Finance & Accounting Finance Business NBFC

An Analysis of Compulsorily Convertible Preference Shares (CCPS) Issued by NBFC

CCPS or Compulsory Convertible Preference Shares is a highly preferred investment instrument for PE investors having a high net worth bridge the gap in the mismatch of valuation expectations between investors and promoters. The CCPS is said to be a hybrid instrument or anti-dilution instrument. NBFC can issue compulsorily Convertible Preference Shares (CCPS) without obtaining any prior approval of RBI if the conversion is capped at less than 26 percent. Hence, it can also be concluded that the approval of RBI is not needed in case there is no progressive increase in shareholding.

However, while converting preference shares into equity, NBFCs must receive prior approval of RBI. NBFC can issue CCPS for a maximum period of 20 years. There shall be no tax implication on CCPS, whether it is issued at par or face value.

What is Compulsorily Convertible Preference Shares (CCPS)?

Compulsorily Convertible Debentures (CCDs) or Compulsorily Convertible Preference Shares (CCPS) are instruments that compulsorily convert into equity shares of the issuing company on the mutually pre-decided conditions at the time of issuance of the instruments. CCPS usually have a lower rate of interest than NCDs. CCPS are also considered as capital instruments, and investment done in CCPS can be made under the FDI route.

According to the Reserve Bank of India (RBI), the compulsorily convertible preference shares or CCPS must be treated at par with equity shares. Indian companies can undertake financial commitments based on the exposure to a joint venture through CCPS. The existing provisions of Overseas Direct Investments visualize setting up or acquiring a joint venture abroad by subscribing or contributing to the equity capital of the venture.

What is Anti Dilution in CCPS Issued by NBFC?

The promoters of the company are benefitted by the Compulsorily Convertible Preference Shares (CCPS) by maintaining the equity stake intake whenever the company issues equity shares to new investor. The promoters can convert the CCPS taken at the time of lower valuation of shares at a time when new investor brings the money at a higher valuation and hence, the promoters can increase its stake without bringing money at a higher cost.

How Compulsorily Convertible Preference Shares (CCPS) Benefits the Private Equity Investors in NBFC?

CCPS also benefits private equity (PE) investors. At the time of conversion, the investors can link the company’s performance. These fundamentally mean that the shares will get converted only when the NBFC achieves the target growth. In case the target set is not made, then the PE firm reserves the right to increase its stake. As per the capital market regulator’s norms, any acquisition of 15% or more in the case of a listed company triggers an open offer. Similarly, a PE firm can intake a direct equity at the rate of 14.9% and also the rest in the form of securities, which may turn into equity within 18 months. In this way, the firms have a scope of exiting the one-year lock-in period for PE investment.

How CCPS Benefits the Start-ups?

The CCPS also provides help to the founder of start-up companies in controlling their stake at the funding stage of new investors without the infusion of new funds. As CCPS are also anti-dilution securities, the founders can manage their equity without adding any further funds. Since the CCPS are also anti-dilution securities so the founders can manage their equity stake to lead the company by holding a substantial stake in the company.

How CCPS Helps in Avoiding Valuation Gap?

The CCPSs helps in avoiding the valuation gap between the founder and Investors. Theoretically, many methods are applied to bring at par the share value of the equity. The most popular method that is involved in calculation is the ‘relative valuation’ method. The other applied valuation method is the discounted cash flow or DCF method. The problem in using this method is that there are too many assumptions involved in valuation. At least five years of forecast must be done here, and the person has to use assumptions to arrive at the applicable capital cost and terminal value. Hence, a simple way to avoid a valuation discussion is if there is any difference of opinion with the promoter in investing through convertible preference shares wherein the angel’s price is determined.

Regulatory Framework for CCPS Issued by NBFC

The issuance of CCPS securities is a strategic decision for NBFCs. It plays an essential role in controlling the equity stake of the promoters of the company. A slight amount of irregularity can impact the substantial holding structure of the founders. Further, the CCPS issued by NBFC involves compliance of four major laws:

Companies Act, 2013

The Issue of CCPS is governed by the provisions of Section 42, section 62, and section 55 of Companies Act, 2013 to be read with Companies (Prospectus and Allotment of Securities) Rules, 2014 and Companies (Share Capital and Debentures) Rules, 2014.

FEMA Regulatory Framework

The CCPS are equity instruments; hence even foreign investors can subscribe under the Foreign Direct Investment Policy under the automatic route subject to the pricing guidelines along with a sartorial cap. Under the said policy, the conversion terms and conditions shall be determined upfront while issuing the said instruments. The price during conversion should not, in any case, be lower than the fair value valued at the time of issuance of such instruments.

It must be noted that Indian companies cannot issue Non Convertible Preference shares (NCPS) under the FDI policy. The External Commercial Borrowing Regulations govern it. Further Indian Companies can issue optionally convertible Preference Shares subject to some restrictions minimum Lock-in period and also assured returns to Foreign Investors. Hence, one must make a sensible decision while selecting the convertibility aspect of the Preference Shares.

Some of the post compliance issue of CCPS is: Filing of the advance reporting form, FCGPR, FYC. The compliance measures are the same as at the time of issuance of equity shares. The FCGPR need not be filed at the time of conversion of CCPS into equity shares. However, it is always suggested to inform RBI regarding the details about the conversion of CCPS into equity shares, so that RBI will update their records relating to the foreign equity holding.

Taxation Regulatory Framework

The valuation of CCPS is subjected to provisions of Section 56 (2)(viib) of the Income Tax Act, 1961.

According to this section, an unlisted company, not being a company where the public is substantially interested gets in any previous year from any person being a resident, any amount as consideration for issue of shares that exceeds the face value of such shares, the aggregate compensation received for such shares which exceed the fair market value of the shares shall be chargeable to income-tax under the head Income from other sources. However, aforesaid pricing restriction is not applicable when shares are issued to non -resident person.

Stamp duty Aspect of CCPS

The treatment on the Payment of stamp duty^[1] on CCPS Certificate is governed by the relevant states Stamp Duty Act. Here, the question arises whether the Stamp duty must be paid again on the issuance of equity share certificate post-conversion. No stamp duty is required to be paid on Equity Share Certificate as it will not change its Category.

RBI Regulations

The offer document made for private placement should be issued within a maximum period of 6 months from the date of the Board Resolution authorizing the issue of the certificate. The offer document must include the names along with the designations of the officials who have been authorized to issue the offer document. The Board Resolution and the offer document shall contain all the information about the purpose for which the resources are being raised.

• The offer document is to be printed or typed as “For Private Circulation Only.” The general information, including all the addresses of the registered office of the NBFC, date of opening or closing of the issue, etc. must be mentioned in the offer document.
• The NBFC must issue debentures for the deployment of funds in its balance sheet and not to facilitate resource requests of group entities or parent companies or associates.
• The private placement by all the NBFCs will be restricted to not more than 49 investors, identified by the NBFC.
• The minimum subscription amount for a single investor will be Rs. 25 lakh and in multiples of Rs.10 lakh afterward.
• There must be a minimum time gap of at least six months between the two private placements.
• An NBFC will not extend loans against the security of its debentures.
• All other instructions related to private investments remain unchanged.
• The provisions of the mentioned guidelines shall override other instructions wherever contradictory

Conclusion

The NBFCs must ensure that at any point in time, the debentures issued, including the short term NCDs, are secured. Hence, in case, at the stage of issue, the security cover is insufficient or not created, the issue proceeds shall be placed under escrow until the creation of security, which in any case should be within one month from the date of issue. The various legal compliances that are involved in making the CCPS are discussed in this article. However, these days, CCPSs are playing a significant role in the strategic decision of the Company, Investors, and Founders.