India: The Curious Case Of Pricing Guidelines

RBI introduces a new standards for pricing guidelines amongst other reforms

  • All pricing guidelines rationalized from DCF / RoE to "internationally accepted pricing methodologies"; and
  • Partly paid shares and warrants can now be issued under automatic route subject to certain terms and conditions.

The Reserve Bank of India ("RBI") this week introduced specific reforms with regard to foreign direct investments ("FDI") in India. Specifically, these reforms are:

  • Revision of pricing guidelines in respect of transfer / issue of shares (with and without options) to provide for greater freedom and flexibility for investors; and
  • Recognition of partly paid equity shares and warrants as "eligible instruments" for the purpose of FDI and foreign portfolio investment (""FPII") under the automatic route.

The reforms have been introduced through relevant amendments to the Foreign Exchange Management (Transfer or Issue of Securities to Persons Resident Outside India) Regulations, 2000 ("TISPRO Regulations") and the issuance of various circulars.1 The amendment to TISPRO Regulations for the revision of pricing guidelines can be found here and relevant RBI Circular No. 4 can be found here. The amendment to TISPRO Regulations with regards to partly paid shares and warrants can be found here and the relevant RBI Circular No. 3 can be found here.

BACKGROUND

Reflecting the evolution of pricing guidelines in line with the change in the business environment, the RBI Governor first indicated the RBI's intention to revise the pricing guidelines with respect to FDI in his First Bi-Monthly Monetary Policy Statement where he stated that it had been decided to withdraw "all existing guidelines relating to valuation in case of any acquisition/sale of shares and accordingly, such transactions will henceforth be based on acceptable market practices."2

The reforms relating to partly paid equity shares and warrants (under review since 2011) come as a pleasant surprise to the market, and once again will provide greater flexibility for facilitating and structuring investments in Indian companies.

POLICY EVOLUTION

Partly paid shares and warrants

Until October 1, 2010, partly paid shares and warrants under the FDI policy were not considered to be "capital" for the purpose of foreign investment. However, Consolidated FDI Circular No. 2 of 2010 (effective from October 1, 2010) stated that partly paid shares and warrants could be issued subsequent to approval by the Foreign Investment Promotion Board ("FIPB"). This policy underwent further change through the Consolidated FDI Circular No. 1 of 2011 (effective from April 1, 2011), which noted that the policy relating to partly paid shares and warrants was under review. This position has been maintained in consequent FDI policies as well.

Pricing Guidelines

The pricing guidelines in case of listed shares have always been based on the price of the share as on the stock exchange3 and this continues under this present set of regulations. However, the policy on pricing guidelines with respect to unlisted shares has been amended over a period of time.

The erstwhile pricing guidelines were first introduced on May 4, 2010 via A. P. (DIR Series) Circular No.49 ("2010 Circular") when the RBI did away with valuation requirements as per the Controller of Capital Issues ("CCI") based guidelines and instead introduced valuation requirements based on the "Discounted Free Cash Flow" ("DCF") method of valuation.

Further, earlier this year, a separate set of pricing restrictions was introduced only with regards to "FDI instruments having optionality clauses".4 The main clarification issued under the Options Circular stated that shares issued to non-residents with options attached thereto would be allowed to be transferred if there were no assured returns.

Specifically:

  • Unlisted equity shares could not be sold at a price greater than the price arrived at on the basis of Return on Equity ("RoE") as per the latest audited balance sheet;
  • Unlisted compulsorily convertible debentures ("CCD") or compulsorily convertible preference shares ("CCPS") could be sold at a price worked out as per "any internationally accepted pricing methodology at the time of exit".

It is not entirely clear why equity shares and convertible securities (with optionality clauses) were provided different treatment, but general market sentiment leaned towards issuance of convertible securities given the greater freedom provided to such instruments. Please see our hotline on the Options Circular and its impact, titled "Foreign Investors Permitted to Put: Some Cheer, Some Confusion" here.

Since, the Options Circular, the RBI has clarified that it would rationalize all pricing guidelines, more formally reflected in the Bi-Monthly Monetary Policy referred to above. The current set of reforms is in furtherance of this intention.

FURTHER REFORMS

Partly paid shares and warrants noted as eligible instruments

Post review by the government and the RBI, and via Circular No. 3 as well as amendments to the TISPRO Regulations, partly paid shares and warrants can now be issued to non-residents (under the FDI and the FPI route) subject to compliance with the other provisions of the FDI and FPI schemes.

With regard to partly paid shares, certain conditions need to be specifically complied with:

  • Pricing of partly paid shares must be determined up front and at least 25% of the total consideration amount is required to be paid up front; and
  • The remaining amount is required to be brought in within a period of 12 months of issuance.

Note: This 12 months period is not required where the issue size exceeds INR 5 billion. Further, a monitoring agency is required to be appointed (in the manner envisaged under applicable SEBI Guidelines) irrespective of whether the company is listed or unlisted, who will monitor the repatriation of monies into India within stipulated time.

For warrants, in line with the requirements of the ICDR Regulations, following are the conditions that need to be specifically complied with:

  • Pricing and conversion formula / price is required to be determined up front and 25% of the total consideration is required to be paid up front; and
  • The remaining amount is required to be brought in within a period of 18 months.

The price at the time of conversion should not be less than the fair value of the shares as calculated at the time of issuance of such warrants. It must further be noted that only companies in which investment can be made under the automatic route, can issue partly paid shares or warrants under this circular. For companies under the approval route, prior FIPB approval will be required to issue partly paid shares or warrants.

All partly paid shares and warrants issued under Circular No. 3 are required to be in full compliance with the Companies Act, 2013 and the Income Tax Act, 1961.

Circular No. 3 also clarifies that non-resident Indians will also be eligible to invest on a non-repatriation basis in partly paid shares and warrants in accordance with the Companies Act, 2013, applicable SEBI Guidelines, the Income Tax Act, 1961 and Schedule 4 to the TISPRO Regulations (which deals with investment by NRIs on a non-repatriation basis).

Circular No. 3 does not specify the consequence of not bringing in the remaining monies (with regard to partly paid shares / warrants) within the above mentioned period. However, as specified under the SEBI regulations, it would likely result in "forfeiture" of the partly paid shares or warrants, although operational details in this regard will need to be specified.

Revised Pricing Guidelines

The DCF based pricing guidelines till date were set out in the 2010 Circular. The pricing guidelines with respect to securities having options, based on RoE, were set out in Regulation 9 of the TISPRO Regulations read with the Options Circular.

Circular No. 3 and Circular No. 4 and the amendments to the TISPRO Regulations have revised the pricing guidelines to be as follows:

DESCRIPTION

PREVIOUS PRICING GUIDELINES

CURRENT PRICING GUIDELINES

Issue of shares

For listed securities:

Price worked out in accordance with the ICDR Regulations issued by the Securities and Exchange Board of India ("SEBI Guidelines")

No amendment to this provision.

For unlisted securities:

Issue price to be not less than the fair value of shares determined as per DCF method.

For unlisted securities:

Issue price to be not less than fair value of shares as per any internationally accepted pricing methodology for valuation of shares on arm's length basis.

Transfer of shares from resident to non-resident

(R to NR)

For listed securities:

Transfer price to be not less than price at which a preferential allotment of shares can be made under the SEBI Guidelines;

For listed securities:

No amendment to this provision.

For unlisted securities:

Transfer price to be not less than fair value of shares determined as per DCF method.

For unlisted securities:

Transfer price to be not less than fair value worked out as per any internationally accepted pricing methodology for valuation of shares on arm's length basis.

Transfer of shares from non-resident to resident

(NR to R)

For listed securities:

Transfer price to be not more than price at which a preferential allotment of shares can be made under the SEBI Guidelines;

For listed securities:

No amendment to this provision.

For unlisted securities:

Transfer price to be not more than fair value of shares determined as per DCF method.

For unlisted securities:

Transfer price to be not more than fair value worked out as per any internationally accepted pricing methodology for valuation of shares on arm's length basis.

Transfer of equity shares having optionality clause*

*Kindly refer to our analysis on scope of optionality clauses below.

For listed securities:

Transfer price to be the market price prevailing at recognized stock exchange where shares are listed.

For listed securities:

No amendment to this provision.

For unlisted securities:

Transfer price to not exceed price arrived at on the basis of RoE as per latest audited balance sheet.

For unlisted securities:

Transfer price to not exceed price arrived at as per any internationally accepted pricing methodology on arm's length basis.

Transfer of convertible securities having optionality clause*

*Kindly refer to our analysis on scope of optionality clauses below.

Transfer price to be price as worked out as per any internationally accepted pricing methodology on arm's length basis at the time of exit.

Transfer price to not exceed price arrived at as per any internationally accepted pricing methodology on arm's length basis.

As we have noted above, the pricing guidelines for listed securities have been mostly left unchanged. Although a case could be made for a more liberal pricing regime when listed securities are traded off the floor / or through off market transactions where value may be a product of negotiation. It is however, equally arguable that off market transactions also have an impact on the market and therefore should be subject to the same pricing regime.

GUIDING PRINCIPLES

As required before, all pricing must be duly certified by a chartered accountant or a SEBI registered merchant banker, and should be adequately disclosed in the financial statements of the company.

The fundamental principle to the newly issued pricing guidelines is that a non-resident investor should not be guaranteed any assured exit price at the time of making of such investment or entering into the investment agreement.

It must further be noted that for optionality based instruments the conditions relating to lock-in for one year or minimum lock-in period relating to the activity (if applicable) shall continue to apply.

WHAT DOES "OPTIONALITY CLAUSE" MEAN?

Although the above mentioned reforms go a long way in rationalizing the pricing guidelines applicable to FDI investments / disinvestments, there is still some ambiguity with regard to certain transfer permutations.

First, it is not clear if this "optionality" reference applies only to 'put options' or if it also applies to other forms of exits as well. Second, a plain reading suggests that even holding securities which have an option / right to exit at an assured return irrespective of the counter party for such rights, is not allowed under exchange control law since such instruments have been classified as "ineligible instruments".

Given that quite a few foreign investors in India currently hold multiple avenues for exit, this clarity will help provide certainty to not just investors but also to investee entities and promoters.

DOING AWAY WITH DCF

In a move that will only boost foreign investor sentiments, the revised pricing guidelines will definitely provide investors (and Indian companies) more freedom and flexibility to negotiate investment / disinvestment transactions based on commercials agreed between parties.

One of the issues with the DCF based pricing guidelines was the dependency on the company for arriving at an accurate valuation. Inputs relating to cash flow projections, current and potential working capital amounts, capital expenditure and other items to determine an appropriate discount factor to cash flows needed extensive company inputs. This left a shareholder in a company relying on the company cooperation to arrive at an accurate amount which was not always available. Under the revised pricing guidelines, fair value can be arrived at without necessarily having to rely on extensive company inputs. This allows investors to determine the fair value and exit even where the company is not cooperating.

Another disadvantage of the DCF based pricing guidelines, (highlighted in our then hotline titled "RBI revises pricing norms for foreign investments" which can be found here) was that the DCF based methodology for fair valuation restricted the valuer from basing his valuations on the assets approach or the market comparables approach. This was particularly problematic in industries with long gestation periods, or for distressed companies which had huge assets in their books but did not anticipate any future cash flows. This is no longer an issue.

UNDERSTANDING "INTERNATIONALLY ACCEPTED PRICING METHODOLOGY AT ARM'S LENGTH"

An important item for consideration is potential disputes regarding pricing methodologies for agreements which refer to exits, purchase or sale at "fair market value". If an agreement does not specifically state which methodology is to be considered, under the revised pricing guidelines it would be possible for parties with conflicting interests to obtain valuations under different pricing methodologies and arrive at completely different (and yet completely justifiable) "fair market values" for the same asset.

A view can, however, be taken that for existing agreements entered into till May 2010 (the date of the 2010 Circular) that CCI based pricing methodology would be applicable, and for agreements entered into after 2010 but before July 15, 2014 (i.e. the date of Circular No. 4) that DCF based pricing methodology would be applicable. But going forward, it would be advisable to ensure that both parties agree to a pricing methodology up front in order to avoid potential disputes at the time of exit.

IFRS 13 "Fair Value Measurement" which sets out the IFRS standards for measuring fair value identifies two broad approaches to fair valuation: (a) market based approach; and (b) income based approach.

Under market based approach, IFRS outlines two techniques, identical / similar instrument technique and comparable company valuation multiples technique. Whereas under income based approach, the DCF technique figures along-side dividend discount model, constant-growth dividend discount model and capitalization model.

In all cases, both IFRS and generally, it must be noted that the choice of a valuation technique is a decision based on the peculiar facts and circumstances of a given transaction, sector and nature of the investee entity. It is likely that now onwards, most investment documents will clearly lay out the methodology which the parties agree to be the "internationally accepted pricing method" for arriving at fair valuation instead of leaving it ambiguous given the potential connotations under the new pricing regime.

Previously, in transactions between related parties, since transfer pricing guidelines (under tax law) were also applicable, share transfers/subscriptions between related parties resulted in the requirement for pricing studies to determine 'arm's length price' that were different from the DCF valuation which was undertaken for exchange control purposes. The liberalization may also mean that a singular study analyzing and concluding the fair valuation at arm's length could be used for both tax and exchange control purposes.

CONCLUSION

The biggest uncertainty for partly paid shares and warrants has always been as to when the balance amount will need to be brought in. By requiring that the full pricing for the partly paid shares and warrants be fixed up front and brought in within 12 and18 months, respectively, the RBI has ensured some comfort is afforded to both the company issuing the securities and the subscriber. This flexibility also enables structuring of earn-outs, post buy-out incentive payments to management and in structuring re-ups.

This full scale revision of pricing guidelines continues the RBI's evolution with regards to how it seeks to regulate transfer / issuance of securities of Indian companies by / to FDI investors. Where previously, cross border transactions were heavily regulated and monitored by the RBI, we are looking at a shift which provides greater freedom and respects party autonomy.

By entrusting valuation intermediaries like chartered accountant and merchant bankers with the right to guide parties to fair valuation based on facts and circumstances of each transfer, the RBI also follows through on the general trend in modern Indian commercial laws where regulatory bodies' are looking to delegate more and more operational regulation to intermediaries.

Footnotes

1 Specifically, relevant circulars are A.P.(DIR Series) Circular No.3 dated July 14, 2014 ("Circular No. 3") and A. P. (DIR Series) Circular No. 4 dated July 15, 2014 ("Circular No. 4").

2 Para 24, Reserve Bank of India, Dr. Raghuram G. Rajan, Governor, First Bi-monthly Monetary Policy Statement, 2014-15, April 1, 2014 available at http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=30911 (last visited on July 17, 2014)

3 Pricing guidelines are as prescribed by the Securities and Exchange Board of India ("SEBI") (Issue of Capital and Disclosure Requirements) Regulations, 2009 ("ICDR Regulations") in case of preferential allotment

4 Reserve Bank of India, Foreign Direct Investment- Pricing Guidelines for FDI instruments with optionality clauses, A.P. (DIR Series) Circular No. 86 dated January 9, 2014 ("Options Circular"). Please note that TISPRO Regulations were also amended in furtherance of the Options Circular.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions