ECBs: One step forward, one step back

By Sanjay Asher and Prerak Ved, Crawford Bayley & Co

Financing has two key components – long-term debt and short-term funds. In an ideal world, a person intending to raise debt finance would be able to raise it from any market that meets his needs of cost, time, repayment and other relevant factors.

Domestic debt financing in India, both short and long-term, is generally more expensive than overseas debt financing. Until the early nineties access to overseas debt markets was limited and subject to government approval. This was partly on account of foreign exchange restrictions and partly due to the protectionist approach towards the (then) lopsided and loss-making domestic banking system, which attempted to subsidize lending to priority sectors with lending to industry.

Liberalization of the economy first requires liberalization of its laws, and the laws in this regard have been significantly liberalized, making overseas debt financing a popular and viable, if somewhat controversial, option.

Regulatory overview

Foreign fund debt infusions in Indian corporations are classified as “external commercial borrowings” (ECBs). This includes funds raised through foreign currency convertible bonds (FCCBs). The ECB regulatory framework is governed by the Foreign Exchange Management Act, 1999 (FEMA), and by notifications issued thereunder, primarily the Foreign Exchange Management (Borrowing or Lending in Foreign Exchange) Regulations, 2000 (FEM ECB Regulations).

Further, the Reserve Bank of India (RBI) issues circulars from time to time, which amend the FEM ECB Regulations. These circulars are consolidated into an annual master circular.

The last master circular governing ECBs is substantially amended by subsequent circulars. Additionally, the Department of Economic Affairs of the Ministry of Finance issues press notes and releases on ECB policy. The issue of FCCBs is governed by additional regulations and ministry notifications. Single window clearance is available, but not single window regulation.

Recent amendments

Welcome liberalization has been introduced in the last couple of years on some aspects of ECBs regulations, including those that increase prepayment limits without RBI approval and increases in ECB amounts that can be raised in one financial year, among others.

Two recent amendments have substantially and prejudicially affected the ECB route for raising funds. The first is a press note of the Department of Economic Affairs, Ministry of Finance, on April 30. The second is a press release of the Department of Economic Affairs notified through the May 21 RBI circular.

Through the first amendment, foreign investments coming into India through preference shares (excluding those fully convertible into equity shares) would be considered as debt and have to conform to ECB guidelines and ECB caps. Preference shares, under Indian company law, are part of the share capital of a company, distinct from its debt funds.

Balance sheets of Indian companies are required to show preference shares as share capital. Dividend is payable at a fixed rate on preference shares only if there are available profits, unlike debt servicing which is profit-neutral.

In addition to being conceptually against the very canons of Indian company law, treating preference shares as ECBs complicates the alternative method of fund raising through the issue of preference share capital. While complying with company law and applicable FEMA requirements regarding the issue of preference shares to non-residents, compliance with ECB guidelines would have to be ensured.

Closed doors

Similarly, in addition to closing the door for ECBs in the realty sector, the second amendment slashes the all-in-cost ceilings for ECBs (defined to include interest, fees and expenses in foreign currency) by 25-30%. This is expected to adversely affect the smaller issuers, whose balance sheets cannot command wafer-thin coupons.

Further, no exemption has been granted for proposed FCCBs/ECBs for which verifiable effective steps (like dispatch of notice for shareholders meeting) have already been taken, which has forced reworking of their commercials and introduced uncertainty into existing deals.

The ostensible purpose behind both amendments (regulating external fund flow to reduce inflation) is laudable, but the execution is not. These amendments would especially impact small and medium enterprises, which should be growth focused. They’ll now have to either curtail expansion or opt for the higher cost of domestic debt, neither of which is good for the economy. It may also raise questions in the minds of international investors about the stability and continuity of the liberalization process.

The government has taken a step forward over the last few years in its ECB policy – and then, judging by these amendments, taken a step back.

Sanjay Asher is a partner with Crawford Bayley & Co, Prerak Ved is an associate.

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