The Reserve Bank of India (RBI), Foreign
Exchange Division, has revised its guidelines for pricing equity
interests that are transferred between Indians and non-residents of
India. The revised guidelines are contained in notifications
released in April and May 2010, amending the applicable foreign
exchange management regulations. They apply to equity shares,
including compulsorily convertible preference shares and
compulsorily convertible debentures. The revised guidelines will
impact the determination of pricing in certain equity
The revised pricing guidelines appear to be an effort to simplify, consolidate and conform pricing guidelines. For example, under the new scheme, all transfers of listed company shares (whether or not a "preferential allotment" or a brokered, exchange transactions) are to be made using the SEBI guidelines for preferential allotments, and all transfers of non-listed shares are to be made at not less than price determined under the discounted cash flow (DCF) method.
However, a number of new potential problems are created under the guidelines, and questions unanswered. They may become problematic in valuing shares of unlisted companies in which the DCF method would otherwise not be a preferred method of valuation of equity interests.
An Indian company is permitted to issue equity shares to non-residents of India subject to the Government of India's Foreign Direct Investment (FDI) policy. "Non-Residents of India" refers to non-Indian nationals, non-resident Indians (NRIs) and foreign institutional investors (FIIs).
The FDI policy includes restrictions on ownership in certain industry sectors, and pricing guidelines that apply to the transfer by way of sale of any shares between Indian residents and non-residents. Under the previous pricing guidelines, the transfer price for listed companies occurring on a stock exchange was the "ruling market price," and the transfer price for non-listed companies was to be the fair value as determined by an Indian chartered accountant using guidelines issued by the erstwhile Controller of Capital Issues (CCI), the predecessor of the Securities and Exchange Board of India (SEBI).1 The current guidelines for valuing shares are now amended.
The revised pricing guidelines affect the transfer by way of sale of shares in unlisted companies, listed companies and "preferential allotments" made in listed companies.
Transfer by Sale of Shares in Unlisted Companies
The pricing guidelines previously in effect for the transfer by
way of sale of shares of an unlisted company to a non-resident of
India by a resident were intended to ensure that transfers were
made at fair value. The stated objective of the CCI guidelines were
to make the best reasonable judgment of the value of an equity
share of a company based upon the net asset value of the company
and the profits earning capacity value of the company.2
The profits earning capacity value was determined by capitalizing
the after tax profits of a company at prescribed rates depending
upon economic sector.3 This valuation approach relied
upon past profits of the subject company to determine the potential
future earnings capacity of the business.
Under the revised guidelines, the approach taken in the CCI guidelines are abandoned, and the applicable transfer price for unlisted shares is required to be at not less than the price determined based upon the DCF method as determined by a SEBI registered Category - I Merchant Banker or a Chartered Accountant.4 The revised guidelines do not provide detailed guidance concerning the implementation of the discounted cash flow valuation method, such as the range of applicable discounts. Thus in a transfer by way of sale of unlisted shares from a resident to a non-resident of India, it will be necessary for the parties to procure a valuation that is certified by a SEBI registered Category - I Merchant Banker or a Chartered Accountant.5 The valuation prepared by such professional must show, using a DCF method, a valuation not lower than the one negotiated by the transerfee and transferor. It will be submitted as part of the documentation associated with the sale to the applicable authorized dealer branch.
In mandating use of the DCF method for valuing unlisted shares, the RBI presumably determined that projected future cash flows rather than past profitability or existing net assets provides a more appropriate value of equity interests that are not listed on an exchange. It is important to note that the valuation determined by the DCF method would be a "floor." The requirement to utilize a DCF valuation would not be problematic so long as it determines a price that is the same or less than the price negotiated by the parties. However, a practical problem may arise if the shares are associated with a business where future cash flows are expected to be volatile or highly speculative. In those circumstances, a DCF analysis may not be an optimal to arrive at an appropriate valuation, but under the revised pricing guidelines, its use is required.
Transfer by Sale of Shares in Listed Companies and Preferential Allotments
The revised pricing guidelines also impact the valuation method
to be used on the transfer by way of sale of listed companies, and
preferential allotments made by listed companies. The previous
rules contemplated transfers completed on the stock exchange
through a registered merchant banker or stock broker, or off
exchange transfers. In the former case, the transfer of listed
company shares made by way of a sale by a resident to a
non-resident could be made only at a price equal to the
"ruling market price."6 In the latter case,
the price was to be determined by taking the average quotations
(average of daily high and low) for one week preceding the date of
application, and permitted a variation of up to five
percent.7 However, where the shares were being sold by a
foreign collaborator or foreign promoter of the Indian company to
the existing promoters in India with the objective of passing
management control in favor of the resident promoters, the price
could be up to 25 percent over market price calculated in the same
Under the revised pricing guidelines, transfers of listed company shares by residents to non-residents are required to be made at not less than the price at which a preferential allotment may be made under the applicable SEBI rules.9 The applicable SEBI rules for the pricing of preferential allotments is contained in the Issue of Capital and Disclosure Requirements Regulations, 2009. In general, the SEBI rules provide for a calculation based upon an average weekly high and low closing price over a trailing six month period, or a trailing two week period, from the "relevant date."10 There is a slight modification if the allotment is being made by a company that has been listed for six months or more.11
One impact of the revised pricing guidelines is to conform the manner of computing the minimum transfer price of preferential allotments and other transfers by sale of listed company shares from residents of India to non-Residents. Any such transfer must now be priced at least at the market price, determined in accordance with the SEBI rules. Therefore, in a transaction in which a non-resident of India is acquiring shares in a listed company, even if the shares are being acquired other than in a brokered transaction through an exchange, the transfer must be at market price.
The rule did not, however, conform the different pricing requirements that apply when the transfer is being made by non-residents to residents. As noted above, the previous rules permitted up to a 5% variation from the market price when non-residents transferred shares of a listed company in an off-exchange transactions back to a resident of India (up to 25% when control is being transferred). This effectively means that residents could pay a premium of up to 25% above the market price in shares that were acquired from non-residents by residents in control transactions. Curiously, the new rule specifies that such transfers cannot be made at more than the minimum price permitted under the SEBI pricing guidelines for preferential allotments.
The revised pricing guidelines appear to be an effort to
simplify, consolidate and conform pricing guidelines. For example,
under the new scheme, all transfers of listed company shares
(whether or not a "preferential allotment" or a brokered,
exchange transactions) is to be made using the SEBI guidelines for
preferential allotments, and all transfers of non-listed shares are
to be made at not less than price determined under the DCF
However, a number of new potential problems are created, and questions unanswered. Does mandating the use of the DCF approach to all transfers of unlisted shares overly limit the flexibility that a valuation expert may use in trying to accurately value a company? Almost certainly. In arriving at a valuation, a valuation expert might often use a variety of valuation methods, including the previously used net asset value method, or income or cash flow multiples based on market comparables. What if future cash flows are indeterminate? The RBI did not provide guidance for such circumstances, including what range of discounts would be permitted. In addition, it is entirely possible that the DCF approach would result in an amount greater than the amount negotiated by the parties. In such circumstances, the pricing guidelines could directly impact the commercial negotiations.
Another possible area of concern is the disparity in the pricing guidelines concerning the transfer of shares of a listed company from a non-resident to a resident in an off-exchange transaction. In this one circumstance -- and not in any other transfer scenario contemplated by the revised guidelines -- the permissible transfer price is capped at the minimum price permitted by the SEBI guidelines. In all other circumstances, the RBI pricing guidelines set a floor relative to the negotiated price. This would appear to be an attempt to limit the premium that can be charged when transferring shares back to residents, very possibly resulting in the regulatory price determination trumping the commercial one.
We plan to monitor future RBI pronouncements on this topic and bring them to the attention of our clients and friends outside of India who are considering investments there.
1. Clause 2.2, Annex to A.P. (DIR Series) Circular No. 16 dated October 4, 2004 ("2004 Pricing Guidelines").
2. Clause 5, CCI guidelines.
3. Clause 7.1, CCI guidelines.
4. Annex-I to A.P. (DIR Series) Circular No. 49 dated May 04, 2010.
6. Clause 2.3(a)(i), Annex to 2004 Pricing Guidelines.
7. Clause 2.3(a)(ii), Annex to 2004 Pricing Guidelines.
9. Annex-I to A.P. (DIR Series) Circular No. 49 dated May 04, 2010.
10. See Regulation 76, SEBI (Issue of Capital and Disclosure Requirements) Regulations 2009 ("ICDR"). "Relevant date" is defined to mean:(a) in case of preferential issue of equity shares, the date thirty days prior to the date on which the meeting of shareholders is held to consider the proposed preferential issue; provided, that in case of a preferential issue of equity shares pursuant to a scheme approved under the Corporate Debt Restructuring framework of Reserve Bank of India, the date of approval of the Corporate Debt Restructuring Package shall be the relevant date. (b) in case of preferential issue of convertible securities, either the date thirty days prior to the date on which the meeting of shareholders is held to consider the proposed referential issue or a date thirty days prior to the date on which the holders of the convertible securities become entitled to apply for the equity shares.
11. See Regulation 76(1), ICDR. If the company has been listed for less than six months, the shares must be allotted at not less than the higher of: (A) the price at which the shares were issued in such company's initial public offer or the value per share arrived at in a scheme of arrangement pursuant to which the equity shares were listed; (B) the average of the weekly high and low of the closing prices of the equity shares for the period the shares have been listed; and (C) the average of the weekly high and low of the closing prices of the shares during the two weeks preceding the relevant date; provided, the price must be recomputed by the issuer on completion of six months from the date of listing with reference to the average of the weekly high and low of the closing prices of the shares during such six months and if such recomputed price is higher than the price paid on allotment, the difference must be paid by the allottees to the issuer.
O'Melveny & Myers LLP routinely provides advice to clients on complex transactions in which these issues may arise, including finance, mergers and acquisitions, and licensing arrangements. If you have any questions about the operation of the applicable statutory provisions or the case law interpreting these provisions, please contact any of the attorneys listed on this alert.
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