Convertible instruments under FEMA — CCPS and CCD pricing guidelines

Introduction

Convertible instruments such as Compulsorily Convertible Preference Shares (CCPS) and Compulsorily Convertible Debentures (CCDs) are commonly used by Indian companies to raise funds from foreign investors. Since these instruments ultimately convert into equity, their issuance to non-residents is subject to the foreign investment framework under the Foreign Exchange Management Act, 1999 (FEMA).

The FEMA framework treats fully, compulsorily and mandatorily convertible preference shares and debentures as equity instruments. Instruments that are not fully and compulsorily convertible are generally treated as debt instruments and are not governed by the same FDI pricing framework.

One of the most important compliance requirements is that the price or conversion formula must be determined upfront when the convertible instrument is issued.

1. What are CCPS and CCDs?

Compulsorily Convertible Preference Shares (CCPS)

CCPS are preference shares that are required to be converted into equity shares in accordance with the terms specified at the time of issue.

For FEMA purposes, preference shares qualify as equity instruments where they are fully, compulsorily and mandatorily convertible and fully paid.

Compulsorily Convertible Debentures (CCDs)

CCDs are debentures that are required to be converted into equity shares.

Under the RBI’s foreign investment framework, debentures that are fully, compulsorily and mandatorily convertible are treated as equity instruments.

Accordingly, the FEMA pricing rules applicable to equity instruments become relevant when CCPS or CCDs are issued to persons resident outside India.

2. FEMA Pricing Requirement for Convertible Instruments

The central FEMA requirement is that the price or conversion formula must be determined upfront at the time of issue.

In other words, an Indian company cannot issue CCPS or CCDs to a foreign investor with an entirely open-ended conversion price that will be decided later.

The RBI Master Direction specifically provides that, in the case of convertible equity instruments:

The price/conversion formula is required to be determined upfront at the time of issue.

Further, the price at the time of conversion cannot be lower than the fair value determined at the time of issuance in accordance with the applicable FEMA rules.

This is a critical point when drafting investment and subscription documents.

3. Pricing of CCPS and CCDs in an Unlisted Indian Company

For an unlisted Indian company, the valuation of equity instruments is required to be undertaken using an internationally accepted pricing methodology for valuation on an arm’s-length basis.

The valuation must be certified by any of the following:

A Chartered Accountant;

A SEBI-registered Merchant Banker; or

A practising Cost Accountant.

The RBI framework expressly recognises this valuation approach for unlisted Indian companies.

Practical example

Assume an unlisted Indian company proposes to issue CCDs to a foreign investor.

The company obtains a valuation determining the fair value of its equity at ₹100 per share.

The CCD terms may specify an upfront conversion formula, for example:

Conversion price = ₹100 per equity share

or a formula that is capable of determining the conversion price upfront, subject to the FEMA requirement that the eventual conversion price does not fall below the applicable fair value determined at issuance.

The commercial terms may provide for conversion at a future date, but the FEMA pricing requirements cannot be ignored merely because conversion takes place later.

4. Why the Conversion Formula Must Be Fixed Upfront

The requirement to determine the conversion formula upfront serves an important regulatory purpose.

Consider a situation where:

A foreign investor invests ₹10 crore through CCDs;

The company does not specify the conversion price at the time of issue; and

The parties decide the conversion price several years later based on the company’s then-current valuation.

Such an arrangement can create uncertainty regarding the foreign investor’s eventual equity ownership and may potentially result in conversion at a price inconsistent with FEMA pricing requirements.

Therefore, the conversion mechanism should be clearly established in the transaction documents at the time of issue.

The RBI’s reporting framework also requires the conversion ratio for CCDs/CCPS to be specified upfront; where there is no upfront conversion ratio, the ratio must comply with the maximum permissible conversion under the applicable pricing guidelines.

5. Listed vs. Unlisted Companies

The applicable pricing mechanism differs depending on whether the Indian company is listed or unlisted.

Listed Indian Company

For listed companies, pricing is linked to the applicable SEBI pricing framework. The RBI framework provides that issue and transfer of shares, including compulsorily convertible preference shares and compulsorily convertible debentures, are subject to the applicable SEBI guidelines.

Unlisted Indian Company

For an unlisted company, valuation is based on an internationally accepted pricing methodology on an arm’s-length basis, with certification by a CA, SEBI-registered Merchant Banker or practising Cost Accountant.

6. Conversion Price Cannot Be Below the Applicable Fair Value

This is perhaps the most important FEMA pricing principle for CCPS and CCDs.

The conversion price cannot subsequently be reduced below the fair value determined in accordance with FEMA at the time of issuance.

Therefore, if the fair value at the time of issue is ₹100 per equity share, the conversion mechanism should not ultimately result in the investor receiving equity at, for example, ₹70 per share.

This principle protects against arrangements under which a foreign investor effectively receives equity at a price below the permitted FEMA valuation.

7. What Happens if the Instrument Is Not Compulsorily Convertible?

Not every preference share or debenture qualifies as an equity instrument under FEMA.

Preference Shares

Preference shares that are not fully, compulsorily and mandatorily convertible are treated as debt instruments under the FEMA framework and are therefore not governed by the NDI Rules as equity instruments.

Debentures

Similarly, debentures that are not fully, compulsorily and mandatorily convertible are treated as debt instruments and are outside the equity-instrument framework under the NDI Rules.

This distinction is important because the regulatory framework applicable to debt instruments can be substantially different from the FDI framework applicable to equity instruments.

8. Key Documents to Review

When an Indian company proposes to issue CCPS or CCDs to a foreign investor, the following documents should be reviewed carefully:

Term Sheet

Share Subscription Agreement

Shareholders’ Agreement

CCPS/CCD Terms

Valuation Report

Board and Shareholder Resolutions

PAS-3 and other applicable MCA filings

FC-GPR filing with RBI

Foreign investor KYC documents

Conversion documentation at the time of conversion

The conversion formula in the transaction documents should be consistent with the valuation and FEMA requirements.

9. FEMA Compliance Checklist for CCPS and CCDs

Before issuing CCPS or CCDs to a foreign investor, an Indian company should consider the following:

Particular Key consideration

Instrument Confirm that the CCPS/CCD is fully, compulsorily and mandatorily convertible

Foreign investment route Confirm Automatic Route/Approval Route applicability

Sectoral cap Check the applicable foreign investment limit

Pricing Ensure compliance with FEMA pricing guidelines

Valuation Obtain appropriate valuation for an unlisted company

Conversion formula Determine upfront

Conversion price Ensure it does not fall below the applicable FEMA fair value

Company law Ensure compliance with Companies Act, 2013

RBI reporting Complete applicable reporting within prescribed timelines

Documentation Ensure investment agreements contain consistent conversion terms

10. FEMA vs. Companies Act: Both Need to Be Considered

Compliance with FEMA pricing rules alone is not sufficient.

An Indian company issuing CCPS or CCDs to a foreign investor must also comply with the Companies Act, 2013 and applicable rules, including provisions governing the issue of preference shares, debentures, private placement and related corporate approvals.

Therefore, the transaction should be reviewed from both perspectives:

Companies Act compliance + FEMA/FDI compliance

The conversion terms should also be commercially and legally consistent across the term sheet, subscription agreement, shareholders’ agreement and constitutional documents.

11. Common Mistakes in CCPS/CCD Transactions

Some common issues that can create FEMA compliance concerns include:

1. Leaving the conversion price open

Simply stating that the conversion price will be determined based on the valuation at the time of conversion may not satisfy the requirement for an upfront conversion formula.

2. Ignoring valuation at the time of issue

The valuation at issuance is important because FEMA requires the eventual conversion price to comply with the applicable fair-value requirement.

3. Using a conversion formula that can result in a lower price

The formula should be structured so that it does not result in conversion below the permissible FEMA price.

4. Treating all convertible instruments as equity instruments

Only instruments satisfying the applicable compulsory-conversion requirements receive equity treatment under the FEMA framework.

5. Focusing only on FEMA

The Companies Act, sectoral restrictions, pricing regulations, reporting requirements and tax implications should also be reviewed.

Conclusion

CCPS and CCDs can provide Indian companies with a flexible mechanism for raising foreign capital while deferring the actual issuance of equity. However, their structuring requires careful attention to FEMA’s pricing framework.

The key principle is straightforward:

Where CCPS or CCDs are issued to a non-resident, the price or conversion formula must be determined upfront, and the eventual conversion price must not fall below the applicable fair value determined in accordance with FEMA.

For unlisted companies, appropriate valuation and certification are particularly important. Transaction documents should therefore clearly specify the conversion mechanism and ensure consistency between the valuation, contractual terms and regulatory filings.

Note: FEMA/FDI rules and RBI directions are subject to amendments. The transaction should be checked against the regulations and RBI Master Direction applicable on the actual date of issue. The RBI’s current framework is available through its Master Direction – Foreign Investment in India.