A Fair Market Value Conundrum: Applicability of Pricing Guidelines for a Rights Issue

Rights issue is one of the many ways in which a company may increase its share capital. It has been one of the most preferred methods due to its lower regulatory compliance requirements. However, complications arise in a cross-border rights issue involving a non-resident shareholder. Under the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (“NDI Rules”) formulated under the Foreign Exchange Management Act, 1999, a company is permitted to issue shares and other equity instruments to persons resident outside India (“Non-Resident”), provided that all applicable sectoral caps, pricing guidelines, and other regulatory requirements are duly complied with^[1]. While compliance with pricing guidelines is mandatory, there is a gap in the applicability of the pricing guidelines fora rights issue exercise. This article examines the applicability of the pricing guidelines under the NDI Rules for a rights issue to Non-Residents.

Background and Regulatory Framework

The NDI Rules regulate foreign investment through equity instruments, including such investments made by way of a rights issue or the issue of bonus shares. In the context of the Companies Act, 2013 ("Act”), a ‘Right Issue’ refers to the offering of shares to existing shareholders in proportion to their equity shareholding in the company at a price determined by the company^[2]. The rights issue ensures that there is an equitable issuance of shares to the company's equity share holders and avoids dilution of their voting rights pursuant to the rights issue. However, when shares are issued or transferred to a Non-Resident shareholder, compliance with the NDI Rules also becomes essential. With regards to the NDI Rules, the question of fair market value becomes critical, as it ensures that investments by a Non-Resident are made at fair prices, aligning with market practices and regulatory standards.

Pricing Guidelines and Rights Issue under NDI Rules

Rule 21 of the NDI Rules outlines the general pricing principles for the issuance and transfer of equity instruments to Non-Residents. With respect to the unlisted entities, Rule 21(2)(a)(ii) of the NDI Rules prescribes that the issuance of equity instruments to a Non-Resident requires an assessment or certification of the fair market value (“FMV”) of the equity securities of the Indian entity, where the valuation to be undertaken must be in accordance with any internationally accepted valuation method and on an arm’s length basis, which shall also be duly certified by a chartered accountant or a merchant banker registered with the Securities and Exchange Board of India or a practicing cost accountant. These requirements ensure that all foreign investments in India take place at or above the FMV, seemingly with an intent of avoiding undervaluation of Indian equity instruments.

In the context of a rights issue by Indian companies to Non-Residents, Rule 7 of the NDI Rules outlines the relevant regulatory guidelines. For unlisted Indian companies, the only requirement is to ensure that a rights issue to Non-Resident must not be priced lower than what is offered to the resident shareholders. This pricing requirement differs from the standard pricing guidelines for Non-Residents, considering it provides an option to an Indian company to offer an identical price to resident and Non-Resident shareholders, with the sole caveat that the price for Non-Resident shareholders should not be less than the price for resident shareholders.

However, this is not the case under Rule 7A of the NDI Rules, which pertains to a situation where the entitlement under rights issue has been renounced by a resident in Favour of a Non-Resident. As per this provision, when a Non-Resident intends to obtain equity instruments through rights renounced in their Favour, such subscription must adhere to the pricing guidelines provided under Rule 21 of the NDI Rules. Similarly as per paragraph 6.12.3 of the Reserve Bank of India’s Master Direction on Foreign Investment in India (“Master Direction”), where the entitlement under rights issue have been waived by a resident, the company may issue such waived equity instruments to a Non-Resident provided that the issue of such securities pertaining to the waived rights shall be subject to adherence to entry routes, sectoral caps or investment limits, pricing guidelines and other conditions as specified under the NDI Rules.

Essentially, while a Non-Resident’s direct subscription to shares under rights issue (under Rule 7 of the NDI Rules) does not require FMV assessment by a valuer, if subscription by such Non-Resident, to a rights issue is undertaken in furtherance of a renunciation or waiver by resident shareholders, pricing guidelines under Rule 21 of the NDI Rules must be adhered to. The fundamental reason for this dichotomy can beat tributed to the fact that for a rights issue pertaining to the original entitlement of a Non-Resident shareholder, all shareholders, including Non-Residents, are given an equitable opportunity to maintain their shareholding in the company. However, in case of a renunciation of the entitlement under rights issue by a resident in Favour of a Non-Resident or a subscription to a rights issue in furtherance of a waiver exercise, the Non-Resident is being granted an additional opportunity to further increase its shareholding in the company, thereby necessitating the need for alignment of regulatory requirements and as such compliance with pricing guidelines.  

Conclusion

With the most recent amendment to the Master Direction, the Reserve Bank of India has closed the loop with respect to waiver of entitlement under rights issue by mandating the applicability of pricing guidelines. However, if the underlying rationale for pricing guidelines is to ensure adequate valuation of securities of Indian companies, from a consistent policy perspective, the different pricing regime for rights issue and preferential allotment may warrant a re-look.

References

[1] Master Direction –Foreign Investment in India (RBI/FED/2017-18/60)

[2] Section 62(1)(a) of the Companies Act, 2013

‍