Till recently, Indian companies were permitted to issue preference shares to foreign investors without any significant restrictions. The only major restriction was on the dividend that could be paid on such shares. The dividend rate could not exceed 300 basis points above the SBI Prime Lending Rate on the date of issue of the preference shares.

The preference shares issued to foreign investors were also not considered as part of "foreign equity" for computing the sectoral limits, unless such preference shares were convertible preference shares. Hence, till recently, it was permissible for foreign investors to invest in redeemable/convertible preference shares issued by Indian companies.

Recent Amendment

However, the Finance Ministry notification of April 30 has imposed severe curbs on issue of preference shares by Indian companies to foreign investors. As per the notification, fully convertible preference shares would be treated as part of share capital and taken into account in computing the foreign equity ceiling, where such ceiling has been prescribed. Further, foreign investment in other type of preference shares, such as non-convertible, partly convertible or optionally convertible, would be regarded as "debt" and require confirming with ECB guidelines.

Indian companies had the flexibility of raising preference capital from foreign investors either as a convertible or redeemable instrument. In most cases, these instruments were structured in such a way so as to provide the investors a fixed return by way of dividend with an option to convert the preference shares into equity at a later period, depending on the performance.

The recent amendment treats all preference shares issued to non-residents, other than compulsorily convertible preference shares, as "loan" which requires conformity with the ECB guidelines.

ECB provisions

It may be noted that ECBs are more tightly regulated than foreign direct investments by way of preference capital. Some of the important provisions of the ECB guidelines are:

RBI approval would be required before draw down of the amount as for FDI, intimation is sent to the RBI post-investment.

ECBs can be raised only from internationally recognised lenders. It is debatable whether the RBI will recognise overseas funds (including private equity funds, venture capital funds, etc., which are significant investors in preference shares) as "internationally recognised lenders".

Ceiling on interest rate LIBOR plus 200/350 basis points.

End-use restrictions not permitted for real estate, capital markets or on-lending.

Raising ECBs not permitted for working capital/general corporate purposes; permitted only for import of capital goods, new projects, expansion, etc.

Financial intermediaries such as banks, financial institutions and NBFCs not permitted to access ECBs.

Impact of notification

The effect of this notification would severely impede the structuring options available for corporates in raising resources from foreign investors. If an Indian company is required to ensure compliance with all the guidelines applicable for ECBs, for issuing optionally/partly convertible preference shares, then, effectively, it may not be able to issue such shares at all.

A number of companies, especially those in the services and technology sectors, are dependent on their overseas partners/venture funds for funding. Most of this funding is in the form of long-term preference shares, with a conversion option. Following this amendment, such companies will find it difficult to access funds to meet their requirements.

It needs to be appreciated that there are a number of restrictions/pre-qualifications for an Indian company to access funds from the banking sector. In such a situation, it is not clear as to why the Government should prohibit the flow of funds as redeemable preference shares into such companies. If the Government's intention is to prevent misuse of this facility by certain sectors, probably this amendment could have restricted the issue of such preference shares by those sectors alone, and not a blanket ban as has been imposed now.

Such sudden changes in FDI regulations may not send the right signals to overseas investors. It is hoped that this amendment will be reviewed, covering only certain specific sectors which are of immediate concern to the Government, thereby permitting the other sectors to continue to make use of the facility which has been available to them for long.

V. N. Shiva Shankar
(The author is a Chennai-based advocate.)