The recent decision of the Department of Industrial Policy and Promotion (DIPP) to classify all equity shares with in-built options or supported by options sold by third parties to non-resident investors as debt, and no longer as foreign direct investment (FDI), appeared at first glance to be rather surprising, and seemingly without precedent.
However, a closer look at previous policy changes and informal advice of regulators reveals various attempts to ensure that non-resident investors could not use price adjustments to avoid the inherent risk in equity investment.
Since 2007 the Reserve Bank of India (RBI) has maintained that any security or instrument, issued to a non-resident entity, permitting parties to predetermine a guaranteed return on the investment, or internal rate of return (IRR), would not be classified as FDI, being more in the nature of debt, that is, an external commercial borrowing (ECB).
The past few years have seen much structuring and manoeuvring by private equity (PE) and financial investors, through variations to the inbuilt flexibility in convertible instruments, in an attempt to minimize the equity risk and assure fixed returns on investments. Regulators have sought to crack down on this practice through a series of policy changes.
One of the earliest was revising the guidelines on issuing preference shares and debentures to non-residents, to stipulate that only preference shares and debentures that were mandatorily and fully convertible into equity shares, within a specified period of time, would be considered as FDI. After that, all optionally or partially non-convertible preference shares or debentures issued to non-residents were classified as ECB, subjecting them to a host of restrictive conditions, including specified end-uses, eligible lenders and strict maturity periods.
Finding access to partially convertible instruments cut off, PE investors, promoters and their advisers were forced to innovate and devise other routes to achieve the desired degree of flexibility. The most popular structure that developed involved manipulating the conversion formula for compulsorily convertible instruments.
To curb this trend, the regulators’ next move was to require that the price of convertible instruments issued to non-residents be specified at the time of issue. Alternatively, parties could determine the price of convertible instruments based on a conversion formula which had to be fixed upfront. As a result, the flexibility offered by convertible instruments – in terms of price adjustments for different scenarios, such as promoter defaults or poor performance of the investee company – was greatly reduced.
As a fallback, agreements were subsequently structured to give non-resident investors a right to “put” their shares to promoters on the occurrence of certain predetermined events (such as failure to provide an exit through an IPO, or return through dividends). However, the authorities began to informally advise both non-resident investors and Indian companies that such put options were imparting debt-like features to equity securities and were therefore inconsistent with the FDI regulations.
To formally clamp down on the trend for promoters to provide assured returns, the DIPP inserted a clause in the FDI policy to classify equity shares supported by options as ECB. The net effect was that arguably all options, even those that had nothing to do with providing an IRR (such as shootout options), were overnight deemed to transform equity instruments into ECBs.
PE deals are typically structured such that in case of a promoter default or winding-up of the investee company, the PE investor can cause the investee company or promoter to buy back its shares at a slight premium on the principal invested. While a buyback at a premium may offer a PE investor a return on investment, such clauses are typically inserted as deterrents.
In attempting to classify options that provided investors with assured returns as ECB, regulators perhaps unknowingly also classified standard default consequences as providing fixed returns, effectively discouraging PE and other investment.
The DIPP relented and deleted the offending clause a month after its insertion, having considered input from stakeholders and perhaps the prevailing economic sentiment. While this move has been welcomed, it also reflects growing divergence on policy within and between government ministries.
Given the regulators’ persistent attempts to clamp down on options of this nature, investors and promoters remain wary that this policy may be mooted again. One can only hope that future attempts to regulate investments by non-residents are better thought out and do not result in any collateral damage.
Jatin Aneja (email@example.com) is a partner, Vidyut Gulati (firstname.lastname@example.org) is a principal associate and Varun Nair (email@example.com) is an associate at Amarchand & Mangaldas & Suresh A Shroff & Co. The views expressed in this article are those of the authors and do not reflect the view of the firm.
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