Wednesday, May 5, 2010

Changes to Minimum Pricing Norms for Transfers of Indian Securities

(In his previous post, Tanmay Amar examined the new base pricing norms for issue of securities by Indian companies to non-resident investors. He now follows it up with an analysis of the new RBI circular, which is hot off the press, that amends pricing norms for transfers of securities between a resident investor and a non-resident investor)

Introduction

This post discusses the revised guidelines issued by the RBI, vide A.P. (DIR Series) Circular No. 49, dated May 4, 2010 (“New Circular”), for the transfer of securities of Indian companies between a resident and a non-resident. This post is also a follow up on my previous where I discussed the recent amendment to the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 (the “FEMA Regulations”), which brought about a significant change to the norms on computing the base price for the issue of securities of Indian companies to non-residents. Pursuant to such amendment, paragraph 5 of Schedule 1 of the FEMA Regulations was substituted with the following paragraph:

“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.”

Limb (c) above refers to the price applicable for transfer of shares from resident to non-resident as per the pricing guidelines laid down by RBI. The existing pricing guidelines were laid down vide A. P. (DIR Series) Circular No. 16 dated October 4, 2004, which prescribed the base price for such transfers to be the fair value of such shares, as computed by a Chartered Accountant in accordance with the guidelines issued by the erstwhile Controller of Capital Issues (“CCI Value”).

The aforesaid amendment left a small lacuna wherein the base price for issue of securities of an unlisted company was not to be less than price computed as per limb (b) (“DCF Value”) as well as limb (c) - the CCI Value, however in cases of transfer, the base price continued to be CCI Value alone. Hence, it would 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 the amendment. However, the New Circular has resolved this lacuna. It appears that the inconsistency was only due to the timing because the base price for issue of shares to non-residents was amended in April 2010, while the base price for transfer of shares to non-residents was amended only by the New Circular in May 2010.

The New Circular has revised the pricing guidelines for the transfer of securities of Indian companies from residents to non-residents, as well as from non-residents to residents.

Transfer from Resident to Non-Resident

The following changes have been brought about:

Existing Provision
Revised Provision
Transfer by Resident to Non-resident (i.e. to incorporated non-resident entity other than erstwhile OCB, foreign national, NRI, FII)

Price of shares transferred by way of sale by resident to a non-resident shall not be less than

(a)    the ruling market price, in case the shares are listed on stock exchange,

(b)    fair valuation of shares done by
a Chartered Accountant as per the guidelines issued by the erstwhile Controller of Capital Issues, in case of unlisted shares.

The price per share arrived at should be certified by a Chartered Accountant.

Transfer by Resident to Non-resident (i.e. to foreign national, NRI, FII and incorporated non-resident entity other than erstwhile OCB)

(a)     where shares of an Indian company are listed on a recognized stock exchange in India, the price of shares transferred by way of sale shall not be less than the price at which a preferential allotment of shares can be made under the SEBI Guidelines, as applicable, provided that the same is determined for such duration as specified therein, preceding the relevant date, which shall be the date of purchase or sale of shares.

(b)    where the shares of an Indian company are not listed on a recognized stock exchange in India, the transfer of shares shall be at a price not less than the fair value to be determined by a SEBI registered Category – I - Merchant Banker or a Chartered Accountant as per the discounted free cash flow method.

The price per share arrived at should be certified by a SEBI registered Category-I-Merchant Banker / Chartered Accountant.


As seen from the above, the base price for the transfer of unlisted Indian securities has been changed from the CCI Value to the DCF Value. This change was expected and it brings the base price for transfer to non-residents in conformity with the base price for issue to non-residents. Additionally, the reference in limb (c) of Paragraph 5 of Schedule I of the FEMA Regulations would also now be to the DCF Value, thereby simplifying interpretational issues for Indian investee companies as well as non-resident investors.

As regards the change brought about in the base price for transfer of listed securities from residents to non-residents, earlier the base price for such transfers was the ruling market price. Now the base price has been replaced with the price of shares for a preferential allotment computed in accordance with the SEBI Guidelines, i.e., SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009. In accordance with the SEBI Guidelines, the price for preferential allotment (where shares are listed for more than 6 months) shall be not less than the higher of the following:

(a)    the average of the weekly high and low of the closing prices of the related equity shares quoted on the recognised stock exchange during the 6 months preceding the relevant date; or

(b)   the average of the weekly high and low of the closing prices of the related equity shares quoted on a recognised stock exchange during the 2 weeks preceding the relevant date.

As per the SEBI Guidelines, the “relevant date” in relation to listed shares is the date 30 days prior to the date of the meeting of shareholders held to consider the proposed preferential issue. For the computation under RBI’s pricing guidelines, it is the date of sale/ purchase.

This change brings the base price for transfer of listed shares from residents to non-residents in conformity with the base price for issue. However, this may lead to certain strange situations where the non-resident is required to purchase listed shares at a price at substantial variance with the ruling market price if there is likely to be a significant variation in the market price in the last 30 days prior to sale/ purchase.

Generally, the market price of listed shares should be considered the fair market value of such shares, which any investor should be required to pay. Preferential allotments are not made at the ruling market price since the process of preferential allotment takes a few weeks and the news of the preferential allotment itself may impact the market price of the shares and also make the price of allotment uncertain if the same were linked to ruling market price. Hence, a separate pricing mechanism is required, based on the price of the shares during a period prior to the preferential allotment. The pricing mechanism prescribed is aimed at ensuring that the investors/ partners who are allotted shares in a preferential allotment pay at least the fair value of the shares. However, such an elaborate mechanism may not be necessary in cases where an investor purchases the shares at the ruling market price (whether in a transaction on the exchange or an off-market transfer), since the investor would, in effect, be paying the fair value of such shares, by purchasing at the ruling market price.

Hence, the mechanism now prescribed by RBI may cause a situation where the non-resident investor is required to purchase listed shares at a price other than the ruling market price, which may be anomalous.

Transfer from Non-Resident to Resident

In addition to the above changes, RBI has also revised the pricing guidelines in relation to the transfer of securities from a non-resident to a resident. The following changes have been brought about:

Existing Provision
Revised Provision
Transfer by Non-resident (i.e. by incorporated non-resident entity, erstwhile OCB, foreign national, NRI,FII) to Resident

Sale of shares by a non-resident to resident shall be in accordance with Regulation 10 B (2) of Notification No. FEMA 20/2000-RB dated May 3, 2000 which as below:

(a)   Where the shares of an Indian company are  traded on stock exchange,

(i) The sale is at the prevailing market price on stock exchange and is effected through a merchant banker registered with Securities and Exchange Board of India or through a stock broker registered with the stock exchange;

(ii) if the transfer is other than that referred to in clause (i), the price shall be arrived at by taking the average quotations (average of daily high and low) for one week preceding the date of application with 5 percent variation.  Where, however, the shares are being sold by the foreign collaborator or the foreign promoter of the Indian company to the existing promoters in India with the objective of passing management control in favour of the resident promoters the proposal for sale will be considered at a price which may be higher by upto a ceiling of 25 percent over the price arrived at as above.

(b)  Where the shares of an Indian company are not listed on stock exchange or are thinly traded,                            
   (i) if the consideration payable for the transfer does not exceed Rs.20 lakh per seller per company, at a price mutually agreed to between the seller and the buyer, based on any valuation methodology currently in vogue, on submission of a certificate from the statutory auditors of the Indian company whose shares are proposed to be transferred, regarding the valuation of the shares, and
  
  (ii) if the amount of consideration payable for the transfer exceeds Rs.20 lakh per seller per company, at a price arrived at, at the seller's option, in any of the following manner, namely:                    
                         A)              a price based on earning per share (EPS linked to the Price Earning (P/E) multiple ,or a price based on the Net Asset Value (NAV) linked to book value multiple, whichever is higher, or               
                        
                         B)               the prevailing market price in small lots as may be laid down by the Reserve Bank so that the entire shareholding is sold in not less than five trading days through screen based trading system, or

                         C)               where the shares are not listed on any stock exchange, at a price which is lower of the two independent valuations of share, one by statutory auditors of the company and the other by a Chartered Accountant or by a Merchant Banker in Category 1 registered with Securities and Exchange  Board of India.

Transfer by Non-resident (i.e. by incorporated non-resident entity, erstwhile OCB, foreign national, NRI and FII) to Resident
Price of shares transferred by way of sale, by non-resident to resident shall not be more than the minimum price at which the transfer of shares can be made from a resident to a non-resident as given in para 2.2 above.



As seen from the above, the computation of the maximum price for transfer of shares from a non-resident to a resident has been brought in conformity with the computation of the base price for transfer of shares from a resident to a non-resident, and with the base price for issue of shares to a non-resident.

In respect of listed securities, there is no longer any freedom to deviate (up to 5% variation permissible earlier) from the price computed, and no control premium (up to 25% of the price computed allowed earlier) is permissible either.

Furthermore, it may create unusual situations where the non-resident investor is required to transfer the shares of a listed company at a price other than the ruling market value. The value of the shares held by a non-resident will no longer be computed as per the ruling market price, but as per the preferential allotment price. The rationale for having an elaborate mechanism to compute the preferential allotment is explained above. The same may not be applicable in cases of transfer of shares, particularly when a non-resident investor is exiting by selling its shares to a resident. In such cases, it may be more practical to link the base price/ ceiling price to ruling market price or the average price for a more immediate period (as was exiting earlier - average quotations for 1 week preceding the sale 5% variation).

Conclusion

It has been mentioned in the New Circular that the existing guidelines were reviewed in consultation with the Government of India and these revisions appear to be a result of such review. However, the rationale for the changes has not been explained further.

Bringing conformity within the pricing guidelines may be desirable to avoid confusion. Prior to the changes, it may have been possible for a non-resident investor to invest in shares of an unlisted Indian company at a particular price on day 1, in accordance with CCI Value and then exit on day 2, at a much higher price computed as per a completely different method. However, in respect of listed companies, this may lead to certain abnormal situations, as explained above.


- Tanmay Amar

15 comments:

Anonymous said...

Clause 2.3(b) at page 5 of the Circular states (in relation to NR-R transfers) that “where the shares of an Indian company are not listed on a recognized stock exchange in India, the transfer of shares shall be at a price not less than the fair value to be determined by a SEBI registered Category-I-Merchant Banker or a Chartered Accountant as per the discounted free cash flow method.” This should have been “not more than” and not “not less than”.

Do you think this is an intentional departure from the erstwhile policy of having a pricing cap for transfers from NR to R? Any views on this?

V. Umakanth said...

@ Anonymous. Thanks for the pertinent observation. The point has been clarified in the update to the post above.

Anonymous said...

A minor correction to the following para above may also be warranted: "As seen from the above, the computation of the "maximum price" for transfer of shares from a non-resident to a resident has been brought in conformity with the computation of the base price for transfer of shares from a resident to a non-resident, and with the base price for issue of shares to a non-resident".

It should read "minimum" and not "maximum".

V. Umakanth said...

@Anonymous2: The wording should be as it stands, i.e. read "maximum". Since it is a transfer of shares from non-resident to resident, RBI would be concerned about greater moneys (by way of purchase consideration) flowing out of India and would hence imposes a maximum limit.

Anonymous said...

RBI has issued a revised circular clarifying this error. Please see: http://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=5647&Mode=0.

Anonymous said...

Dear Mr. Umakanth,

Please note that the RBI has revised its circular which has been put up on the website. The error pointed out in the first comment has been corrected.

Tanmay said...

Just to add an update on the apparent drafting error in clause 2.3(b) of the New Circular. The para has been deleted by RBI in a new revised circular (http://www.rbi.org.in/scripts/NotificationUser.aspx?Id=5647&Mode=0)

The new para 2.3 (b) in relation to transfer from NR to R has been deleted, in effect leaving the following to be the operative provision for transfer of shares from NR to R for both listed as well as unlisted companies:

“Price of shares transferred by way of sale, by non-resident to resident shall not be more than the minimum price at which the transfer of shares can be made from a resident to a non-resident as given in para 2.2 above.”

Anonymous said...

The RBI has issued a revised Circular correcting the error by deleting Clause 2.3 (b)which was causing the confusion.

V. Umakanth said...

Thanks for all the comments and updates regarding RBI's correction of the Circular. The blog post has now been amended to reflect the corrected position.

pramit said...

So now, for a preferential allotment of a listco's shares to an NR, there will be two valuations:

1. as per Chap. VII of ICDR - 'relevant date' being 30 days prior to EGM.

2. as per the new RBI circular - 'relevant date' being the date of sale/purchase. [Here again, since there's no sale/purchase, do we treat the date of issue as the 'relevant date'?]

The higher of the above two values will be the 'base price'. Is this correct?

Tanmay said...

Hi Pramit!

Actually the issue price for issue of shares to NRs continues to be
not less than the "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". Here there is no reference to the relevant date being any different from that which is provided under the SEBI Guidelines.

In the new para 2.2(a), which deals with transfer from R to NR, it is provided that price for the transfer shall be not less than the price at which a preferential allotment of shares can be made under the SEBI Guidelines. Provided that the relevant date shall be the date of purchase or sale of shares. However, since this para deals solely with transfer, it will have no bearing on the computation of the minimum issue price.

Therefore, in a preferential allotment to NRs, only 1 valuation will be required - the one under the SEBI Guidelines, with relevant date being the day 30 days prior to the general meeting.

pramit said...

Thanks Tanmay.

I would imagine the newly introduced 5(c) of Schedule 1 of FEMA 20 would be relevant for computing the pricing applicable to a preferential issue to an NR. It is on this basis that I thought there was a dichotomy in arriving at the 'relevant date'.

Could you explain why you're saying you'd go with 5(a) as opposed to 5(c) for a pref allotment?

Thanks.

Tanmay said...

Thanks Pramit.

There is room for the interpretation that you are suggesting. However, as you yourself pointed out, this would lead to an onerous burden on the non-residents who will need to subscribe at the higher of the preferential allotment prices computed taking the relevant date as the date 30 days prior to general meeting in one case and the date of purchase in the other case. This will be particularly arduous when the price is computed with respect to date of the preferential allotment, in which case the average prices being taken into account to compute the preferential allotment price, would themselves have been substantially affected by the news of the preferential allotment. It will, in effect, destroy PE investments by non-residents in listed companies.

Courts would always avoid an interpretation which leads to such onerous consequences, when they have more than one interpretative positions open before them.

Further, 5(a) would be rendered practically useless if the interpretation taken were that in cases of preferential allotment of listed securities to NRs, the base price is computed as per 5(c). In the interpretation I have taken, para 5(c) does get rendered redundant now. However, it comes at the benefit of avoiding a completely bizarre interpretation, which would cast undue burden on investors as well as targets and para 5(c) was of some use in the limited period between the notification of the change to the issue price and the issue of the circular changing the computation of the price for transfers.

pramit said...

Thanks Tanmay.

Appreciate your view but I feel that till the RBI comes out with a clarification on this issue, it would be difficult to take the view that 5(c) is redundant. Especially since this is a new entry brought in through this amendment and RBI has specifically addressed the issue of pref allotment.

Hopefully the RBI will clarify this point soon.

Anonymous said...

Thnks Tanmay n everyone for their enlighting comments.. On reading of limb (c) of new issue of shares guidelines i wake of new transfer of shares guildelines too- would like to get a little more clarity, as to the need and usefulness of limb (c), which interalia calculates the pricing of preferential allotment of share with the DCF method. The limb (a) applicable to issue of shares also applies DCF menthod. In light of above facts dont u think limb (c) is redundant in case to issue of shares by unlisted companies.