Tuesday, April 27, 2010

Changes to Minimum Pricing Norms for FDI in Unlisted Companies

(The following post is from Tanmay Amar, senior associate at Luthra & Luthra. Tanmay discusses a significant change to the minimum pricing norms for issue of shares by Indian companies to foreign investors. This change is bound to affect the manner in which valuations are to be arrived at, especially for investments by financial investors such as private equity funds. It is not clear as to what the motivation behind this change is, but it is likely to place restrictions on the flow of foreign investment into unlisted companies)

The Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 (the “FEMA Regulations”) have been recently amended to include a significant change regarding minimum pricing norms. The Reserve Bank of India (“RBI”) has altered the mechanism for computing the base price for issue of shares by an Indian unlisted company to a non-resident. The same was notified in the Official Gazette on April 21, 2010, although the Gazette notification or the amendment itself is apparently yet to be made available on the RBI website.

Until now, the price for issue of shares of unlisted Indian companies to a non-resident could not be less than the price computed by a chartered accountant (“CA”) in accordance with the guidelines issued by the erstwhile Controller of Capital Issues (“CCI value”). As the CCI value was based on historical performance parameters, it often tended to be relatively moderate.

Post this amendment, for a new issue by an unlisted Indian company to non-residents, the base price would be the higher of (i) the fair value computed by a CA/ Merchant Banker, as per the discounted free cash flow method (“DCF Value”), and (ii) (where the issue of shares is on a preferential allotment basis) the price applicable to transfer of shares from a resident to a non-resident, as per guidelines notified by RBI. The relevant provision is as follows:

In Schedule 1 [of the FEMA Regulations], for paragraph 5, the following paragraph shall be substituted, namely:--

“5. Issue price

Price of shares issued to persons resident outside India under this Schedule, shall not be less than—

(a) the price worked out in accordance with the SEBI guidelines, as applicable, where the shares of the company [are] listed on any recognised stock exchange in India;

(b) the fair valuation of shares done by a SEBI registered Category-I Merchant Banker or a Chartered Accountant as per the discounted free cash flow method, where the shares of the company [are] not listed on any recognised stock exchange in India; and

(c) the price as applicable to transfer of shares from resident to non-resident as per the pricing guidelines laid down by the Reserve Bank from time to time, where the issue of shares is on preferential allotment.”
Since the base price for issue of shares is linked to the price for transfers, it is necessary to note that currently the price applicable to transfer of shares (for unlisted companies) from a resident to a non-resident is the CCI Value. As yet, no amendments seem to have been announced to such pricing guidelines for transfers, and even assuming any amendments have been effected, they have not been widely publicized.

Till such time that RBI amends the pricing guidelines for transfer of shares of an Indian company from a resident to a non-resident, an anomaly will remain, whereby the issue of shares to a non-resident will be subject to a base price which is the higher of CCI Value and DCF Value. However, it may be possible for an Indian company to issue shares to a resident entity, which entity may immediately thereafter transfer the shares to the non-resident, at a price which is subject only to the CCI Value and not the DCF Value, and therefore frustrate the intention behind this amendment.

While the CCI Value was computed as per a given set of regulator-issued guidelines which were fairly detailed, I believe that there is much scope for ambiguity in computing the DCF Value. Perhaps an accounting professional may be able to elaborate.

DCF Value is generally likely to be higher than CCI Value and could challenge private equity valuations in on-going deals, as well as closed private equity deals or joint ventures, which provide for multiple investment tranches or other scenarios where a non-resident is to be issued further shares at a subsequent point of time.

Certain news reports speculating on the amendment seem to indicate that it may have been RBI’s intention to replace the base price for issue of shares from CCI Value to DCF Value. However, going by the drafting, it appears that (in all cases involving preferential allotments) two separate computations for the CCI Value and DCF Value will be required and the higher of the two will be the base price. Perhaps this may be to guard against the ambiguity in DCF Value computation, which could possibly be exploited, in certain cases, to obtain a DCF Value which is lower than CCI Value.

- Tanmay Amar

(Update: Please see further developments in this subsequent post)


Nitish said...

Why has 5 (c) been qualified for preferential allotment? Considering that pricing for rights issue is dealt with in Reg-6, what other modes of share allotment was the RBI contemplating? Another possible interpretation could be that for pref allotment, only cci would be used-but then that would be defeating the amendment altogether.
Further, considering "; and" has been used after (b), (c) should also apply to (a) - which would result in market price being compared with market price in the case of a listed company.
Shoddy drafting I'd say.

Jay said...

Tanmay - dont quite think your analysis and view, albeit being the "safest" one to adopt, about the interpretation of 5(c), is what was intended by the legislature.
In my view, the intent was to ensure that SEBI guidelines was adpoted for listed companies and DCF valuation was adhered to for unlisted companies. In that sense, (c) clearly looks like an addition that has no meaning. The point is this surely warrants a clarification, but such time what should be the advise to clients? I am very averse to advising higher of the DCF and CCI valuations - that, to my mind, is completely incorrect.

Tanmay said...

Hi Jay!

Thanks for your comment. As I've mentioned, it does appear from media reports that it may have been RBI's intention to replace the CCI value with DCF Value, as the base price. However, we have no official / formal indication of the same. And the provision does merit some clarification.

That said, going by the existing drafting, if we take your interpretation, then limb (c) is rendered completely otiose, and as per principles of statutory interpretation, an interpretation which renders any provision(s) meaningless must, as far as possible, be avoided.

Based on the same, it would be the safest and perhaps the most prudent interpretation to state that the base price would be the higher of DCF and CCI Values.

As regards advice to the clients, till such time that a clarification is issued, it would be a minor inconvenience to them in terms of cost and time spent in obtaining an extra valuation.

However, given that base price can, henceforth, certainly not be lower than DCF Value and the CCI Value would, in all probablility be lower than the DCF Value, there may not be any adverse practical impact of taking the interpretation I suggested, while advising the clients. And it would have the huge benefit of the client avoiding being the guinea pig in any potential regulatory action/ compounding.

Jay said...

Tanmay - thanks for the response. Did bear in mind that 5(c) could be rendered otiose; but legislative 'over-zealousness' leading to bad-drafting will certainly have a terrible impact on deal valuation and on the market, as a whole! As business lawyers, we must bear client interests in mind as they will need to go in for higher valuation as DCF will certainly be higher than CCI valuation (unless 'innovative' CAs/Merchant Bankers find a way out). Perhaps we can delve further on this using the 'pref allotment' language added in the end of 5(c) and use that to make some sense of the entire amendment. Will let you know if i do stumble upon / discover 'another' interpretation... till then, i am not advising my clients to go in for 2 valuations!

Mihir Naniwadekar said...

Do these circulars apply to private companies seeking to issue shares to their foreign parent company, in pursuance of a proposed increase in capital? Supposing an Indian subsidiary (private company) wishes to issue shares to its parents, can it do so at the face value of the shares?

Mihir Naniwadekar said...

(The above comment was added by Rajesh M.J.)