Investing in India through convertible instruments

By Uday Walia, S&R Associates

There are certain issues an overseas investor should take into account when structuring an investment in an unlisted Indian company through instruments that are compulsorily convertible into equity shares of the company.

Foreign direct investment (FDI) in securities of unlisted Indian companies is governed by the Foreign Exchange Management Act, 1999, and the regulations issued under it, including the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000 (together, FEMA). FDI also governed by the FDI policy of the Indian government.

Uday Walia,Partner,S&R Associates
Uday Walia
S&R Associates

Instruments that are fully and mandatorily convertible into equity securities within a specified time period are treated as FDI under FEMA and the FDI policy. Instruments that are optionally or partially convertible are treated as debt and any foreign investment through such instruments (and other debt instruments, such as non-convertible debentures) must comply with the regulations governing external commercial borrowings, issued by the Reserve Bank of India (RBI).

This article relates to securities issued by unlisted Indian companies that are compulsorily convertible into equity shares.

For the purposes of FDI, compulsorily convertible preference shares (CCPSs) and compulsorily convertible debentures (CCDs) have similar features and advantages. There are some differences, however. CCPS holders have limited voting rights as shareholders, and cannot institute winding-up proceedings as they are not creditors of the company. Further, the distribution of dividends under CCPSs is subject to requirements relating to distributable reserves under the Companies Act, 1956. The holders of CCDs have priority over all shareholders, including holders of CCPSs, in the event of a company being wound up.

Consideration: Similar to equity shares, the entire subscription amount for CCD and CCPS issues must be paid upfront; payment of any deferred consideration requires prior approval by the RBI. The subscription price must equal or exceed the fair value of the company (determined by a chartered accountant under Controller of Capital Issues guidelines) at the time of instrument issue; but this does not apply to a fresh issue of such securities to foreign venture capital (FVC) investors registered with the Securities and Exchange Board of India (SEBI).

Conversion: Except in the case of FVC investors, the conversion price must be equal to or higher than the fair value of the company at the time of conversion. The conversion formula for most compulsorily convertible instruments is linked to a particular internal rate of return, and may be structured to reflect the future financial performance of the company, or other benchmarks.

Under current SEBI regulations, all convertible instruments must be converted prior to filing a draft red herring prospectus, which poses difficulties for conversion calculations that are linked to the IPO price. To deal with this, investment agreements sometimes involve the transfer of equity shares by the promoters of the Indian company to the investor for a nominal consideration, or a put option for the investor. (However, it should be noted that other factors influencing the enforceability of put options over equity shares in unlisted public limited companies need to be considered.) These structures work best with non-resident promoters, since the pricing requirement does not apply to transfers between non-residents of India (although it may apply to FVC investors making secondary acquisitions).

Dividends and coupon: Compulsorily convertible instruments may have a coupon rate of up to 300 basis points above the prime lending rate of the State Bank of India, on the date of the issuer company board meeting at which the instrument issue is recommended.

“Same field” restriction: Under FDI policy, prior approval must be gained from the Foreign Investment Promotion Board if at 12 January 2005 the prospective investor had an existing joint-venture, technology transfer or trademark agreement in the same field of business as the company in which foreign investment is contemplated. Exceptions include cases in which the prior investment is less than 3%, or is in certain sectors such as IT and mining for the same mineral in the same area. Applications for prior approval must be accompanied by a “no objection” certificate from the existing joint venture entity and its Indian shareholders.

Reporting requirements: Under FEMA, in relation to any issue of CCPSs or CCDs the investor must file a report with the RBI in respect of the remittance received towards the issue, within 30 days of the receipt of funds and through an authorized dealer. Similarly, a report must be filed within 30 days of the issue and allotment of the CCPSs or CCDs, and another with respect to any equity shares issued upon conversion of the CCPSs or CCDs.

Voting rights: The Companies Act grants holders of preference shares the right to vote only on resolutions which directly affect the rights attached to those shares. A resolution for winding up the company, or for the repayment or reduction of its share capital, is deemed to directly affect the rights attached to preference shares. If dividends have remained unpaid for a period specified in the Companies Act, then holders of preference shares have the right to vote on every resolution and at any shareholder meeting.

Uday Walia is a partner at S&R Associates, a New Delhi-based law firm.


S&R Associates

64 Okhla Industrial Estate Phase III

New Delhi 110 020


Tel: +91 11 4069 8000

Fax: +91 11 4069 8001