(Aswath Srinivasan, Editor at IELR)
Upon a cursory reading, the pricing guidelines given in rule 21 of the Foreign Exchange Management (Non-Debt Instrument) Rules, 2019 (NDI Rules) appear straightforward. Broadly, rule 21(2)(a) governs pricing of Indian Equity Instruments issued to a Person Resident Outside India (PROI), rule 21(2)(b) governs transfer pricing of such instruments when transferred from a Person Resident in India (resident) to a PROI, and rule 21(2)(c) governs pricing of such instruments when transferred from a PROI to a resident. The real impact that these guidelines have from the perspective of structuring transactions can only be truly understood by applying them to the infinite variations of such transactional structures. One may observe how such structures play out, and how the pricing guidelines affect their permissibility. This article addresses some of those peculiar consequences that practitioners should anticipate while structuring transactions.
Firstly, the pricing of Indian Equity Instruments in a share swap arrangement is addressed. Secondly, the dual treatment of Foreign Owned or Controlled Corporations (FOCCs) is also discussed. Lastly, the article highlights the impact of pricing guidelines on two types of investor rights: Anti-dilution and Exit.
Pricing a Swap Transaction
A share swap is a transaction that entails the sale or issue of shares in one company, in exchange for shares in another company. Such transactions attract the pricing guidelines under the NDI Rules when one of the parties is a resident, and the other is a PROI, and when Equity Instruments of an Indian Company are involved. There are various commercial reasons for which parties may choose to enter such a swap arrangement. Most recently, Indian start-up companies (PhonePe and Zepto, etc) have sought to redomicile their foreign parent companies to India, from jurisdictions like Singapore, or the United States. This process is often referred to as reverse flipping. A share swap is one of the ways in which a reverse flip may be undertaken. While the commercial considerations of a share swap are outside the scope of this article, the legal intricacies that affect these transactions deserve attention.
Rule 21(2)(c)(iv) governs the pricing of Indian Equity Instruments in a swap. It gives that valuation in such a swap will have to be made by a Merchant Banker registered with SEBI or an investment banker outside India who is registered with the appropriate authority in such country. Rule 21(2)(c), as discussed previously, addresses pricing of Indian Equity Instruments transferred by a PROI to a resident. To understand how to price Indian Equity Instruments flowing from a resident to a PROI as a component of a swap, one would have to look towards rule 21(2)(b) (or rule 21(2)(a) in case of fresh issue). However, the contents of rule 21(2)(c)(iv) have not been replicated in rules 21(2)(a) and 21(2)(b). Both these rules remain silent on swap pricing. Thus, one may infer that rule 21(2)(c)(iv) applies to swap arrangements in which the direction of flow of Indian Equity Instruments is from a PROI to a resident. Prima facie, it appears that a swap is only permissible when the direction of flow of Indian Equity Instruments is from a PROI to a resident, and not otherwise. One may gain valuable insights in this regard when these rules are compared with the parallel provisions under the erstwhile Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2017 (TISPRO). The pricing guidelines were given in Regulation 11. Regulations 11(1), 11(2) and 11(3) corresponded to rules 21(2)(a), 21(2)(b) and 21(2)(c) respectively. However, swap pricing under TISPRO was governed by Regulation 11(4), which was independent of those sub-regulations above it. This means that it governed swap pricing regardless of whether the resident or PROI was the transferor/issuer. The NDI Rules thus mark a clear shift in the way the pricing guidelines have been drafted in this regard. In undertaking a transaction where a swap entails transfer of Indian Equity Instruments from a resident to a PROI, questions arise as to whether it is sufficient to comply with Fair Market Value (FMV) requirements of rule 21(2)(b)(ii), or whether government approval will have to be sought. Clarification by the regulator on the correct position, and the rationale for this significant shift appears necessary. The permissibility and pricing of such swaps also means that reverse flips via swaps are in a grey area.
Dual Treatment of FOCCs
The dual treatment of FOCCs from a pricing perspective, and in terms of reporting requirements is a very peculiar predicament within the FEMA regime. This section focusses only on the dual treatment in terms of pricing. Rule 23 of the NDI Rules deals with downstream investment, and one may infer that when an FOCC is the seller of Indian Equity Instruments, it is treated as a PROI for the pricing purposes. This means that when an FOCC sells Indian Equity Instruments to a PROI, the pricing guidelines under rule 21 will not be attracted. On the other hand, if an FOCC sells Indian Equity Instruments to a resident, then given that this is a transaction between a resident and an FOCC which is treated as non-resident, the pricing guidelines under rule 21 will be attracted.
The NDI Rules are silent on the applicability of the pricing guidelines to transactions involving the acquisition of such Equity Instruments by FOCCs. Intuitively, a logical transposition of the treatment of FOCCs in rule 23 would mean that the FOCC should be treated as non-resident even when acquiring such instruments. Thus, this would imply that pricing guidelines would be attracted when an FOCC acquires such instruments from a resident, and not from a PROI. However, in practice, various Authorised Dealer (AD) Banks have taken a different view. Some AD Banks have applied the pricing guidelines even to transactions in which an FOCC acquires such instruments from a PROI. This means that an FOCC is treated as a PROI when selling Indian Equity Instruments to residents or PROIs and while acquiring such instruments from a resident but is treated as a resident when acquiring from a PROI. The table below represents the applicability of pricing guidelines to these transactions.
Seller | Buyer | Pricing guidelines |
FOCC | Resident | Yes |
FOCC | PROI | No |
Resident | FOCC | Yes |
PROI | FOCC | Yes |
This dual treatment also has a very peculiar consequence on transactions involving a simultaneous acquisition of such instruments by an FOCC, from resident and PROI sellers. In such transactions, FOCCs are either required to employ differential pricing, or acquire shares at FMV, as FMV will be the only price point that the pricing guidelines will permit on account of it being price floor and price ceiling in either limb of the acquisition.
Enforceability of Investor Rights
Anti-dilution
The pricing guidelines have very significant impacts on investor rights such as anti-dilution protection and exit. There are multiple ways in which an investor and an investee entity may agree upon anti-dilution protection (full ratchet, broad based weighted average, or narrow based weighted average). Each of these methods yields an adjusted issue price or conversion price. This is the price at which shares are issued to an investor in the event of a dilution. If an investee company undertakes a down round (raising further capital at a lower valuation than the previous round), anti-dilution will kick in.
The following is a brief illustration of how a broad-based weighted average (BBWA) method is used. A foreign investor (FI) is issued convertible securities at an original conversion price (OCP) of INR 100. At this stage, the company’s shareholding is as follows:
Entity | Shares | Percentage holding |
Promoters | 60,000 | 60% |
FI | 40,000 | 40% |
Subsequently, a new investor (NI) invests at a discounted valuation of INR 50 per share, meaning that this is a down round (valuation in the previous round in which FI invested was higher). NI is issued 20,000 shares at this valuation. BBWA anti-dilution uses the following formula to arrive at an adjusted conversion price to replace the existing conversion price.
In this example, this formula yields an adjusted conversion price of INR 95.45. At this price, the foreign investor will have a total of 40,000 (100/95.45) = 41,906 shares post anti-dilution. Post anti-dilution, the company’s shareholding is as follows:
Entity | Shares | Percentage holding |
Promoters | 60,000 | 53.62% |
FI | 41,906 | 35.74% |
NI | 10,000 | 8.93% |
Anti-dilution protection is typically not available in case the subsequent valuation is higher than the previous round, given that the value of the investment increases. In a steep down round, the valuation at which funds are being raised is significantly lower, and this reflects in the calculated issue/conversion price. Companies may undertake such rounds for multiple reasons, including among others, onboarding of strategic investors with technical expertise. The valuation in such a round is not always at par with FMV, and when undertaken for strategic reasons, may be lower than FMV. Investments on Shark Tank are a good example of such a down round, where Sharks often invest at lower/discounted valuations, but bring expertise, connections, and publicity to the table. Further, reduced liquidity in smaller businesses means that such investors anticipate a higher risk, because of which they tend to enter at lower valuations. Anti-dilution becomes unenforceable when this adjusted conversion price is also lower than FMV, which is the price floor for issue of shares to a foreign investor, as given in rule 21(2)(a).
The industry is yet to find a way around this issue, but a solution that can be explored is to structure the protection as entailing an issue/conversion at the adjusted price or FMV, whichever is higher. This may be coupled with a covenant that requires the payment of liquidated damages to the investor, to the tune of the difference between the adjusted price and FMV, where FMV is higher. The purpose of this structure is to facilitate the anti-dilution at a price compliant with FMV, while compensating the investor as though the right were exercised at the lower adjusted price. The liquidated damages covenant is compensation to the investor for being unable to enforce this right at the adjusted price. If AD Banks take the view that paying liquidated damages is a current account transaction, then they are likely to allow this transaction. This is because while capital account transactions are prohibited unless explicitly permitted, that is not the case with current account transactions. Thus, while the consideration for the issue will be in compliance with the pricing guidelines, the liquidated damages on account of being a current account transaction, in theory should not invite regulatory action. However, such a covenant remains untested, and it is unlikely that the regulator will look favourably upon such a structure designed with the sole purpose of flouting the pricing guidelines.
Exit
Lastly, the pricing guidelines also complicate the enforcement of exit rights. Firstly, any exit with an internal rate of return (IRR) is likely to be treated as an assured return prohibited by the NDI Rules (rules 9 and 21). The interpretation of such covenants has been a topic of discussion for some time, and the subject of some jurisprudence. Beyond this, an exit that assures an exit at a value higher than FMV will also become unenforceable as FMV is a price ceiling when a foreign investor is selling shares. To resolve this, parties have resorted to arbitration, and have sought damages, the remittance of which may not be a capital account transaction. Further, parties may also consider a similar liquidated damages covenant as suggested above, to stipulate that exit may be completed at the exit price agreed or FMV, whichever is lower, and liquidated damages to the tune of the difference, where FMV is lower. However, it is difficult to predict how AD Banks will view such structures, and they are unlikely to pass any test of substance as they are clearly designed with the purpose of subverting FMV requirements imposed by the pricing guidelines.
Conclusion
When applied to different transactions, the pricing guidelines have complex and peculiar consequences. The goal of this article was to highlight some of these hurdles that transactional lawyers should anticipate and be vigilant for in drafting and structuring these rights and transactions. Some of these hurdles and consequences can be avoided if the regulator were to clarify the position of law, while the rest are likely to be recurring ones in certain transactions.
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