On April 27, 2020, the Central Government notified the Foreign Exchange Management (Non-debt Instruments) (Second Amendment) Rules, 2020 (“FEMA NDI Amendment”). The FEMA NDI 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.

Why Rights issue?

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 Foreign Exchange Management (Non-debt Instruments) Rules, 2020 (“FEMA NDI Rules”) (including erstwhile Foreign Exchange Management (Transfer or issue of security by a person resident outside India) Regulations, 2000 (“FEMA 20”) and the Foreign Exchange Management (Transfer or issue of security by a person resident outside India) Regulations, 2017 (“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.[1]

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 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[2] – 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.

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.[3]

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.[4]

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.[5] As per the SEBI regulations, listed companies can determine the rights issue price in consultation with the lead manager for the issue.[6] 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 implications and analysis

To appreciate 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 #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[7] – 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.

[1] Rule 7 of the FEMA NDI Rules

[2] 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.

[3] 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’

[4] Rule 21(2)(a)(ii) of the FEMA NDI Rules

[5] Rule 21(2)(a)(i) of the FEMA NDI Rules

[6] Regulation 73(1) of the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018

[7] 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.