FDI and convertible instruments: trial and error

The foreign direct investment (FDI) regime relating to convertible instruments has been the changed several times over the years. This almost gives the impression that the regulators are relying on trial and error to fine tune the regulations. For investors in the private equity sector and possibly also the real estate sector this has resulted in a fair amount of uncertainty.

Policy add-ons

Through AP (DIR Series) circulars no 73 and 74, both dated 8 June 2007, read with press note dated 30 April 2007, investments in optionally or partially convertible instruments were placed in the realm of external commercial borrowings as they were considered to be “intrinsically debt like”.

The consolidated FDI circular 1 of 2010 mandated that Indian companies can issue equity shares; fully, compulsorily and mandatorily convertible debentures; and fully, compulsorily and mandatorily convertible preference shares. Companies doing so were to be subject to pricing guidelines and valuation norms prescribed in regulations under the Foreign Exchange Management Act, 1999, (FEMA). However, the pricing of the instruments was to be decided/determined upfront at the time of issue of the instruments.

The consolidated FDI circular 1 of 2011 amends this and allows the option of a conversion formula being stated at the time of the issue of the instruments. In addition, it states: “the price at the time of conversion should not in any case be lower than the fair value worked out, at the time of issuance of such instruments, in accordance with the extant FEMA regulations”.

As it stands

Under current regime, (i.e. notifications no. FEMA 20/2000-RB of 3 May 2000 read with FEMA 205/2010-RB of 7 April 2010, notified through GSR no. 341(E) of 21 April 2010) the price of shares issued to persons resident outside India cannot be less than:

a. the price worked out in accordance with applicable Securities and Exchange Board of India (SEBI) guidelines (for listed companies);

b. the fair valuation of shares done by a SEBI registered category – I merchant banker or a chartered accountant as per the discounted free cash flow method (for unlisted companies); and

c. the price as applicable for transfer of shares from resident to non-resident as per the pricing guidelines laid down by the Reserve Bank of India (RBI) from time to time (in case of preferential allotment).

A welcome change?

Investments through convertible instruments are popular, particularly as they provide a quick source of finance for a company and also a reasonable amount of flexibility to investors in terms of conversion dates, etc.

It is especially useful in sectors or ventures where a differed valuation may lead to additional gains (e.g. new ventures and infrastructure projects with long gestation periods). Therefore, convertible instruments can also act to promote the performance of a company.

Cause for confusion

The FDI circular 1 of 2010 required that “the pricing of the capital instruments should be decided/determined upfront at the time of issue of the instruments”. This had raised doubts in the investor circles as the requirement to specify the conversion price appeared to negate the benefits of a differed valuation, mentioned above. As such, it would deter private equity investments through convertible instruments.

Prior to the FDI circular 1 of 2011, there was also some debate on what was to be decided upfront: the formula or the price itself. Perhaps the most prevalent view was that the RBI required upfront disclosure of the maximum equity upon conversion. However, it is understood that the RBI has informally advised that a formula should be adequate (subject to clearly stating that shares will be issued at a price higher than the regulatory floor).

Be that as it may, the multiplicity of views clearly did not create a favourable business environment. It is reported that between April 2010 and February 2011, FDI inflows into India declined by 25% to US$18.3 billion.

The FDI circular 1 of 2011 has, of course, cleared the air on that front. Parties can now agree on a formula for the conversion price. This allows parties to link the conversion to future events and valuations, and ensures they can take advantage of the inherent commercial benefits of convertible instruments. The requirement (described above) that the minimum price should not be lower than fair value at the time of issue, protects Indian promoters and also gives them an incentive to improve the company’s performance.

Inder Mohan Singh is a partner at Amarchand & Mangaldas & Suresh A Shroff & Co, where Mayuri Roy is a senior associate designate. The views expressed in this article are those of the authors and do not reflect the official policy or position of Amarchand Mangaldas.