Central bank liberalizes foreign investment norms

By Sundeep Dudeja and Varsha Nair, Luthra & Luthra Law Offices
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The Reserve Bank of India (RBI) has recently brought about significant changes to exchange control norms which are likely to contribute greatly towards facilitating foreign investments into India and providing commercial freedom to parties in structuring cross-border transactions.

Pricing guidelines eased

The RBI has had a series of flip-flops in the past over guidelines on pricing for acquisition/transfer of shares in an Indian company by non-resident investors, which have ranged from norms based on the discounted cash flow (DCF) method to norms, in relation to foreign direct investment (FDI) instruments with optionality clauses, based on return on equity (RoE).However, the RBI, in line with its latest policy statements, has now decided to take a leap of faith by permitting parties to select any internationally accepted pricing methodology to govern their transactions in respect of unlisted securities, so long as the transaction is on an arm’s length basis. Further, the RBI has retained its fundamental philosophy that a non-resident investing in an FDI instrument should not be granted any assured exit price.

Sundeep Dudeja
Sundeep Dudeja

The new guidelines are a noteworthy step toward capital account convertibility for India. The earlier pricing restrictions were a major irritant for foreign investors who struggled to relate to and comply with the rigid framework prescribed by the RBI. These norms were also often taken advantage of by Indian entities subsequently wishing to renege on their contractual commitments.

DCF valuations were infamously regarded to be reliant on the cooperation and data provided by the management of the target company, which was especially troublesome in cases where relations had soured with investors desiring a smooth exit from the Indian company. The DCF method was also criticized for being too dependent on future cash flow projections, which was biased against companies that were asset heavy and those with long gestation periods. The RoE methodology was also slammed by investors who highlighted the mismatch in needing to comply with the DCF valuation based on future projections on entry into the Indian market and the RoE valuation based on past performance on exit with lesser returns.

The new principles are well balanced as they provide commercial flexibility for parties to choose the most appropriate pricing methodology, while ensuring that there is no undue flight of capital from the country or any schemes to avoid a tax impact. Additionally, by bringing in the arm’s length principle, the requirements under foreign exchange laws and transfer pricing norms are sought to be harmonized.

To be able to effectively derive gains from this positive step, it is vital to avoid any disputes related to choosing an appropriate methodology. The onus is on the parties and their chartered accountants/merchant bankers to adequately justify the valuation. Accordingly, it is advisable for the parties to agree and finalize, at the time of entering into the transaction, the pricing methodology that is to apply to the securities in question.

Newly eligible instruments

Warrants and partly paid shares were traditionally not considered as capital and investments even in automatic route sectors could only be made with prior approval of Foreign Investment Promotion Board, which was time consuming and tedious. However, the RBI has now permitted partly paid shares and warrants to be issued to non-residents for sectors or activities under the automatic route subject to certain conditions. For example, the pricing and/or conversion formula for the instruments must be decided and 25% of the total consideration must be brought in upfront, with the residual 75% to be brought in within 12 months for partly paid shares and 18 months for warrants. Larger issues over a prescribed threshold do not have to adhere to these time periods.

Varsha Nair
Varsha Nair

This measure is welcome since warrants and partly paid shares bring significant flexibility, both to the company (in terms of raising capital) and the investor, which has the scope to stagger payments at a pre-agreed price, based on the requirements of the company. Allowing such instruments under the automatic route will provide significant freedom to parties to structure their investments.

That said, it would have been preferable had the norms allowed the parties to choose the pricing for warrants based on valuation computed either at the time of issuance or on conversion, which is permitted under Securities and Exchange Board of India guidelines.

Further, practical guidance in terms of using such instruments to fulfil minimum capitalization requirements in certain sectors and the process to be followed on forfeiture of the upfront payment would also be helpful.

In conclusion, the latest reforms from the RBI are encouraging and signal a marked shift toward promoting party autonomy and boosting investor sentiment by making the regulatory climate in India more mature and stable. The RBI needs to continue working in this direction by rationalizing regulation regarding investment, without fear of misuse, while ensuring pragmatic facilitation.

Luthra & Luthra Law Offices is a full-service law firm with offices in New Delhi, Mumbai and Bangalore. Sundeep Dudeja is a partner and Varsha Nair is an associate at the firm.

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