Thursday, March 31, 2011

Changes to FDI Policy – Part I: Convertible Securities

The Department of Industrial Policy and Promotion (DIPP), Government of India today released its new edition of the Consolidated FDI Policy, Circular 1 of 2011 that comes into effect April 1, 2011. This is part of the bi-annual review process that the DIPP commenced last year so as to ensure that the policy is in tune with dynamics in the economy and industry.

The recent round of review has introduced a number of changes, and we will attempt to discuss all of the major ones on this Blog. At a broad level, the changes appear to be investor friendly as they seek to remove several obstacles that have long held back foreign investment in crucial sectors. In fact, this round represents one of the more progressive sets of changes made to FDI policy in recent times, as we shall examine. Neither the substance of the policy nor its timing are surprising, given recent reports appearing in the press about a steady drop in the FDI flows into India in recent times. Clearly, the effort seems to be to arrest the slide.

This post surveys the changes relating to pricing of convertible instruments. Investors, particularly financial investors such as private equity funds, are generally keen on investing in convertible instruments (such as preference shares or debentures) because the conversion price can be linked to future performance of the company, thereby incentivizing the management and promoters to make the business more profitable. This is more important in businesses where the value lies in the future. Start-up or early stage businesses may command low valuations based on current performance, but may demonstrate tremendous potential that may be realized only in the future. Convertible instruments enable promoters and managers to capture that potential in current valuation by linking the conversion price to the performance. Commercially, such conversion based on a formula seems beneficial to the company and its promoters (by their ability to secure better valuation) as well as investors (who minimize the risk of poor performance).

Even though convertible instruments are accompanied by sound commercial logic, they have not been very welcome by regulators in India. After long periods of ambiguity in the FDI policy, the erstwhile Consolidated Circular of 2010 provided as follows:
3.2.1 Indian companies can issue equity shares, fully, compulsorily and mandatorily convertible debentures and fully, compulsorily and mandatorily convertible preference shares subject to pricing guidelines/valuation norms prescribed under FEMA Regulations. The pricing of the capital instruments should be decided/determined upfront at the time of issue of the instruments.
As the underscored portion above suggests, there was no flexibility whatsoever regarding the conversion price. It had to be determined upfront by the company and investors, which effectively eliminated any of the commercial benefits of investing through a convertible instrument. It is believed that such an approach effectively curbed the market for convertibles.

The DIPP has done well to recognise this issue, and has attempted to address this by amending the relevant clause in the new policy (Circular No. 1 of 2011) as follows:
3.2.1 Indian companies can issue equity shares, fully, compulsorily and mandatorily convertible debentures and fully, compulsorily and mandatorily convertible preference shares subject to pricing guidelines/valuation norms prescribed under FEMA Regulations. The price/ conversion formula of convertible capital instruments should be determined upfront at the time of issue of the instruments. The price at the time of conversion should not in any case be lower than the fair value worked out, at the time of issuance of such instruments, in accordance with the extant FEMA regulations [the DCF method of valuation for the unlisted companies and valuation in terms of SEBI (ICDR) Regulations, for the listed companies].
These amendments carry several positive implications.
First, it is open to parties to agree upon a pricing formula. Note that the earlier policy required fixing the absolute price, and did not entertain a formula as such. This changes brings the use of convertible instruments in India in line with normal market practice.
Second, the minimum regulatory pricing norms (DCF, or SEBI, as the case may be) will be applicable with reference to the date of issue of the convertible instruments. Hence, parties are free to set any formula for conversion as long as the price so arrived at is not less than the regulatory minimum pricing as of issue date. The minimum pricing as of issue date will effectively operate as the floor price, as the conversion cannot result in issue of shares at a discount to such price. By pegging the regulatory minimum pricing to the issue date, the new policy introduces a great amount of certainty, because the parties already know that price at the time of the issue of the convertible instrument. Moreover, since the pricing can be at any amount in excess of that, it enables companies and their management to realize the upside potential in the business in future. It also enables investors to take a call on the future, and they are only limited by the minimum regulatory pricing, a risk that may be well worth taking considering the possible upside to their investment in the future.
On the whole, these changes to the FDI policy makes convertible instruments assume the their usual character, without being hamstrung by pricing restrictions. This may likely increase the use of such instruments while investing into India.
At the same time, the new policy is confined only to matters of pricing and there are no changes regarding the fundamental nature of convertible instruments themselves. In other words, only compulsorily convertible instruments continue to be treated as FDI. Non-convertible and optionally convertible instruments continue to be treated as external commercial borrowings (ECBs). It remains to be seen whether future rounds of changes to FDI policy will bring even optionally convertible instruments within its purview so as to broaden the flexibility available to investors. But, as of now, there does not seem to enough momentum to extend that far.

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