Need to clarify preferential share norms

Early this month, the Ministry of Finance came out with a simplistic policy change to treat rupee-denominated preference shares held by persons resident outside India on par with foreign exchange-denominated borrowings. A month later, the market is still reeling under lack of policy clarity even while more measures have been announced to curtail external commercial borrowings (ECB).

In an environment where dollars are in excess supply and the Indian Rupee is strengthening hard, the Reserve Bank of India (RBI) and the government would naturally be inclined to reduce inflow of dollars. Even while the market was wondering how to force-fit preference shares into the ECB policy, the government reduced the permitted cost ceilings for ECBs by shaving off 50 basis points from the ceiling for borrowings with a tenure of three to five years, and another 100 basis points for borrowings with a tenure of over five years.

Development of integrated townships, which was the only exception to the prohibition on foreign lending to real estate, has now been removed from a permitted activity for usage of foreign debt. The RBI has gone a step even further. The hotel industry, according to the RBI would now not qualify for an automatic approval, since it would either fall within the real estate sector, or would form part of the services sector for which capital expenditure would not be necessary.

By this token, one does not know how the RBI would treat hospital companies, or for that matter, any industry that is real estate intensive.

Against this backdrop, while the government's concerns over preference shares being used as a conduit to circumvent the prohibition on lending to real estate may be understandable, the policy suffers from abject non-application of mind. This column (Without Contempt edition dated May 3, 2007) had dealt with how preference shares and ECBs were as different as chalk and cheese. Restrictions on cost ceilings, end-use of funds, tenure of the debt, prepayment, sources of funds, and nature of borrowers, as applicable to the ECB policy would make a mockery of the very concept of preference shares under Indian company law.

Even if a user of the law were desirous of raising funds through preference shares in compliance with the new government policy, he would find that it would be more difficult than force-fitting a square peg in a round hole. For instance, the 'all-in-cost' ceiling under the ECB policy is linked to the London Inter-Bank Offered Rate ("LIBOR"). Preference shares are denominated in Indian Rupees and there is no quoted LIBOR for Indian Rupees. The LIBOR-linked US Dollar cost cap would work out to about 7 per cent . One could argue that this rate would have to be applied to the dividend rate on the Indian Rupee-denominated preference shares, but even the best pedigree borrower in India will not be lent funds in Indian Rupees at that rate.

Only recognised lenders such as banks and institutions can lend under the ECB policy. When applied to preference shares, it would mean that only banks and institutions can subscribe to preference shares issued to persons resident outside India. That would put paid to any issuance of preference shares to any venture capital fund or private equity fund.

Another peculiar quirk of this simplistic law is that only preference shares in the hands of a person resident outside India would be treated as debt. Therefore, should a company issue preference shares initially to persons resident in India and list these shares, immediately upon a foreign institutional investor purchasing the shares in the stock market, the instrument would notionally be regarded as debt. When the share is purchased again by a resident person, it would become a preference share.

All of this is impossible to administer. It is a settled cannon of law-making that anything incapable of being administered is bad law. The market is waiting with bated breath for clarity from the regulators on how to ensure compliance for those who would desire to use the law fairly and squarely. It is not enough to simply make a sweeping policy amendment "� the law-makers should also follow it up with processes and procedures for implementing the law.

If the real target of the effort to curb preference shares was the real estate sector, all the government needed to do was prohibit real estate companies from issuing preference shares to non-resident persons. That would have ensured that life for the others is not made so complicated.

The author is a partner of JSA, Advocates & Solicitors.
The views expressed herein are his own.