For years, offshore financial and strategic investors have struck deals with their Indian partners to put in place an easy exit arrangement. It gave the abroad investor the right to sell back his equity shares to the promoter of the Indian company where he had invested.

The understanding between the two partners helped closely-held Indian firms draw overseas financial and strategic investors who, in turn, derived comfort from the arrangement. But now, there are clear indications that the Reserve Bank of India will soon shut the exit door.

Foreign investors exercised such a right when the local company failed to perform or came out with an initial public offering. Objecting to the put option arrangement, the RBI argued that a put option to the offshore investor meant the money obtained by the local company is not foreign equity but foreign debt, which is governed by stringent rules, particularly in sectors like property loan.

But the argument was never used against plain equity investment backed by put options. The recent case where the RBI has expressed reservations relates to a put option against a foreign direct investment in the equity of a logistics company which has missed the listing deadline.

"The law of the land allows such options to be used. In fact, there is a 30-year-old government circular which permits such options in joint venture agreements and collaborations between a resident entity and a non-resident investor," said H Jayesh, founder-partner of law firm JurisCorp.

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The central bank, which often has the last word on cross-border fund flows, has recently disapproved the sellback transaction by a foreign investor, said a banker familiar with the case. "The decision can have far-reaching implications. Eight out of 10 private equity deals have such underlying agreements," said Anup Shah, partner at Mumbai-based chartered accountancy firm Pravin P Shah & Co.

Till now, the RBI has been objecting to such deals, particularly by real estate firms, where securities issued by Indian firms (to foreign investors) are debt or quasi debt in nature, such as convertible debentures, optionally convertible bonds, compulsorily convertible papers and preference shares.

"But this is the first time it has objected to sell-back transactions in a plain equity deal. It's an extreme view," said the banker. Legally, a right to sell back securities is executed by giving the foreign investor a put option that he can exercise to sell the shares back to the Indian sponsor.

According to investment bankers and legal experts, most foreign direct investments, particularly in unlisted firms, are against special rights given to foreign investors who can exercise such rights under certain conditions. For instance, foreign partners in many Indian insurance companies have a right to raise their stake as and when the government allows a higher foreign ownership in the sector at a pre-agreed pricing formula.

"So long as the shares are sold in accordance with the pricing guidelines of the Foreign Exchange Management Act (FEMA), the regulator should not have any problem," said Shah. The FEMA rules require shares to be sold above a floor price to a foreign investor.

"Some have supported the RBI view in case of convertible debentures. Here, a put option allows the foreign investor to exit before the conversion of the debentures into equity. But in case of pure equity investment, it is difficult to figure out why they should object," he said.

Bankers feel the RBI is often uncomfortable with the language ofthe option agreements that uses terms like the minimum internal rate of return (IRR) that the company has to generate, failing which the put will be exercised.

"It talks about yield and IRR, and the RBI, ever uncomfortable with leveraged money flowing in, reaches a conclusion that the money is loan not equity. But there is also another side to it. Often the local partner, unwilling to pay up, highlights these points in his proposal to the RBI, hoping to wriggle out of the payment commitment. Such cases inevitably end up in arbitration or disputes," said an investment banker.

There is also a growing perception that financial market regulators may be veering around to a common view on put/call option on Indian shares. The Securities and Exchange Board of India , the capital market watchdog, had opposed the agreements on put/call options between Cairn and Vedanta in the $9.6-billion deal where Cairn agreed to sell a majority stake in Cairn India to Vedanta. A few days ago, Sebi circulated a guidance note that opposed such put/call arrangements against Indian shares between two non-resident entities.
Source: [ET]