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November 1, 2011 FDI Policy on Options in Equity Instruments Amended Background By way of a corrigendum that came out on October 31, 20111 to the FDI Policy issued on September 30, 2011 (“FDI Policy”), the Department of Industrial Policy and Promotion (“DIPP”), an instrumentality of the Ministry of Commerce and Industry, deleted the contentious Clause 3.3.2.1 of the FDI Policy within thirty days of its introduction. The deleted Clause 3.3.2.1 read as follows: “Only equity shares, fully, compulsorily and mandatorily convertible debentures and fully, compulsorily and mandatorily convertible preference shares, with no in-built options of any type, would qualify as eligible instruments for FDI. Equity instruments issued/transferred to non-residents having in-built options or supported by options sold by third parties would lose their equity character and such instruments would have to comply with the extant ECB [External Commercial Borrowing] guidelines.” The deleted provision had the effect of nullifying the equity character of an equity instrument when such instrument was issued or transferred with an in-built optionality (a put option or a buy back provision, for example). Having lost their equity character, such instruments were required to comply with the extant ECB regulations. The regulatory chaos that ensued had led the legal community also to express its discomfort. We have discussed, in elaborate details, the implications and consequences of this change in our hotline “New Consolidated FDI Policy: Entry is welcome – Exit at our ‘option’” on October 3, 2011. The Position Now Clause 3.3.2.1 received categorical and unequivocal opposition from all industry quarters. Representations were made to the DIPP by industry associations pointing out the severe implications that such a provision could have on legitimate foreign investments in India. Clause 3.3.2.1 cast a cloud of uncertainty over a host of options, including call options, put options, or even tag along and drag along rights or any right that the investor could exercise at a future date, even though these heavily negotiated rights were contractually agreed between sophisticated parties. As we had pointed out immediately following the issue of the FDI Policy2, the ban on put options denied private equity players a safe exit in the event the promoters of the investee company failed to deliver as per the projected business plans. It also adversely affected the ‘options’ available to joint venture partners to consolidate or alienate its stake in the joint venture, in case of a fall-out between the joint venture partners. Though one may interpret this deletion to mean that options on equity instruments are now permitted, there is an ambiguity whether deletion of Clause 3.3.2.1 merely restores the status quo. While it is definitely a positive and a welcome move on the part of the government to remove this unwarranted ambiguity, one should not jump to the conclusion that the attendant regulatory uncertainty on ‘put options’ that was existent prior to the FDI Policy stands cleared or that the deletion connotes regulatory acceptance of such options. It may be recalled that even prior to the FDI Policy, the Reserve Bank of India (“RBI”) had issued notices on the inclusion of such options in the investment agreements and had raised objections to the legality of such options. Just to capsulate the issue, the RBI had been issuing notices on a case to case basis with respect to put options being granted to non-resident investors on the following two counts: (1) The ECB Perspective: RBI has issued notices to several private equity investors in the past on the ground that equity investments with a put option attached qualified the instrument as a redeemable instrument, which was akin to a debt instrument. Interestingly, RBI was indifferent if such a put option was exercisable on the company or on any of its shareholders; if there was a put option, the regulatory approach was to look at such instruments as ECB. Pertinently, RBI’s objections to options were rather absolute. It had no nexus to the question whether the options warranted the investor an assured return, thus arguably diluting his commitment to the ‘risk’ capital. It also did not treat options differently on the basis of their trigger event. An option available to an investor as an exit mechanism whether on the occurrence of a material event of default or on the failure of the investee company to initiate an Initial Public Offer was treated alike. In our interactions with the regulators, it appeared that the view is grounded on the premise that foreign direct investment is intended to be ‘lasting interest’ in the company, and a put option divorces such lasting interest and commitment to risk capital of the company by allowing the investor an assured exit. (2) The Derivative Perspective: Another regulatory approach to options that did not find a mention in the FDI Policy is the RBI’s perception of such options being regarded as derivative contracts separate from the underlying equity security. RBI, in its notices issued to a few private equity investors, regarded any kind of option attached to equity securities as a derivative contract, which are not permissible under the FDI route. This view was taken by the RBI notwithstanding representations that in the first place, no separate consideration over and above the purchase consideration for the securities was paid by the foreign investor to secure these options, and more importantly such options were not independently tradable contracts3. In fact, the FDI Policy did not clarify whether Clause 3.3.2.1 was intended to apply retrospectively, or in other words whether the new Clause 3.3.2.1 was in the nature of a new policy change or a mere clarification. If the change was clarificatory in nature, retrospective application seemed likely and there were concerns on the regulatory approach to put options granted to the investor prior to October 1, 2011. With Clause 3.3.2.1 deleted altogether, this debate is set to rest. The risk to enforceability and the likelihood of RBI penalizing the grant of options to a non-resident (on a case to case basis), however, cannot be ruled out for reasons mentioned above. Conclusion While the prompt deletion of Clause 3.3.2.1 by the DIPP is indeed commendable and does indicate the regulatory sensitivity towards foreign investments and the need for investor exit, there is a clear need to lend more stability to the extant fluid regulatory environment. To that extent, it may be helpful if amendments as significant as Clause 3.3.2.1 emerge out of a well-formulated policy and comprehensive discussions and fruitful consultations with stakeholders. Though deletion of Clause 3.3.2.1 has indeed partially mitigated the risks arising out of options attached to equity securities issued to a foreign investor, considering RBI’s approach in the past, there is a clear need for the investor to carefully weigh its reliance on such options as an exit mechanism in light of the risks of unenforceability of such provisions.
_________________ 1 See Press Release dated October 31, 2011 available at: http://pib.nic.in/newsite/erelease.aspx?relid=76910, last visited on October 31, 2011. 2 See Simone Reis, Nishchal Joshipura and Siddharth Shah, FDI Policy- Is India Still an Option?, Economic Times, October 10, 2011. 3 See Shraddha Nair and Khushboo Narayan, Regulators frown at put option mode of exit, The Mint, August 14, 2011 available at: http://www.livemint.com/2011/08/14230735/Regulators-frown-at-put-option.html last visited on October 31, 2011.
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