Conversion of ECB into Equity Key Legal and Regulatory Requirements
CS Rachit Sharma
Sr. Manager, Research and Advisory, Taxmann
CS Neha Sharma
Team - Research and Advisory, Taxmann
Conversion of ECB into Equity Key Legal and Regulatory Requirements
CS Rachit Sharma
Sr. Manager, Research and Advisory, Taxmann
CS Neha Sharma
Team - Research and Advisory, Taxmann
Contents 1.
Introduction
5
2.
Key points to be examined before conversion
5
3.
Evaluation Of Law
5
4.
Conclusion
9
1.
Introduction
Can an outstanding ECB be converted into equity? Yes, but the conversion is not simply a matter of adjusting a loan against share capital. When debt raised from a foreign lender is converted into equity, the transaction moves from the debt framework to the foreign investment framework, bringing together the requirements of the Companies Act, 2013 and FEMA. The conversion may involve several regulatory checkpoints i.e. corporate approvals, valuation, FDI entry route and sectoral caps, pricing norms, exchange-rate treatment, and ROC and RBI reporting.
2. Key points to be examined before conversion Before converting an ECB or other loan into equity, the company should verify: (a)
Authorisation under the loan agreement for conversion into equity.
(b)
Authorisation under the articles of the company.
(c)
Eligibility of the foreign investor under FEMA.
(d)
Entry route, sectoral cap and investment limit applicable to the investment.
(e)
Applicable valuation and pricing requirements under the Companies Act and FEMA.
(f)
Treatment of accrued interest, conversion costs and other outstanding amounts.
(g)
Exchange-rate requirements for determining the ECB liability eligible for conversion.
3. Evaluation Of Law 3.1
Compliance under Companies Act, 2013
3.1-1
Authority for conversion and Valuation of Shares under the Companies Act
Where a company having share capital proposes to issue further shares to any person, including an existing shareholder or any other person, otherwise than through a rights issue, the issue may be made pursuant to a special resolution under Section 62(1)(c) of the Companies Act, 2013. Whether such shares are issued for cash or for a consideration other than cash, the price of such shares must be determined by the valuation report of a registered valuer, subject to the conditions prescribed under Rule 13 of the Companies (Share Capital and Debentures) Rules, 2014. However, where the terms of the loan (including an ECB) contain an option to convert the loan into shares of the company, and such terms were approved by a special resolution passed in general meeting before the loan was raised, the increase in subscribed capital on exercise of such option is outside the scope of Section 62. In such a case, a fresh special resolution under Section 62(1)(c) is not required at the time of conversion. Where no such
Conversion of ECB into Equity Key Legal and Regulatory Requirements
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option was approved before raising the loan, the conversion must be undertaken as a preferential allotment under Section 62(1)(c). Accordingly, where an outstanding loan is proposed to be converted into equity shares, the company should determine the amount of the loan to be converted, the number of shares to be issued, and the issue price in accordance with the applicable valuation requirements. The conversion terms should also be consistent with the approvals obtained under the Companies Act and the terms of the underlying loan arrangement. For a listed company, the preferential issue (including pricing) must also comply with Chapter V of the SEBI (ICDR) Regulations, 2018.
3.1-2 Private Placement Requirements for issue of shares under the Companies Act Where a company proposes to issue equity shares to a select group of persons, other than through a public offer, the issue may fall within the private placement framework under Section 42 of the Companies Act, 2013, subject to the prescribed conditions. In a loan-to-equity conversion, the lender may be the person to whom the equity shares are proposed to be issued. Accordingly, where the proposed issue qualifies as a private placement, the company must comply with the applicable requirements of Section 42 read with Rule 12 and Rule 14 of the Companies (Prospectus and Allotment of Securities) Rules, 2014. The Board of Directors should approve the proposed conversion and allotment in a Board meeting. The special resolution passed for the issue must be filed with the Registrar in Form MGT-14 within 30 days of its passing. Thereafter, the company must file the return of allotment in Form PAS-3 with the Registrar of Companies within 15 days from the date of allotment, along with the certified true copy of the Board resolution, special resolution, valuation report, and list of allottees.
3.1-3 Post-allotment compliances under the Companies Act (a) Maintain Register of Members [Section 88 read with Rule 3 of the Companies (Management and Administration) Rules, 2014]
The company must update the Register of Members in Form MGT-1 with the details of the allottee and shares allotted within 7 days after the Board of Directors or its duly constituted committee approves the allotment. In case of demat shares, the depository’s register of beneficial owners is treated as the corresponding register. (b) Issue Share Certificates in case of physical shares [Section 46 and Section 56(4)(b) read with Rule 5 of the Companies (Share Capital and Debentures) Rules, 2014]
Where shares are issued in physical form, issue the share certificate in Form SH-1 within 2 months from the date of allotment. Where shares are required to be held in dematerialised form, follow the applicable dematerialisation requirements. (c) File corporate action form with depository if shares are issued in demat form [Section 29(1A) read with Rule 9A and Rule 9B of the Companies (Prospectus and Allotment of Securities) Rules, 2014]
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Conversion of ECB into Equity Key Legal and Regulatory Requirements
Where shares are issued in demat form, the company must file the corporate action form with the concerned depository for credit of shares to the allottee’s demat account. Further, unlisted public companies and private companies (other than small companies) are required to issue securities only in dematerialised form.
3.2
Compliances under FEMA and ECB framework
Where an External Commercial Borrowing (ECB) is proposed to be converted into equity shares of an Indian company in favour of a person resident outside India, the transaction must satisfy the applicable provisions of the Foreign Exchange Management Act, 1999, the Foreign Exchange Management (Borrowing and Lending) Regulations, 2018, the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019, and the RBI’s Master Direction: External Commercial Borrowings, Trade Credits and Structured Obligations.
3.2-1 Conditions and Compliances of conversion of ECB into equity Paragraph 7.4 of the RBI’s Master Direction on External Commercial Borrowings, Trade Credits and Structured Obligations specifically deals with conversion of ECB into equity. An ECB, including a matured but unpaid ECB, may be converted into equity, subject to the following conditions and compliance with the FEMA (Non-Debt Instruments) Rules, 2019. i. The activity of the borrowing company is covered under the automatic route for FDI or Government approval is received, wherever applicable, for foreign equity participation as per extant FDI policy. ii. The conversion should be with the lender’s consent and should not result in contravention of eligibility and breach of the applicable sectoral cap on the foreign equity holding under the FDI policy. iii. There should be no additional cost payable to the lender for facilitating the conversion. iv. Applicable pricing guidelines for shares are complied with. v. In case of partial or full conversion of ECB into equity, the reporting to the Reserve Bank will be as under: (a) For partial conversion, the converted portion is to be reported in Form FC-GPR prescribed for reporting of FDI flows, while monthly reporting to DSIM in Form ECB 2 Return will be with suitable remarks, viz., “ECB partially converted to equity”. (b) For full conversion, the entire portion is to be reported in Form FC-GPR, while reporting to DSIM in Form ECB 2 Return should be done with remarks “ECB fully converted to equity”. Subsequent filing of Form ECB 2 Return is not required. (c) For conversion of ECB into equity in phases, reporting through Form FC-GPR and Form ECB 2 Return will also be in phases. vi.
If the borrower has availed of other credit facilities from the Indian banking system, including foreign branches/subsidiaries of Indian banks, the applicable prudential
Conversion of ECB into Equity Key Legal and Regulatory Requirements
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guidelines issued by the Department of Banking Regulation of the Reserve Bank, including guidelines on restructuring, are complied with. vii. Consent of other lenders, if any, to the same borrower is available or at least information regarding conversions is exchanged with other lenders of the borrower. viii. For conversion of ECB dues into equity, the exchange rate prevailing on the date of the agreement between the parties concerned for such conversion or any lesser rate can be applied with a mutual agreement with the ECB lender. It may be noted that the fair value of the equity shares to be issued shall be worked out with reference to the date of conversion only.
Illustration X Ltd. has an outstanding ECB of USD 10,00,000 from its foreign parent. Z Ltd(Lender). The lender enter into an agreement to convert the ECB into equity on 1 June, when the exchange rate is Rs. 85.50 per USD. The shares are allotted on 20 June, when the exchange rate is Rs. 86.20 per USD, and the fair value of an equity share as on the date of conversion is Rs. 450. The ECB dues may be converted at Rs. 85.50 (the rate on the date of agreement) or any lesser rate mutually agreed with the lender, but not at Rs. 86.20. At Rs. 85.50, the amount converted is Rs. 8,55,00,000 and the number of equity shares to be issued is 1,90,000 (Rs. 8,55,00,000 / Rs. 450). The fair value of Rs. 450 must be determined with reference to the date of conversion.
3.2-2 FDI entry route and sectoral cap Once the ECB is converted into equity, the transaction assumes the character of a foreign investment in an Indian company. Therefore, the resulting issue of equity instruments to a person resident outside India must comply with the FEMA (Non-Debt Instruments) Rules, 2019. In particular, Rule 5 read with Schedule I of the NDI Rules should be examined to determine whether the investment is permitted and the conditions applicable to the issue of equity instruments. The company must verify the applicable entry route, sectoral cap or investment limit and other conditions prescribed for foreign investment. Further, an entity of a country which shares a land border with India, or where the beneficial owner of an investment into India is situated in or is a citizen of any such country, can invest only under the Government route. Accordingly, where the ECB lender or its beneficial owner falls within this category, prior Government approval is required for the conversion, irrespective of the sector. The issue of equity shares against an amount payable by an Indian company to a person resident outside India is also recognised for FEMA purposes. The Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019, vide Explanation (i) to Regulation 3.1(I)(A)(1), specifically includes the issue of equity shares by an Indian company against funds payable by it to the investor within the explanation relating to consideration.
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Conversion of ECB into Equity Key Legal and Regulatory Requirements
3.2-3 Pricing of equity shares issued to a non-resident The issue price of equity instruments issued to a person resident outside India should not be less than (i) in the case of a listed Indian company, the price worked out in accordance with the relevant SEBI guidelines; and (ii) in the case of an unlisted Indian company, the valuation of the equity instruments determined using an internationally accepted pricing methodology on an arm’s-length basis. The valuation report must be duly certified by a Chartered Accountant, SEBI-registered Merchant Banker, or practising Cost Accountant.
3.2-4 Reporting requirement The procedural requirements for the issue and reporting of equity instruments are governed by the Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) Regulations, 2019, notified as Notification No. FEMA 395/2019-RB dated 17 October 2019, as amended from time to time. (a)
Form Foreign Currency-Gross Provisional Return (FC-GPR): An Indian company issuing equity instruments to a person resident outside India and where such issue is reckoned as Foreign Direct Investment must report such issue in Form FC-GPR, within 30 days from the date of issue of equity instruments.
(b)
Annual Return on Foreign Liabilities and Assets (FLA): An Indian Company which has received FDI or an LLP which has received investment by way of capital contribution in the previous year including the current year, shall submit Form FLA to the Reserve Bank on or before the 15th day of July of each year. The year for this purpose shall be reckoned as April to March. The company should therefore complete the applicable FEMA reporting for the issue of equity shares pursuant to ECB conversion and separately comply with the reporting requirements applicable to the ECB transaction/ modification. Any delay in reporting attracts a late submission fee, as may be decided by the Reserve Bank.
In addition to reporting related to the issue of equity instruments, the borrower should ensure the conversion is appropriately reflected in the ECB reporting framework and that the transaction is reported through the designated Authorised Dealer (AD) bank in accordance with applicable RBI directions.
4. Conclusion Conversion of an outstanding loan or ECB into equity requires careful coordination between corporate law and foreign exchange regulations. From obtaining the necessary corporate approvals and determining the appropriate valuation to satisfying the applicable FDI entry route, sectoral cap, pricing conditions and ROC & RBI reporting requirements, each stage of the conversion must be appropriately documented and completed.
Conversion of ECB into Equity Key Legal and Regulatory Requirements
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