Compliance for Rights Issue under FEMA Rules

Varun Hariharan

24 Jun, 2020

Overview of rights issue under FEMA

Companies listed in stock exchanges are allowed to offer securities to the public. Before providing any security to the public, a company would offer the shares to existing shareholders. Such an offer of shares first to existing shareholders is known as a ‘rights issue.’ Compliance for rights issues is mandatory. Companies that offer rights issues have to comply with the laws related to companies’ acts. Apart from this, compliance for rights issue under FEMA is also crucial. Rights issues under FEMA will only be applicable if shares are offered to shareholders outside India.

What are the Rights Issue?

As per section 62(1) of the Companies Act, 2013 rights issue can be understood as a new issue of shares to existing shareholders. Rights issues under FEMA can be used by companies that offer shares to foreign shareholders and non-resident Indians.

The rights issue by a company is also known as pre-emption. This is called pre-emption as shares are offered to existing shareholders before offering it to the public. The shares offered to exist shareholders must be in proportion to the number of shares held by the existing shareholders.

For example, if a person has a specific number of shares in the company, then the company in a rights issue has to offer a fresh issue of shares to the individual before providing them the shares to the public.

What are the objectives of the rights issue under FEMA?

Rights issue under FEMA have the following objectives:

• Companies that offer shares to foreign shareholders have to comply with the rules related to FEMA.
• One of the main objectives of the rights issues under FEMA is the principle of equal distribution of shares to all company shareholders. This would include new and existing shareholders.
• Another objective of a rights issue is the company would not want the existing shareholders voting rights in a company to be diluted by the fresh offer of shares.
• This way of capital formation is beneficial to exist shareholders who do not have to go through the company’s initial issues.
• There are no pre-conditions related to the price at which shares are offered to existing members. Therefore offering this to existing shareholders is not expensive for the company.

Hence compliance is required for rights issue under FEMA rules. The rights issue of a company has to comply with the Companies Act, 2013, and the Listing Rules of Securities Exchange Board of India (SEBI Listing Rules).

Renunciation of Rights Issue under FEMA

The meaning of renunciation is not provided in the Companies Act 2013. Renunciation can be understood as where a formal right related to a specific subject matter is refused or abandoned. For rights issue under FEMA, renunciation of shares is allowed.

The procedure of renunciation of rights issue under FEMA is as follows:

• This process is also known as the issue of shares to outsiders of the company.
• Under rights issue, shares are issued first to existing shareholders of the company.
• If an existing shareholder is not interested in the fresh issue of shares, then he/she can renounce the same. Shares that are renounced must be given or issued in favor of another person.
• This is usually an outsider who is not a member of the company.
• Therefore shares that are renounced by an insider can be given to an outsider.
• The company can carry out the rights issue of shares as per the requirements of the Articles of Association of the Company (AOA). If the company’s articles permit rights issue of shares, it can be allowed by having formal board meetings with the directors.
• If the offer for a rights issue is present in the AOA, it must be provided in the offer letter to the shareholder.
• Rights issue is a mode of exercising rights on an issue of shares under FEMA.
• It must be known that the price offered for a rights issue under FEMA would be lesser than the average/market price of the shares. Hence the price will be determined as per the market value of the shares.
• The holder of the shares would be allowed to renounce the rights to a specific amount of shares by selling such rights to the subscriber of shares.

Renunciation of Shares – Company Procedure

The shareholder must decide the renunciation of shares. Once the shareholder has renounced or waived the shares, then the Board of Directors of the Company has the responsibility of issuing the shares to outsiders of the company.

The offer of shares will be present in the offer letter on rights issue. This offer letter would be provided to existing shareholders.

If the shareholder wants to renounce shares, an offer of non-acceptance must be given back to the company. The decision of the renunciation of shares must be communicated to the board of directors.

Suppose the shareholder decides to accept the rights issue, then the letter of acceptance must be sent to the company. Once this occurs, the company also has to receive the application money.

After this, the period of the offer of rights issue of shares must be closed. The board of directors must hold a board meeting for the allotment of shares to the shareholder.

Therefore for rights issue under FEMA, the shares will be offered to an existing shareholder. The existing shareholder either has to accept the rights issue or reject the rights issue. On rejecting the rights issue of shares, the same must be given to a third party.

This can be either the subscribed portion of the unsubscribed portion of the shares which are given. As per the companies act according to good practice, shareholders are asked to apply for shares (additional shares) over the number of shares which are allocated to them as rights issue.

Regulation of Rights Issue under FEMA

Rights Issue of shares is regulated initially by the Companies Act 1956. Many factors affected the regulation of rights issue. Hence the definition of rights issue was amended under the Companies Act 2013. Apart from this, rights issue apply to listed and unlisted entities. Therefore the provisions related to SEBI share listing would be applicable for rights issue for a listed entity. Under the Companies Act, 2013, listed companies have flexible options under the rights issue of shares.

When shares are offered to foreign investors and NRIs, the provisions related to foreign exchange will come into effect. The Government of India and Reserve Bank of India (RBI) are the main regulatory authorities for foreign exchange transactions within the country. For regulating foreign exchange, the RBI brought out the Foreign Exchange Management Act, 1999.

Along with this, various circulars and notifications are issued by the RBI.  The following are the regulations and notifications that affect the issue and transfer of shares:

• The Foreign Exchange Management (Non-Debt Instruments) Rules, 2020;
• The Foreign Exchange Management (Transfer or Issue of a Security by a person resident outside India) Regulations, 2000 (TOIS); and
• The Foreign Exchange Management (Transfer or Issue of a Security by a person resident outside India) Regulations, 2017 (TOIS).

The above three regulations govern the transfer of shares. Rights issue under FEMA would apply to shares allotted or transferred by an Indian company to a Non-Resident Indian.

The Non Debt Regulations speaks about the pricing on rights issues under FEMA for residents as well as non-residents. Hence it would cover transactions where renunciation of rights issue occurs by a resident as well as a non-resident Indian.

Applicability of Renunciation

The following will be applicable for renunciation of rights issue under FEMA:

• Renunciation of shares by a resident Indian- Here, the resident Indian would offer shares to a non-resident Indian after the existing shareholder officially renounces the shares.
• Renunciation of shares by a Non-Resident Indian- Here, the non-resident Indian would offer shares to a resident Indian after the existing non-resident shareholder officially renounces the shares.

Non Debt regulations apply to the rights issue of shares. The TOIS regulations would also apply to the rights issue of shares. As stated earlier, a company offers rights issues due to flexibility. Apart from this, rights issue are subject to free pricing. Hence the company would not have to determine the price applicable to shares. The price that is offered for a rights issue is lesser than the market price.

However, it must be noted that a listed company and an unlisted company can offer rights issues. Therefore securities offered for a listed company would be under the regulations of SEBI listing. For unlisted companies, the price would be determined according to the market value of shares.

Price at which rights issue has to be offered to residents

For a rights issue, the shares must be offered to existing shareholders. There has to be no form of price differentiation between residents and non-residents. Under regulations, the price at which shares are offered to the resident in a rights issue should be the same as the price offered to non-resident Indians.

As per the rules and regulations under FEMA, NRIs (Non-resident Indians) are allowed to have shares allotted under their name. The Non Debt Regulations speak about the price at which shares are offered and no price differentiation between residents and non-residents. However, there is no clarity on the amount of investment after the renunciation of the rights issues. Must this investment be treated as the same after a rights issue or not?

The following views are developed due to lack of clarity:

• Is the renunciation of rights issues treated as a capital transaction? If this is the case, then all capital transactions are not allowed under FEMA.
• For determining renunciations, do existing principles of the Companies Act 2013 apply to rights issues?

The TOIS (2000 and 2017) regulations provide clarity on the same to reduce the amount of confusion. For rights issue under FEMA, the above regulations specify that price flexibility and renunciation of rights would come under the purview of the rights issue of shares from Resident to Non-resident Indian. This will also apply for rights issue from a Non-resident Indian to a resident Indian.

The Non Debt regulations provided clarity on the renunciations. It also stated the respective pricing guidelines would apply for rights issues for a person resident in India to a Non-resident Indian.

Changes in Price of Rights Issue

When resident Indians renounce rights issues, they would be offered to Non-resident Investors. Due to this, there would be a change in price as a part of the rights issue. The pricing guidelines have to be followed as per the rules under FEMA.

This would not be a concern for listed companies as the price of rights issue is determined by a lead manager under the SEBI listing regulations. For Unlisted Companies, there is no regulation for determining the price. As per the principles of FEMA, the price for an unlisted company would be according to the fair value of shares.

International Valuation methods would be considered for determining the price for rights issue for shares for unlisted companies. For this, a SEBI registered Merchant Banker or a Chartered Accountant will be used. A plain reading of the regulations suggests that a listed company’s price would apply to renunciations.

Example

To understand rights issue under FEMA, let us consider the above example. XYZ is a company that is not listed in a stock exchange. X and Y are non-resident shareholders (NRI), having 20% and 40% shareholding in XYZ. Z is a resident Indian having 40% shareholding in XYZ LTD.

• If Z renounces the rights issues offered by XYZ and transfers the same to X, then the price of shares of the rights issue will not change.
• If the X and Y participate in the rights issue, then the original price would be offered, and the price for the rights issue would not change.
• Shares that are renounced can be offered to the outsider W also.

Conclusion