’s still welcomed in that until now, there has either been confusion or prohibition on both these topics.

Doshi: Explain this to me, the warrants would be converted again at any price that is acceptable as per international pricing methodology or is that the effective part in this or why is this so important, he said that these are important ways of structuring FDI

Joshi: What he said and what you are saying are two different things. One, what he is saying is that it has to convert in 18 months and therefore this is what is prescribed in listed companies.

Doshi: That is the Foreign Investment Promotion Board (FIPB) policy for listed companies?

Joshi: But it’s prescribed now to the unlisted companies as well.

Doshi: I got the duration issue that he raised but that standard FIBP policy that applies to listed companies as well.

Joshi: The second point what you are asking is that as to the valuation, the circular states that it should not be lower than the value that was arrived at the time of issuance of warrants. So, the conversion of warrants when it converts should not be less than what it would have been or had it been converted at that time.

Doshi: So that offers a great clarity?

Rau: At one point of time there was a problem where there was an argument being made in the market that the conversion price should meet the valuation methodology at the time of conversion. So, a foreigner coming in had not visibility of whether it is commercially agreed price would be valid at the time of conversion because the underlined valuation methodology value could change, that was clarified by the Reserve Bank of India (RBI), where they said, conversion price has to be determined with respect to the floor that applied at the time of subscribing to convertible instrument.

Doshi: Give me an illustration

Rau: So effectively if I have a compulsorily convertible preference share or a warrant which gives me a certain number of shares at a particular value, let’s assume, I get one CCPS at Rs 100 which is convertible into one equity share, let’s assume at the time of conversion, the value of that company has moved from Rs 100 to Rs 300, I have not left with 1/3rd of share in my example, I effectively get one share at the price at which I had originally invested so I have the benefit of the interim appreciation of the value of the company, which is a logic in why anybody would do a convertible instrument. There is still a floor but the floor is applied at the sensible point of time which is the point at which the investor makes the investment and that theme continues through the set of amendments as well. So, all of this is progressive.

Joshi: He is right but what he alluded to earlier is that they prescribed 12 months for partly paid-up share and 18 months for warrants, in the context of what they want to do is not to issue quasi debt instruments so if you took preference shares, if you took debentures, they talked that they have to be compulsorily convertible but they don’t prescribe a period at which, so long as they are within the overall scheme of the law, it could be converted at anytime. However, when it comes to these partly paid-up and warrants, they prescribed a period.

Doshi: So we have created now distinction…

Joshi: When you are seeing from a listed situation and a Foreign Exchange Management Act (FEMA) perspective, I think they want to say don’t issue an instrument which never converts and you get a benefit of a quasi debt.

Doshi: That’s why they have put in the same thing that applies to listed companies.

Joshi: If that’s the ethos of the underlying principle then 18 months or 12 months is neither here and there, so long as they get paid. I think it’s a fantastic move in terms of recognizing it.

Rau: I am not carrying the RBI's brief but there is logic to what they have done because the difference between CCPS or compulsory convertible debentures (CCD) is that from an exchange control perspective, the company and the country is in the money from day one so the entire investment comes in right upfront. Whereas, if you look at a warrant or partly paid-up, the money comes in subsequently. They are still willing to give the benefit of the upfront valuation provided they bring the entire sum within 12 or 18 months. There could have been an argument for why it shouldn’t have been longer but there is rationale for why there is a time cap for these instruments as opposed to instruments which are in the money from day one.

Joshi: There is a good point there but 12 & 18 months is probably is too short.

Doshi: Well, you can’t have an RBI set of notifications and not complain about something in that. I want to come to the issue of Options, what they have said in these notifications today that the guiding principle will be that the nonresident 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. If you take what they have done with regards to the pricing of entry or exit and now this language when it comes to Call and Put Options, it cleans up the entire space that was so full of controversy right? As long as you are not promising assured returns and you are following an internationally accepted pricing methodology as the floor or the cap, you are in good hands, is that fair? It is a huge change because it is only this year that we infact got any validity or the blessings of RBI when it came to Call and Put Options being valid and now we finally in six months have a very liberal regime for Call and Put Options.

Joshi: Absolutely. Liberal regime yes, I think in a sense you got to step back because if you see where there were protectionist measures for the domestic investors, there used to be press note one. This perhaps is the only piece now remaining in terms between a resident and nonresident in terms of protections. So that particular piece remains, in that I think there has been a great movement. In terms of RBI saying that basically they will not step in the realm of valuations, and that is a uniform principle now throughout whether it is a simple transfer or whether it is a transfer with optionality. So I think it is a good move.

Rau: I think it is clearly a move forward, a welcome move. The problem with the earlier change in January, we discussed it, was effectively the RBI was expecting a foreign investor to come in on the basis of projections which was discounted cash flow (DCF) but get out on the basis of past history. So ROE was extremely prescriptive and that was raising a lot of concern. This particular flexibility as far as pricing is concerned I think will go a long way in giving foreign investors comfort that they can effectively come and do deals on the basis of what the commercial agreement is without the risk of behind the scenes manipulations potentially by their counterparties to thwart commitments that have been made on the basis of even ROE for example. You could try and trigger Options and engineer exercises of Options in a particular period when you had a bad year etc, that is now hopefully with this particular methodology they have left pricing to the parties. As long as a valuer is ready to put his/her name on a valuation, you can do it. There is a safeguard because if you are going to do it on the basis of a valuation and tomorrow it is actually established that the valuation was cooked up, there is still that protection, the RBI has kept from an exchange control standpoint.

Doshi: So now there is nothing stopping you from being able to enter Call and Put Options in a foreign direct investment situation which involves unlisted shares, nothing whatsoever?

Joshi: No, nothing.  

Doshi: Everything has been cleaned up?

Joshi: Except the price. The price will have to be supported by a valuation.

Doshi: So that could be any internationally accepted pricing methodology that you can use right?

Rau: There is still one prohibition that continues, and if you look at it from a policy standpoint I think a lot can be said in favour of that particular limitation which is that there still cannot be an assured price exit which is guaranteed.

Doshi: Yes but I think that mindset has been RBI's position for a long time now, saying we will not allow you to bring in debt emasculating as equity?

Joshi: Exactly, you are subscribing to equity and you should take equity risks.

Doshi: That seems like a fair position right?

Rau: I think it is fair.

Doshi: Let me add a 'but' to this conversation and that is that prospectively you might have now no hurdles left when it comes to the signing of Call and Put Options but what happens to those Options that were already signed? It is a question that needs to be answered, would you consider that they are not valid because they didn't have the blessings of SEBI and RBI anyways till date last year and early this year or what would you apply as the pricing methodology for those, how will this work?

Rau: If you looked at it from a foreign investor standpoint, the element of retrospectivity which is very clearly here because it was mentioned in January and it has not been in that sense modified is a cause for complaint because at the end of the day the foreign investor is going to turnaround and say that if you are applying this position from way back, why did it take you so long to clarify it. The policy argument against that is any arrangement. Now if you really look at what they have done, they have said that as long as it is validly valued, it is valid. The only argument that one can come up with is if I had a fixed price exit sometime ago that was put into place, I would argue that look this particular change is impacting me. The policy argument against that is that at the end of the day equity by its very definition means unlimited downside and upside.

Doshi: What are you going to do practically now for those clients who have signed Call and Put Options a long time ago and now are wondering at what level value can they exit?

Rau: I think the answer is as long as they can find a valuer applying internationally accepted valuation norms...

Doshi: I am sure they will be able to find a valuer very easily.

Rau: That is my point, it is not as simple as that. At the end of the day there is liability for both parties as well as the valuer.

Doshi: What do you mean by liability for both parties and the valuer?

Rau: For a breach of law. If at the end of the day it is established that it was not internationally

Doshi: The valuer is applying a method that suits the foreign investor to exit at what doesn't look like a fixed price but is infact an assured price.

Rau: And that is where the arms length basis will also come through and if its proved that it is not internationally accepted valuation norms on an arms length basis and instead was party accepted norms for convenience to facilitate whatever the business arrangement was, there is going to be liability.

Doshi: I am sure RBI is keeping a close eye on that.

Joshi: Yes the onus is also on the industry because when the regulator liberalises, the industry should comply in letter and spirit. RBI has not dismantled the enforcement directorate and if they find that there is lot of abuse in this relation I am sure they will look into it.

Doshi: In simple English what you are saying is hereon Call and Put Options can be signed as long as you make sure there are no assured returns and all those Call and Put Options that were signed earlier if they were signed on the basis of assured returns - too bad; we need to recalculate and go by whatever the current prevailing fair prices based on the internationally accepted pricing methodology - that's how it will work, right and do not try and rig it because like Abhijit pointed out the ED is still alive.

Rau: He makes a very important point because at a point in time where we are seeing so much legislating for the exception, you have a regulator who has taken that leap of faith and said I want to facilitate commerce and I want to facilitate investment. The last thing that you need is for the market to get smart - to abuse it and then cause the regulated regret what they have done and then rollback.  

Doshi: Maybe this is a question I should have asked on the top - what they mean by internationally accepted pricing methodologies? In my view it could be any pricing methodology whether it is based on return on equity or based on DCF that pertains or suits that industry, that business, etc. Have I understood that correctly?

Joshi: Their views internationally recognised because at the end of the day that is bit of a sophistication but at the end of the day we do not have methodologies which are largely different than how the value anywhere else whether its DCF, whether it is net asset value, whether it is the price earning method, etc and this realm has been crossed in many of the restructuring matters when courts had to pronounce on it and there is no right or wrong method, there could be combination of methods, there could be weightages and there are evolved industry practices, benchmarks, etc… so in that sense if you have internationally recognised principles of weightages - let's say distribution of what you will put in a particular industry or what kind of methodology you will adopted in a particular industry. If it is more accepted internationally then probably that is what you should follow - that is what you are saying because valuation is such a subjective exercise that 'A' valuer can swing from 'B' valuer and both of them have done a good job and therefore what they are saying is, for example if there is a particular method which is more used in infrastructure companies because of long gestation project and which is now the news all over the world and a particular weightage is given then you follow that by and large with your own objective.

Doshi: As simple as that or do you think this in itself could throw up some complication?

Rau: Let us look at it purely from a legal perspective. There is a standard that is applied which is internationally accepted. So, let us assume you have a valuer who is willing to tailor a valuation for you by applying certain principles. The question to us from a compliance perspective at that point is, is there authority through market practice and valuation norms and practices in other markets as well which basically support the valuation methodology. If you do not have adequate support it goes into the route of international acceptance. So, the valuation methodology - what this seeks to do is to basically ensure that you aren't able to cook up methodologies to suite the convenience of a particular case.  

Doshi: Why is this so important - we talked about fairly technical stuff saying this is linked to the way foreign investors look at India? Why is this so important?

Joshi: Because this lends a lot of logic, this lends a lot of commonsense which is not so common and it rationalizes the regulator's outlook, which is to say and as Ashwath alluded earlier, a step towards about capital account convertibility, is to say that you are free to decide among yourself.  

Doshi: It treats investors like adults - probably for the first time in a long-long time, doesn't it?

Rau: It actually gives them the benefit of doubt and basically welcomes them and it actually brings in clarity.  

Doshi: Which is contrast to the way we otherwise do laws in the recent past. Those laws are based on - you could be a crook so we are going to legislate against that, instead here they are saying we trust you to behave like adults and we hope you won't abuse that trust. Big change for the way foreign investors will look at India?

Joshi: Absolutely, because per se you can view this as an event but if you see it as a trend as to what is unfolding, I think you will have more policy which is robust, less prescriptive policy which is a good sign.  

Doshi: Will it be appealing to foreign investors?

Rau: In and off itself the three measures which is option pricing, warrants, partly paid up shares are great developments from a foreign investor's standpoint. It ensures that we are bringing our exchange control regime in line with other markets where it says ultimately let the commercials decide the price at which you enter and exit and basically get an interest in a company. Therefore, at the end of the day a pro investment change on part of the RBI and as Abhijit said its part of list of things they have been doing in recent past, moving towards that direction which is also heartening.


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