Impact of revised pricing guidelines

By Pooja Ramchandani, Amarchand & Mangaldas & Suresh A Shroff & Co
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The Reserve Bank of India (RBI) recently amended the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations 2000 (FEMA Regulation) with respect to the issue price for a preferential issue of shares by unlisted companies in India. The amendment came into effect on 21 April.

Pooja Ramchandani Senior associate Amarchand & Mangaldas & Suresh A Shroff & Co
Pooja Ramchandani
Senior associate
Amarchand &
Mangaldas &
Suresh A Shroff & Co

In terms of the amendment the minimum issue price for a preferential issue of shares should be the higher of (i) the fair valuation of shares computed by a chartered accountant or a Category I Merchant Banker registered with the Securities and Exchange Board of India (SEBI) in accordance with the discounted free cash flow (DCF) method and (ii) the price applicable to transfer of shares from residents to non-residents in accordance with the pricing guidelines issued by the RBI from time to time.

Until now, shares of unlisted companies transferred to non-residents were priced according to the guidelines issued by the erstwhile Controller of Capital Issues (CCI). However, the revised pricing guidelines for the transfer of shares, preference shares and convertible debentures issued by the RBI on 4 May, does away with the need for two valuations for preferential issues by unlisted companies and introduces the DCF method in place of the CCI guidelines.

While under the CCI guidelines the fair value of shares was determined by averaging the net asset value (NAV) and profit-earning capacity value (PECV) of a company, DCF uses future free cash flow projections of a company and discounts it at an appropriate rate to arrive at a present value. In doing so it enables an investor to consider the risks associated with future cash flows while determining the price of shares and brings the valuation of an unlisted company on par with the market value.

Even when the CCI guidelines were in place, several valuations including the DCF method were being independently undertaken. The government’s Department of Disinvestment also uses the DCF method particularly in case of the transfer of a business as a going concern. While the change to the DCF method may not impact foreign investments, as investors often pay even more than the DCF floor price, it will affect the pricing of buyback of shares and cause a reduction of capital, thereby increasing the cost of consequential repatriation of funds.

Listed company share transfers

The revised pricing guidelines of the RBI for transfer of shares of listed companies have replaced the ruling market price with the pricing formula for preferential issue of shares and convertible instruments under the SEBI (Issue of Capital and Disclosure Requirements) Regulations 2009.

According to the SEBI Regulations, the price at which a preferential allotment of shares shall take place is the higher of the average of the two weeks and six months look back of the weekly high and low closing prices of shares quoted on a recognized stock exchange, preceding the relevant date. The ‘relevant date’ under the SEBI regulations is 30 days prior to the date of the shareholders meeting to consider the preferential issue. In the RBI’s revised pricing guidelines, the relevant date is the date of purchase or sale of shares.

This change from the prevailing market price to the pricing mechanism under the SEBI regulations creates an anomaly as regards stock exchange transactions. Transactions on the stock exchange can either be an open market purchase in the normal segment, a bulk deal or a block deal. While trading in the normal segment and bulk deals are subject to circuit breakers that are typically a price band of +/- 8% of the previous day closing price, block deals cannot exceed +/- 1% of the previous day closing price of shares.

Prior to this amendment, non-residents were required to ensure that the sale of shares on the floor of the exchange was at the ruling market price or within the permitted circuit breakers or the block deal price. Now, non-residents will need to ensure that the sale price is determined in accordance with the SEBI regulations. It is possible that the price determined according to the SEBI regulations does not meet the circuit breakers or the permitted block deal price.

This change could deter foreign investment as it may impede transactions on the stock exchange by non-residents. Moreover, the intent of SEBI in issuing pricing guidelines for preferential allotment of shares by listed companies was to bring its pricing in line with the prevailing market price so as to protect the interests of public shareholders. Prior to the issue of these guidelines, the price at which a preferential issue took place was unrelated to the prevailing market price. Thus allottees of preferential shares benefited with respect to the share price, as they could purchase shares at a price lower than the market price.

As the transfer of shares of listed companies according to the previous pricing guidelines was in any case at the prevailing market price, the applicability of the current pricing mechanism under the SEBI regulations seems to be extraneous. It will be interesting to see how transactions by non-residents on the stock exchange pans out. (For more information on the regulatory implications, see page 54).

Pooja Ramchandani is a senior associate at Amarchand & Mangaldas & Suresh A Shroff Co.

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Email: shardul.shroff@amarchand.com

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