ROLE OF FCCBs IN INDIAN MARKET SCENARIO

Ekta Gupta, 5th Year, National Law University, and Vaibhav Kakkar, Associate, Luthra & Luthra Law Offices, Delhi.

Abstract Efficient capital markets are a critical component for any developed economy and Indian capital markets today are amongst the best regulated markets wherein the regulatory framework has kept pace with the significant growth in the securities markets. The story of Indian capital market reveals an efficient trading and settlement infrastructure, high levels of disclosure and fostering an environment of innovation. In this back drop it is seen that a new trend of corporate financing is gaining ground. The sale of Foreign Currency Convertible Bonds by domestic companies and banks has surged over the last couple of years. Thus, this article in the first part seeks to examine some fundamental concepts related to Foreign Currency Convertible Bonds, viz, its nature, regulatory mechanism, tax treatment, advantages and disadvantages. The second part analyses whether Foreign Currency Convertible Bonds can be considered as a Golden instrument for raising funds in all market scenario wherein it is concluded that Foreign Currency Convertible Bonds can be advantageous only in a booming market and cannot be the buzzword in a bearish market, which the Indian markets did experience a little while back. In a bearish market, listed companies may resort to Qualified Institutional Placements that have been introduced by SEBI vide guidelines dated May 8, 2006. Lastly, the article also examines the concerns arising out of sudden increase in access to foreign currency convertible bonds by Indian companies. In this regard it is concluded that Press Note released by the Finance Ministry on November 17, 2005 relaxing the pricing guidelines is indeed a step in the right direction.

Key Words: Foreign currency convertible bonds, capital markets, boom, Participatory Notes, Qualified Institutional Placements, Pricing norms

INTRODUCTION In recent times a new trend of corporate financing is gaining ground. The sale of Foreign Currency Convertible Bonds (FCCBs) by domestic companies and banks has surged in the last couple of years. On March 22, 2006, Reliance Communication Ventures Limited announced the completion of an international offering of US$500 million of FCCBs- the largest one till date. Many other companies including HDFC, Mahindra & Mahindra, Arvind Mills, Pantaloon Retail, United Phosphorus, Amtek Auto and J&K Bank, are also following the same path.1 This article in the first part seeks to examine some fundamental concepts related to FCCBs, vis its nature, regulatory mechanism and tax treatment. The latter part analyses whether FCCBs can be considered as a Golden instrument in the current market scenario for raising finance. Lastly the article puts forth the bottlenecks faced with respect to the pricing norms and the latest Press Note released on 17th November 2005 relaxing the pricing guidelines.

WHAT ARE FCCBs? FCCBs means bonds that are issued by an Indian company and subscribed by non resident in foreign currency, that are convertible into equity shares of the issuing company , either in part or in whole on the basis of equity related warrants attached to the debt instrument. As per the provisions of Foreign Exchange Management Act, 1999 (FEMA) and applicable rules, regulations issued there under FCCB means a bond issued by an Indian company expressed in foreign currency and the principle and interest in respect of which is payable in foreign currency.

Interestingly, the aforementioned definition of FCCB does not speak of convertibility at all. Infact the definition states that Principle and interest is payable in foreign currency. Thus to put it simply, FCCB is essentially a debt instrument, which is convertible into local equities of a company (the borrower) after a pre-decided period at the set strike price. An investor makes a profit, if the strike price is lower than the traded price and he
1

Amtek in final stage of buying two foreign companies, 21st September 2005, Business Standard

is in a loss, if the strike price is more than the traded price. The conversion takes place at the discretion of the investor. If the investor is not willing to convert the bonds into shares, he can hold the securities till maturity and receive regular interest payments and principal on redemption. One feature of FCCBs is that when equities rise, the sensitivity is higher. And when equities fall, this sensitivity comes down.

FCCB v. ECB As opposed to the concept of FCCBs, External Commercial Borrowings (ECBs) are commercial loans, in the form of bank loans, buyers credit, suppliers credit, securitized instruments (e.g., floating rate notes and fixed rate bonds) availed from non-resident lenders with minimum average maturity of 3 years. Thus having defined the two, distinction becomes quite clear-FCCBs are basically debt instruments that are convertible into equity, either in part or in whole on the basis of equity related warrants attached to the debt instrument, while ECBs are simple debt that continue to remain debts and cannot be converted into equity.

FCCB: AS AN INSTRUMENT FCCB, which is a debt instrument, is convertible into equity, either immediately after issue, or upon maturity, or during a set period. The conversion price is at a premium over the current stock price, or is set by a formula based on the price at the time of redemption. The issuer may some times have a call option, generally with a call hurdle, i.e. subject to a minimum stock price at the time of call which means that invariably at the exercise of a call, the investors would opt for conversion into equity. The convertibility of the bond is akin to a put option to the bondholder, as he can redeem the bond while opting for conversion. As an investor in the equity, the bondholder has a call option in the sense that he has the right to the buy equity at the set price.

VALUATION OF FCCB

The FCCB has two components, namely a bond component and an equity component. The Present Value of the bond component is arrived at by discounting the future cash flows at LIBOR + credit premium. The value of call option on equity is arrived at as per Black Sholes model. The values so arrived are mutually exclusive at any point of time value of the bond would be higher of the two + accrued interest. The investor also needs to evaluate the currency risk on final redemption of the investment in addition to 1. Credit risk, in terms of credit spread included in the Yield to maturity (YTM), and, 2. Earnings risk on the equity. There is also impact of capital gains tax applicable as on the date of conversion, in contrast to tax on coupon income (if taxable in home country). For the issuer, the cost of capital would be: post-tax coupon of the bond and cost of equity. While average cost of capital may be adopted as a matter of convenience, the average cost post-conversion would be vastly different from the pre-conversion cost.

REGULATORY MECHANISM The issue of FCCBs is primarily regulated by the Issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depository Receipt Mechanism) Scheme, 1993 (the FCCB Scheme) issued by the Government and the Foreign Exchange Management (Transfer or Issue of any Foreign Security) Regulations, 2000, as amended (the Bond Regulations). The RBI has pursuant to its A.P. (DIR Series) Circular No. 60 dated January 31, 2004 and its Master Circular No.5/2004-2005 dated July 1, 2004 (the Circular) liberalised the policy for the raising of ECBs by Indian corporates and has extended the liberalization made for ECBs to the issue of FCCBs in all respects. FCCBs continue to enjoy this liberalization even under the latest Master Circular released by RBI on July 1, 2006.

The FCCB Scheme and the Bond Regulations, read with the Circular, provide that the issue of FCCBs in the aggregate principal amount of up to US$500 million or equivalent is permissible under the automatic route subject to compliance with the

following conditions: 1. Automatic Route and Maturity- The automatic route is available for issue of FCCBs for an aggregate principal amount of up to of US$500 million. FCCBs for an aggregate principal amount of up to US$20 million are required to have a minimum average maturity period of three years and FCCBs for an aggregate principal amount of above US$20 million and up to US$500 million are required to have a minimum average maturity of five years. 2. Permitted End Uses of Proceeds of Issue- The proceeds from the issue of FCCBs are permitted to be utilized only for the following end uses: For investment (e.g. import of capital goods), implementation of new projects, and modernization/expansion of existing production units in real sector, industrial sector including small and medium enterprises (SME) and infrastructure sector. For Overseas direct investment in Joint Ventures (JV)/Wholly Owned Subsidiaries (WOS) subject to the existing guidelines on Indian Direct Investment in JV/WOS abroad. For the first stage acquisition of shares in the disinvestment process and also in the mandatory second stage offer to the public under the Governments disinvestment programme of PSU shares. For lending to self-help groups or for micro-credit or for bonafide micro finance activity including capacity building by NGOs engaged in micro finance activities. Refinancing of an existing ECB FCCB, provided that the fresh FCCB is raised at a lower all-in-cost and the outstanding maturity of the original FCCB is maintained. 3. Not permitted End Uses-The end uses that are not permitted for the FCCB under the Automatic route are as follows Utilization of FCCB proceeds for on-lending or investment in capital market or acquiring a company (or a part thereof) in India by a corporate. Utilization of FCCB proceeds in real estate.

Utilization of FCCB for working capital, general corporate purpose and repayment of existing Rupee loans.

4. Pricing of the Shares to be issued on Conversion- Chapter XIII of the SEBI (Disclosure and Investor Protection) Guidelines, 2000, (the DIP Guidelines) as amended from time to time prescribes the pricing norms for issue of shares to a select group of persons under Section 81 (1A) of the Companies Act on a private placement basis. The pricing norms set out in the DIP Guidelines provide for issue of shares at a price not less than the higher of: Average of the weekly high and low of the closing price of the shares for the two weeks immediately preceding the relevant date; or Average of the weekly high and low of the closing price of the shares for the six months immediately preceding the relevant date. The relevant date means the date thirty days prior to the date on which the meeting of the general body of shareholders is held, in terms of section 81 (IA) of the Companies Act, 1956, to consider the proposed issue. It may also be noted that for regulatory purposes, FCCBs are treated as foreign direct investment and therefore, holders of the FCCBs would need to comply, at the time of conversion of the FCCBs to equity shares, with the applicable regime in India regulating foreign direct investment.

TAX TREATMENT FOR FCCBs Taxation on FCCBs explains yet another reason for more and more corporates resorting to FCCB issues. Firstly, interest payments on the Bonds, until the conversion option is exercised and tax on dividend on the converted portion of the bond are allowed deduction from TDS at the rate of 10%. Secondly, conversion of FCCBs into shares does not give rise to any capital gains liable to income-tax in India. Lastly, transfer of FCCBs made outside India by a non-resident investor to another non-resident investor does not give rise to any capital gains liable to tax in India. ADVANTAGES OF FCCBs

In a rising stock market, FCCB is preferred means of raising medium to long term resources for the reason that1. The company gains higher leverage, as debt is reduced and equity capital is enhanced upon conversion, subject to favourable stock price. 2. The impact on cash flow is positive, as most companies issue FCCB with a redemption premium, which is payable on maturity, only if the stock price is less than the conversion price. 3. FCCB do not dilute ownership immediately, as the holders of ADR / GDR do not have voting rights. 2 4. Conversion premium adds to the capital reserves. 5. FCCB carries fewer covenants as compared to a syndicated loan or a debenture, hence more convenient to raise funds for Mergers and Acquisitions.

DISADVANTAGES OF FCCBs 1. In a falling stock market, there is no demand for FCCB. In globally listed companies, prices in other stock exchanges also impact the issue of FCCB. 2. FCCB, when converted into equity, bring down the earnings per share, and eventually, dilute the ownership. 3. In the long run, equity is costlier than debt, and hence, when interest rates are falling, FCCB are not preferred. 4. Book value of converted shares depends on prevailing exchange rate.

FCCBs IN A BEARISH RUN Without prejudice to the fact that the restrictions under the FCCB guidelines are unwarranted, there are much larger issues that demand attention. The FCCB guidelines stipulate that overseas issues have to be priced at the average six monthly prices or the average price of the last fortnight before the due date, which is a month before the AGM approving the overseas issue. This may not be relevant in a bull market, but will

Ibid

make it much harder to raise capital in a falling market. In other words, it must not be forgotten that amidst the merry bullish run also, we did experience a bearish fever, a trend where prices were falling. Now in such a situation where the market is on a bearish run, it anyways becomes difficult to fetch capital and profits are automatically sluggish. If the regulator further adds to the misery and tightens the guidelines requiring the issues to be priced at the average six monthly prices or the average prices of the last fortnight before the due date, there remains no scope whatsoever for corporates to fetch capital and make profits. Thus, it must not be forgotten that FCCB as a debt instrument cannot be regarded as a golden means to access overseas capital. The viability of FCCBs depends on the market trend, i.e., whether it is bullish or bearish. Given below are the advantages and disadvantages of FCCBs in a rising and falling market. Hence, in a bearish market scenario listed companies may resort to Qualified Institutional Placements that have been introduced by SEBI vide guidelines dated May 8, 2006. Thus listed companies which comply with the prescribed requirements of minimum shareholding of the listing agreement can raise funds in the domestic market by placing securities with qualified institutional buyers. These guidelines provide that Qualified Institutional Placements may be made for securities, which can be issued through equity shares or any securities, other than warrants, which are convertible into or exchangeable with equity shares and are called specified securities. These Specified Securities can only be issued to qualified institutional buyers as defined under sub- clause (v) of clause 2.2.2B of the DIP guidelines. The main advantages of these Qualified Institutional Placements over the FCCBs are1. Medium sized companies who do not have a presence on a global scale would be able to raise capital domestically. 2. The cost considerations and the time involved in such placements would be lesser than those in a FCCB issue. 3. Such placements offer new vistas to the Indian companies for raising capital and also open more options to the Indian retail investors for investment.

THE CURRENT SCENARIO

The sale of FCCBs by domestic companies and banks had surged during 2005. During 2005, local companies sold FCCBs worth approximately $6 billion. In 2004, the cumulative issuances were worth $2.4 billion, while in 2003 it was a meager $150 million. What after all is the reason behind this mad race for FCCBs? Is it just one of those short term fads? Or it is something else? The story of the bullish stock market is known to every one now and it is this robust stock market has driven up investor appetite for local FCCBs. The benchmark sensex has risen from 6,600 to as much as 11,447 levels. Its a big gain for global investors, who bought FCCBs at a strike price for stocks, which may be lower than the current market levels.3 The Government, in September 2005, has directed that unlisted companies who have sold FCCBs or GDRs, to list in a domestic stock exchange within a stipulated time frame. This listing needs to be completed within three years of the FCCB/GDR issue or on earning a profit in any financial year beginning 2005-06, whichever is earlier. Companies, which have not raised funds through these instruments, will need to do a prior or simultaneous listing in the domestic stock market.

ALARM RINGING Though our equity market has primarily been on a bullish over the last couple of years, it did experience a bearish complexion in between. With the equity markets booming for a good part of the last year, several Indian companies, including quite a few firms, which are relatively unknown to even local investors, have accessed the overseas equity capital markets. The government therefore has been put on alert by a number of Indian promoters resorting to a rash of surrogate private placements while raising capital through FCCBs. After the finance ministry analyzed the data on FCCBs for the JanuaryJune 2005 period, it has found that a number of issuers had raised money on overseas stock exchanges with offerings ranging between $8-15 million.4 But what aroused the suspicion of the government was the fact that some of these companies had privately placed the stock with a select band of investors at a discount to the local market price.
3 4

Local cos. sell $2.8bn FCCBs till date in 2005, 6th October 2005, The Economic Times Govt sounds alert over rising surrogate private placements, 26th September 2005, The Economic Times

According to investment bankers, this is called a surrogate private placement where the equity issued abroad is placed with, or subscribed to, by overseas corporate bodies, nonresident Indians or with friendly bankers or friends. This has fuelled suspicions about the nature of the placements (or subscriptions) and forced the government to infer that some of the promoters might be using this route to indirectly bolster their own equity holdings. More importantly, the private placement is done in exchanges located in jurisdictions where disclosure norms are not as stringent as they are in the major global exchanges and which seek to attract global capital. Therefore the FCCB route might be misused by many market players and some of the promoters to manipulate scripts of their own companies just the way it happened during the 2001-02 securities scam. It is believed that in most of the cases, before going to the international market, promoters pep up the stock prices in the domestic market to get a good price abroad. Not only this, when companies raise money from the international market, most of the time promoters plough that back in the domestic market to make quick bucks. Sometimes, they get back the fund through Participatory Notes (P-Notes) with FIIs. As FIIs are not bound to reveal name of the PNote holders, the regulator can not find the source of money, being invested in the market. In fact, main instrument of rigging the market in 2000 was P-Notes. This P-Note rigging is happening in the current Bull Run also.5 As the economy is performing well during this phase, promoters are gaining heavily. But, the source said the market may crash when they sell out, which will hit small investors.

WHAT COURSE OF ACTION HAS BEEN ADOPTED? The government has now decided to play safe and has thus decided to choke off overseas equity issuance route by tightening norms relating to FCCB offerings. Between January and July 2005, 24 Indian companies raised over $1.3 billion through FCCBs, while between January and June, 2005, domestic corporates raised $639 million through GDRs and ADRs. Some of the measures under taken in the new guidelines are1. The new guidelines bar investment in such issues by firms which have been barred by regulators here from investment and from the local capital markets,

Indian firms raise huge sum abroad, 24th September 2005, Economic Times

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besides making it mandatory for a simultaneous or prior local listing for unlisted companies. 2. The pricing norms also have been tightened. These rules stipulate that overseas issues have to be priced at the average six monthly prices or the average price of the last fortnight before the due date, which is a month before the AGM approving the overseas issue. This has created its own little storm with many market observers describing the move as arbitrary and indifferent to market realities. In addition, critics complain that the government should not penalise all capital raisers for the misdemeanours of an errant few. Recently, investment bankers represented to the finance ministry against the new norms, but it was rejected.

THE DEBATE OVER PRICING NORMS Every coin has two sides and the robust use of FCCBs to access overseas capital is no exception to this. On one side there is immense suspicion that this is nothing but a perfect onset of another securities scam where in the FCCB route is being misused by many market players and some of the promoters to manipulate scripts of their own companies just the way it happened during the 2001-02 securities scam. It is also apprehended that since our economy was until now also performing during this Bull Run, the P-Note rigging is happening in the current Bull Run also, like the one that happened in 2000. It is apprehended that promoters are bringing back their own money via GDRs and FCCBs. The suspicions are largely about, particularly money raised in small markets like Luxembourg through FCCBs. Otherwise how else does one explain the fact that several Indian companies, including quite a few firms, which are relatively unknown to even local investors, have accessed the overseas equity capital markets? Is it not justified for the government in a situation like this to call the shots and tighten the FCCB guidelines? The government realizing the need of the hour is acting like a responsible government and is thus absolutely justified in tightening the pricing norms and barring investments in such issues that have been barred by the Indian regulator and local capital markets.

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On the other side the governments decision to impose pricing restrictions on all overseas equity issues (ADRs/GDRs/FCCBs) is considered arbitrary and indifferent to market realities. It is regarded as retrogressive and anti-globalization since it restricts access to capital.6 No doubt, there might have been a few problems but it seems like the whole market is being punished for the sins of a few. An analysis of data collected by Economic Times, makes the governments suspicions regarding the origin of the funds being invested FCCBs futile.

For 10 FCCB issues that were examined over the same period, the number of investors was at an average 60.7 The split between the geographical source of investment (Asia, Europe, US) was also almost equal. Large issues like HDFC ($300 Million) ICICI Bank ($437 million), both ADRs or UTI Bank (a $257m GDR issue) have a very large and varied investor base. The government is concerned about 6-7 companies that have raised money through GDRs/FCCBs, including a small software company, a couple of small pharma firms, and a metal manufacturer. The whole market is being punished for the sins of a few. But is it justified to punish all the innocent companies for the sins of a miniscule few?

OUTCOME OF THE DEBATE The Press Note released on 17th November 2005 by the Finance Ministry was made in response to representations received from the industry to relax the pricing guidelines for those planning simultaneous issues here and abroad. The earlier pricing norm that was considered stringent, stipulated that overseas issues have to be priced at the average six monthly prices or the average price of the last fortnight before the due date, which is a month before the AGM approving the overseas issue. Vide this press note the companies have been exempted from the recent American Depository Receipts and FCCB guidelines, which had brought all such issues in compulsory alignment with SEBI norms for domestic public offers. This means, companies going in for a public offer in the domestic and foreign markets at the same time, or within 30 days(includes the book
6 7

Govt neednt fret about foreign equity issues, Monday, October 03, 2005, The Economic Times Ibid

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building period) of the domestic issue, would not need to stick to the SEBI price discovery rules. The exemptions which would definitely reduce the hardship have been permitted provided the companies secure approval from the market regulator. However, there has been no change in the guidelines for unlisted companies. Those companies which have already issued GDRs\FCCBs in the international markets, and are to list in the domestic market, would have to do so by March 31, 2006.8 At the same time it must be remembered that companies will have to keep their overseas issue price at par with, or more than, the domestic prices. This is to block any entity from making a possible arbitrage from the new relaxation Consequently in lieu of the exemptions, several Indian corporates and banks will step into the overseas market in the next four to five months to mop up over $3 billion through a mix of securities. The new money will finance their expansion and refinancing plans.9 For instance, following the relaxed pricing guidelines, Videocon is looking at raising $500 million through a mix of FCCBs and GDR issues in December or January for capacity expansions, and refinancing some of its off-shore debt.

CONCLUSION FCCB undoubtedly is an effective and efficient instrument for corporate financing but the same cannot be regarded as a golden instrument for raising money in all situations. Having analyzed the pros and cons of FCCBs, it is clear that FCCBs can prove to be of utmost advantage only in a booming market and cannot be the buzzword in a bearish market, which the Indian markets did experience a little while back. Since volatility is inevitable in the stock market, appropriate steps have been taken by SEBI by issuing guidelines for Qualified Institutional Placements on May 8, 2006 to take care of fund raising by listed companies domestically in a bearish run. Further, by the Press Note released in November 2005, the right string has been struck and the relaxation on simultaneous issues, both domestic and abroad is a step in the right direction.

Companies neednt follow Sebis pricing rules for FCCB, ADR listing, Friday, November 18, 2005, The Economic Times. 9 Corporate India may shop for funds abroad, Wednesday, November 16, 2005, The Economic Times

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