It is quite common for foreign investors to take up convertible instruments in Indian companies. These instruments are issued as either preference shares or debentures to begin with and are convertible into equity shares of the Indian company at a later date. The conversion may occur in one of two ways: either at the option of the investor, or compulsorily (without any option whatsoever). Such instruments carry characteristics of multiple securities and hence take on nomenclatures such as “hybrids” and “quasi-equity”.
From a legal and regulatory (more specifically, foreign direct investment) standpoint, however, the question is whether such convertible instruments constitute debt, thereby falling within the purview of regulations governing external commercial borrowings (ECBs), or whether they constitute equity, thereby falling under the guidelines pertaining to foreign direct investment (FDI). Previously, all preference shares with an option to convert into equity were treated as FDI, and were counted towards the sectoral caps. As regards convertible debentures, although the policy does not appear to have been entirely clear, there have been instances where convertible debentures have been allowed by the Foreign Investment Promotion Board (FIPB) under the FDI policy. In other words, wherever there was a possibility that the instrument would be converted into equity, that would be treated as equity investment for FDI purposes.
However, the policy was made significantly tighter by the Reserve Bank of India (RBI) in 2007 for preference shares and debentures whereby only fully and mandatorily convertible instruments are now considered to be FDI. All other preference shares and debentures (and including those that are optionally convertible) are considered to be debt and hence governed by the guidelines on ECBs. In its 2007 policy on convertible debentures, the RBI noted the reasons for this:
“It has been noticed that some Indian companies are raising funds under the FDI route through issue of hybrid instruments such as optionally convertible/ partially convertible debentures which are intrinsically debt-like instruments. Routing of debt flows through the FDI route circumvents the framework in place for regulating debt flows into the country. It is clarified that henceforth, only instruments which are fully and mandatorily convertible into equity, within a specified time would be reckoned as part of equity under the FDI Policy and eligible to be issued to persons resident outside India under the Foreign Direct Investment Scheme in terms of Regulation 5 (1) of Foreign Exchange Management (Transfer and Issue of shares by a Person Resident outside India) Regulations, 2000 notified vide Notification No. FEMA 20/2000-RB dated May 3, 2000.”
Subsequent to this policy change, several Indian companies have undertaken issuances of compulsorily convertible debentures to foreign investors. However, a recent news report indicates that a further review by RBI of the working of the policy is under way. The report states:
“The department of industrial policy and promotion (DIPP) has asked the Reserve Bank of India (RBI) to clarify whether compulsory convertible debentures (CCDs) are to be treated as debt or equity, …
Should the RBI decide that CCDs are to be treated as debt, corporate borrowing overseas could be affected. Funds raised through this route would then be included in external commercial borrowing, which is subject to a company-specific ceiling of $500 million. On the other hand, treating CCDs as equity would mean that such investment would have to comply with sectoral FDI limits.”
At the outset, one may wonder why there is a need for a clarification as the policy is quite unambiguous. But, it appears that the confusion arises because of the variations involved in structuring the convertible debentures, particularly the put option. As the news report further notes:
“Confusion has arisen because sometimes CCDs are structured in a way that takes them closer to debt, the official said. For example, at times CCDs have a put option which requires the issuing companies to buy back the shares issues on conversion at a fixed price. This structuring makes it debt like.”
Looking at the basic nature of the instrument, the existence of a put option that requires issuing companies to buyback shares (arising out of conversion) should not alter its character. Compulsorily convertible instruments are nothing but deferred equity; by their very terms they will become equity, albeit at a later point in time. In the interim, they partake the character of preference shares or debentures. Even when converted, the exercise of a put option on the company will be subject to the existing rules on buyback, which carry several restrictions. For instance, there are limitations on the amount that can be expended on a buyback (25% of net worth), amount of share capital that can be bought back (not exceeding 25% each year), solvency certifications from the board of directors and the like. Whether the instruments are convertible in nature or were issued as shares in the first place, there would be no difference to the outcome as these rules will have to be complied with in any case.
It is hoped that these (and other related) issues are considered by RBI while reviewing the existing guidelines or providing clarification on convertible instruments.