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Friday, July 08, 2016

Tata-Docomo: What went wrong, and what we need to do different

by Bhargavi Zaveri and Radhika Pandey.

Background


An international arbitration tribunal recently reportedly ordered Tata Sons to pay $1.17 billion to NTT Docomo for breach of a contract between Tata Sons and Docomo. The contract obligated Tata Sons to buy back the shares held by Docomo in Tata Teleservices at a pre-agreed price that was higher than the `fair market value' of Tata Teleservices. Paying Docomo this price for its shares would have violated the regulatory framework governing capital controls in India, which prohibits a non-resident from 'putting' her shares on a resident at a pre-determined price.

The Tatas had reportedly applied to the Reserve Bank of India for an exemption from this restriction. RBI was reportedly keen to allow a one time exemption from its regulations. An earlier article on this blog expressed concern about an individual transaction being exempted from FEMA: while such an exemption may bring temporary cheer to an individual investor, it is more important to (a) stick to the rule of law; and (b) fix the mistakes in FEMA, as opposed to applying discretion in exempting some persons from the the bad law. When the matter was referred to the Central Government, the Central Government argued against case-by-case departures from the law, exhorted RBI to carry out deeper regulatory reform, and refused to grant this ad-hoc exemption.

Now we have the arbitration award. This arbitration award will likely lead to the following fall-out:

  1. Docomo will apply for enforcement of the award in India.
  2. Tata will argue that the pre-agreed contractual price cannot be paid, as it violates the laws governing foreign exchange transactions in India.
  3. If the Indian court refuses to allow the award to be enforced, the global press will write about the repercussions of this on India's competitiveness as an investment destination.

This situation is likely to come up in all transactions where foreigners seek to exit their Indian ventures by asking their Indian partners or the Indian company to buy-back the shares held by the foreigners at a contractually agreed price. The root of this problem lies in the capital controls framework which imposes restrictions on the manner in which a foreigner may exit from an Indian venture.

In this article, we argue that the restrictions on the exercise of put options by non-residents lacks an economic rationale. We then attempt to sketch a broad outline for designing a clean and coherent legal framework for governing capital controls in India.

Put options as an exit mechanism


Put options are a very common tool for exiting an investment. Typically, in an investment agreement, investors negotiate several time-bound exit rights for themselves, such as:

  1. Exit by an IPO or offer for sale by existing shareholders on the exchange - The investee company will list and the investor will sell her shares pursuant to the listing.
  2. Put or buy-back options - The investee company or the Indian promoter will buy or procure a buyer for, the shares held by the non-resident. The timing for the exercise of such options is linked to specific triggers. For example, in the Tata-Docomo agreement, Docomo reportedly had an option to put its shares on Tata within three years at half the value of the orignal investment. Similarly, investors often negotiate a put option linked to the investee's failure to achieve performance targets and the like.
  3. Tag and drag along rights - Depending on the stake held, the investor may negotiate a right that where any other shareholder in the investee company sells her shares, the selling shareholder will be bound to ask the new purchaser to buy the other shareholders' stake as well (i.e. the investors 'tag along' with an exiting shareholder). Where the investor sells her stake, she may require another shareholder in the investee company to also sell her shares to the same purchaser (i.e. the investor may 'drag along' another shareholder).

Flip-flops on put options


From a capital controls perspective, RBI had reportedly been objecting to the creation of put options in favour of non-residents prior to 2011, even when the law did not explicitly prohibit the creation of such rights. Thereafter, on September 30, 2011, the Department of Industrial Policy and Promotion (DIPP) issued a press release declaring that a put option in favour of non-residents would be regulated like an external commercial borrowing (which, at that time, meant that it would be regulated under the framework applicable to foreign currency denominated borrowings). DIPP mandated that:

Equity instruments issued/transferred to non-residents having in-built options ... would lose their equity character and such instruments would have to comply with the extant ECB [External Commercial Borrowing] guidelines.

This effectively meant that the proceeds of such shares could be used only for permissible end-uses and that there would be a cap on return on such equity, etc. After a month of heavy lobbying by parties that had already contracted such rights, the DIPP withdrew its restriction. After more than a year of uncertainty on this issue, RBI issued a circular which represented a somewhat compromised position by allowing put options in favour of non-residents, subject to certain conditions:

  1. The non-resident investor should have been locked in for a minimum period of one year, that is, she cannot exercise the put option unless she has held shares in the company for atleast a year.
  2. The non-resident should exit without an assured or pre-agreed return. This restriction fundamentally defeats the reason for negotiating a put option which is intended to protect the investor from a downside.
  3. Until 2014, the price payable to a non-resident when she 'put' her shares on a resident, could not exceed return on equity (calculated as Profit After Tax divided by Net worth) as per the latest audited balance sheet of the investee company. From 2014 onwards, the price cannot exceed the fair market value of the shares arrived at as per any internationally accepted pricing methodology in the case of unlisted companies and the price of the shares on the floor of the exchange in case of listed companies.

The futility of restrictions on rupee-denominated instruments


The claimed reason offered for restricting non-residents from obtaining an assured pre-agreed return on the exercise of put options is: a put option with a pre-agreed price would make the contract akin to debt. As RBI has a relatively stricter regulatory framework governing issuance of debt instruments by Indian residents to non-residents, allowing non-residents to obtain an assured return on put options would allow them to circumvent the RBI-framework governing debt. This argument is incorrect at several levels.

If there is an equity spot asset at $S$, and there is a put and call option at an exercise price $X$ on date $T$, where the options are valued at $P$ and $C$, and the interest rate is $r$, then put-call parity tells us that $S+P = C + X(1+r)^{-T}$. In other words, a spot investment that's risk-managed using a put option is not tantamount to a bond. It's tantamount to a complicated combination of a bond and a call option.

The rights in a default situation are different. There is neither any underlying security if the company or the promoter defaults on the put nor does the default on put give the non-resident rights which a creditor generally has (such triggering dissolution, etc.).

Even if you ignore the call option part, and focus on the rupee debt, the rationale for capital controls on these is absent. There is no systemic risk arising from foreign investment in Rupee-denominated instruments, where the currency risk is borne by a non-resident. As explained in the Report of the Committee to Review the Framework of Access to Domestic and Overseas Capital Markets (popularly referred to as the Sahoo Committee Report on External Commercial Borrowings), systemic risk is limited to the situations where the currency risk is borne by the resident. When a firm undertakes foreign currency borrowing, its balance sheet is exposed to exchange rate fluctuations. If there are numerous firms that undertake foreign currency exposure that is not hedged, there is a possibility of co-related failure in the event of a large exchange rate movement. However, a rupee-denominated loan by a non-resident to an Indian resident is akin to a loan given by an Indian resident to another Indian resident. We do not impose any restrictions on the contractual arrangements involving put options amongst residents.

In keeping with this thinking, the regulatory framework for Rupee-denominated borrowings has been relatively liberalised in the recent past. For instance, there is no cap on the interest rate that can be charged by a non-resident for the Rupee-loans advanced by her to the Indian borrower. In light of such liberalisation, there is no case for continuing with the same restrictive regime for put options, under the apprehension that parties will structure debt flows as equity with put options.

Transitioning toward a clean regulatory framework for foreign capital flows


In India, there are multiple levels of capital controls through different methods such as sectoral caps to control quantum of inflows, conditionalities to control kind of inflows and end-uses, exemptions for certain investment routes, penalising other investment routes, etc. Restrictions of this kind do not belong in an aspiring emerging market.

An extensive academic literature has hypothesised that economic agents learn to evade capital controls over time (Browne and Mcnelis (1990), Mathieson and Suarez (1991) and Patnaik and Shah (2012)). We in India take cognisance of the methods agents employ, and impose further controls to plug such evasion, adding hundreds of pages of complicated law and bureaucratic overhead. This complex maze of restrictions increases the costs of administering the law on capital controls, increases transaction costs for economic agents and fails to address the real issue where capital controls have value: the systemic risk associated with unhedged foreign currency denominated borrowings.

The story of restrictions on put options is revealing: (a) RBI created a restrictive framework for foreign denominated debt that lacked economic rationale; (b) It then suspected that economic agents were structuring their transactions as put options on equity to over-ride the restrictions. This was followed by uncertainty on the enforceability of such put options. (c) RBI modified the law to alter contractual rights of parties that had contracted put options on rupee-denominated instruments, thereby vitiating genuine transactions along with suspected ones which may have intended to evade the law. (Also, see another recent example being played out in China.)

This regulatory risk and cost of dealing with bureaucracy is driving up the cost of doing business in India. Unless we undertake deeper reform, we will see this story playing out time and again. This calls for a neat and coherent legal framework of the kind codified in the draft Indian Financial Code Version 1.1, which, in turn, is a culmination of the U.K. Sinha-led Report of the Working Group on Foreign Investment and the Justice B.N.Srikrishna-led Financial Sector Legislative Reforms Commission. This clean framework is based on three core principles:

  1. Barriers, if any, on inflows must be placed at the point of entry. For example, sectoral caps are a barrier at the point of entry.
  2. Once the entry barrier is crossed, all investments of a kind, whether made by residents or non-residents, must be treated equally. For example, local sourcing norms must not be imposed on non-residents if they are not so imposed on residents. Put options must be allowed in favour of non-residents if they are so allowed for residents.
  3. Government approval for an investment, if at all, must be mandated only for considerations of national security, that is, for investment in critical technology and critical infrastructure.

The Finance Act, 2015 amended the Foreign Exchange Management Act, 1999 to allow the Central Government to regulate all capital flows which did not constitute debt. This was a major milestone in Indian financial reform. The power to transition the current regulatory framework into a clean law, to the extent applicable to flows which are not in the nature of debt, now vests in the Ministry of Finance. An extensive body of work in this field has been done in the last decade. The time is ripe to start implementing it and avoiding more Tata-Docomo like disputes and the ensuing damage to India's competitiveness as an investment destination.

References


Donald J. Mathieson and Liliana Rojas-Suarez, Liberalization of the Capital Account: Experiences and Issues, IMF Working Paper (1992).

Browne, Francis and Paul D. Mcnelis, Exchange Controls and Interest Rate Determination with Traded and Non-traded Assets: the Irish-United Kingdom Experience, Journal of International Money and Finance, Vol.9, No.1 (March 1990), pp. 41-59.

Ila Patnaik and Ajay Shah, Did the Indian capital controls work as a tool for macroeconomic policy, IMF Economic Review, Vol. 60, Issue 3 (September 2012), pp. 439--464. The authors are researchers at the National Institute for Public Finance and Policy.


The authors are researchers at the National Institute for Public Finance and Policy.

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