This article is written by Shruti Jha pursuing a law firm Bootcamp. This article has been edited by Ojuswi (Associate Lawsikho).
This article has been published by Sneha Mahawar.
Companies running short of finances to conduct the operational activities seek out the options available to them in the Indian market. The most popular ways to raise funds are through the issue of share capital, debentures, bonds, or other financial aids such as external commercial borrowings, etc. External commercial borrowings are the kind of financial aid that a company or institution seeks to bring in fresh investment by raising funds in foreign currencies outside India. One among these external commercial borrowings is foreign currency convertible bonds (FCCBs).
Generally, a bond means a fixed-income investment that represents a loan made by an investor to a borrower, usually corporate or governmental. Bonds get secured by the collateral or physical assets of the issuing company/ borrower. In a very strict sense bonds cannot be converted into equity shares and there is no flexibility in converting such bonds into shares. But FCCBs though being bonds could be convertible. This article attempts to explain what exactly an FCCB is, its features and other nuances
What is FCCB
A Foreign Currency Convertible Bond is a kind of external commercial borrowing and as the name suggests the funds are raised in foreign currency through these bonds, specifically outside India. These funds are borrowed funds. These bonds are also convertible bonds, unlike the usual bonds which are non-convertible. These bonds could be converted into equity shares on the option of the investor/bondholder after the expiry of a fixed time period.
This means that FCCBs are like the bonds which make regular interests (also known as coupons) and principal payments, and these bonds give the bondholder the option to convert their bonds into stocks/equity shares.
The nature of the FCCB is hybrid as it is typically a mix of both debt and equity. Hence, it is also called a Hybrid instrument. Typically, FCCB is equity-linked debt & could be converted into stocks after a specific period. Generally, the specific period for the FCCB is around five years but could be more or less upon the option of the issuing company.
It is the discretion of the investor or bondholder whether to convert the bonds into equity or take back the loan amount along with interest upon the expiry of the specific period. Hence, FCCB could be retained as a bond or with pre-determined price or exchange rates to convert into equity.
Conversion prices are the pre-determined price or exchange rates that are agreed upon at the time of getting into the whole borrower and investor arrangement. Generally, these prices are dependent upon the issuing company and the market structure of the period the bond would be converted in. If the price of the stock is below the conversion price at the time of the conversion, then the bond will not be converted.
An interesting fact about FCCB is that they are listed and traded in the foreign stock exchanges and are issued only in foreign currency with a fixed rate of interest. The interest payment is called coupons and the loan amount is called the principal. The FCCBs are issued in a foreign currency and which has a fixed interest rate that is lower than the rate of any other debt instrument which is non-convertible. So, comparatively, FCCB would be a considerable choice for issuing companies as the rates are lower.
The nature of FCCB is the same as that of the convertible debentures in India. Just like convertible debentures could be converted into equity shares FCCB can also be converted into equity shares. The only difference between convertible debentures and FCCBs is that convertible debentures are issued only in India whereas FCCBs are issued outside India only. Hence, the scope of jurisdiction of FCCB is wider than the scope of the convertible debentures. In simple words, it is clear that the FCCBs are issued only to the non-residents of India in foreign currency and shall be subjected to conversion at the expiry of the specific date of the bond.
How does a Foreign Currency Convertible Bond work
A foreign currency convertible bond (FCCB) is a convertible bond that is issued in foreign currency only, which means the principal repayment i.e., redemption amount and the periodic interest/coupon payments will be made in the very same foreign currency.
In simple words, these bonds could only be issued to a country outside India, which means the currency that follows the arrangement is foreign i.e., the payment of the interest or the wholesome loan amount is to be made in the foreign currency only, rather than making it in rupees. At the time of the conversion, the exchange rates are the determining factor as to what could be the value of the bond and is it par with the face value of the equity shares.
In case an investor doesn’t want to convert his bonds then he’d be paid back the principal amount along with the rate of interest this wholesome amount is known as redemption price.
Let’s understand this by way of an example:
Suppose there’s an Indian company ABC ltd, which is interested in raising its funds. Considering all the factors it opines that as the interest rates are low why not borrow the funds through an entity outside India. The most ideal instrument is the FCCB. Supposedly there is a Mr.Spongebob who lives in Washington DC, USA. He is interested in the shares of the company and has been keeping tabs on its operations. He wants to invest in the company to have fruitful returns. If ABC Ltd. issues FCCB in the foreign stock exchange for a period of five years, Mr. Spongebob can buy these bonds in the USD. Now after observing the operations of the company closely in these five years it would be the discretion of Mr.Spongebob whether he wishes to be part of ABC or not. Mostly he would opt to be part of the company only if he could practically see that the dividend of the company is higher than the coupon rate. In this case, the returns would be higher but in case the dividends are much lower than the coupon rate, then converting would do no good to Mr. Spongebob and hence he would get redemption upon the exchange rates at that point in time.
Salient features of the FCCBs
- FCCB is an unsecured instrument
- It has a fixed rate of interest
- The investor has an option for conversion into a fixed number of equity shares of the issuing company
- Interest/ coupon and redemption price are to be payable in foreign currency
- FCCB shall be denominated in any foreign currency
Participants for FCCB
The participants required during the process of issuance of FCCB are:
Issuer, Local legal advisor, Local accountants, Local custodian, Lead Manager, Depository bank, Overseas legal advisor, Escrow bank
Eligibility for a company to issue FCCBs
To be eligible to issue FCCB the company needs to compliant with the regulations as follows:
- Issue of Foreign Currency Convertible Bonds and Ordinary Shares (through depository receipt mechanism) Scheme, 1993 (“Scheme”) – the rule was introduced vide a notification to provide global capital market access through the issue of FCCB to the Indian corporate sector and wider the scope of finances.
- Master Circular on External Commercial Borrowing (“ECB”), issued by the Reserve Bank of India (RBI) – these circulars are issued frequently by the RBI for the regularisation of the External commercial borrowings and also regulate FCCB.
- Foreign Direct Investment (“FDI”) Master Circular and Sectoral Caps – the circulars are related to the sectoral caps on the FDI which are also issued by the RBI.
- FEM (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000 – as the name suggests the regulation was issued vide notification restricting the transfer and issue of security to a person residing outside of India.
- FEM (Transfer or Issue of any Foreign Security) Regulations, 2000 – as the name suggests the regulation was issued vide notification regulates the transfer and issue of any foreign security to the Indians.
Benefits to issuing company and investor
The benefits to the issuing company by the issue of FCCB are listed below:
- The Coupon rate is low- as it is a hybrid instrument the investor is at the advantage in both cases.
- No credit ratings assessed by the rating agencies are required
- Immediate equity dilution
- Less time consuming comparatively with other instruments
- Favourable in the exchange rate which results in the reduction in the cost of debt
The benefits to the investor by the issue of FCCB are listed below:
- Advantage of both debt and equity – the investor at the start could invest through the bonds and later if the dividends are more can convert into the equity shares.
- The fixed coupon rate of payment.
- Low tax liability.
Drawbacks to issuing company and investor
The Drawbacks to the issuing company by the issue of FCCB are listed below:
- If the stock market is in a negative cycle, the demand for FCCB would be low.
- The ownership dilutes when the bonds are converted into equity.
- If the currency exchange rate is changed it will be a loss to the company.
- If not converted need to pay back.
The Drawbacks to the investor by the issue of FCCB are listed below:
- The credit risk is subjected to the exchange rate at the time of conversion or redemption.
- If the company goes bankrupt, repugnant face value at maturity will no longer be plausible.
- Investors have no control over established conversion and prices.
From the above text, it is safe to say that FCCBs seems to be a win-win situation for both, the buyer/bondholder and the issuing company. Generally, Foreign investors buy FCCBs because they have an option to convert their bonds into shares at a fixed price, apart from earning fixed interests and pocketing a quick gain as a result. Conversion prices are usually set at a premium to the prevalent market prices, as it is assumed that the prices of the stock would always continue to rise. Companies consider this as “free money” which they would not be liable to repay, as the bonds would inevitably get converted into equity. But in cases when the investor doesn’t want to convert the share, the fairy tale ends and the low-cost option to raise funds doesn’t remain so low-cost anymore.
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