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Guidelines for Compulsorily Convertible Preference Shares under FEMA

Varun Hariharan

| Updated: Jun 16, 2020 | Category: FEMA

Compulsorily Convertible Preference Shares

Capital instruments are securities such as Equity Shares, Preference Shares, and debentures provided by a company to raise money. These instruments also include different forms of shares, such as convertible preference shares and Compulsorily Convertible Preference Shares (CCPS). Capital instruments can be issued to investors within India and outside India. Raising finance through the means of capital instruments is another way of making money for a company.

Types of Capital Instruments- Compulsorily Convertible Preference Shares

Radial Diagram

This article is going to talk about preference shares more particularly with Compulsorily Convertible Preference Shares.

What are Preference Shares?

From the name itself, preference shares are understood as shares which have preference over other shares. Preferential rights are present with preference shares in comparison with equity shares and other forms of shares. These shares have to be differentiated from equity shares. Preference shares are more common and typically used in the USA.  It is also called as preferred stock.

Companies use preference shares for the following reasons:

  • They offer more flexibility for the company.
  • The company can redeem these shares at any point in time.
  • They have preferential treatment when compared to other forms of shares.
  • These shares are different from other forms of shares.

Types of Preference Shares

Companies offer different forms of preference shares. The types of preference shares provided by the company are as follows:

  • Cumulative Preference Shares- Cumulative preference shares have the right to receive specific arrears for dividend declared. However, this would only apply to dividend, which is paid in the previous year.
  • Non Cumulative Preference Shares- There is no form of arrears for the payment of dividends for non-cumulative preference shares. Companies can offer cumulative preference shares and non-cumulative preference shares to the shareholders.
  • Participating Preference Shares- As the name implies, participating preference shares means the shareholders who have the right to participate in the dividend declared to equity shareholders. After paying the amount of fixed amount of dividend to the preference shareholders, the shareholders are allowed to acquire the surplus of shares on winding up of the company.
  • Non Participating Preference Shares- Non-Participating Preference shares cannot get any form of participation rights for the dividend that is declared to equity shareholders. Therefore, these forms of preference shares cannot participate in the payment of dividend
  • Convertible Preference Shares and Compulsorily Convertible Preference Shares- Convertible Preference shares can be converted to equity shares. This is an option that is provided by the company while issuing the shares. These shares can only be converted to equity shares on the happening of certain events in the company related to shares.  Compulsorily Convertible Preference Shares have to be converted into equity shares. Shares once converted cannot be a part of the company. They would not secure any form of preference from the company.
  • Non Convertible Preference Shares- These shares are provided to shareholders but cannot be converted into equity shares. Hence the company can redeem these forms of shares. The shares can be considered as preference shares and not equity shares.
  • Optionally Convertible Preference Shares- Shares offered by the company which has the exclusive option of being converted to equity shares. Once converted into equity shares, the shares would lose any rights associated with them. Therefore, when preference shares are converted to equity shares, the preferential rights would become void.
  • Compulsorily Convertible Preference Shares- Once the company issues these shares; they must be mandatorily converted by the company. The shares, once offered, would be treated as equity shares that are provided by the company.

Regulation for compulsorily convertible preference shares

The law dealing with preference shares is the Companies Act 2013. Under the previous companies law (Companies Act 1956), section 85 of the act regulates both equity shares and preference shares. Equity shares are ordinary shares issued by the company. Preference shares are shares issued by the company which has preferential treatment in respect of shareholders.

Preferential rights are given to shareholders when it comes to payment of dividends and when they wind up the company. Hence preference shareholders are given preferential treatment when it comes to disbursement of dividends and winding of the organization.

Apart from the Companies Act, the SEBI guidelines provide a specific requirement for the operation of shares.  Even Compulsorily convertible preference shares come under the ambit of SEBI regulation. For the preferential issue of shares, the SEBI DIP guidelines would be applicable. Under section 2(h) of the Securities Contracts (Regulation) Act 1956, preferential shares are defined.

Shares can be allotted and purchased by foreign companies. The Government of India and the Reserve Bank of India (RBI) have brought out guidelines for foreign exchange in India. Such guidelines are known as the Foreign Exchange Management Act, 1999. Apart from this, the RBI, from time to time, provides circulars and notifications related to the regulation of foreign exchange in the country.

The RBI provides master guidelines to Authorised dealers to deal with foreign exchange transactions within the country. Authorized Dealers (Category-I)/ Authorised Persons act on behalf of companies and businesses to conduct foreign exchange transactions. The Government of India has brought out the Foreign Exchange Management (Transfer or Issue of a Security by a Person outside India) regulations.

These regulations guide capital instruments issued by an Indian company to a foreign company in exchange for consideration. Compulsorily convertible preference shares are also securities that can be issued by an Indian company.

DIPP (Department of Industrial Policy and Promotion) brought out guidelines for Foreign Direct Investment (FDI) in India. These guidelines have the respective sector caps which apply to foreign direct investment in the country.

Under the FDI consolidated policy 2017, foreign direct investment is allowed for Indian companies and limited liability partnerships. These entities are permitted to issue preference shares/ compulsorily convertible preference shares or any other security as per the FDI guidelines.

As per the Foreign Exchange Management Rules, the following guidelines would apply to issue of preference shares by a company:

  • Any form of a dividend on the preference shares cannot exceed the prime lending rate of The State Banking of India (SBI), equal to +3%.
  • When the company plans to issue equity shares or preference shares, the rate must be determined by taking a resolution of the price of the preferred shares.
  • This must be on the agenda of the board meeting where preference shares are recommended.
  • Suppose the prime lending rate of the company is 10%, then the maximum amount of preference dividend, which can be offered, is 13%. Therefore for a prime lending rate of more than 20%, the maximum preference dividend, which can be provided, is 23%.
  • As per the governing norms of the Department of External Affairs, Government of India and the Ministry of Finance, preference shares must be treated as ordinary shares. The regular shares offered by the company are considered as equity shares. For the respective FDI sector caps, these shares should be treated as equity shares if they are fully convertible.
  • When preference shares are not convertible to equity shares, then they would be treated as External Commercial Borrowings. Therefore, if the shares come as non-convertible shares, they would come under the purview of external commercial borrowing regulation.
  • The other form of preference shares, such as optionally convertible preference shares, partially convertible preference shares, and non-convertible preference shares must be treated as external commercial borrowings. Therefore Compulsorily convertible preference shares can be treated as ordinary equity shares under this regulation. A company issuing compulsory convertible preference shares to shareholders can convert the same.

Hence companies that offer capital instruments such as compulsorily convertible preference shares must adhere to the prescribed guidelines related to FEMA.

Apart from this, the RBI has provided certain specifications regarding the time of issue for compulsory convertible preference shares under FEMA.  The pricing of shares must be according to accepted international prices. The price offered for the issuance of shares by the company must be reasonable. Apart from this, the price suggested by the company must be determined at the time of offering such shares. The price must not be lesser than the fair value of the price as per the pricing guidelines offered by FEMA.

Applicability of Compulsorily convertible preference shares to exit options

Exit options are specific strategies used by Non-resident Indians. These can also be used by foreign entities conducting business in India. Exit options would only apply to preference shares, equity shares, and compulsorily convertible preference shares.

The following considerations have to be taken for capital instruments such as compulsorily convertible preference shares (CCPS):

  • The principles of valuation must be under the international standards of valuation.
  • A SEBI must determine the price of a registered Merchant Banker.
  • The price of exit must be determined as per the internationally accepted standards.

Categories of Capital Instruments which can be issued for consideration

Only the following capital instruments can be issued to a foreign investor for consideration:

  • Non-Convertible Preference Shares;
  • Optionally Convertible Preference Shares; and
  • Partially Convertible Preference Shares.

For raising foreign investment in capital instruments, the above capital instruments are allowed.

For Debentures and preference shares which are provided as capital instruments for foreign investment, the following conditions would apply:

  • The above three Preference shares are issued on and up to 30 April 2007.
  • Optionally convertible/ partially convertible debentures are issued up to 07 June 2007, which have a maturity period as applicable.

Partly paid-up shares, which are issued after 08 July 2014, would be considered as capital instruments. When issued to an NRI or a person resident outside India, these shares have to be called up fully. The commission received for these forms of shares is 25%. Such a way of consideration should be paid upfront.

Loan for Capital Conversion under ODI (Overseas Direct Investments)

  • Any form of loans that are provided overseas can be converted into any form of equity or Compulsorily Convertible preference shares under the automatic route.
  • This loan must be reported to the concerned authorized bank through the RBI.
  • If a loan is converted into Compulsorily Convertible Preference shares, it must be reported to the RBI.
  • Any other conversion of loan into preference shares do not require any form of reporting to the RBI.
  • Shares that are provided to an overseas company, a JV or WOS, can be held in the partner’s name if the host country laws allow it.
  • Compulsorily Convertible Preference shares have to be treated on par with equity shares if such shares are given for ODI.

Hence Compulsorily Convertible preference shares can be issued by an Indian company to the foreign investor under the FDI route. These preference shares must be treated as equity shares for overseas direct investment.

Conclusion

Companies can issue capital instruments for raising some form of finance. These instruments can be offered within India and outside India. One such capital instrument offered is the Compulsorily Convertible preference shares (CCPS). CCPS can be converted to equity shares. This is an option that is provided by the company while issuing the shares. These shares can only be converted to equity shares on the happening of certain events in the company.  Compulsorily Convertible Preference Shares have to compulsorily be converted into equity shares.

For ODI, any amount offered to a JV or a WOS can be treated as a loan. A loan can be converted into preference shares. Prior approval is required from the RBI for carrying this out.  Compulsorily Convertible Preference Shares require prior approval from the RBI. This form of approval is not required for any other form of preference share.

Also, read: Guidelines on Master Circular for Foreign Investment in India.

Varun Hariharan

Varun Hariharan has completed the Legal Practice Course from BPP Law School, Manchester. He has a Masters in Commercial and Corporate Law from the Queen Mary University of London and LLB Honours from Bangor University, UK. He specialises in law related to corporate, artificial intelligence and technology law.

Business Plan Consultant


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