Shift in regulatory responsibility and reduced procedures to attract FDI
June, 05th 2008
In 2004, under a major unshackling of exchange control regulations, dealing of cross border transactions, including share transfers of Indian companies, were delegated to banks designated as authorised dealers (AD). This came under the automatic route, doing away with FIPB and RBI approvals, except in certain sensitive sectors and special cases. As there was no change in the pricing guidelines for transaction valuations, in case of any deviation, the parties would have to seek RBI permission.
Undoubtedly, the shift in regulatory responsibility and simplification of procedures reduced the timeframe for bringing in FDI, whether for fresh issues or transfers. But the pricing guidelines for unlisted companies remained the same, notwithstanding changes in capital inflow trends, structuring and investment options and global valuation norms. What is really absurd is the continued, reliance placed on the obsolete CCI guidelines.
Some of us remember that the Controller of Capital Issues (CCI) was the regulator of all share issues priced higher or lower than face value. For the purpose of price determination, CCI had prepared guidelines based on an average of the Net Asset Value (NAV) and Profit Earning Capacity Value (PECV) methods both based on recent past NAV on book value as per latest annual accounts and PECV on the average of post tax profits.
Even in the restricted scope of a closed economy, these guidelines came under severe criticism as being unrealistic and inequitable. Any commerce student knows that NAV does not recognise revaluation of fixed assets, unless they are several years old thereby does not reflect the proper market value, which lowers the share valuation significantly.
The PECV method proceeds on an erroneous premise for capitalisation after tax profits at different rates for manufacturing and trading companies, while not addressing companies providing services finance, leasing activities. Therefore, shares held by residents are bound to be undervalued and Indian sellers are not happy if offered a consideration as per the Pricing Guidelines.
The Pricing Guidelines for transfers by non-resident to resident, provide that in case of shares the price should be the lower of two independent valuations, one by the company's statutory auditors and the other by a Chartered Accountant or Category I Merchant Banker. No restrictions are placed on valuation methodologies.
It is not my purpose to compare various valuation methodologies, but to understand the implications of retaining CCI guidelines, when CCI was abolished in 1992 as a part of the reform process to deregulate market forces.
At that point of time itself, CCI guidelines were viewed as having lost their relevance, being based on historical data, ignoring future potential of companies.
SEBI replaced CCI so that the market based approach of regulation could prevail for listed companies. Currently issue and or transfer of listed shares are determined on the basis of weekly average quotations with five per cent variation for sale by non-residents except when a foreign partner or promoter of an Indian company sells out to its Indian counterpart, a premium up to twenty percent is automatically permissible. The role of merchant bankers and chartered accountants have become critical in determining the price from both investors and issuers perspective.
RBI recognises the flexibility of methodology in computing the price for transfers by residents to non-residents except that the lower of the two methods prevails, and upward variation is permitted up to about ten percent of such valuation, otherwise, the AD or the parties need RBI"s permission on justifying that the variation is necessary. If the objective is providing protection to domestic sellers from undervaluation, then the NAV or PECV methods are far from "fair" valuation.
Its another matter that ADs are fairly liberal in permitting upward deviations the thumb rule being that the AD can approve upward deviations from the fair valuation, even if the negotiated price is four or five times higher, as long as the Indian seller benefits.
Policy makers have failed to appreciate that even for transactions outside the securities market, partial capital account convertibility complicates foreign exchange risks.
Anti-money laundering initiatives such as KYC and the Basel Committee demands have required Banks to gear up their risk assessment. The above "no holds barred" approach is nave and jingoistic as it overlooks possibilities of round tripping which SEBI is combating in the securities market front. Simply reporting non-standard FDI is not the solution, and by retaining the CCI guidelines, India is not acting smart.