Conversion terms of convertible instruments

Compulsorily convertible instruments have been the preferred investment route for private equity and strategic investments entering India, as they offer protection from equity risks. In the absence of specific regulatory prohibition and a pro-foreign investor market atmosphere, investors and promoters of Indian companies have so far agreed to determine the conversion price of these instruments at a future date using pre-determined conversion formulae.

Changing sentiments

However, recently there has been a growing regulatory shift against such formula-based conversion terms as they are seen as prejudicial to the interest of resident promoters. It is argued that these instruments favour foreign investors as they have fixed conversion terms and prices.

The Consolidated FDI Policy of 1 April 2010 provided that the pricing of convertible instruments was required to be decided upfront at the time of issue (this requirement continues in the revised consolidated policy of 1 October). As such, foreign direct investment transactions involving compulsorily convertible instruments began to be structured with an upfront determination of the minimum conversion price and the maximum number of shares that the convertible instrument will be converted into.

Requirements

This meant the parties involved could convert the instrument at a price higher than the specified minimum price, into a lesser number of equity shares than the specified maximum. So, while the investment could start of with a conversion number that would ensure it is risk averse, the parties could subsequently convert the instrument into equity shares in a manner that would enable the investor to achieve the agreed rate of return on its investment.

The rationale in support of such an interpretation was that giving away a lesser number of equity shares at a conversion price higher than that stated to the Reserve Bank of India (RBI), would be beneficial to the resident promoter, and so in line with the view being considered by the regulatory authorities.

However, recent media reports indicate that the RBI in a missive to the Ministry of Commerce and Industry dated 29 September, has argued that a “build-in optionality with regard to the pricing of convertible security instruments makes it ineligible as FDI-compliant as investors are not taking future risks, whether upwards or downwards and therefore are able to avoid the risks that an ordinary shareholder of an Indian company deals with.”

The RBI appears to be of the view that the exact number of equity shares that the convertible instrument would be converted into needs to be specified upfront and that no deviation (whether upward or downward) should take place from the specified number. Although the RBI has not officially published a clarification about this, it could impact transactions that are based on fixed returns and how they are structured.

While there are several reasons for the RBI’s views on this, a notable one is the protection of resident promoters. The rationale is that by forcing foreign investors to be exposed to and absorb part of the equity risks faced by the company, the Indian party would be relieved from having to service onerous guaranteed return terms especially in an unfavourable scenario.

However, the resident promoter could be adversely affected by fixed conversion requirements as it may be difficult for Indian companies and foreign investors to commercially agree on a fair price for the shares. So, at the time of the investment, given the nascent stage of the company and the risk that it may not grow as expected, while the issuing company might be unwilling to agree on a lower price of conversion, the investor could be unwilling to pay a higher price.

Further, if an Indian company is in dire need of seed investments it may be forced to undervalue its equity at the time of issuance of the convertible instruments. This also means the company would be unable to price the shares at a higher value at the time of conversion even if it does significantly well over the next few years it. As such, this protection may just be on paper.

The way forward

Consequently according this kind of protection to Indian promoters would not be advisable. While the recent changes in the regulatory regime makes it necessary for greater innovations in structuring of such investment instruments, it is vital to protect the interests and rights of both the investors and the issuing Indian companies and the resident promoters, while still achieving the commercial intentions of the parties.

Alternative structures which permit the issuance of FDI compliant convertible instruments and lead to a commercial result acceptable to both the investor and the issuing company are clearly the need of the day.

Jatin Aneja is a partner at Amarchand & Mangaldas & Suresh A Shroff & Co. The views expressed are those of the author and do not reflect the official policy or position of Amarchand Mangaldas.