Exits by foreign investors: decoding the pricing norms
March 2017 | SPECIAL REPORT: EMERGING MARKETS – OPPORTUNITIES AND RISK MANAGEMENT
Financier Worldwide Magazine
India is fast becoming one of the largest recipients of foreign direct investment (FDI), aided by the government’s recent effort to improve the ease of doing business. The United Nations ‘World Economic Situation and Prospects 2017’ report has projected the Indian economy will remain the fastest growing large developing economy in the fiscal year 2017 with a growth rate of 7.7 percent.
Over the last few decades, the Indian economy has liberalised in many ways, and recently, there has been a major overhaul of the regulatory framework to align jurisprudence with changing business needs. The GST roll-out, the consolidation of insolvency and bankruptcy laws and amendments to the bilateral international treaties, are a few recent examples. Further, the government has progressively liberalised the FDI regime, be it by increasing the limits on foreign investment across sectors or bringing more activities under the ‘automatic route’ (i.e., where prior government approval is not required). The finance minister of India, while presenting the union budget in the parliament on 1 February 2017, announced that further liberalisation of the FDI policy is under consideration.
While the government is trying to woo foreign investors by creating a business-friendly environment, variations and inconsistencies in the interpretation and implementation of laws have thrown up significant challenges. One prime example is the concern over the regime governing pricing norms applicable to foreign investors looking to exit India. A case in point is the ongoing dispute between Tata Sons and NTT DoCoMo (Docomo). The outcome of this case is being carefully monitored to test the enforceability of foreign arbitral awards in India. Moreover, such rulings are likely to impact overall business sentiment in India and so are of great importance in any assessment of the country as an investment destination.
Exchange control rules laid down by the Reserve Bank of India (RBI) impose pricing restrictions on the acquisition and disposal of shares in Indian companies by foreign investors. Briefly, the ‘fair value’ serves as a floor or a cap on the price, depending on whether the foreign investor is acquiring from, or selling to, an Indian resident. In 2014, the RBI rationalised the pricing guidelines for unlisted companies from the discounted free cash flow and return on equity methodologies to ‘internationally accepted pricing’ methodology. The fair value for unlisted companies is calculated using any internationally accepted pricing methodology on an arm’s length basis. The new policy has given investors more freedom and flexibility to negotiate transactions based on commercials agreed between parties. In the case of listed companies, fair value is a function of the prevailing market price on the exchange, prior to the completion of the transaction. Any share transfer or issuance which does not comply with the applicable pricing guidelines would require the prior permission of the RBI.
Lately, the RBI has permitted payment of a portion of the purchase consideration for transfer of shares between a resident Indian shareholder and a non-resident on a deferred basis, subject to certain conditions. Parties involved in cross-border transactions now have greater flexibility in structuring payments, particularly in cases where the creditworthiness of the seller is in doubt.
Evolution of put option and enforceability
A put option is a common commercially agreed term characteristically found in investment and joint venture agreements. It is a right (but not the obligation) of a shareholder in a company to sell his shares to another person at a pre-agreed price or at a price determined in a pre-agreed manner. Often, put options are used as an exit mechanism allowing foreign investors to liquidate their investment. It has the benefit of providing both liquidity and a threshold return, depending on the terms of the put option. However, the enforceability of put options has been a debatable topic over the years, with conflicting views across forums. Put options in the case of listed and unlisted public companies were restricted as they did not qualify as ‘spot delivery contracts’ under the Securities Contracts (Regulations) Act, 1956. Despite this, put options have been a popular tool for private equity investors and other foreign investors. However, over the last few years, without any specific legislative change, the RBI has adopted a view that instruments with put options constituted debt instruments and hence could not fall under the FDI policy.
With recent amendments to the Companies Act, 2013, and change in stance by the Securities and Exchange Board of India (SEBI) and the RBI, put options are now recognised by the regulators. In October 2013, the SEBI rescinded its previous notification which prohibited contracts other than spot delivery contracts or those entered into through the stock exchange mechanism and legitimised put and call options. Following the change in policy stance by the SEBI, the RBI too recognised put options subject to the condition that the non-resident investor is not guaranteed any assured exit price at the time of making such an investment and shall exit at the fair price calculated at the time of exit. Curiously, these conditions were imposed retrospectively and therefore directly affected the enforceability of put option contracts entered into prior to the date of these conditions. As a result of this, a number of put option contracts have come under question and several have entered dispute resolution.
One of the more prominent examples of a dispute involving put options is that between the Tata Sons and Docomo. The price which Docomo gets to exit its investment in a joint venture with Tata Sons is the bone of contention in the ongoing dispute. In 2009, Docomo acquired 26.5 percent in Tata Teleservices Limited for approximately $2.5bn. The shareholders’ agreement it signed with the Tatas had a put option which gave Docomo a right to sell its stake at ‘fair value’ or 50 percent of the acquisition price, whichever is higher. Tata Sons had the obligation to provide an exit opportunity to DoCoMo by either arranging for another person to buy the shares or buying DoCoMo’s shares at the agreed price.
In 2014, Docomo wanted to exit its investment and sought a price of about INR 58 per share, around 50 percent of its acquisition price, which was higher than the fair value.
As Tata Sons failed to find another purchaser to buy the shares, it agreed to buy the shares at the assured price and approached the RBI for its permission to go ahead since the price at which the sale was to be undertaken was in excess of the fair value of the shares. The RBI refused to grant permission citing the new rules that prohibit put options with an assured price at exit.
Invoking the arbitration clause in the shareholders’ agreement, Docomo approached the London Court of International Arbitration (LCIA) to resolve the dispute. The LCIA ruled in favour of Docomo and ordered Tata Sons to pay $1.17bn to Docomo for breach of contract.
Docomo thereafter approached the Delhi High Court for enforcement of the foreign arbitral award. Tata Sons has deposited $1.17bn with the Delhi High Court without prejudice to its legal rights. The RBI pressed to intervene in the ongoing enforcement proceedings and requested the court allow the regulator to state its position regarding the legality of the award. The Delhi High Court has allowed the RBI to file an intervention application in the enforcement proceedings.
Thus, the proceedings continue even though a substantial amount of time has elapsed and even though Tata’s stated position is that they desire to adhere to the put option, but are hamstrung by the regulations.
In a number of other cases, particularly in connection with contracts entered into prior to 2014, Indian promoters have sought to avoid their put option obligations by obtaining guidance from the RBI to the effect that the put option is contrary to the regulations. This has made several foreign investors wary of entering India, since they view this as retrospective legislation prejudicing only foreign investors.
The revision of pricing guidelines to ‘internationally accepted pricing’ methodology is a move in the right direction as it indicates a shift in the RBI’s approach from heavily regulating cross-border transactions to providing greater freedom and party autonomy. The RBI has also taken a significant step by permitting deferred consideration mechanisms.
However, the Tata-Docomo dispute is an example of the legal risks associated with foreign investments in India, due to ambiguities in the regulatory regime. It would be interesting to see if the RBI changes its stance and permits assured returns on investments made by non-resident investors, or whether this be disregarded as a one-off case. A reasoned and structured approach to settle this dispute by the regulators and the Indian courts will boost the confidence of foreign investors.
Many foreign investors predicate their investment on the existence of an enforceable downside protection mechanism – be it put options, liquidity preference or penny warrants. However, under the current regime, many of these mechanisms suffer from regulatory infirmities, primarily due to the variation between the inherent value of the concerned security and the value that the downside protection mechanism is supposed to provide. Regulators in India may need to consider introducing a more flexible approach on these mechanisms, whereby, within reasonable limits (for example, treating the value at the time of investment as a base), such downside protection mechanisms can be made more effective and enforceable.
Ankit Majmudar is a partner and Shriti Shah is an associate at Platinum Partners. Mr Majmudar can be contacted on +91 22 6111 1900 or by email: firstname.lastname@example.org. Ms Shah can be contacted on +91 22 6111 1900 or by email: email@example.com.
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Ankit Majmudar and Shriti Shah