Issuance of equity instruments by an Indian company to a person resident outside India under the FDI route requires compliance with pricing guidelines according to extant foreign exchange laws. These guidelines stipulate that in case of an unlisted Indian company, valuation should be carried out by following any internationally accepted pricing methodology on an arm’s length basis. Additionally, the valuation is to be duly certified by a chartered accountant or a merchant banker registered with SEBI or a practising cost accountant.

There were however certain exemptions to the pricing guidelines. One of them was issuance of shares to a person resident outside India for subscription to the Memorandum of Association, which could be at the face value of the shares.

Another exemption available until recently was issuance of shares pursuant to a rights issue. The ability of a person resident outside India to subscribe to equity instruments of an Indian company pursuant to a rights issue was subject to specific provisions contained in the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (NDI Rules). These rules stipulated that in case of an unlisted Indian company, the rights issue to persons resident outside India shall not be at a price less than the price offered to Indian residents. Accordingly, such issuance could be at a price lower than the fair market value, provided the Indian shareholders are also offered shares at the same price.

With the change now introduced to the NDI Rules under Rule 7A pursuant to the notification dated April 27, 2020, a person resident outside India who has acquired a right from an Indian resident who has renounced it, may acquire equity instruments (other than share warrants) against the said right as per the pricing guidelines specified under Rule 21 of the NDI Rules.

This would mean that where a person resident outside India subscribes to rights shares which are its entitlement, it will continue to be entitled to the exemption from pricing guidelines. Similarly, if an existing non-resident shareholder renounces its right to another person resident outside India, the benefit of exemption from pricing guidelines may be applicable since this is not sought to be restricted under the notification. Given the above, a person resident outside India participating in a rights issue of an unlisted Indian company is likely to end up having different subscription prices for the rights shares should there be a combination of events as above.

Perhaps the thinking behind incorporating Rule 7A in the NDI Rules is to restrict any value benefit being renounced by an Indian resident in favour of a person resident outside India due to free pricing norms governing rights issues.

Many a times, the reason for a renunciation by an existing shareholder may not be clear. It could be a case where the Indian promoter has promised a certain target valuation of the shares issued to a non-resident investor shareholder. A rights issue at a nominal price could result in the non-resident shareholder holding larger stake in the Indian company and achieving the target valuation. Similarly, where price protection is offered to an existing non-resident investor in respect of subsequent fund raises, a rights issue could help bridge a valuation gap.

Typically, rights issues are priced lower than the prevailing trading price in case of a listed company or lower than the fair market value in case of an unlisted Indian company in order to encourage existing shareholders to contribute more equity. As equity shareholders, they would be taking a monetary risk if the company has significant debt or there is a substantial time period for return of equity value/liquidity. Some equity shareholders may however be comfortable taking a long-term view on sustainability of the business, and such shareholders may be willing not only to subscribe to the shares upto their full entitlement, but also participate where there is renunciation/non-participation by any of the existing shareholders.

The amendment to the NDI Rules does not make any distinction as above, but merely stipulates that if a person resident outside India acquires a right from an Indian resident to participate in a rights issue, pricing guidelines would apply. In a way, the amendment to the NDI Rules reinforces the principle that what cannot be done directly (i.e. subscription to shares at lower than fair market value), should not be done indirectly, and compliance should also be with the spirit and not merely the letter of law.

With Press Note 3 of 2020 restricting any direct/indirect participation under the automatic route for FDI through entities based in countries sharing a land border with India, and the revision to the NDI Rules governing rights issues, the government seems to be adopting a stricter approach to valuation for specific investments into India.

NDI Rules

A stricter approach to valuation for specific investments