Mumbai: Private equity (PE) and other foreign investors will not be able to exit their investments through a so-called put or buyback option as regulators are finding such arrangements legally invalid.
Under the put option, a promoter buys back the investors’ share at a pre-determined price at a particular date in future. Typically, such an option is part of a shareholders’ agreement when investors put money in unlisted entities. They exit when the firm floats its initial public offering, or IPO, but if the market conditions are not conducive for an IPO, as is the case now, promoters buy back the shares to protect the investors’ interest.
With many firms shelving their IPO plans in a highly volatile market, investors are looking for exits through this route, but neither the capital market regulator nor the banking regulator are in favour of such an arrangement.
The Securities and Exchange Board of India, or Sebi, considers the put option a futures contract which can be traded only on an exchange, while the Reserve Bank of India (RBI) sees the put option as an external commercial borrowing (ECB), which is permitted only in certain sectors.
“Two of our clients received show-cause notices from RBI when they tried to exercise the put option," said Ruchir Sinha, co-head, real estate investments practice, at law firm Nishith Desai Associates. “RBI does not believe it is a valid contract even between two shareholders."
Most of the agreements that PE investors enter into have a put option.
“RBI is issuing show-cause notices to companies almost daily," said the legal head of a real estate fund, which also has put options in its agreements with firms in which it has invested. He did not want to be named as he is not authorized to speak to the media on legal issues.
According to Sinha, a significant majority of offshore funds need a put option as an exit and the uncertainty around enforceability of such options will definitely be a big deterrent to foreign direct investment (FDI).
Sebi norms say enforcing a put option is a futures contract and such contracts can be traded only on a stock exchange and not between shareholders of a company. A futures contract is a contractual agreement to buy or sell a particular commodity or financial instrument at a pre-determined price in the future.
So far, investors treated a put option in a shareholders’ agreement as a spot delivery, but both Sebi and RBI recognize it as futures contract, say lawyers.
Spot delivery is a contract in which the delivery of the securities and the payment for the securities is done within the same day as the date of the contract or the next business day.
An email sent to Sebi did not elicit any response.
An RBI spokesperson said that under the Foreign Exchange Management Act (Fema), notification 20 (regulations 3, 4 and 5), only Sebi-registered foreign institutional investors and non-resident Indians are allowed to invest in exchange-traded derivative contracts where the underlying securities are equity shares of an Indian firm. “No other class of foreign investor is allowed to enter into any derivative contract where the underlying security is an equity share of an Indian company."
According to Fema norms, “no optionality (explicitly or implicitly) can be built into any FDI-compliant instruments (namely equity shares, fully and mandatorily convertible debentures or mandadorily and fully convertible preference shares). As far as capital account transactions are concerned, unless they are explicitly allowed under the existing regulations, they’re not permissible."
According to RBI norms, foreign investment is allowed only through compulsory convertible preference shares (CCPS) or compulsory convertible debentures. These are equity instruments and a price cannot be pre-determined for the exit. In other words, the exit must take place at the prevailing valuation.
In 2007, RBI was concerned about the large debt inflows into the country and had banned instruments such as optionally convertible preference shares and partially convertible preference shares.
Many PE firms invest through CCPS and have a put option as a downside protection. But going by RBI norms, if an investor has CCPS attached with a fixed put option price, it’s the same as debt and hence an ECB, pointed out Sinha. “This is in violation of Fema provisions, according to RBI," he added.
Exits through buybacks have been on the rise. In 2008, there were five exits with promoters buying back shares. It rose to 11 in 2009 and 17 in 2010. So far, 13 such deals have taken place in 2011, according to data from VCCEdge, a financial research platform.
With the rise in the frequency of buybacks, such incidents are now on the regulators’ radar.
In the recent past, Analjit Singh-owned Max Healthcare bought shares back from Warburg Pincus India; Rustomjee Constructions from Trinity Capital Plc, and JBF Industries Ltd from Citi Venture Capital International.
If the put option is considered invalid, it denies one of the exit routes available to PE investors, experts said.
“If this option goes away, the risk associated with PE transactions will increase," said Sunil Rohokale, executive director at ASK Investment Holdings Pvt. Ltd, a real estate fund. “It will change the contours of deal making as PE firms will try to compensate the high risk associated through entry valuations and different structures."
Lawyers have started advising their clients to avoid this option in their agreements.
“We always highlight to our clients that the enforceability of a put option presents some level of regulatory interpretational risk. We advise them to avoid relying solely on this right and build in a cascade of other protective rights, wherever possible." said Vijay Sambamurthi, founder partner, Lexygen, a law firm.