The Reserve Bank of India prompted the Department of Industrial Policy and
Promotion (“DIPP”) to revise its acceptable structure for FDI in India.

Only equity shares; fully, compulsorily and mandatorily convertible debentures; and fully, compulsorily and mandatorily convertible preference shares, with no in-built options of any type, will qualify as eligible instruments for the purposes of FDI. Equity instruments issued or transferred to non-residents having in-built options or supported by options sold by third parties will lose their equity character and will be treated as debt instruments requiring compliance with external commercial borrowing ("ECB") guidelines.

Further, a sellback right, or a put option, to foreign investors would be treated as a  derivative deal, and under the Foreign Exchange Management Act, 1999 (“FEMA”), only Securities and Exchange Board of India (“SEBI”) registered foreign institutional investors and non-resident Indians are allowed to invest in exchange-traded derivative contracts where the underlying securities are equity shares of an Indian company. No other class of foreign investor is allowed to enter into any derivative contract where the underlying security is an equity share of an Indian company.

When capital market conditions are good, the primary exit mode for private
equity (“PE”) investors is through an initial public offering. However, in times of market uncertainties, PE investors seek exits through put / call options, or by requiring the promoter to cause the investee company to effect a buy-back of shares, or such other methods. Now that the Circular has become effective, PE investors will not be able to provide for such exit rights in agreements because such rights will be make the investment a debt investment requiring compliance with ECB guidelines. The ECB guidelines are quite onerous in that it is not easy to be an eligible lender under the guidelines, and then there are various end use restrictions on the investment.

In addition, since last year, the RBI has mandated the use of the discounted free cash flow valuation methodology on most share transfers between residents and non-residents. Although this has created its own problems, it has served as an exit restriction of some sort. Also, notionally treating an equity investment as debt may give rise to various accounting issues, and auditor's will have to wear their thinking hats on this one. All in all, workarounds will have to be thought through.