FDI Instruments, Reporting and Enforcement

In one line

This chapter follows an FDI transaction from the instrument used to the consequence of getting it wrong. The investment must be made in an equity instrument, which means an instrument that is equity in substance and not debt; it must be reported through the Single Master Form on the Reserve Bank's FIRMS portal within the prescribed time; a delay is regularised by paying a Late Submission Fee; and a substantive breach is a contravention under section 13, ordinarily settled by compounding under section 15.

Equity instruments: where the line between equity and debt is drawn

The Non-debt Instruments Rules apply only to non-debt instruments, so the first question in any FDI transaction is which side of the line the instrument falls on. Get it wrong and the whole regulatory apparatus changes: equity is governed by rules of the Central Government under section 6(2A), debt by regulations of the Reserve Bank under section 6(2)(a), and an instrument that is really debt is an external commercial borrowing, with its own maturity, cost and end-use conditions.

"Equity instruments" means equity shares, convertible debentures, preference shares and share warrants issued by an Indian company. But the convertible varieties count as equity only if they are fully and mandatorily convertible into equity shares. A debenture or preference share that is optionally convertible or redeemable is a debt instrument, because the foreign investor retains a right to get his money back rather than taking the equity risk.

Two consequences follow, and both are examinable.

The price or conversion formula must be fixed upfront. For a convertible instrument the price, or the formula by which it will be converted, must be determined at the time of issue, and the price at conversion must not in any case be lower than the fair value worked out at the time of issuance. An open formula that lets the foreign investor take more shares if the company does badly is an assured return by another name.

An assured return is not permitted. Because the instrument must be equity in substance, the foreign investor cannot be given an exit at an assured price or a guaranteed return; he may be given an exit at the fair value prevailing at the time of exit. This is the reason so many joint venture agreements are drafted around put options at fair value rather than at a fixed price.

Share warrants may be issued to a person resident outside India provided at least twenty-five per cent of the consideration is received upfront and the balance within the period specified in the Rules, failing which the amount received is forfeited.

Convertible notes are a separate instrument for startup companies. A person resident outside India, other than a citizen of or an entity registered in Pakistan or Bangladesh, may purchase convertible notes issued by an Indian startup company for an amount of twenty-five lakh rupees or more in a single tranche. A convertible note evidences receipt of money initially as debt, repayable at the option of the holder or convertible into equity shares within the period the Rules specify. It is the Indian answer to the problem that an early stage company cannot be valued, and it is the one place where the law lets an investment start as debt and become equity.