Anti-Dilution Rights - How to Work Around the FEMA (TISPRO) Regulations, 2017 for Non-Residents [Part 5 of the five-part series]

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In order to avoid the ‘Pricing Guidelines’ [discussed previously in Part 4 of this story], the additional shares to be allotted to the original investor of the Indian startup company to comply with the Anti-Dilution Rights must be issued under the ‘rights issue’ mechanism under Section 62 (1) (a) of the Companies Act, 2013 instead of ‘preferential allotment’ mechanism under Section 62 (1) (c) of the Companies Act, 2013.

The FEMA (TISPRO) Regulation, 2017, under Regulation 6, clearly lays down the provisions governing the ‘acquisition of shares through a rights issue or a bonus issue’ to a ‘person resident outside India’. Regulation 6 (5), clearly lays down that, “In case of an unlisted Indian company, the rights issue to persons resident outside India shall not be at a price less than the price offered to persons resident in India.” This means that, under ‘rights issue’, the shares can be issued at any price (including price per share lower than the fair market value), provided the Indian company offers the shares under ‘rights issue’ to the other shareholders at the same price.

Generally, all investment agreements, which have Anti-Dilution Rights, have elements of shareholders agreements and are accordingly executed by all shareholders of the investee company (new shareholders of the investee company are inducted into such ‘investment agreement’ therein through addendum). Therefore, contractually, if one can bind the other shareholders of the investee company to reject such shares offered under ‘rights issue’, then the non-resident investor can exercise its ‘rights issue’ and subscribe to such number of shares that is required to comply with the Anti-Dilution provisions.

Anti-Dilution Rights – Exception for Non-Residents [Part 4 of the five-part series]

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Contravention of FEMA (TISPRO) Regulations, 2017

It is clear from the ‘Introduction’ [Part 1 of this story] that, if the Anti-Dilution Rights gets triggered, a startup company must issue additional shares to the investor exercising such Anti-Dilution Rights at no price or at a price lower than the value at which the fresh subscription has been made by the new investor.

This actually directly violates the ‘Pricing Guidelines’ under Regulation 11 of FEMA (TISPRO) Regulations, 2017, in the event the original investor is a ‘person resident outside India’ under FEMA (TISPRO) Regulations, 2017. As per the said Pricing Guidelines, no Indian unlisted company can issue shares to a ‘person resident outside India’, at a price lower than the fair market value, determined by a Chartered Accountant or a Securities and Exchange Board of India registered Merchant Banker or a practicing Cost Accountant.

Under the Companies Act, 2013, any fresh issue of securities to a new investor can be made only under Section 62 (1) ©of the Companies Act, 2013, and accordingly the Company within 30 days of such allotment must file a Return of Allotment under Form PAS-3 of the Company (Prospectus and Allotment of Securities) Rules, 2014. One of the mandatory conditions under Rule 12 (7) of the Company (Prospectus and Allotment of Securities) Rules, 2014 is that any shares issued under Section 62 (1) ©of the Companies Act, 2013, must attach a valuation report of a registered valuer (an independent SEBI Registered Merchant Banker or Chartered Accountant in practice having a minimum 10 years of experience) along with the Form PAS-3 filed for this.

Thus, any sale of additional shares by the Indian unlisted company, at no price or a cost below the fair market value determined by a registered valuer under Rule 12 (7) of the Company (Prospectus and Allotment of Securities) Rules, 2014, for the purpose of compliance with the Anti-Dilution Rights will contravene the ‘Pricing Guidelines’ under the FEMA (TISPRO). In the next part of this story, we shall discuss the work-around to this problem.