Tuesday, June 8, 2010

More on the Pricing Guidelines for Foreign Investment

(The following post is contributed by Raghav Sharma, who is an associate with a law firm in Delhi)

This post relates to Mr. Somasekhar Sundaresan’s article titled “RBI cuts sorry figure over norms for share transfers” wherein the author has highlighted certain ambiguities arising from the Reserve Bank of India’s (“RBI”) A.P. (DIR Series) Circular No. 49 dated May 4, 2010 (the “May Circular”). This article, which has been published in Business Standard’s edition on June 7, 2010, makes a very interesting reading for those who regularly come across difficult pricing issues in cross border transactions. Below are a few observations regarding the arguments canvassed by Mr. Sundaresan (I hope this would offer some food for thought for all of us):

Argument
Counter
In relation to NRIs and FIIs the new pricing norms stipulated under the May Circular are in conflict with already existing exchange control rules which allow NRIs and FIIs to trade on the stock exchange without adhering to any special pricing norms.

The May Circular amends the pricing guidelines stipulated under A.P. (DIR Series) Circular No. 16 dated October 4, 2004 (the “October Circular”). The May Circular includes NRIs and FIIs in the list of eligible non-resident transferees while prior to this, NRIs and FIIs were not eligible as transferees under the October Circular. However, as per paragraph 4 of the May Circular, it only amends paragraphs 2.2 and 2.3 of the Annex to the October Circular (dealing with pricing) and all other instructions of the October Circular remain unchanged.

Paragraph 2.1 of the October Circular (which has not been amended by the May Circular) states that the pricing guidelines stipulated therein are applicable to transfers from residents to non-residents or vice versa, by way of sale under “private arrangement”. The crucial term is “private arrangement” which according to common understanding is a transaction where the buyer and seller know each other’s identities. Such a transaction may also occur on the stock exchange e.g. a block deal.

The exchange control rules which allow NRIs and FIIs to sell on the stock exchange without any price restriction are those stipulated under Schedule 3 and Schedule 2 of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 (“FEMA 20”) respectively, i.e. the portfolio investment route. In such transactions, the buyer and seller do not know the identity of each other and the sale and purchase occurs on the normal segment of the stock exchange. Therefore, there does not appear to be any conflict as argued by Mr. Sundaresan.

The only effect of the May Circular is that transfer by a resident to an NRI or an FII under Regulation 10A (b) of FEMA 20 can take place under the automatic route if the pricing guidelines are adhered to. Under the October Circular, NRIs and FIIs were not eligible transferees and thus, transfer by a resident to NRIs or FIIs by way of private arrangement would have required approval under Regulation 10A (b) of FEMA 20.
One of the consequences of applying the SEBI guidelines applicable in case of preferential allotment to transfer of shares of listed companies from residents to non-residents or vice versa would be that in case of companies whose equity shares have been listed for less than six months, the parties could potentially violate the foreign exchange law by either receiving less than the floor price or paying more than the ceiling price.

It seems that the reference in this argument is to Regulation 76(3) of the Securities Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2009 (“ICDR Regulations”) which requires recomputation of issue price of shares allotted on preferential basis in similar circumstances and payment of differential by the allottee to the issuer company.

However, such a consequence does not flow from the text of the May Circular. The May Circular does not incorporate all the provisions of Regulation 76 by reference. It only adopts the SEBI pricing formula as a standard for determining the sale price while taking the relevant date to be the date of purchase or sale of shares. Mr. Sundaresan’s view appears to be a remote possibility as the text of the May Circular does not warrant the conclusion that the specific principle of recomputation specified in Regulation 76(3) was intended to be adopted in the May Circular.
SEBI has not envisaged a preferential allotment being made within two weeks of listing of a company. Thus, the price formula would not work in such cases and as a consequence of this no cross-border transfer of such shares may legitimately take place during such period.

Chapter VII of the ICDR Regulations (which deals with preferential allotment) does not prohibit a preferential allotment within two weeks of listing of a company. Assuming that the period of listing of the company is less than two weeks from the relevant date, Regulation 76(2) provides that where equity shares have been listed for a period less than six months as on the relevant date, then the floor price for allotment has to be higher of the following:
(a)    price at which equity shares were issued by the issuer in its initial public offer or value per shares arrived in a scheme of arrangement pursuant to which shares were listed, as the case may be, or

(b)   average of weekly high and low of the closing prices of the related equity shares quoted on the recognised stock exchange during the period the shares have been listed preceding the relevant date.

There is no provision in the ICDR Regulations which prohibits a preferential allotment being made within two weeks of listing of a company and appropriate pricing formula has been prescribed.

- Raghav Sharma

2 comments:

Somasekhar Sundaresan said...

A good debate is always welcome.

First, there is no point in having two price parameters for the same transaction by the same person. If the price at which an FII could puchase listed shares would be regarded as being a fair price, when bought at the ruling market price, it is not quite logical to say that the same FII may buy it off-market should be at a price based on historical average price.

Until the May Circular was issued, it was apparent that purchases by FIIs and NRIs need not be covered by a minimum price regime at all since they are free to buy in the market, and in any case, any person resident outside India could purchase at the ruling market price. Bringing in a distinction in a manner that creates inexplicable dichotomy is precisely what the comment is about.

Second, when a price formula is incorporated by reference by the RBI in exchange controls, it would naturally follow that all the terms and conditions for price computation would have to be adopted. Reading down the formula when the price formula has been clearly cross-referenced and adopted, would be facile. This is precisely why policy-making ought to be unambiguous. One can raise such arguments of reading down when faced with a show cause notice from the Directorate of Enforcement, or when presenting a case for compounding, but such an argument would be an argument in defence in expensive regulatory proceedings and litigation - not a good predictable environment for carefree investing.

Third, the column in Business Standard said preferential allotment within two weeks of listing is not "envisaged". It is not right to read Regulation 76(2) without reading regulation 76(3), which reads as:-

"(3) Where the price of the equity shares is determined in terms of sub-regulation (2), such price shall be recomputed by the issuer on completion of SIX MONTHS from the date of listing on a recognised stock exchange with reference to the average of the weekly high and low of the closing prices of the related equity shares quoted on the recognised stock exchange DURING THESE SIX MONTHS and if such recomputed price is higher than the price paid on allotment, the difference shall be paid by the allottees to the issuer."

There are two historical average price periods that have to be taken into account for determining the floor price - one is for six months, the other is for two weeks. The ICDR Regulations deal with topping up for a shortfall from the six-month price average, and do not deal with a potential shortfall from the two-week average. Indeed, the policy-makers in SEBI cannot logically imagine a preferential allotment being made within ten working days of completing a public fund-raising.

Fund-raising by a listed company is required to be explained, and it would beat reason to expect a company that raises funds to have an unfulfilled appetite for another round of fund raising. A simple reading of the entire scheme of the ICDR Regulations would show the heightened alert that SEBI places on any future fund-raising after a substantial fund-raising. Even in an IPO offer document, one would have to explain any possibility of future issuance within six months. A qualified institutional placement cannot be made within six months of another qualified institutional placement. One has to read regulatory provisions in their entire purposive scheme and not just from a narrow limited perspective in drawing conclusions about whether or not any situation is envisaged by the regulator.

Finally, for a policy-maker, the easiest way to deal with a problem is to deny that there is a problem. Capital does not draw such solace easily, particularly when an alleged violation could result in a penalty that is three times the amount involved, and when compounding proceedings in an enforcement situation are conducted without transparent and publicly notified paramters for determination of a compounding amount. Good law is one that is predictable, easy to administer, and does not give room for debates like this one!

Jyotika Bajaj said...

Change in situations brings changes in law.

It may be noted that there is a slight difference in the explanation in which the term 'non-resident' has been worded. In the Oct, 2004 Circular, paragraph 2.2 reads out non-resident to include "incorporated non-resident entity other than erstwhile OCB, foreign national, NRI, FII" which has now been changed to "foreign national, NRI, FII and incorporated non-resident entity other than erstwhile OCB".

Neither a foreign national nor an NRI can be 'incorporated'. However, probably to remove possibility of any confusion, the same has been re-worded.

If that be considered, the requirement of prior approval of RBI for the transfers made by a resident to an NRI or an FII were already done away with under paragraph 3.2 of the October, 2004 Circular.

As rightly pointed out by Mr. Sundaresan, not just the SEBI pricing formula is adopted for determining the sale price but also all the terms and conditions are taken into account for price computation of shares.

The revised provision i.e., paragraph 2.2(a) of the May,2010 Circular reads as below:

"(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."

It say "SEBI Guidelines" and not just "SEBI pricing formula".