The Practical Lawyer

Foreign Currency Convertible Bonds

India is the seventh largest and the second most populous country in the world. It is also the fourth largest economy in the world1. A series of striving monetary reforms stimulating foreign investment has moved India firmly into the frontrunners of the rapidly emerging markets. The Foreign Exchange Management Act2 1999 (FEMA), the successor of the Foreign Exchange Regulation Act, 1973 (FERA) represents the evolution from “regulation― to “management― as FEM propounds a more positive, flexible and contemporary approach towards the market trends. With the opening up of the Indian economy there has been a considerable statistical enhancement and substantial improvement in the country’s foreign exchange reserves, constructive growth in the foreign trade, and rationalisation of various tariffs. In addition, there has also been a significant liberalisation of Indian investment abroad and relaxation of policies regulating foreign investments in India, increased access to external commercial borrowings by Indian companies and major participation by the foreign institutional investors in the domestic stock markets. India is the seventh largest and the second most populous country in the world. It is also the fourth largest economy in the world1. A series of striving monetary reforms stimulating foreign investment has moved India firmly into the front-runners of the rapidly emerging markets. The Foreign Exchange Management Act2 1999 (FEMA), the successor of the Foreign Exchange Regulation Act, 1973 (FERA) represents the evolution from “regulation― to “management― as FEMA propounds a more positive, flexible and contem approach towards the market trends. With the opening up of the Indian economy there has been a considerable statistical enhancement and substantial improvement in the country’s foreign exchange reserves, constructive growth in the foreign trade, and rationalisation of various tariffs. In addition, there has also been a significant liberalisation of Indian investment abroad and relaxation of policies regulating foreign investments in India, increased access to external commercial borrowings by Indian companies and major participation by the foreign institutional investors in the domestic stock markets. With the rapidly rising index and heavy funds investment in the Indian market, the corporate sector has seen a massive surge of profits in the recent past. According to a recent World Bank report, India is now the largest recipient of nonresident transfers in the world. Following the trail of the booming Chinese economy, the Indian Government has introduced an alternative means for the Indian entities to raise funds from the international markets by way of the bonds issue. The most common facet of this bonds issue is the foreign currency convertible bonds which are open to the foreign markets by making regular coupon and principal payments and also giving the foreign bondholders an option to convert the bond into stock when the market fluctuations favour them.

FCCB — An insightForeign currency convertible bonds are “bonds― inclusive in the definition of “debt instruments―â instrument― means an instrument which creates or acknowledges indebtedness, and includes debenture, stock, bonds and such other securities of a body corporate, whether constituting a charge on the assets of the body corporate or not.3 The explanation as provided by the Organisation for Economic Cooperation and Development (OECD) reads as under: Existing debt instruments typically arise out of contractual relationships under which an institutional unit (the debtor) has an unconditional liability to another institutional unit (the creditor) to repay principal with or without interest, or to pay interest without principal. These instruments include debt securities [like debentures4 and bonds5], loans, trade credit, and currency and deposits. Debt instruments may also be created by the force of law—in particular, obligations to pay taxes or to make other compulsory payments—or through rights and obligations that result in a debtor accepting an obligation to make future payment(s) to a creditor.6 Succinctly, these corporate bonds are an interest-bearing instrument in which the entity (corporate or governmental) pays to the investors a fixed sum of money at some future time. These corporate bonds are sometimes issued as “convertible bonds― with the option of being converted to equity. Bonds carrying such optionally element attract the investors making debt investment in the bonds issuing entity. A bond that can be converted into a fixed amount of the company’s equity is usually done at the discretion of the bondholder. Features of the bond issue7:

- Status.—Bonds constitute direct, unsubordinated obligetions of the company and rank pari passu inter se with all other existing debts and borrowings of the company as regards repayment of principal and interest thereon by the bonds issuing company. - Redemption.—(a) Redemption on maturity—Unless previously redeemed or purchased by the company, the bonds are redeemed at par on the expiry of a predetermined period from the date of the allotment. (b) Put option8—When the bondholder redeems the bonds after expiry of a certain period commencing from the date of allotment, he is said to exercise the put option. (c) Call option9—When the company purchases the bonds from the bondholders at discount, par or premium in the open market or otherwise, the company is said to exercise its call option. Keeping in pace with the latest economic financial trends, Indian corporates have started issuing these “convertible bonds― in international markets commonly known as “foreign currency convertible bonds―10. FEMA Notification No. 120/RB-2004 i.e. the Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004, defines “foreign currency convertible bonds― (FCCBs) under Regulation 2(g) which reads as: http://www.supremecourtcases.com

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Foreign Currency Convertible Bond (FCCBs) means a bond issued by an Indian company expressed in foreign currency, and the principal and interest in respect of which is payable in foreign currency11. When these bonds are issued in a currency other than the issuer’s domestic currency with an option to convert them in the equity of the issuer company, such quasi debt instruments are called foreign currency convertible bonds (FCCB). The FCCBs are exceedingly popular with corporate India for raising funds that are usually utilised for debt restructuring, infrastructure development and expansion. Generally, the investors on account of two main reasons favour such types of bonds: firstly, receipt of fixed payments on these bonds i.e. the principal and the interest accruing on these bonds which are payable in foreign currency and secondly, that these investors can avail the benefit of converting their bonds into equity during the value appreciation of the issuer company’s shares. Following are some common features of the foreign currency convertible bonds:

- FCCB can be secured as well as unsecured.12 Mostly FCCBs issued by the Indian companies are unsecured. - Credit rating13 of bonds is not mandatory, since corporations having excellent track record mostly issue such bonds. However, rating done by the credit rating agency14 certainly adds value to the bonds issued. - Indian companies, eligible to issue shares to persons resident outside India15 under the Foreign Direct Investment Scheme16 (including sectoral cap and sectors where FDI is permissible) can raise foreign currency resources abroad through the issue of American depository receipts17 (ADRs) or global depository receipts18 (GDRs). - The “bond to equity― convertible option attached to FCCBs is subject to the Reserve Bank of India guidelines19. Such FCCBs can be converted by exercising the “call option―20 and “put option21― to suit the structure of the bond. - FCCBs are generally listed on the National and Regional Stock Exchanges to improve liquidity. - Public issue22 of FCCBs shall be only through reputed lead managers in international capital market. In case of private placement, the placement shall be with banks, or with multilateral and bilateral financial institutions, or foreign collaborators, or foreign equity holder having a minimum holding of 5% of the paidup equity capital of the issuing company. Private placement with unrecognised sources is prohibited.23 - FCCB issue related expenses shall not exceed 4% of issue size and in case of private placement, shall not exceed 2% of issue size.24FCCB issue by the Indian companies needs to conform with various regulatory requirementsBefore the foreign currency convertible bonds (FCCB) hit the international markets innumerable compliances and conditions have to be adhered to by the company desiring to raise finances by facilitating the issue of FCCBs. Trying to ride the bull phase, corporate sector is leaner and meaner now, with the focus on cost control, and the restructuring of operations over the recent past adding a few crucial percentage points to operating profit margins. Regulatory measures help maintain prudent limits for these total external borrowings that are acquired by the FCCB issue. Requirements as prescribed by the several provisions of the company law25FCCBs are bonds which fall within the definition of “debentures―26, and therefore the process for issue of debentures shall be applicable to the issue of FCCBs: A. Prior intimation may be given to the stock exchange by the issuer company listed at the stock exchange at least 7 days before the date of Board meeting in which the FCCB issue is to be considered.27 B. Power to issue FCCBs vests with the Board of Directors of the issuer company who are obligated to pass a Board resolution pertaining to the issue of FCCBs.28Role of SEBI—Pre-issue and Post-issue requirements and conditions to be fulfilled by the issuer company - An application for listing of the bonds has to be made to the stock exchange of the country where FCCBs are to be issued and treaded i.e. international stock exchange. - “In principal― approval has to be obtained from the Indian stock exchange to list the shares issued upon conversion of bonds, when the bondholder exercises the convertibility option. - Filing the offer document35 (offering circular) with the Securities Exchange Board of India, Reserve Bank of India and stock exchanges prior to FCCB issue.36 RBI’s37 regulatory frameworkThe Government of India considers the funds raised through FCCB issue as foreign direct investment (FDI). 38 The latest comprehensive RBI guidelines on FCCB are contained in the 1-7-2008 Master Circular39 on External Commercial Borrowings and Trade Credits that provides the scheme and policy to be followed by the issuers of FCCBs as the circular itself very distinctly provides that the policy laid down for the external commercial borrowings40 are likewise applicable to the issue of FCCBs:

- 1. The ECB Master Circular lays down that borrowing funds through FCCB issue can be accessed under two routes viz. (i) FCCB issue up to US $500 million under the automatic route, (ii) FCCBs issue beyond US $500 million with the specific approval of Reserve Bank i.e. under the approval route. 41 - 2. The Circular42 makes available the eligibility criteria on the numerous kinds of entities and individuals for borrowing and lending during FCCB issue under the automatic route.Eligibility of the issuer(i)Indian corporates except financial intermediaries such as banks FIs, NBFCs. (ii)NGOs engaged in micro-finance activities. (iii)Individuals, non-profit making organisations and trusts are not eligible.Eligibility of the subscriber(i) International capital markets (ii) International banks http://www.supremecourtcases.com

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(iii) Multilateral financial institutions (iv) Export credit agencies (v) Suppliers of equipment (vi) Foreign collaborator (vii) Foreign equity holder, subject to - minimum holding of equity of 25% in the borrower’s company for raising ECB up to US $5 million; - minimum holding of equity of 25% in the borrower’s company and a debt equity ratio of not more than 4:1, for raising ECB above US $5 million.(viii) Overseas organisations and individuals (lend to NGOs in microfinance activities). - 3. FCCB issued proceeds need to conform with the “End use―43 conditions as prescribed by RBI in the abovementioned ECB Master Circular:Permitted end use - Investment in “real industrial― sector including SMEs44 and infrastructure sector through expansion, modernisation, import of capital goods, new projects, etc. - Overseas direct investment in joint ventures/wholly owned subsidiaries. - First stage acquisition of shares in the disinvestment process and also in the mandatory second stage offer to the public under the Government’s disinvestment programme of PSUs45. - 25% of the FCCB proceeds can be used for general corporate restructuring. Prohibited end use - Investment in real estate excluding integrated town ships. - On lending. - Investment in capital markets. - Acquisitions. - As working capital. - For general corporate purposes. - For repayment of rupee loans.Law governing the FCCB issue through the ADR/GDR mechanismIn the recent past, some corporates have raised funds through issue of American depository receipts and/or global depository receipts. Under such a mechanism, the companies issue shares to the depositories who in turn issue these ADRs/GDRs to the ultimate investors functioning in the international markets. For this purpose the entities issuing the ADRs/GDRs enter into an agreement with the depository to the effect that the depository would not exercise voting rights in respect of shares held by them or they would exercise voting rights as directed by the managerial authorities of the issuer companies.46 It may be further noted that the Indian companies are permitted to issue foreign currency convertible bonds and ordinary shares through global depository mechanism47. The aforesaid circular48 further lays down that these foreign currency convertible bonds are required to be issued in accordance with the scheme viz. “Issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depositary Receipt Mechanism) Scheme, 1993―.49 The following diagram depicts the mechanism of FCCB issue through the depository receipts (ADRs/GDRs):50

 Indian Company     Ordinary Shares FCCB     Domestic Depository Bank     Overseas Depository Bank Receipts     Investors The Scheme defines “foreign currency convertible bonds― as: 3. (b) “Foreign currency convertible bonds― means bonds issued in accordance with this scheme and subscribed by a non resident in foreign currency and convertible into ordinary shares of the issuing company in any manner, either in whole, or in part, on the basis of any equity related warrant attached to debt instruments.51 The Scheme further provides the eligibility conditions for issue of convertible bonds or ordinary shares of issuing company:52 (a) Obtain prior permission of the Department of Economic Affairs, Ministry of Finance, Government of India. (b) Issue ADRs/GDRs if the company is eligible to issue shares to persons resident outside India under the FDI Scheme. (c) Indian listed company not eligible to raise funds from the Indian capital market including a company restrained from accessing the securities market by (SEBI) will not be eligible to issue ADRs/GDRs. (d) Unlisted companies would require prior or simultaneous listing in the domestic market on issuance of ADRs/GDRs. (e) Unlisted companies already issued ADRs/GDRs have to list in the domestic market on making profit or within three years of such issue, whichever is earlier. (f) GDRs/ADRs/FCCBs issue is likely to exceed the percentage limits under the automatic route, or implementing a project falling under approval route, issuing company required to obtain prior FIPB53 and the Ministry of Finance approval.Current scenarioHaving discussed in length the entire procedure for the FCCB issue, it may be worthwhile to excerpt an FCCB issue deal in progress between the low cost carrier Spice Jet and an American PE firm W.L. Ross & Co. promoted by billionaire Wilbur Ross who is known for restructuring failed companies.54 Sluggish demand in the domestic market, current economic slowdown and mounting ATF (aviation turbine fuel) prices have led to a mammoth downturn in the aviation industry, resulting into mergers, acquisitions and borrowings by the airline companies that were running into massive losses. The low cost airline Spice Jet, currently facing turbulence due to soaring fuel prices is expected to raise funds by issuing the foreign currency convertible bonds to the ace investor Wilbur Ross, who has agreed to pump in Rs 354 crores (US $80 million) to tide over this financial crunch. The conversion price of FCCBs is pegged at Rs 56 per share and this convertibility option may be exercised anytime till 2010. The proposed fund infusion would meet the working capital requirements including the losses of the company thereby maintaining the carrier’s productivity until the crude oil prices eventually stabilise. http://www.supremecourtcases.com

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Thus, the FCCBs have yet again proved to be an economic financial rescue means by propping up the budget airline especially as the market sloth adds to its undesirable and downbeat performance.

ConclusionIn view of the above, monies raised by the FCCB issues, amounting to foreign investments in India, prove to be a boon as they are affirmatively utilised for corporate development and expansion. In the Indian context, the FCCB route, a financial instrument operated by the non resident investors, has provided a new way of investing in the Indian markets. However, there is a constant watch on such corporate actions as these steps are an open invitation to either “foreign investments― or what the regulatory authorities term to be “foreign intervention―. Despite the bright prospects Indian stock markets have been known for severe manipulations and it is suspected that the recent boom has come in handy for several unscrupulous elements to take advantage of such market gyrations. But it is for the Government to ensure that the Indian corporates exploiting such avenues duly comply with the instructions and the finances thus borrowed are in conformity with the prescribed guidelines. Any violation of the law should be viewed seriously and responded with adequate punishment.

- D.T. Khilnani, FEMA Ready Reckoner (Vol. 1, 15th Edn., July 2008). - Foreign Exchange Management Act, 1999 came into force on the 1st day of June, 2000 thereby repealing the Foreign Exchange Regulation Act, 1973. - As defined in 1.2.1 (xi) of the Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines, 2000. - “Debenture― as defined under Section 2(12) of the Companies Act, 1956 includes debenture stock, bonds and any other securities of a company whether constituting a charge on the assets of the company or not. - Bond is an obligation to pay a fixed sum of money, at a definite time and with a stated interest. Therefore, “bond― is generally a long term debt security. Black’s Law Dictionary. - OECD Glossary of Statistical Terms . - SEBI Capital Issue Debentures and Listing by K. Sekhar (3rd Edn., Vol. 1). - A put option gives the bondholder the right but not an obligation to sell a fixed number of equity shares of a company at a specified price at any time on or before the maturity date. - A call option is a contract giving its owner the right to buy a specified number of equity shares of a company at a specified exercise price at any time on or before the fixed maturity date. - In the US such bonds listed with SEC are called yankee bonds, while they are referred to as bulldog bonds (in the UK) and samurai bonds (in Japan). - The Foreign Exchange Management Act, 1999 defines “foreign currency― under Section 2(m) as, “foreign currency means any currency other than Indian currency;― - FCCBs issued by companies are either “security― backed FCCBs i.e. which create a charge on the assets of the body corporate or unsecured depending upon the issue requirements. - “Rating― means an opinion regarding securities, expressed in the form of standard symbols or any other standardised manner, assigned by a credit rating agency and used by the issuer of such securities, to comply with the requirement specified under the Securities Board of India (Credit Rating Agencies) Regulations, 1999. - “Credit rating agency― means a body corporate which is engaged in, or proposes to be engaged in the business of rating of securities offered by way of public or rights issue as defined under Section 2(h) of the Securities Board of India (Credit Rating Agencies) Regulations, 1999. - The Foreign Exchange Management Act, 1999 under Section 2(w) states that, “ ‘a person resident outside India’ me a person who is not resident in India;― - Issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depositary Receipt Mechanism) Scheme, 1993. - “American depository receipts― means a security issued by a bank or a depository in the United States of America against underlying rupee shares of a company incorporated in India. - “Global depository receipts― means a security issued by a bank or a depository outside India against underlying rupee shares of a company incorporated in India. - Reserve Bank of India has issued master circulars, regulations and guidelines which regulate the issue of FCCB by Indian players in the international corporate market. - See, supra, n. 5. - See, supra, n. 4. - “Public issue― means an invitation by a company to public to subscribe to the securities offered through a prospectus as defined in the SEBI (Issue and Listing of Debt Securities) Regulations, 2008. - Schedule I—The automatic route for issue of Foreign Currency Convertible Bonds (FCCBs) of the Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004. - Ibid. - The Companies Act, 1956. - Section 2(12) of the Companies Act, 1956, “2. (12) ‘debenture’ includes debenture stock, bonds and any other secu of a company, whether constituting a charge on the assets of the company or not;― - Clause 19(a) of the listing agreement. - Section 292 of the Companies Act, 1956. - Section 293(1)(d) of the Companies Act, 1956. http://www.supremecourtcases.com

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- Section 293(1)(a) of the Companies Act, 1956. - Section 81(1-A) of the Companies Act, 1956. - Section 117-A of the Companies Act, 1956. - Section 117-B of the Companies Act, 1956. - Section 117-C of the Companies Act, 1956. - “Offer document― means prospectus in case of a public issue or offer for sale and letter of offer in case of a rights issue which is any document inviting deposits from the public or inviting offers from public for the subscription or purchase of any shares in, or debentures, bonds of any body corporate and includes any notice, circular and advertisements. This definition is taken from the Securities and Exchange Board of India (Disclosure and Investor Protection) Guidelines, 2000 and the Companies Act, 1956. - Filing of information with RBI within 30 days from the issue date including total amount of the bonds issued, names of the investors resident outside India and the amount repatriated to India supported by foreign inward remittance certificates as provided by Notification FEMA No. 120 i.e. the Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004, under Part III—Investments in foreign securities other than by way of direct investment. - Reserve Bank of India. - International Monetary Fund (IMF) explains that “foreign direct investment― is the category of international investment that reflects the objective of obtaining a lasting interest by a resident entity in one economy in an enterprise resident in another economy. The lasting interest implies the existence of a long-term relationship between the direct investor and the enterprise and a significant degree of influence by the investor on the management of the enterprise. - RBI/Master Circular No. /07/2008-2009—Master Circular on External Commercial Borrowings and Trade Credits. - ECB. - Also stated in FEMA 120—The Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004. - See, supra, n. 40. - Emphasis supplied—the ultimate application of the funds raised by the body corporate through the FCCB issue. - Small and medium enterprises. - Public sector undertakings. - Issue of American Depository Receipts (ADRs)/Global Depository Receipts (GDRs) Deopsitory Agreement. - Global Depository Receipts mechanism is wherein an instrument in the form of a depository receipt or certificate created by Overseas Depository Bank outside India and issued to non?resident investors against the issue of ordinary shares or the foreign currency convertible bonds of the issuing company. - See, supra, n. 43. - Hereinafter to be referred as the “Scheme―. - Rajiv Jain, Guide on Foreign Collaboration, (9th Edn.). - Section 2(b) of the Scheme. - Law governing the ADR/GDR Scheme. - Foreign Investment Promotion Board. - Wilbur Ross Board’s Spice Jet with US$80 million—The Economic Times, Mumbai Edition 16-8-2008.

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