Protection of Exit Clauses for Foreign Investors under FEMA

Narendra Kumar

08 Feb, 2021

What is the worth of FDI to a country like India?

Foreign Direct Investment (FDI) is very crucial in the fortification and strengthening of an economy. In the context of the Indian Economy, Foreign Direct Investment has helped develop key sectors in India like infrastructure. It has brought in newer technologies to the Indian soil; it has led to increased capital inflow; it has helped develop the export sector; there have been more employment opportunities created, and have also helped strengthen the financial sector of the country. Foreign in-flows also help stabilize the exchange rate of a nation and over a period, leads to the overall improvement in the living conditions and lifestyle of the general public of the country. This article describes the Protection of Exit Clauses for Foreign Investors under FEMA.

Foreign investment figures of India in recent years

(Source: RBI^[1])

Sectors in India that have received the maximum FDI in the last fiscal year

Country wise inflow in India in the last fiscal year

What is FEMA and how is it related to FDI?

FDI or Foreign Direct Investment is regulated by the Foreign Exchange Management Act, 2000 (FEMA) in India. The FEMA rules and regulations are overseen by the Reserve Bank of India.

Interested foreign investors can invest in an Indian company or business entity either through the Automatic Route in which approval from the RBI or the government is not required or the Government Route in which case the relevant ministry or government department needs to approve the investment.

The government route is mandatory in case of: –

• 11 notified sectors – mining, defense, small arms, broadcasting, print, civil aviation, satellites, telecom, private security agencies, telecom, satellites, trading, financial services that have more than one regulator or there is doubt about the regulator, banking sector, and pharmaceuticals.
• Bangladeshi and Pakistani entities or individuals

FDI’s are categorized under various sub-heads – Foreign Portfolio Investors (FPI), Foreign Institutional Investors (FII), Foreign Venture Capital Investors and Non-Resident Indians. Violations related to FDI are penalized under FEMA and the apex bank of the country – RBI, as well as the Directorate of Enforcement under the Ministry of Finance has the powers to investigate any such violations of rules and regulations.

What is the put and call option in the context of FDI?

Vide notification no. FEMA 294/2013-RB dated 12^th November 2013 the Foreign Exchange Management Regulations, 2000 (Transfer or Issue of Security by a Person Resident outside India) was amended to allow Put and Call options to foreign investors.

A Call option is a criterion by virtue of which an investor can buy shares in an entity at a mutually agreed price while a Put option is defined as a situation that enables the shareholders to sell off their shares. Foreign investors can use the Put option when certain conditions are not met like timely listing or fulfillment of a project by the Indian company. Based on the above amendment foreign direct investors could now use these two options in their contractual agreements with an Indian business entity.

This amendment was followed by the circular named Foreign Direct Investment – Pricing Guidelines for FD Instruments with optionality clauses dated 9^th January 2014 vide RBI/2013-14/436 A.P. (DIR Series) that added that the optionality clause could be permitted to be used with equity shares but on compulsory basis had to be used with convertible preference shares/debentures that a foreigner or a non-resident Indian issues under the FDI Scheme. Some key features of the circular were –

1. The investor could sell his securities at the prevailing price or value that is settled on during the time the optionality clause is exercised.
2. The foreign investor can exit without any assured return subject to –
3. For a listed company, the investor sells at the existing market price at a recognized stock exchange.
4. For the unlisted company, the investor will be able to exit at a price that is not higher that arrived on basis of Return on Equity (RoE) as per the last audited balance sheet. RoE here means Profit after Tax/Net Worth where Net Worth is inclusive of free reserves and paid-up capital.
5. The price in case of Compulsorily Convertible Debentures (CCDs) and Compulsorily Convertible Preference Shares (CCPs) will be worked out as per pricing methodologies that are internationally accepted and needs to be certified by a Chartered Accountant or a SEBI registered Merchant Banker. In this case, the investor has no guarantee of any assured exit price when he makes an investment and the price applicable will be finally decided at the time of exit.
6. The optionality clause is subject to certain conditions like –

Minimum lock-in period of 1 year or as prescribed by FDI regulations, whichever is higher. The start of the lock-in period will be effective from the date such shares or convertible debentures are issued or as per prescribed FDI regulations. It is essential to note here that certain sectors have intrinsically higher lock-in periods like the Defence which has a mandatory period of 3 years.

The above rules need to be mandatorily followed while drawing up contracts for the contracts to be considered compliant with FDI rules and regulations.

Read our article:How Government’s new FDI rules can affect E-commerce retailers and business

What does all this mean in terms of enforcement of options under FEMA?

Protected exit clauses under FEMA have been demanded by foreign investors for quite some time now – something that was on hold for a long time. The industry overall has listed a few distinct advantages of the circulars passed by RBI –

• Thanks to the clarity provided vide the circulars, the foreign direct investment in the private sector is expected to go up substantially.
• It has also helped remove ambiguities about the exit prices.
• Also because of the stringent and tight rules debt will not be brought as equity.

Though the above changes and amendments made by RBI have been welcomed by foreign investors but the clause of ‘no assured return’ that has also been interpreted as stringent valuation restrictions is considered disadvantageous for new FDI projects and ventures.

The enforceability of these options also has limitations especially in case of the exit clause mentioned for unlisted companies. Here the investors are still not able to take advantage of businesses especially new ones that have just been set up – ones that have good future potential but are still in their gestation period.

When exiting such ventures, the foreign investor who had invested at the market price will get to exit only at the book value rather the price is calculated using a method that takes into account potential cash flows in the future – this has acted as a detrimental factor for foreigners to put in their money into new projects of unlisted companies.

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