Twice a year, India's Ministry of Commerce and Industry consolidates and updates the country's foreign direct investment ("FDI") policy framework. Pundits had been expecting the October 2011 update to allow FDI into multi-brand retail and other moves to further deregulate foreign investment into India. The Indian government, however, has surprised the market by moving in the other direction. Not only does multi-brand retail remain off limits to FDI, but the October policy statement has effectively eliminated a common aspect of private equity and venture capital investment in India – the right of foreign investors to force a "redemption" of shares by having the right to put the shares to the issuer or its founder or promoter at a fixed price or internal rate of return ("IRR").
Private equity investments in India are commonly structured as minority investments in closely held companies controlled by a founding family or promoters. Private equity investors, looking for liquidity and to protect against downside risk, often negotiate the right to put their shares to the company or the promoters after a fixed period, if there is not a sale or IPO that occurs before then. The put right is usually at the higher of the purchase price or the fair market value of the company at the time the put right is exercised.
Over the past several years, the Reserve Bank of India (the "RBI") has taken the position that instruments that include a guaranteed return should be treated as debt, not equity, and should be required to comply with the rather onerous regulations that apply to external commercial borrowings (commonly referred to as ECB) in India. For example, in June 2007, the RBI adopted a regulation which made all optionally convertible preference shares equivalent to ECB, and stated that only compulsorily convertible preference shares, convertible into equity within a specified time, and with no redemption option, would be treated as equity for FDI purposes. Over the past several months the RBI has gone further, challenging the validity of preferred equity instruments that contain put options in shareholder agreements with foreign investors and restricting the exercise of existing put options against promoters.
On October 1, the Indian government modified the FDI policy to provide that equity instruments with "in-built" options or supported by options sold by third parties, if issued or transferred to foreign investors, would lose their equity character and such instruments would have to comply with ECB guidelines. Prior to this change, there had been some question about whether it was permissible to include an option on shares in public companies, because the option could constitute a futures contract, and futures contracts are valid only for exchange traded derivatives. By including a no options clause in the FDI policy, the Indian government has effectively prohibited the inclusion of any form of options in FDI contracts, because doing so would make the investment subject to the ECB guidelines.
The new regulation, which was adopted without the typical comment period, effectively prohibits private equity investors from negotiating redemption or put rights that are typical in other countries. Further, the language of the regulation is broad and vague, and does not expressly grandfather existing instruments, so it could be read to have retrospective effect. Accordingly, the regulation could have significant collateral, and perhaps unintended, consequences for new and existing private equity investments from foreign investors.
Some potential impacts of the change, in addition to the effective elimination of put options as an exit route, could include:
- Vague, Undefined Concepts. The language of the new regulations is quite broad and vague. Most practitioners believe the intent is to prohibit put options at a fixed price or IRR. However, a literal reading of the language could be seem to apply to all kinds of options, including drag along rights, rights of first offer, qualified IPO provisions with a minimum price threshold and other similar provisions.
- Joint Venture Structuring. In cases of joint ventures, in the event of breach, change of law or deadlock, the availability of a put or call option on the shares is an essential structuring tool. In many cases, the option attached to the security may be a call held by the foreign investor or a put option held by the Indian counterparty. The new regulations could be read to require such options comply with the ECB guidelines.
- Retrospective Operation. Though the FDI policy takes effect from the date of its issuance and is applied prospectively, because there is no express grandfathering of existing put rights, it is unclear whether such rights would be enforceable. This has already caused significant uncertainty in the private equity community. In addition, the RBI has been challenging the exercise of existing put rights, further muddying the waters in this area.
Options are investment safeguards traditionally provided to investors across the world. The volatility of the stock markets and the complexity of liquidation in India compromises the ability of foreign investors to easily exit their investments. In the short term, the regulations have already caused significant uncertainty regarding enforceability of existing agreements and for new agreements. In the long term, we believe the government will likely clarify the rules to narrow their scope. In the meantime, we have discussed with clients certain alternative structures to provide foreign investors with a similar economic result.
Yash Rana and Brinda Dutta are based in our Hong Kong office
Goodwin Procter LLP is one of the nation's leading law firms, with a team of 700 attorneys and offices in Boston, Los Angeles, New York, San Diego, San Francisco and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.
This article, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. © 2011 Goodwin Procter LLP. All rights reserved.