Under the former FDI path, FEMA 20(R) only recognized completely and compulsorily convertible instruments, whereas instruments like optionally or partially convertible instruments were treated as debt.
Under the former FDI path, FEMA 20(R) only recognized completely and compulsorily convertible instruments, whereas instruments like optionally or partially convertible instruments were treated as debt. Though the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (NDI Rules) included the definition of “hybrid securities” to mean hybrid instruments such as optionally or partially convertible preference shares or debentures which can be issued by an Indian company or trust to a person resident outside India; the term was not used further in the rules.
It could at most imply that investments made through hybrid instruments would most likely be governed under the NDI Rules. A hybrid financial instrument is one that possess some attributes of debt as well as equity. Ordinarily the bond will convert into shares of stock in the issuing company. The RBI also issued the Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) (Amendment) Regulations, 2020, permitting the use of Special Non-Resident Rupee Account balances for investments. Further, the sale proceeds of non-debt instruments can also be now remitted outside India.
Though foreign investments using hybrid instruments were allowed through the FDI route until 2007, RBI was of the view that issuing such instruments went against the spirit of the FDI regulations, which aimed at encouraging investments in the form of equity capital rather than debt instruments. Under the new scenario, hybrid instruments are categorized as debt, and the RBI's External Commercial Borrowings (ECB) framework regulates them.
The aim of hybrid instruments is to allow a business to include equity-like capital while maintaining capital security and returns. Hybrid instruments have a relatively higher risk mitigating aspect. Allowing security of the capital amount seems reasonable, particularly when such protection can be arranged by liquidation preferences.
Although the RBI continues to oppose guaranteed returns, the courts are of a different view. A ‘pro-enforcement' bias has been evident in a number of decisions involving capital security clauses in investment contracts. The Supreme Court of India decided on the issue of multifaceted investments by FDI in the case of IDBI Trusteeship Services Limited v. Hubtown Ltd. in 2016. It was decided that if the instruments did not assure the investor a certain return, then they should be regarded as equity instruments and therefore allowed under the FDI regime.
The two types of hybrid instruments mentioned in the ECB regulations are:
i. Foreign Currency Exchangeable Bonds (FCEBs) pertaining to securities denominated in a foreign currency that are issued under the Issue of Foreign Currency Exchangeable Bonds Scheme, 2008. FCEBs may be exchanged for equity shares of another corporation (the Offered Company) in any way, in whole or in part, or on any equity-related warrants basis attached to debt instruments. However, FCEBs must be issued in accordance with all other relevant regulations.
ii. Foreign Currency Convertible Bonds (FCCBs) being instruments denominated in a foreign currency that are issued under the Issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depositary Receipt Mechanism) Scheme, 1993. Here also, other relevant legislation must also be followed when issuing FCCBs. However, FCCBs should be free of any warrants.
The New ECB Framework streamlines the Old ECB Framework by combining Track I (Medium term foreign currency denominated ECB with Minimum Average Maturity also known as MAM of 3/5 years) and Track II (Long term foreign currency denominated ECB with MAM of 10 years) into a single track known as "Foreign Currency Denominated ECB."
Under the old framework, there were individual lists of Eligible Borrowers for each track. The list of Eligible Borrowers has been extended under the New ECB Framework to include all organizations eligible to receive FDI. Thus, an Indian company or an Indian limited liability partnership (LLP) functioning in an industry where FDI under the automatic route is permitted up to 100 percent, including start-ups, is eligible for ECB.
The New ECB Framework's stated goal is to make the mechanism "instrument neutral," and product harmonization appears to be a step in that direction. FCEBs are no longer subject to the approval route and will now fall under the automatic route. In the near future, rules regulating hybrid instruments such as partially convertible debentures are expected to be implemented.
In many niche areas, hybrid instruments, especially in the start-up domain, attract foreign investments. The principle behind hybrid financing is to provide lenders with a mix of benefits of both equity as well as debt instruments. Equity instruments offer the investor a sense of control and a residual right on the cash flows, while debt instruments generate cash for the firm's economic development. Although Bond-like returns are combined with equity-like uncertainties in hybrids making them more lucrative these investors will recover their sums only at the very end, if a company gets wound up, since they are prioritised after senior bondholders and other lenders.
Due to Covid-19, the real impact of these changes in the ECB guidelines has not been felt in full as investors are not investing as much as they would have in normal circumstances. Let us hope, the changes give a boost to foreign investment in India, especially the start- ups and MSMEs, which require funding the most.
The author, Raj Bhalla, is law firm Partner and former legal chief at SEBI. The views expressed are personal
First Published: IST