Change in pref shares to hurt investment

The corporate finance market is in a tizzy. Mailboxes of lawyers and bankers are flooded with anxious e-mail. Life has suddenly changed. In a single stroke late Monday evening, the ministry of finance struck a simplistic and harsh blow by declaring that it would treat foreign investment in preference shares that are not fully convertible into equity shares, issued by Indian companies on par with foreign debt.

Under the Indian company law, companies can issue only two types of shares - equity shares and preference shares. Shares that entail a preferential right to dividend, and to the proceeds of liquidation at winding up, are "preference shares". All other shares are equity shares regardless of whether they have differential rights as to voting, dividend etc.

Company law disallows perpetual preference shares, that is, these shares have to be redeemed within an outer time limit of 20 years from their issue. They can also get converted into equity shares. Issuers tend to issue preference shares with an element of optional or mandatory conversion into equity shares either partially or fully.

Issuers also tend to agree to pay dividend on preference shares either at a specific rate or in terms of a pre-agreed formula.

An agreed rate of dividend coupled with the mandatory redemption requirement can make preference shares synthetically look like bonds - after all, bonds have an agreed tenure, and an interest element. However, it is pertinent to note that dividend, unlike interest, may be paid only from profits.

Moreover, redemption of preference shares may be made only from profits or balances in the securities premium account or a fresh issue of shares. With bonds, the obligation to redeem is an integral contractual obligation and one need not make profits or have securities premium balances to redeem debt.

However, the likeness between bonds and preference shares has provided tremendous structuring potential to corporate finance professionals. Venture capital funds that wish to make risky investments would like to stand in priority to equity shareholders should the investee company go bust. Therefore, preference shares convertible into equity at pre-agreed milestones are quite popular. Non-convertible preference shares too were popular. The investor would take a higher risk as compared to debt - without an assurance of dividend or redemption, while the issuer could raise funds on terms less onerous than those available for debt.

The Reserve Bank of India too was conscious about the similarity between preference shares and debt. It regulated dividend payable on preference shares held by persons not resident in India by imposing a cap linked to interest rates. The last applicable ceiling was 300 basis points above the State Bank of India's prime lending rate.

The summary and cryptic amendment to policy by the Ministry of Finance has wreaked havoc. Any preference share issued to a person resident outside India, if not fully and mandatorily convertible into equity, although denominated in Indian rupees would now be treated as external commercial borrowing, which is the term used for foreign currency debt incurred by persons resident in India. ECBs have a completely different regulatory dispensation.

An ECB, unlike preference shares, is purely debt and has to be serviced with interest payment and would normally have to be repaid, all of which has no linkage to whether the borrower makes profits. The lender of an ECB stands ahead of the preference shareholder in the queue during a winding up. Indeed, failure to pay a sum of Rs 500 by a corporate borrower could result in a petition for winding up being filed against a borrower.

The ministry has now amended policy to state that foreign investment in preference shares of any nature other than a fully and mandatorily convertible preference share, including non-convertible (that is, purely redeemable), optionally convertible or partially convertible preference shares would be considered as debt and "shall require confirming to ECB guidelines / ECB caps".

This inarticulate amendment, at face value, would mean that every element of the ECB policy would now govern foreign investment in preference shares although the preference shares would be denominated in Indian rupees.

ECB guidelines entail restrictions on who can borrow, who can lend, minimum tenures of the borrowing (depending on the size of borrowing), costs of borrowing (linked to 6-month LIBOR), the end-use of borrowed funds, extent of prepayment etc. Although preference shares are denominated in Indian rupees, all these restrictions would now apply in a blanket manner.

The amended policy takes immediate effect. However, there are several executed agreements and proposed transactions pending with the Foreign Investment Promotion Board entailing investment in preference shares.

The government would do well to give deferred effect to such a sweeping and fundamental policy change so that investors who have already executed binding agreements are not put to undue hardship.

It is high time such policy changes are published in a draft form for public comment (which would lead to the market modifying its conduct based on anticipated policy changes) before implementing them.