Sunday, February 24, 2008

Analysing Foreign Currency Exchangeable Bonds (FCEBs)

When it came to borrowings in foreign currency, Indian companies hitherto had two options, namely (i) external commercial borrowings (ECBs) where they borrow monies in foreign currency, or (ii) foreign currency convertible bonds (FCCBs) where they issue bonds denominated in foreign currency that are convertible into shares of the issuer company.

About a week ago, the Ministry of Finance granted Indian industry a third option (but only in fulfillment of a Budget promise made last year), which is foreign currency exchangeable bonds (FCEBs). The Ministry issued a notification on February 15, 2008. I have been meaning to study this over the last few days, but finally got down to doing so only today.

I located a summary of the notification on LawFuel which is less technical than the notification itself. Although it appears that this type of instrument is fairly common internationally, it is unique to the Indian markets, and presents some interesting elements that we shall see.

Under this option, an issuer company may issue FCEBs in foreign currency, and these FCEBs are convertible into shares of another company (offered company) that forms part of the same promoter group as the issuer company. In other words, if company A issues FCEBs, then the FCEBs will be convertible into shares of company B that are held by company A and where companies A and B form part of the same promoter group. There is a fundamental difference between an FCCB and an FCEB whereby in the case of an FCCB offering, the bonds convert into shares of the company that issued the bonds, while in the case of an FCEB offering, the bonds are convertible into shares not of the issuer company, but that of another company forming part of its group.

There are a couple of other mechanical matters that are of interest. In an FCCB, when the holder exercises the option to covert, the issuer company will issue fresh shares to the holder in exchange for the bonds. However, in case of FCEBs, when the option is exercised, there is no issuance of fresh shares. What occurs is a transfer by the issuer company of the shares it holds in the listed (offered) company to the holder in exchange for the bonds. Further, although the FCEBs are issued on the strength of the underlying shares held by the issuer company, it does not automatically means that the shares are pledged in favour of the FCEB holder. In the event of bankruptcy of the issuer company prior to conversion, the position of the FCEB holder would be only that of an unsecured creditor, and to that extent, this structure is not bankruptcy proof so far as the issuer company is concerned.

Pros and Cons

In doing a pros and cons analysis, one finds several advantages in this scheme. First, it provides an additional avenue for Indian companies raising funds from overseas. Second, it helps companies unlock the value of their holdings in other companies. Simply stated, it allows companies (such as holding companies or investment companies) that hold shares in other group companies (which are listed on the stock exchange) to leverage on the value of their investments by borrowing on their strength. Third, it helps companies raise financing without further dilution. For instance, instead of a listed company issuing further shares to raise capital, one of its promoter entities may issue FCEBs on the strength of its holding in the listed company and fund the listed company with the proceeds of the FCEB offering. This way, the promoter entity’s shareholding in the listed company would not be diluted at all, unlike in the case of direct capital raising by the listed company. Fourth, there seem to be no perceived disadvantages from a taxation standpoint (although some doubts have been raised on some technical issues regarding taxation: see The Hindu Business Line).

The principal disadvantage of FCEB route lies in its scope. It is permissible only in certain areas and to the extent that ECBs and FCCBs are permitted. Changes effected to the ECB/FCCB policy last year (that are perceptibly linked to capital controls and the need to stem the rising Rupee) have restricted such borrowings only to very limited types of activities. This has resulted virtually in a demise of these routes, unless and until they are resuscitated by further policy change. Further, proceeds of FCEBs cannot be used for investment in the real estate sector or in capital markets.

Therefore, unless and until foreign currency borrowings are permissible for Indian companies in a wider array of activities and with lesser restrictions, it is unlikely that the route will be utilised in any meaningful way by Indian companies. Until then, it will remain on the rule book without implementation, and to that extent this single disadvantage pretty much overshadows all its benefits that are largely on paper. At the same time, any positive changes to the policy on foreign currency borrowing will spring this route into action.

3 comments:

Siddharth Nair said...

Interesting development, this. Do you think securities laws and exchange control laws need to be amended to facilitate the sort of exchange contemplated under the FCEB guidelines?

For instance, the exchange control laws currently make the transfer of shares to a non-resident for consideration other than cash subject to regulatory approvals. Would an amendment to FEMA 20 be required?

In addition, would SEBI regulations need to be amended to permit this sort of off-market transfer of listed shares?

Umakanth V said...

Siddharth,

Thanks for your questions. I do not see the need for any amendment to the laws relating to exchange control or securities regulation to facilitate FCEB transactions.

As for your specific points, the FCEB transaction is a cash transaction—not for consideration other than cash. It just so happens that the cash (for the underlying shares) is received by the issuer company up front when it issues the FCEBs and not at the later stage when the underlying shares are transferred (upon conversion of the FCEBs). In that sense, there is a time lag between the receipt of consideration for the shares and the actual transfer of the shares. Until the conversion option is exercised, the amount will possibly remain as an advance or loan in the books of the issuer company.

There may be technical aspects of FEMA (and various regulations) that this transfer may not comply with. Often, it is the case that FIPB or Ministry of Finance (MOF) make amendments to various schemes involving issue of securities to foreign investors, but there is a delay on the part of RBI in making consequential amendments to FEMA and regulations. However, in the case of FCEBs, since the issuer company will have to approach the RBI for approval for issuance of FCEBs (see para 5(1) of the notification), it would be possible to get RBI to bless the entire sequence of transactions emanating from the FCEB issuance.

Similarly, transfer of shares in listed entities beween two parties outside the stock exchange should not pose problems, especially because it is been carried out in pursuance of a transaction that has been provided for by the MOF itself. Just to take another example, when there is a conversion of ADRs/GDRs into underlying shares, there is technically a transfer (outside the stock exchange) of shares from the depository to the ADR/GDR holder, and these transactions occur all the time.

Kannan Rahul said...

Hi Umakanth,

Banks are currently falling outside the FCCB / ECB fencing and are not eligible for the purpose of raising funds through issue of FCCBs or for availing ECBs. It is pertinent to mention here that banks which are authorised dealers may otherwise carry out foreign currency borrowings from their correspondent banks subject to certain limits and in an unlimited manner throught their overseas branches (pursuant to the RBI Master Circular on Risk Management and Interbank Dealings and a circular issued by it in 2000 pertaining to borrowing or lending in foreign currency (amended from time to time).

However, in the case of FCEBs, the eligibility criteria is inter alia that the "Offered Company" is to be an entity eligible to issue FCCBs / avail of ECBs. This can be utilised by banks in India (acting through offices in India) to unlock the potential of their holdings in entities of their promoter group which are not financial intermediaries. Even though, as mentioned earlier, authorised dealers can borrow without limit through and for use of their overseas branches, offices in India can only do so from correspondent banks. In the case of a bank which seeks to borrow foreign currency acting through Indian offices, a loan from specifically identified entities (in form of bilateral loans, syndicated loans etc.) with restrictions on the lenders that they can assign their exposure only to entities qualifying as correspondent banks of the borrowing bank is an effective method of raising funds, but a senior bond issuance to insitutional investors / retail investors outside India would be a problem since they would not qualify as correspondent banks and such restrictions on transfer would be impractical on a listed and liquid instrument. This means that a bank seeking to carry out a senior bond issuance in foreign currency acting through Indian offices would need to obtain the prior permission of RBI - difficult since the intention embedded in the RBI circular is that borrowings other than through overseas offices should be from correspondent banks only.

FCEBs (even though prior RBI permission is required here as well) would then be an avenue for banks in India to reach out to a different debt investor base and to raise foreign currency funds acting out of India, for utilisation in India, and at the same time unlock potential of their holdings in group companies, since the "correspondent bank restricition" is not applicable herein.