India Eases Restrictions on Instruments with Put and Call Options as an Exit Mechanism for Foreign Investors

January 16, 2014

Pursuant to a notification dated November 12, 2013 and a subsequent circular dated January 9, 2014 ("RBI Notification")[1], the Reserve Bank of India ("RBI") has legalized the use of call options and put options as an exit mechanism for foreign investors. RBI’s new policy removes the uncertainty regarding the validity of contracts containing put and call options in relation to the securities of Indian companies held by foreign investors. This is in keeping with the recent notification of the Securities and Exchange Board of India[2], which removed the uncertainty under Indian securities laws, concerning the enforceability of contracts containing put/call options and other pre-emption rights in relation to the securities of Indian public (listed and unlisted) companies.

Background

While there was no specific restriction under India’s foreign direct investment policy ("FDI Policy") on the ability of a foreign investor to provide for put or call options in relation to securities of an Indian company held by such foreign investor, the RBI had consistently taken the view that any kind of built in optionality in relation to such securities was in violation of India’s FDI Policy. Accordingly, where investments were made in such securities with exit options through put and call options, the RBI had questioned such investments and treated the definite exit mechanism provided to foreign investors through put/ call options as being analogous to a fixed return on capital (similar to a loan). Consequently, the RBI treated all foreign investor-held securities coupled with an option as ‘debt’, and not as ‘foreign direct investment’, in an Indian company.

New Amendments

Under the RBI Notification, an exit through put and call options in relation to the securities of Indian companies held by foreign investors are now specifically treated by the RBI as foreign direct investment consistent with India’s FDI Policy, subject to the following key conditions:

(a)     No assurance can be given to the foreign investor with respect to the exit price. The exit price must be determined in accordance with prescribed pricing requirements (discussed below).

(b)     A foreign investor holding securities (coupled with a put or call option) cannot transfer such securities for at least one year from the date of allotment of such securities.

(c)     The following pricing requirements must be followed in relation to the exercise of the put or call option at the time of exit:

• For equity shares in listed companies, the price (in the event of transfer) should not exceed the market price determined based on the price prevailing on the relevant recognized stock exchanges.
• For equity shares in unlisted companies, the exit must be at a price not exceeding the determination based on ‘return of equity’ ("ROE") as per the last audited balance-sheet of the company. ROE is defined as profit after tax / net worth (including all free reserves and paid up capital).
• For compulsorily convertible preference shares/debentures, the exit must be at a price determined on the basis of any internationally accepted pricing methodology, duly certified by an Indian chartered accountant or a Securities and Exchange Board of India registered merchant banker. The RBI has further added that the pricing mechanism should not constitute a guarantee to the foreign investor of any ‘assured’ exit price at the time of investment in the company.

(d)     The amendments promulgated by the RBI Notification are retrospective in effect, and all existing contracts which provide for put/call options are required to comply with the aforementioned provisions of the RBI Notification.