RBI On Call & Put Options

- A non-resident has to buy from a resident at not less than DCF based valuation, sell to a resident at not more than DCF based valuation and in the case of selling to a resident using an option – Sell at not more than price arrived on basis of RoE in latest audited balance sheet

Interestingly for investment in preference shares and debentures, the entry pricing is specified but the exit pricing can be as per any internationally accepted pricing methodology

RBI PRICING NORMS Non-Resident + Listed Equity - Buy  at not less than preferential allotment price - Sell at not more than preferential allotment price - With Option: Sell at market price

 RBI PRICING NORMS Non-Resident + Unlisted Equity - Buy at not less than DCF based price - Sell at not more than DCF based price - With Option: Sell at not more than RoE based price

 RBI PRICING NORMS Non-Resident Exit Via Option ‘In case of equity shares of unlisted company, at a price not exceeding that arrived on the basis of Return on Equity (RoE) as per latest audited balance sheet. Any agreement permitting return linked to equity as above shall not be treated as violation of FDI policy. 

CNBC-TV18’s Menaka Doshi spoke to RBI Executive Director G Padmanabhan on RBI’s Circular on Call and Put options.

Doshi: Let me start by asking you why it was not enough for the RBI in its notification or circular to simply state that look we will not allow for an assured return? Why did you think it was necessary to impose a new set of pricing criteria - whether it is listed equity or unlisted equity - creating a dual pricing mechanism of sorts?

Padmanabhan: I think we thought about this for quite some time as to what we need to put in there. Whether we like it or not, one of the aspects that is happening mostly in respect of the foreign direct investment (FDI) is, that the pricing gets notified by the government and the RBI. That has been the rule always. If we would have given a formula, we would be placed with a plethora of questions whether this is right, that is right and we would be facing a number of questions. So we needed to be very clear as to we give one basic formula based on which the market will be able to take it forward. Having said that, let me also admit that probably the last line on this has still not been written. We want to see how this will impact, how the market will take this forward and if there are operational difficulties still, let me place it on record that the RBI would be willing to continuously look at it and improve the system. We look for a better indicator and from our discussions, the best indicator possible was this where an assured return was not given.

Doshi: When you said that you needed to put in a pricing requirement because that has been the tradition at RBI, let me ask you this question, you already do have a pricing requirement. When it comes to both the entry and the exit of foreign investment in this country, you have put in a DCF floor for unlisted and a DCF cap for unlisted. Similarly there are criteria for listed and I will not list all of that right now. Why is it that was not enough?

Padmanabhan: If you ask any finance guy, the discount that cash flow cannot be considered as something where an assured return is not being given. In a way yes, I agree with you but the problem with the discounted cash flow is that the final price depends upon what is the discount factor you put there and the discount factor could be anything. So whether discounted cash flow is the ideal way of moving forward? In my personal view; probably not. So we have to give a number which probably gave less amount of freedom to interpret that what could be the discount factor because the next set of problems we could be facing is that we would be faced with a number of questions about what could be the discount factors, how do we know that - please remember that we are talking - a discounted cash flow basically takes in the account the future prospects of the company also. The future prospect nobody knows. And as far as the equity investment is concerned, the difference between the debt investor and the equity investor is that the equity investor has to take the risk as far as the company’s performance is concerned. That is what we tried to achieve by prescribing the return on equity.

Doshi: There is no argument on the fact that of course an equity investor must take risk and there is nothing like an assured return when you are using equity as an instrument of investment but you have tacitly in a sense admitted that DCF is fudgeable. In that case the shift from CCI pricing guidelines to DCF which took place not very long ago, I think around year and a half or two years ago in itself comes under scrutiny or under question?

Padmanabhan: There is a slight difference between- while I agree in substance with what you are saying- here we are talking about an agreement or a contract where the investee company is compulsorily forced to write this option. So this is where we wanted to give some kind of a better arrangement rather than the DCF. Now if you ask personally what would be my take on the whole thing? I think progressively we should move towards a regime where neither Reserve Bank of India (RBI) nor the government gets into the question of pricing and the pricing is decided by the buyer and the seller.

Doshi: If my audience was here, there would be a loud round of wild applause to that but unfortunately we are not there yet; right? Because we now have not just one pricing regime, that has been further compounded by the fact that you have this curious circular which says ‘at a price not exceeding that arrived on the basis of Return on Equity (RoE) as per latest audited balance sheet’- this applies to the exit of foreign investments by a foreign investor to an Indian company in unlisted shares?

Padmanabhan: With an optionality clause.

Doshi: With an optionality clause- of course as per latest audited balance sheet- does it have to be the annual balance sheet, quarterly or half yearly?

Padmanabhan: No, we have not said anything like that. It has to be an audited balance sheet. It could be anything.

Doshi: And when you say ‘arrived on the basis of return on equity’?

Padmanabhan: Now, to explain that, I think we need to understand not merely the letter of this circular but the spirit of this circular. The problem why the optionality was banned in the first place was that there was a problem between the money coming in through this route which is an ECB money where an assured return is being taken. So we have tried to curb that and we said the optionality is completely stopped but then we also will have to realize that we live in a world where we will have to compete with the rest of the world in receiving this money. So completely stopping optionality- if rest of the other countries permit this optionality- then there would have been a problem. So we wanted to have some kind of a via media where we ensure that an ECB does not come in through this route- which was primarily the concern why we stopped this and finding out a via media- if it is understood in that spirit then basically what we are saying that an annualized return on your equity with an optionality clause if your return on equity for that year of company is 15 percent, it can be anything between zero and 15.

Doshi: For that year?

Padmanabhan: Absolutely.

Doshi: If this is a 5 or 7 year investment- which is typically how foreign venture capital investments work and I am using that subset because that is the subset that gets most impacted.

Padmanabhan: Absolutely.

Doshi: Foreign venture capital exists between 5 year and 7 year and for them it is the last return for the last audited balance sheet as you have pointed out is 12-15 percent? They earn 15 percent over a 5-7 year period.

Padmanabhan: We agree that a one year money the return has to be less than a five year money. A person who is putting five year money, we are saying that you calculate your return on annualized basis for this five year based on your return on equity of the last year. So if the company has been improving on performance, take higher amount out. We have no problem.

Doshi: Can you give me an illustration- just so that this is crystal clear for everybody?

Padmanabhan: What I am saying is that the company’s performance increases over five year starting from 8 percent to 15 percent- we are saying that the optionality says that 15 percent - that 15 percent annualized for the five year, you can take it out.

Doshi: So that is 15 into 5?

Padmanabhan: I am not talking about the numbers. You get an annualized return, that is a technical way of putting it - at the RoE basis as per the last audited balance sheet.

Doshi: Will this be capped by DCF in any fashion? So that is the other question that came up.

Padmanabhan: Please remember we are dealing with two sets of contracts or even in our view two sets of instruments. One is an instrument which is a pure FDI instrument where there is no optionality built in. Here we are talking about an optionality built in. Again I have explained to you the background for this and where an optionality is getting built in, that is based on only the provisions of this circular and not beyond this. So the DCF does not come into the picture at all.

Doshi: So if you are exiting using an optionality, then there is no DCF cap that applies to you?

Padmanabhan: And even the other way round. If you are not exiting using this optionality but this optionality was built in, you cannot force the investor then. You cannot have a contract stating that I will have the right to say that either I will use the option or we will use the DCF method if I don’t have the option. Then the purpose of issuing this circular is defeated.

Doshi: So you cannot arbitrage between the two is what you are saying. If the RoE based rate of return was not or the RoE based price was not working out to the advantage of the foreign investor and that could happen- businesses go through ups and downs, one cannot envisage every single situation in advance - then can the foreign investor let the option be cancelled or lapsed etc and choose to exit not via an option and thereby use the DCF valuation criteria as a cap?

Padmanabhan: Let me try to probably edit my earlier answer and say that that cannot be a part of the contract.

Doshi: I don’t know how RBI will even check all of this because how are you going to check what is written into a variety of these agreements or where will you be able to monitor all of this?

Padmanabhan: I think honestly this country will have to move towards believing that we would be facing a society which believes in compliance. So if the RBI has to police every contract that is written between the investor and the investing company, that is not possible. So whatever cases that we got- based on which all these developments happen were those cases which came to us for compounding because at some stage it got caught. They said it is not as per the FDI policy that came to us for compounding and that is where all these policy changes happened.

Doshi: There is one issue that is still bothering many people and that this circular is not prospective?

Padmanabhan: If you had written an optionality before this circular was issued after it was banned in 2007, that was not a valid contract at all because we said that is not an FDI compliant instrument. So what we have tried to do is an exit route. What we have said is that earlier if there are any existing contracts - in fact one of my lawyer friends talked to me when the government notification was issued alerting me on this that if you could give them some exit option of the existing contracts as long as it is corrected to comply these norms then it would be a better way forward. In fact, we thought we had given an exit clause and the market should be happy about it.

Doshi: I would like to now come to the third instance. There is the exit of listed equity and we will come to that later on in the show. The exit of unlisted equity which you have spent quite a bit of time clarifying on how it will work and then the exit of a foreign investor using an optionality via preference shares or debentures and in that case the RBI has given a considerable amount of latitude to the investor to determine the price as per any internationally accepted pricing methodology. The broad view amongst most lawyers and investors that most foreign investors will prefer to come in via CCPS/ CCD and exit via CCPS/ CCD because that gives them a lot more latitude on determining pricing as opposed to unlisted equity where you have put in several restrictions.

Padmanabhan: As I said this is just one stage before we make all the instruments based on internationally accepted pricing norms. We wanted to address the issue of the FDI having these options on listed company separately because there were lot of problems with that. We have addressed that. We are in discussion with the government obviously to make these pricing guidelines uniform across. So it is a matter of time before this uniformity sets in. I agree that as of now there is a little difference between what is there for the CCDs and CCPS, but it is a matter of time I hope before we would be able to have uniform pricing guidelines across all instruments.

Doshi: You said you are in the process of unifying- so I just want to make sure you want to move CCPS/CCD to ROE based as well or you want to convert unlisted to internationally accepted pricing?

Padmanabhan: Please remember that the way forward at least as far as the FEMA guidelines are concerned is to liberalize. They do not go back to a more regimented or stricter kind of calculations or the formula. So these are two separate regimes as it exists today. You would also know that there is lot of work taking place. Government and Reserve Bank of India (RBI) are looking at revamping the entire FDI guidelines to make it simpler. So today the problem that has cropped up is these are two different regimes and as a result of this, two separate pricing guidelines apply. So our idea is to make this all uniform as quickly as possible. The work is on. When that will be completed I do not know, but it will be very quickly I hope. Having said that the specific answer to your question that whether it will be more strict or liberal, it will be towards further liberalizing.

Doshi: Currently we have got a situation of product arbitrage.

Padmanabhan: The way in which the FEMA has worked and the markets have developed in this country there is a product arbitrage into several other spheres as well. It is not relating to this particular circular. We recognize that this difference is there and we are trying to work towards harmonization.

Doshi: For every single instrument there are multiple pricing situations. I will go to listed equity now which we have not discussed at all. All exits from listed equity is now required to be on the stock exchange. That seems to be the first implication of this notification. Secondly, you have said that if it is done on the stock exchange, it has to be done at market price, but the entry into listed equity might also draw the preferential allotment pricing guidelines of SEBI.

Padmanabhan: It is not to be interpreted out of the circular that the listed shares have to be exited only through the stock exchange, we have not said that. We are here talking about only the pricing guidelines.

Doshi: At the market price determined on the floor of the recognized stock exchange.

Padmanabhan: Yes there is a price which is recognized and a price which has to be taken.

Doshi: But if it is to be determined on the floor, then the only way to determine it is on the floor of the stock exchange is to trade it on the stock exchange. There is no other way to determine a market price on the floor of the stock exchange. You could have said at the last closing price or something like that. It does not say that. The language seems to imply that you want all of these transactions to be done on the floor of the stock exchange?

Padmanabhan: At least that was not the intention when we were discussing this. If the circular gives that impression, we would look into this and see whether any clarification needs to be issued on that.

Doshi: Here too the entry price valuation methodology is different from the exit price valuation methodology. So my point is for listed equity there is duality, for unlisted equity there are several different situations and scenarios and for CCPS/ CCD there is product arbitrage. How does all of this reconcile with the RBI's position of let us simplify, let us liberalize, let us treat investors at adults?

Padmanabhan: Your question is perfectly valid. I am not disputing the aspects that you have brought out in your question. The point that I am trying to tell you is that the RBI, through this circular, has not attempted to completely rationalise the pricing guideline. That process is on and very soon we would be coming out with whatever harmonization is possible to make things easier. The only thing that we attempted through this circular was to make sure that this optionality issue was taken care of.

Doshi: This brings me to a grouse that comes up every now and then when we deal with regulations or notifications issued by the RBI and that is why don't you put these drafts out for consultation?

Padmanabhan: Normally we do when there is a major policy change, but in this case when we were trying to sort out an issue which was there, if we had put out this as a consultative paper then if we receive 100 different opinions then the whole things gets taken forward or delayed by another six months or one year. So the consultative thing can be done. On this we thought we did a fair bit of consultation with the market players and with the consultants who were involved in this, who came to us for compounding. The discussions happened with government and there was a fair bit of agreement that this is a good way forward to start with. We have done it.

Doshi: You said you were open to feedback from industry based on which you might consider changing some aspects of this. Would you consider doing away with all these different entry price valuation criteria, exit price valuation criteria, different for listed, different for unlisted, different for CCPS, different for CCD and try and give us some uniformity?

Padmanabhan: I will answer this question in two parts. One is as far as making the pricing guidelines uniform across the board is concerned that is a principle on which we are working and the sooner we are able to come to a solution about this and that is something on which you please take it onboard that we will be putting out a consultative paper, because that is a major change. As far as the other aspect is concerned, we are completely open. As I said this we thought was the better way forward. If the market thinks that there are alternate methods where the without assured return result can be achieved, but that works in a much more professional and simpler manner the industry can very well come back to us and we are completely open to making any changes in this part of the circular.

Doshi: You said that you are looking at harmonizing all pricing guidelines. Do you want to tell us the scope of that and what the timeline for that is?

Padmanabhan: Very soon. Advance discussions have happened. We are in discussions with various stakeholders involved, let us hope.

Doshi: So you are hoping to harmonize all pricing guidelines across various different investment groups?

Padmanabhan: We are hoping to harmonize pricing guidelines in such a way that there is complete, if not reasonable amount of freedom to the buyer and seller.