RBI allows foreign investors to use 'Put' and 'Call' options

NEW DELHI: After months of dithering, the Reserve Bank of India has allowed foreign investors to use ‘call’ and ‘put’ options to structure their investments in India. But experts said the stringent valuation restriction is detrimental to new investments or joint ventures.

RBI has amended the foreign exchange management regulations to allow use of these financial instruments, which are extensively used by private equity players for structuring of cross-border mergers and acquisitions. “Further, shares or convertible debentures containing an optionality clause but without any option/right to exit at an assured price shall be reckoned as eligible instruments to be issued to a person resident outside India by an Indian company,” RBI said in a notification published in the gazette.

A ‘call’ option allows a holder to buy shares in an entity at an agreed price while a ‘put’ option allows an investor to sell. Though popular, these instruments had remained out of RBI’s favour as it was worried that they bring in foreign debt disguised as equity.

Put options, which give special rights to foreign investors to sell back equity if certain conditions such as timely listing are not fulfilled by the Indian company, were seen largely as facilitating debt flows that would go out after a certain period. “This is a long-term reform measure that would lead to markets having to treat shares as shares. There could be short-term pain but it is good for the future,” said Somasekhar Sundaresan, partner at J Sagar Associates. The issue has been hanging fire since 2011 when the Department of Industrial Policy and Promotion (DIPP), through a press note, banned these instruments but soon retracted under intense lobbying pressure.

Last year, RBI, finance ministry, Securities and Exchange Board of India (Sebi) and DIPP reached an understanding to allow them with a one-year lock-in, after which Sebi announced changes in regime for listed companies in October.

“This is a good step to at least bring clarity on the issue that has been pending for long. The notification is line with RBI’s continued stand that guaranteed exit provisions to non-resident investors should not be permitted and treated as external commercial borrowing,” said Darshan Upadhyay, partner at Economic Law Practice.

Others, however, questioned the valuations norm imposed on exits in the case of unlisted companies. While in the case of a listed company, the share price would be the basis of valuation, in the case of unlisted company, RBI has specified that the exit cannot be at a price in excess of that arrived at on the basis of return of equity as per the latest audited balance sheet.

Experts say this valuation does not take into account the potential of business and can be a “deal killer” as the investor does not get upside of a potentially lucrative business idea “Valuation restriction is, therefore, detrimental to new investments or joint ventures… It is onerous to require the foreign investor to invest at market value but exit only at book value,” said Akash Gupt, executive director at PwC.

“This may have a negative impact on asset-heavy industries and especially those that have just finished their set up/gestation period where the cap on exit value would be considering past profitability rather than the future potential of the business,” said Zulfiqar Shivji, partner and head of transaction advisory and support at BDO India LLP.

Experts instead favour the discounted cash flow method that takes into account potential future cash flows. “The proposed formula can lead to absurd results due to high or low profits or losses as per the last audited financials. It will lead to uncertainty for foreign investors regarding the returns they can expect from selling the securities by exercising the option. RBI should consider DCF method,” said Punit Shah, cohead of tax at KPMG. The notification comes into effect from December 30, 2013.