In the comments section to my previous post on the new FDI policy, reader Menaka highlights another important clarificatory change regarding the policy stance of the Government that now clearly outlaws options in securities held by foreign investors in Indian companies. The relevant clause in Circular No 2 of 2011 is as follows:
220.127.116.11 Only equity shares, fully, compulsorily and mandatorily convertible debentures and fully, compulsorily and mandatorily convertible preference shares, with no in-built options of any type, would qualify as eligible instruments for FDI. Equity instruments issued/transferred to non- residents having in-built options or supported by options sold by third parties would lose their equity character and such instruments would have to comply with the extant ECB guidelines. [emphasis supplied]
Although the Reserve Bank of India has been adopting this stance lately (as discussed here), it is now well-etched in the policy of the Government of India as a formal matter, and not just in the form of interpretation of the regulations. This suggests that the Government has taken strong exception to the use of put options in equity investments as a method of guaranteeing returns to foreign investors and providing financial protection against their investments. It is bound to curtail investments in certain sectors and by specific types of investors (e.g. financial investors such as private equity funds) who tend to rely upon put options in securities as an essential component of the transaction structure.Another aspect to consider is that even though the concern of the foreign investment regulators arises in the context of a “put” option as that may provide the investment with the character of an external commercial borrowing (ECB), a plain reading of the clause in the new FDI policy quoted above is wide enough to extend it to “call” options as well. This would lead to the result that foreign investors holding call options will also fall within the proscription contained in the new policy, although it does not carry the same reasoning for a ban as that of put options.