Foreign investors invest in Indian companies through equity shares or securities that are fully and mandatorily convertible into equity shares within a specified time period. These convertible securities include compulsorily convertible preference shares (CCPS) and compulsorily convertible debentures (CCD).
Convertible securities are considered foreign direct investment (FDI) under the Foreign Exchange Management Act, 1999, (FEMA). Both CCPSs and CCDs have similar features and advantages although there are differences such as limited voting rights for CCPS holders. Also, the distribution of dividends to CCPS holders is subject to the requirements relating to distributable reserves under the Companies Act, 1956, and in the event of a company being wound up, CCD holders are considered creditors of the company and have priority over all shareholders including CCPS holders.
Traditionally, there has been some flexibility in structuring investments by foreign investors through convertible securities especially with respect to the conversion price. For example, the conversion price could be linked to the performance of the investee company. However, recent regulatory developments suggest that this position may have changed and the conversion price may now need to be a fixed price determined at the time of the issue of the convertible securities.
On 31 March, the Department of Industrial Policy and Promotion (DIPP) issued Circular 1 of 2010, which, with effect from 1 April, consolidates and rescinds all previous press notes, press releases and clarifications on FDI issued by the DIPP that were in force and effect as on 31 March. Although this circular specifies that it does not intend to make any changes to the existing regulations, it introduces certain changes, including in respect of the pricing of convertible securities.
Paragraph 3.2.1 of Circular 1 specifies that an Indian company may issue CCPSs or CCDs subject to the pricing guidelines specified under FEMA. It also states that “the pricing of the capital instruments should be decided/determined upfront at the time of issue of the instruments”. This suggests that the conversion price is required to be fixed when the convertible security is issued and cannot be determined on the basis of an agreed formula linked to certain benchmarks or milestones.
As such, a fixed historical conversion price may not reflect the value of the company on the date of conversion. For example, if the company’s performance declines and its valuation at the time of conversion is lower than when the convertible securities were issued, a foreign investor who is forced to convert at a higher historical price may get only a smaller equity shareholding in the company. Conversely, if the company performs well, equity shares will be issued to the foreign investor at a lower price not reflecting the company’s valuation at the relevant time.
Under the FEMA, at the point that the issue of convertible securities is completed and the transaction is closed, the Indian company must comply with certain reporting requirements. This includes filing a report with the Reserve Bank of India (RBI) through an authorized dealer in a specified format (part A of form FC-GPR) within 30 days of issue.
When certain Indian companies recently issued convertible securities and filed part A of form FC-GPR with the RBI through an authorized dealer, the RBI requested information on the conversion ratio and the number of equity shares that will be issued upon conversion, even though form FC-GPR, in its current format, requires only the issue price of convertible securities to be specified, and not the conversion price or ratio.
Although the RBI published revised pricing guidelines for the issue of securities to foreign investors in April, it has not formally clarified its position on the conversion price of convertible securities.
The approach of the DIPP and the RBI is also at odds with the pricing guidelines specified by SEBI in respect of the issue of convertible securities by listed companies through a preferential allotment or a qualified institutional placement. According to SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009, the conversion price must not be less than the average of the weekly high and low of the closing price of the equity shares during a specified period preceding the “relevant date”. The “relevant date” can be linked to the date on which the convertible securities are issued or the date on which their holders become entitled to apply for equity shares. These regulations provide flexibility in determining the conversion price such that it could be a historical price or determined closer to the time of conversion.
The rationale for this proposed policy change by the DIPP and the RBI could be that the conversion price should be fixed on the date of the issue of convertible securities to determine compliance with the pricing guidelines on that date (currently, the discounted free cash flow method). A fixed conversion price may also assist in determining the “ownership” of Indian companies for purposes of the guidelines for calculation of FDI in Indian companies (previously specified in press note 2 (2009 Series)). However, from a foreign investor’s perspective, this change, if implemented going forward, will effectively eliminate one of the key features of investment in a convertible security.
Rajat Sethi is a partner and Tanya Aggarwal is an associate at S&R Associates, a New Delhi-based law firm.
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