Analysis of FEMA Non Debt Instruments Rules 2nd Amendment

Before, reading this article, please take note of following abbreviations used in this article:

Foreign Exchange Management (Non-debt Instruments) (Second Amendment) Rules, 2020 (“FEMA NDI Amendment”)

The Foreign Exchange Management (Non-debt Instruments) Rules, 2020 (“FEMA NDI Rules”) 

Foreign Exchange Management (Transfer or issue of security by a person resident outside India) Regulations, 2000 (“FEMA 20”)

Foreign Exchange Management (Transfer or issue of security by a person resident outside India) Regulations, 2017 (“FEMA 20R”)

Introduction

On April 27, 2020, the Central Government notified the Foreign Exchange Management (Non-debt Instruments) (Second Amendment) Rules, 2020 (“FEMA NDI Amendment”). This Amendment seeks to modify the position on pricing of rights issue – in case of renunciation of rights in favour of a non-resident by a resident, pricing guidelines will apply. We have analysed the implications of the FEMA NDI Amendment on rights issue of securities in this blogpost.

Rights issue has been a preferred mode of raising capital from the existing shareholders of a company as there are no prescriptive conditions on issue price. Companies have the flexibility to determine issue price in case of rights issue under company law as well as SEBI regulations (applicable to listed companies). This gives companies much-needed flexibility to structure a capital raise from existing investors, especially in times of need.

The Ministry of Finance had earlier classified instruments issued under the Foreign Exchange Management Act, 1999 as debt and non-debt instruments

FEMA NDI Rules (including erstwhile FEMA 20) and the FEMA 20R have explicitly recognised free pricing of rights issue. The FEMA NDI Rules prescribe that 

(i) in case of unlisted companies, securities have to be offered to non-residents at a price not less than the price offered to residents under a rights issue; and 

(ii) in case of listed companies, the price will be as determined by the listed company.[Rule 7 of the FEMA NDI Rules]

Given the flexibility in pricing, companies, promoters, and investors have explored the rights issue route for capital raise.

Renunciations of rights – regulatory to and fro

As mentioned above, FEMA 20 specifically recognised the ability to issue shares to non-residents as part of the rights issue. However, it was silent on whether investment pursuant to renunciation of rights would be treated in a manner similar to a rights issue. This led to varying views on treatment of renunciations under FEMA – one view being that renunciation of rights pursuant to a rights issued constituted a capital account transaction, which was not specifically permitted under FEMA and the other view being that renunciation should be treated no differently as it was an extension of the principles recognised under company law.

When FEMA 20 was re-invented as FEMA 20R on November 7, 2017, a specific explanation (expl. provided below) was added, which put this debate to rest. The amendment recognised the principle that the same set of rules applied to renunciation of rights as well, – effectively permitting pricing flexibility for an investment pursuant to a renunciation of rights. In fact, the explanation was also retained in the FEMA NDI Rules, which replaced the FEMA 20R issued on October 17, 2019.

Explanation to Regulation 6 of FEMA 20 R: Explanation: The above conditions shall also be applicable in case a person resident outside India makes investment in equity instruments (other than share warrants) issued by an Indian company as a rights issue that are renounced by the person to whom it was offered 

Subsequently, the FEMA NDI Amendment changed the position with two key changes – 

(i) the explanation specifically permitting renunciations has been deleted; and 

(ii) a new rule has been introduced, which stipulates that pricing guidelines would apply in case rights have been renounced by a person resident in India in favour of a non-resident.

Rule 7A of the FEMA NDI Rules (as amended by the FEMA NDI Amendment) states that ‘a person resident outside India who has acquired a right from a person resident in India who has renounced it may acquire equity instruments (other than share warrants) against the said rights as per pricing guidelines specified under rule 21 of these rules

Therefore, the implication of the FEMA NDI Amendment is that renunciation of rights in favour of non-residents would reset any pricing arbitrage offered as part of the rights issue and the pricing guidelines would have to be complied with. For unlisted companies, this means that all issuances pursuant to a renunciation of rights issue must be undertaken at or above the fair market value of the company, determined using an internationally accepted pricing methodology by an independent chartered accountant/ merchant banker at an arms’ length basis. [Rule 21(2)(a)(ii) of the FEMA NDI Rules]

Interestingly, the implication is different for listed companies – the FEMA NDI Rules point to SEBI regulations on pricing for issue of shares by listed companies.[Rule 21(2)(a)(i) of the FEMA NDI Rules]

As per the SEBI regulations, listed companies can determine the rights issue price in consultation with the lead manager for the issue.[Reg.73(1) of ICDR, 2018] 

Hence, a plain reading of the regulations suggests that the price determined by a listed company for a rights issue of shares can continue to apply for renunciations as well.

Key amendments

The following are the key changes deemed to have come into effect as from 27 April 2020.

Investments in Non-Debt instruments upto 100%

The amendment has allowed 100% investment in the Non-debt instruments of following intermediaries through automatic route:

Intermediaries or Insurance Intermediaries including insurance brokers, re-insurance brokers, insurance consultants, corporate agents, third party administrator, Surveyors and Loss Assessors and such other entities, as may be notified by the Insurance Regulatory and Development Authority of India from time to time, 

Further, the new investments shall be subject to the new conditions as prescribed by the amendment.

Issue of rights shares: acquisition after renunciation of rights

A nonresident who has acquired a right from an Indian resident who has renounced that right, may acquire equity instruments (other than share warrants) against the said rights in accordance with the pricing guidelines specified under rule 21 of the FEMA NDI rules.

Sector specific changes

The second amendment rules give effect to the following amendments to foreign direct investment (FDI) policy in specific sectors introduced by Press Note No. 4 (2019 series) and Press Note No. 1 (2020 series) issued by Department for Promotion of Industry and Internal Trade (DPIIT).

Single brand retail trading

When evaluating the applicability of sourcing norms for entities undertaking single brand retail trading of products using “state-of-art”' and “cutting-edge” technology, where local sourcing is not possible, it has been clarified that sourcing norms will not apply until three years after the commencement of the business (i.e., the opening of the first store, or the start of online retail activities, whichever is earlier).

FDI policy in the insurance sector

Intermediaries or insurance intermediaries including insurance brokers, reinsurance brokers, insurance consultants, corporate agents, third party administrators, surveyors, loss assessors, and such other entities as may be notified by the Insurance Regulatory and Development Authority of India (IRDAI), are eligible to receive 100% FDI under the automatic route (requiring no prior approval from the Indian government or the Reserve Bank of India for the receipt of FDI). The FDI is subject to verification by the IRDAI, and is governed by the Indian Insurance Companies (Foreign Investment) Rules, 2015.

The requirement to be Indian owned and controlled does not apply to intermediaries and insurance intermediaries, but insurance intermediaries with majority foreign ownership must meet the following criteria in addition to the other conditions specified in the notification of NDI rules for FDI in the insurance sector:

• Be incorporated as a limited company under the Companies Act, 2013;
• At least one of the chairperson of the board of directors, CEO, principal officer, or managing director must be a resident Indian citizen;
• Obtain prior permission from the IRDAI for the repatriation of dividends;
• Employ the latest technological, managerial, and other techniques;
• Make no payments to promoters, the foreign group, or subsidiary, interconnected, or associated entities beyond what is necessary or permitted by the IRDAI, and ensure that all required or permitted payments are disclosed on a timely basis and in the format specified by the IRDAI; and
• Ensure the composition of the board of directors and key management personnel meet the requirements specified by the relevant regulators.

Divestment by foreign portfolio investors (FPIs)

It has been clarified that, in addition to the conditions prescribed by the NDI rules, the divestment of holdings by FPIs, and the reclassification of FPI investment as FDI may be subject to further conditions specified by Securities and Exchange Board of India, and the Reserve Bank of India

Key implications and analysis

To analyse the implications of the FEMA NDI Amendment, let us consider a practical example – X Ltd, an unlisted Indian Company, is proposing to undertake a rights issue. 

X Ltd has three shareholders – 

A (non-resident holding 30%), 

B (non-resident holding 30%) and 

C (resident holding 40%). 

We have considered some scenarios below:

1. Renunciation by resident: C, a resident, renounces its rights is favour of A, non-resident – this clearly falls within the purview of the FEMA NDI Amendment and accordingly, for the rights renounced by C in A’s favour, i.e. 40%, the issue price will have to be re-computed on the basis of the pricing guidelines. Having said this, this leads to a situation of differential pricing for the same issue, i.e. A will have the right to subscribe 30% of the securities at the original rights issue price and will have to pay the new issue price determined in accordance with the pricing guidelines for the 40% of the securities renounced by C. It will also have to be examined if such differential pricing results in any adverse tax implications for the subscriber as well as the company.

2. Renunciation by a non-resident: A, a non-resident, renounces its rights in favour of D, another non-resident. D should be able to subscribe the renounced rights at the original rights issue price as the price reset requirement is applicable only if a resident renounces rights in favour of a non-resident.

3.Failure by resident to subscribe: The resident shareholder C doesn’t participate in the rights issue and non-resident shareholders A and B participate – the non-resident shareholders should be able to subscribe to the securities at the original rights issue price and the subscription price would not have to be reset by applying the pricing guidelines.

4.Board allots unsubscribed portion to non-residents: In respect of the fact pattern in No.3 above, the Board of Directors of X Ltd decide to allot the unsubscribed portion by C in favour of say A and B or in favour of another non-resident – as such Rule 7A of the FEMA NDI Rules only applies to renunciations by residents in favour non-residents and the board of directors decision to allot the unsubscribed portion in favour of non-resident appears to be outside the purview. However, given the intent of the amendments, it is advisable that any such action should be an outcome of a genuine and rationale board decision. [See Section 62(1)(a)(iii) of the Companies Act, 2013. The Board of directors are permitted to deal with the unsubscribed portion of a rights issue in a manner which is not disadvantageous to the Company]