Comprehensive Guide to RBI and FEMA Regulations for Financial Asset Valuation

The valuation of financial assets in India is governed by a strict regulatory framework established by the Reserve Bank of India (RBI) and the Foreign Exchange Management Act (FEMA). These regulations ensure that cross-border transactions, bank investments, and the disposal of stressed assets are conducted at fair values, preserving the integrity of the Indian financial system.

1. Informational: Regulatory Framework and Key Definitions

Understanding the distinction between different types of foreign investments and bank asset classifications is the first step in regulatory compliance.

Foreign Direct Investment (FDI) vs. Foreign Portfolio Investment (FPI)

FEMA regulations distinguish between FDI and FPI based on the percentage of holding in an Indian company:

• Foreign Portfolio Investment (FPI): This is defined as any investment made through capital instruments where the investment is less than 10 per cent of the post-issue paid-up share capital on a fully diluted basis, or less than 10 per cent of the paid-up value of each series of capital instruments of a listed Indian company.
• Foreign Direct Investment (FDI): If an investment in a listed company is 10 per cent or more, it is treated as FDI. Additionally, any investment through capital instruments in an unlisted Indian company is automatically categorized as FDI.

Bank Investment Portfolio Classifications

The RBI requires banks to classify their entire investment portfolio, including Statutory Liquidity Ratio (SLR) and non-SLR securities, into three specific categories for valuation purposes:

1. Held to Maturity (HTM): Securities acquired with the intention to hold until they mature.
2. Available for Sale (AFS): Securities that do not fall into the HTM or HFT categories.
3. Held for Trading (HFT): Securities acquired with the intent to be traded to take advantage of short-term price/interest rate movements.

2. Commercial Investigation: Pricing Guidelines and Valuation Frameworks

Commercial investigations into financial assets must adhere to specific pricing floors and ceilings determined by the residency of the parties involved.

FEMA Pricing Guidelines for Capital Instruments

The transaction price for securities involving a person resident outside India must comply with the following mandates:

Issuance by an Indian Company to a Non-Resident

The price of capital instruments issued to a person resident outside India shall not be less than:

• Listed Companies: The price determined as per relevant SEBI guidelines.
• Unlisted Companies: Valuation must be conducted as per any internationally accepted pricing methodology for valuation on an arm’s length basis.
• Certification Requirement: This valuation must be duly certified by a Chartered Accountant, a SEBI registered Merchant Banker, or a practicing Cost Accountant.

Transfer from a Resident to a Non-Resident

When a person resident in India transfers instruments to a non-resident, the price shall not be less than:

• Listed Companies: The price as per relevant SEBI guidelines.
• Preferential Allotment: The price at which a preferential allotment of shares can be made under SEBI Guidelines.
• Unlisted Companies: Valuation according to internationally accepted pricing methodologies on an arm’s length basis, certified by the authorized professionals mentioned above.

Transfer from a Non-Resident to a Resident

In this scenario, the price shall not exceed the following:

• Listed Companies: The price as per relevant SEBI guidelines.
• Unlisted Companies: Valuation as per internationally accepted pricing methodologies on an arm’s length basis, certified by a Chartered Accountant, Merchant Banker, or Cost Accountant.

Summary Table: FEMA Pricing Thresholds

Valuation of Bank Investment Portfolios

The RBI provides distinct valuation methodologies for each bank portfolio category:

• HTM Valuation: These are carried at acquisition cost unless the cost exceeds face value, in which case the premium is amortized over the remaining period to maturity. Banks must recognize any non-temporary diminution in the value of investments in subsidiaries or joint ventures individually.
• AFS Valuation: Individual scrips are marked to market at quarterly or more frequent intervals.
• HFT Valuation: Individual scrips are marked to market at monthly or more frequent intervals.

Sale of Stressed Assets

To enhance transparency, the RBI requires banks to follow a structured valuation policy when selling stressed assets to Securitization Companies (SCs) or Reconstruction Companies (RCs):

• Valuation Policy: Boards must spell out the discount rate used in valuation exercises.
• High-Value Exposures: For stressed asset exposures beyond Rs. 50 crore, banks are mandatory required to obtain two external valuation reports.
• Cost Burden: The cost of the valuation exercise must be borne by the bank.

3. Transactional: Compliance, Implementation, and Prohibitions

Transactional success depends on meeting specific timelines and adhering to RBI prohibitions regarding overseas investments.

Rules for Transfer of Capital Instruments

In transfers between residents and non-residents, the following transactional rules apply:

• Deferred Payment: Up to 25 per cent of the total consideration can be paid by the buyer on a deferred basis within 18 months from the date of the transfer agreement.
• Escrow Arrangements: Transactions can be settled through an escrow arrangement between the buyer and seller for a period not exceeding 18 months.

Swap of Capital Instruments

In cases of investment by way of a swap of shares, the valuation of the shares involved must be made by a Category I Merchant Banker registered with SEBI or an Investment Banker outside India registered with the appropriate host-country regulatory authority. This requirement applies regardless of the transaction amount.

Overseas Direct Investment (ODI) Prohibitions and Rules

The RBI prohibits Indian residents from making investments or financial commitments in the following:

• Restricted Entities: Foreign entities engaged in real estate or banking business without prior RBI approval.
• Financial Products: Overseas entities offering financial products linked to the Indian Rupee (e.g., non-deliverable trades).

Valuation for Partial or Full Acquisition

When an Indian party acquires an existing foreign company:

• Investments > USD 5 Million: Valuation must be performed by a Category I Merchant Banker (SEBI registered) or an Investment/Merchant Banker outside India.
• Other Cases: Acquisitions below this threshold can be valued by a Chartered Accountant or a Certified Public Accountant.

Key Takeaways for Valuers

• Rule of Ten: Use the 10% threshold to distinguish between FPI and FDI for listed entities; unlisted is always FDI.
• The 50 Crore Rule: Stressed assets exceeding Rs. 50 crore require two independent external valuations.
• Pricing Floors/Ceilings: Always check residency; transfers to non-residents have a floor price, while transfers to residents have a ceiling price.
• Line Formulas for Reference:
  • Exit Price Formula: Exit Price = Price payable to dissenting shareholders determined by regulated mechanisms.
  • Capital Gain Formula: Capital Gains = Sale consideration - Fair Market Value at allotment.
  • Net Asset Value Formula: Net Asset Value = Total Assets - Total Liabilities.

Important Terms

• Arm's Length Basis: A transaction where the parties act independently and have no relationship to each other.
• Mark-to-Market: The process of valuing an asset based on its current market price rather than its book value.
• Yield to Maturity (YTM): The rate used for valuing non-traded bonds, which must be at least 50 basis points above equivalent Government of India loans.
• Person Resident Outside India: An individual or entity whose residence for legal purposes is outside the territory of India.