The Finance Minister, in his 2007-08 Budget speech, promised a mechanism for Indian companies to unlock a part of their holding in group companies to meet financing needs by issuing exchangeable bonds. This led to the formulation of the “Issue of Foreign Currency Exchangeable Bonds Scheme, 20081 in February 2008 (the “Scheme”). The Scheme was operationalised pursuant to A P (DIR Series) Circular No 17 dated September 23, 2008 by the Reserve Bank of India (the “RBI”) to facilitate the issuance of foreign currency exchangeable bonds (“FCEBs”).
Previously, Indian companies had the option of raising foreign currency debt by either raising external commercial borrowings (“ECBs”) in accordance with the master circular on external commercial borrowing and trade credits or issuing foreign currency convertible bonds (“FCCBs”) convertible into shares. The Scheme has now opened the doors for Indian companies to explore a third option for raising foreign currency debt through the issuance of FCEBs.
What are FCEBs?
FCEBs have been defined in the Scheme as a “bond expressed in foreign currency, the principal and interest in respect of which is payable in foreign currency, issued by an Issuing Company and subscribed to by a person who is a resident outside India in foreign currency and exchangeable into equity share of another company, to be called the Offered Company, in any manner, either wholly, or partly or on the basis of any equity related warrants attached to debt instruments”.
Thus, pursuant to the Scheme, the “Issuing Company” which is a part of the Promoter Group of the “Offered Company”, would issue FCEBs, denominated in a foreign currency and exchangeable into shares of the “Offered Company”, only to persons resident outside India.
The Scheme requires that, at the time of issuance of the FCEBs, the “Issuing Company” hold the shares of the “Offered Company” which are exchangeable for the FCEBs.
1 Notification G.S.R.89 (E) dated February 15, 2008 issued by the Government of India, Ministry of Finance, Department of Economic Affairs.
Under the Scheme, both “Issuing Company” and “Offered Company” are defined to mean Indian companies under the Companies Act, 1956, as amended and are required to be part of the same “Promoter Group” .
We note that while the Scheme specifically requires the Offered Company to be a listed company, it is ambiguous as to whether the Issuing Company must also be listed. In prescribing eligibility to issue FCEBs, the Scheme states that “an Indian company which is not eligible to raise funds from the Indian securities market, including a company which has been restrained from accessing the securities market by the SEBI, shall not be eligible to issue FCEBs”. This language is similar to that used in Regulation 3(1)(A) of the Issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depository Receipt Mechanism) Scheme, 1993 (the “FCCB Scheme”). Regulation 3(1)(A) of the FCCB Scheme, has been interpreted by the RBI to mean that only listed Indian companies are eligible to issue FCCBs. The RBI may take a similar view in respect of the eligibility of Issuing Companies under the Scheme. However, in our view, since the Scheme requires that the Offered Company to be listed, an additional requirement that the Issuing Company also be listed should not be necessary.
FCCBs vs FCEBs
There are fundamental differences between FCCBs and FCEBs. In the case of FCCBs, the bonds convert into shares of the company that issued the bonds, while in the case of FCEBs, the bonds are exchangeable for shares of another company, i.e., the Offered Company.
Further, in the case of FCCBs, when the holder exercises the option to convert, the issuer company issues fresh shares to the holder upon conversion of the FCCB. However, in the case of FCEBs, when the exchange option is exercised, there is no issuance of fresh shares by the Offered Company. Instead, it is a requirement that the shares of the Offered Company, into which the FCEBs are exchanged, be held by the Issuing Company at the time of issuance of the FCEBs and until redemption or exchange. Thus, upon exchange, there is merely a transfer of the shares (of the Offered Company) held by the Issuing Company to the holder of the FCEB. As such, the issuance of FCEBs will have only a limited effect on the price of shares of the Offered Company since there is no threat of future dilution, unlike in the case of FCCBs.
2 Promoter Group has the same meaning as under the Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines, 2000, as amended (“DIP Guidelines”). Pursuant to the DIP Guidelines, in the case of a company, ‘Promoter Group’ includes (i) a subsidiary or holding company of that company; (ii) any company in which the promoter holds 10% or more of the equity capital or which holds 10% or more of the equity capital of the promoter; and (iii) any company in which a group of individuals or companies or combinations thereof who holds 20% or more of the equity capital in that company also holds 20% or more of the equity capital of the issuer company.
Salient Features of the Scheme
Eligibility criteria for companies issuing FCEBs
- FCEBs can be issued only by Indian companies.
- Issuing Company and the Offered Company are required to be part of the same Promoter Group.
- At the time of issuance of the FCEBs and until redemption or exchange, the Issuing Company is required to hold the shares of the Offered Company into which the FCEBs are exchangeable.
- The Issuing Company must be eligible to raise funds in the Indian securities market and shall not have been restrained by the Securities and Exchange Board of India (“SEBI”) from accessing the securities markets. As discussed above, this may be interpreted to mean that the Issuing Company must be listed.
- The Offered Company must be listed on a stock exchange and must be engaged in a sector eligible to receive foreign direct investment under the Government of India’s foreign direct investment policy (the “FDI Policy”).· The Offered Company must be eligible to issue FCCBs or avail of ECBs.
Eligibility criteria for subscribers of FCEBs
- Only person residents outside India can subscribe to FCEBs subject to compliance with the FDI Policy.
- Entities prohibited by SEBI from buying, selling or dealing in securities are not eligible to subscribe to FCEBs.
Use of proceeds
- The proceeds of the FCEBs may be invested by the Issuing Company as follows:
(1) by way of direct investments, including in joint ventures or wholly-owned subsidiaries in accordance with the existing guidelines on such investments, and
(2) in Promoter Group companies, which, in turn, may invest such amounts in accordance with the ECB guidelines then in force, which currently restrict end-uses to the following activities:
(a) investment, e.g., import of capital goods (as classified by the Director General of Foreign Trade in the Foreign Trade Policy), by new or existing product units, in real sector, in the industrial sector, including small and medium enterprises, and in the infrastructure sector which is defined as power, telecommunications, railways, roads including bridges, sea ports and airports, industrial parks and urban infrastructure (water supply, sanitation and sewage projects).
We note that the use of FCEB proceeds is more limited that the use of ECB proceeds since the Issuing Company may only use such proceeds for direct investments abroad or in Promoter Group Companies. It is the Promoter Group companies that may, in turn, use such proceeds in the manner set forth in the ECB guidelines.
(3) Retention or deployment of FCEB proceeds is required to be in accordance with applicable ECB guidelines.
(4) Investments in the capital markets or in the real estate sector in India are expressly prohibited.
Approvals required
- Prior approval of the RBI is required for any issuances of FCEBs.
We note that under the ECB guidelines, certain borrowings that fall under the “automatic route” do not require the prior approval of the RBI. A similar dispensation should have been included in the Scheme in respect of FCEBs that comply with the requirements, including end-use restrictions, specified in the ECB guidelines. Prior approval should have been mandated only where the specifications set forth in the Scheme were not met.
- Prior approval of the Foreign Investment Promotion Board (“FIPB”) should be obtained, if required under the FDI Policy for investment by the subscriber.
Pricing and Maturity
- Maturity: The minimum maturity period for the FCEBs is five years. We note that under the ECB guidelines, minimum maturity for borrowings less than US$ 20 million is three years and for borrowings in excess of such amount, five years. A similar distinction should have been made in the Scheme. It appears incongruous to mandate a lock-in of 5 years for amounts less than US$ 20 million.
- Redemption: FCEBs may be exchanged, in part or full, into equity shares of the Offered Company any time prior to redemption.
(1) Upon exercise of the option to exchange, the Issuing Company is required to deliver the shares of the Offered Company to the subscribers i.e., cash settlements are not permitted.
- All-in-Cost: The rate of interest payable on FCEBs and the issue expenses incurred in foreign currency by the issuing company must be within the all-in-cost ceiling set forth in the ECB guidelines. At present, the all-in-cost ceiling is LIBOR + 200 bps for FCEBs with a tenure of 3-5 years, LIBOR + 350 bps for a tenure of 5-7 years and LIBOR + 450 bps for a tenure exceeding 7 years.
- Pricing: The exchange price of the listed shares of the Offered Company at the time of issuance of the FCEBs must not be less than the higher of the two average closing prices of the shares of the Offered Company on the stock exchange:
(a) the average of the weekly high and low closing prices for the 6 months preceding the relevant date; and
(b) the average of the weekly high and low closing prices for the 2 weeks preceding the relevant date.
For the purposes of the Scheme, "relevant date" means the date on which the board of directors of the Issuing Company authorises the issuance of the FCEBs.
Tax
- Interest payments on the FCEBs, until the exchange option is exercised, are subject to deduction of tax at source as per the provisions of sub-section (1) of section 115 AC of the Income Tax Act, 1961, as amended.
- Tax on dividend on the exchanged portion of the FCEBs shall be in accordance with the provisions of sub-section (1) of section 115 AC of the Income Tax Act, 1961, as amended.
- Exchange of FCEBs into shares will not give rise to any income-tax on capital gains in India.
- Transfers of FCEBs between non-residents will not give rise to any income-tax on capital gains in India.
Miscellaneous
- The Issuing Company and the Offered Company are required to comply, among other things, with the provisions of (i) the (Indian) Companies Act, 1956, as amended, with respect to authorisations required and (ii) the SEBI Act, 1992, as amended, and the rules, regulations and guidelines issued thereunder with respect to disclosure of the Issuing Company’s shareholding in the Offered Company.
- The Issuing Company is prohibited from transferring, mortgaging, offering as collateral, trading in, or creating any encumbrance on, the shares of the Offered Company which are exchangeable for the FCEBs.
Conclusion
The Scheme provides Indian promoter companies the option of raising money overseas by unlocking the value embedded in the shares held by them in other “Promoter Group” companies, without causing equity dilution. This avenue may prove to be useful in the case of promoter shares that are subject to a three-year lock-in pursuant to the DIP Guidelines. We note that the underlying FCEB, in such instances, will be exchangeable for shares only upon expiration of the lock-in period. As such, the marketability of the FCEB will depend entirely on prevailing market conditions and the future value of the Offered Company's shares.
While the Scheme is undoubtedly a step in the right direction, its benefits are inherently limited on account of the restrictions on the use of proceeds, minimum maturity, the all-in-cost ceiling and the requirement of prior RBI approval in all cases.
The writer is managing partner, Amarchand & Mangaldas & Suresh A. Shroff & Co.
