Demystifying FEMA - FDI - Instruments Other Than Equity

Direct Investment implies investment in equity with a long term commitment. A short term commitment in equity is in the form of portfolio investment.

FDI traditionally has been seen as investment in equity with a long term commitment. This long term commitment is in the form of JV or WOS. Long term commitment by individuals is seen in the form of Private Placement or Subscription to the Memorandum and Articles of Association.

Over the years, however, some non-equity instruments, which have a nature of long term commitment, have also been taken as instruments of Direct Investments.

Prominent among these are Convertible Debentures. Initially only Compulsorily Convertible Debentures were treated as Direct Investments. However, recently, Optionally Convertible Debentures have also been permitted as elegible instruments.

As Compulsorily Convertible Debentures ultimately lead to subscription to equity, these were treated as commitment of longer duration.

Optionally Convertible Debentures, on the other hand, may not result in subscription to equity. These have still been permitted to be treated as equity only if the exit clause does not ensure any assured exit price. Hence, these debentures cannot be redeemed at face value or a predetermined premium or discount. Thus, in effect, these debentures exhibit a characteristics of equity.

Other instrument in this category is Compulsorily Convertible Preference Shares. CCPS are also long term commitment which ultimately gets converted into equity. CCPS have additional restriction regarding the assured dividend that can be promised. The rate of dividend promised shall not be more than 300 basis points above the prime lending rate of State Bank of India on the date of the board meeting in which the dividend has been fixed.

The conversion price of CCDs or CCPS into equity has to be determine upfront at the time of issue. This price can be in the form of a fixed price or a price determined by a formula. However, the price thus determined or fixed should not be lower than the fair value of equity as on the date of issue of CCD or CCPS. Further, the entire inflow of FDI has to be used at the time of conversion.

Warrants and Partly paid Equity Shares have also been permitted to be part of FDI. The pricing has to be decided upfront and shall not be less than fair value. Further, 25% has to be brought upfront. The balance, in case of partly paid shares, has to be brought with in 12 months. However, if the issue size is more than Rs. 500 Crores the requirement of 12 months may be relaxed. In that case a monitoring agency will have to be appointed. The time frame for getting the balance 75% amount in case of warrants is 18 months.

 

Demystifying FEMA - The Basics

Let us start with the Fundamentals. FDI in India is guided by the Consolidated FDI Policy Circular of 2015 of Government of India in this regard.

Who can Subscribe to Security: Any entity resicent outside India can invest in securities of Indian entity with some exceptions. Residents of Bangladesh have to take approval from Foreign Investment Promotion Board (FIPB). Residents of Pakistan, apart from taking approval from FIPB, are prohibited from investing in specific sectors. Residents of Nepal and Bhutan can invest only in non-repatriable form.

Types of Instruments that can be issued: Indian companies can issue equity shares, fully and mandatorily convertible debentures, fully and mandatorily convertible preference shares and warrants. From December 30, 2013 optionally convertible instruments have also been permitted. Guiding principle for optionally convertible debentures is that there has to be a lock-in period of 1 year and there should be no assured return. (price not exceeding that arrived at on the basis of Return on Equity (RoE) as per the latest audited balance sheet. This condition has been removed.). The exit price should not be higher than the fair value of shares as determined by a Chartered Accountant or Merchant Banker registered with SEBI based on any Internationally acceptable methodology.

The Issue Price of Security: Under FDI fresh Shares to be issued to Non-residents should not be at a price less than the Fair Value. Fair Value of shares of a listed company is as prescribed by SEBI guidelines. In case of unlisted companies, it is as determined by a SEBI registered Merchant Banker or a Chartered Accountant as per as per any internationally accepted pricing methodology on arm’s length basis. If we see old instructions, earlier it used to be as prescribed under CCI guidelines. This was later modified to Discounted Cash Flow method.

Other Ways of Acquiring Equity: Equity can be subscribed to by converting Debentures and Preference Shares. Non-Convertible Debentures are not treated as FDI. The conversion price of Debenture has to be decided upfront. This can be a predetermined fixed value or it can be based on a formula. The guiding principle of conversion price is that it can not be less than the fair value of equity prevailing on the date of issue of debenture.

Compliance with other Acts: The company has to submit a certificate (format prescribed in FEMA20) from a Company Secretary regarding compliance with the Companies Act and any other conditions that might have been imposed by Government of India.