INDIAN FeCBs

Current Scenario

CS. G. RAGHU BABU and CS. T. SANDHYA

FCCS is the most happening news of the Indian Corporate World. Initially. it was in the news as a great tool for raising funds for the companies' capex requirements. Later, discussions were on their redemption/conversion. FCCB, which was thought to be a boon for the companies, turned out as a millstone around the neck of India Inc. This is because mast of the bonds are up for redemption in next couple of years and with the markets taking a beating. many calculations went wrong and have a negative impact on the capital structure of the issuer companies. This article attempts to understand these developments of FCeB and also looks at the alternatives available before Indian corporate.

INTRODUCTION

1. Foreign Currency Convertible Bond (FCCB) is an instrument in the debt market issued in a foreign currency with the option of being converted into equity.

2. FEATURES OF BOND ISSUE

• Bonds constitute direct, unsubordinated obligations of the company and rank paripassu inter se with all other existing debts. and borrowings of the company as regards repayment of principal and payment of interest by the bonds issuing company.

• Redemption

(a) Redemption on maturity - Unless previously redeemed or purchased by the

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company, the bonds are redeemed at par on the expiry of a pre-determined period from the date of the allotment.

(b) Put Option - When the bondholder redeems the bonds after expiry of a certain period commencing from the date of allotment, he is said to exercise the Put Option .

(c) CaLL Option- When the company purchases the bonds from the bondholders at discount, at par or premium in the open market or otherwise, the company is said to exercise its Call Option .

• Indian companies have to adhere to various compliances /regulations / guidelines under FEMA, RBI, Stock Exchanges, SEBI, and Company Law for issue of FCCBs. Indian

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companies which are eligible to issue shares to persons residents outside India under the Foreign Direct Investment Scheme (induding Sectoral Cap and Sectors where FDI is permissible) can raise foreign currency resources abroad through the issue of Foreign Currency Convertible Bonds (FCCBs), American Depository Receipts (ADRs) or Global Depository Receipts (GDRs).

3. BENEFITS TO THE ISSUER COMPANIES

• Few years back Indian and emerging markets were on high growth and were giving high returns. Keeping pace with the then existing economic-financial trends, Indian companies issued FCCBs which became a popular tool to finance the ambitious capex plans of companies. It proved to be a boon then.

• Among a plethora of options for raising funds, such as, qualified institutional placements, private equity placements, public issue and bank funding, India Inc. found FCCS as a better option.

• The reasons, behind FCCS becoming so popular and companies opting for it aggressively, were following:

(i) Being hybrid instrument, the coupon rate on FCCS is particularly lower than pure debt or zeta, thereby reducing the debt financing cost

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(ii) FCCBs are book value accretive on conversion. It saves the risk of immediate equity dilution as in the case of public shares. Unlike debt, FCCS does not require any rating nor any covenant like securities, cover and so on. It can be raised within a month while pure debt takes longer to raise. Because the COUpOll is low and usually payable at the time of redeeming the instrument, the cost of withholding tax is also lower for FCCBs compared with other ECS instruments [Withholding tax is like TDS and is payable by the issuer on income remitted to a party overseas. If the coupon is lower than the yield, as has been the case with most of the Indian issues, since a smaller amount is due to be paid every year in the form of coupon (and assuming conversion and not redemption takes place), the cost of withholding tax is lower].

4. BENEfiTS TO THE INVESTORS

• It has the advantages of both equity and debt.

• It gives the investor much of the upside of investment in equity, and the debt element protects the downside.

• Assured returns to investors on bond in the form of fixed coupon rate payments.

• Ability to take advantage of price appreciation in the stock by means of warrants attached to the bonds, which are activated when price of a stock reaches a certain point.

• Significant Yield to Maturity (YTM) is guaranteed at maturity.

• Lower tax liability as compared to pure debt instruments due to lower coupon rate.

5. FEW ISSUER COMPANIES

India Inc. rose about $19 Billion FCCBs during period 2004 to 2008 and few prominent companies are:

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S.No. Name of the Issuer Company FCCBs Due in Conversion Market Price
issued in Price in Rs. as on May 25,
USD (MN) 2009 (in Rs.)
1. Wockhardt Ltd. 110 Oct. 2009 486 122.90
2. Larsen & Toubro Ltd. 125 Oct. 2009 1122.8 1304.70
3. Larsen & Toubro Ltd. 100 Dec. 2010 2498.44 1304.70
4 Tata Chemicals Ltd. 150 Dec. 2009 231.75 226.25
5. Glenmark Pharmaceuticals Ltd. 20 Jan. 2010 862.394 251,95
6. Glenmark Pharrnaceu ticals Ltd. 50 [an. 2010 * 251,95
7. Glenmark Pharmaceuticals Ltd. 30 Dec. 2010 . .. 251,95
8. Tata Power Co. Ltd. 200 Mar. 2010 590.85 1076.35
9. Jubilant Organosys Ltd. 30 Apr. 2009 818.23 186.55
10. Jubilant Organosys Ltd. 75 Apr. 2010 1365.32 186.55
11. Jubilant Organosys Ltd. 200 Apr. 2011 413.45 186.55
12. Aurobindo Pharma Ltd. 60 Jul. 2010 522 364.95
13. Aurobindo Pharrna Ltd. 50 Apr. 2011 1014 364.95
14. Aurobindo Pharrna Ltd. 150 Apr. 2011 665 364.95
15 Tata Motors Ltd. 99 Jan. 2011 1001.39 3;15.95
16. Tata Motors Ltd. 450 Jun. 2012 960.96 345.95
17. Reliance Communication Ventures Ltd. 500 Feb. 2011 480.68 322.25
18. Reliance Communication Ltd. 1000 Jan. 2012 661.00 322.25
19. Mahindra & Mahindra Ltd. 200 Mar. 2011 922.00 633.80
20. Subex Azure Ltd. 180 Mar. 2012 656.00 50.80
21. Moser Baer India Ltd. 75 Jun. 2012 545.93 92.45
22. Moser Baer India Ltd. 75 Jun. 2012 611.45 92.45
23. Tata Steels Ltd. 875 Sep. 2012 876.62 368.70 Conversion price:

• higher of (n) Rs, 500 peI share or (b) at a 35% premium to the average of the company's volume weighted average closing price for the period commencing 15th September, 2006 ending 14th November, 2006 on the Stock Exchange, Mumbai.

-'higher of (a) Rs. 317.25 peT share or (/» at a 35% premium to the average of the company's volume weighted average closing price for the period commencing September 10, 2007 and ending November 10, 2007.

6. ACCOUNTING TREATMENT OF FeCB

• Earlier there was no specific Accounting Standard on FeeR an d most companies 11a ve used Accounting Standard (AS) 29 on provisions, contingent liabilities, read in conjunction with section 78 of the Compa-

nies Act, 1956, to arrive at an approach to account for redemption premium .

• Some companies have charged it to the securities premium account, while others treated it as contingent liability and, hence, not accounted fo! it. No company has charged

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CORPORATE LAWS -INDIAN FCCBs - CURRENT SCENARIO

it to the profit and loss account. Thus, companies' profit and loss accounts have been by-passed from the actual cost/burden of the interest on FCCBs, under reporting their true indebtedness and inflating profitability. Though the balance sheets carry the entire debt, yet the actual burden of servicing the FCCB is not factored in at all.

• The two most Widely-accepted accounting standards are International Financial Reporting Standards (IFRS), and the US Generally Accepted Accounting Practices (US GAAP). Under both systems, proportionate redemption premium is charged through the profit and loss account.

6.1 Accounting Standard 31 - Financial Instruments Presentation

• It has come into effect in respect of the accounting periods commencing from April 1, 2009. It is optional for the first two years and compulsory from 2011. It requires the FCCB issuers to classify the instrument or its components either as equity or debt right from the start.

• This could lead to uncertainty in the earnings of the issuers. The volatility arises in cases where FCCB Issuer Company included a cash settlement option on FCCB maturity. (Cash settlement option - issuer can choose to pay cash in the event bond holders opt for conversion. This is done by those companies which do not want to dilute their equity.) The point of concern here is this option would prevent the share conversion to be treated as equity and instead it would lead to share conversion being treated as derivatives. As per AS-31, the gains and losses on derivatives due to the fluctuation in the share price and foreign currency need to be marked to the market at the end of each quarter. This results in sharp deviations from earnings forecasts.

• Apart from this, the decline in stock prices, in many cases way below the FCCB conversion rate, has reduced the possibility of these bonds being converted to shares on expiry, making redemption a strong pos-

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sibility. In such an event, there is a risk of a significant one-time cash outflow from these issuers

7. TRANSLATIONAL LOSSES

• It is another important facet of FCCB.

Translational losses arise due to fluctuation in the foreign exchange.

• It makes utmost sense for companies to plan for the risk of non-conversion of FCCBs and keep setting aside some amount of money every quarter for the eventuality of the investor not converting the debt into equity. Forex losses are associated with such risk due to fluctuation in the forex, But many of the companies did not recognize or provide for forex losses, with the assumption that the FCCBs can potentially get converted into equity. As a result, companies have boosted their profits. Though it is not a best practice, yet it is a permitted practice, as most of the companies do not follow AS-30: financial instruments recognition and measurement, becauseitbecomes effective from 2011. Looking at the continuing trend of deterioration in Re/$ ratio, translational loss along with the hedging would pinch the earnings of the companies at the time of redemption of FCCBs.

• jaiprakash Associates did not provide for forex losses on outstandingFCCBs ofUS$400m through its profit and loss accountand plans to provide for such losses/ gains at the end of the year. Even, Reliance Communications did not provide for such loss.

Even if companies change their accounting methods now because of rupee deterioration, and start booking translational losses in their profit and loss account, they may have to look ways to insulate their profits from such losses.

• On the other hand, there are also companies which considering the translational losses, while issuing FCCBs, have agreed for fixed rate of exchange on conversion of rupee to dollar at the time of redemption of FCCBs. For example, Aurobindo Pharma at the time

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of FCCB issue, fixed rate of exchange on conversion of Rs. 45.145 per US dollar.

8. TAXATIDN ON FeeB

• Interest payments on the bonds, until the conversion option is exercised, shall be subject to deduction of tax at source,

• Tax on dividend on the converted portion of the bond shall be subject to deduction of tax at source.

• Conversion of FCCB into shares shall not give rise to any capital gains liable to incometax in India.

• Transfers of FCCB made outside India by a non-resident investor to another non-resident investor shall not give rise to any capital gains liable to tax in India.

9. CURRENT SCENARIO AND ITS EFFECT ON INDIA INC.

• Everything was fine during the Bull Run.

In May 2007, some of the companies - NITT,

• Bharti Airtel, Sun Pharma, Clenmark Pharma, Amtek India, etc., converted FCCBs into equity at a pre-fixed price decided at the time of their issue. As the share prices were on rise at that time, the FCCB holders have witnessed a significant rise in value of their investments in these companies.

• However, with the demise of Indian stock markets in the later period, the stock prices are hovering significantly below their FCCB conversion price. The sustained dip in the stock markets has ruined the chances of the companies of offering investors the option of converting the bonds into equity at premium.

• Factors having impact on conversion of FCCBs to equity are :

(i) Tight and expensive debt market

(ii) Lackluster equity markets' performance (iii) Low investors' appetite

These are making the conversion of FCCBs to equity very unlikely.

• Wockhardt has issued USD 110 million worth

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of FCCBs in 2004 at a conversion price of Rs.486 per share due to be converted in October, 2009. At a coupon rate of 5.25 per cent (compounded semi-annually), investors will earn a return of 29.58 per cent on their investment at the redemption. For the investors to consid er converting their bonds into shares, the Wockhardt scrip will have to trade higher by at least 29.58 per cent over the conversion price of Rs. 486. At present, its share is trading at Rs.122.90 (as on May 25, 2009). For any prospect of the FCCBs being converted into shares, the share price should raise around 400 per cent from the current level which is very unlikely.

• In the case of Subex Azure, the conversion price is fixed at Rs. 656 at maturity in March, 2012. Now, the company stock is quoting at Rs. 50.80 (as on May 25, 2009). Most of the companies scrips are trading at 50 per cent to 70 per cent discount to its conversion price.

• The issuer company with high debt-equity ratio will be forced to convert the FCCBs into equity as they cannot go for more debt.

• Companies which converted their FCCBs to equity:

(i) Jubilant Organosis Ltd. has converted FCCBs amounting to $7_193 million, $1.25 million, $6.5 million and $0.5 million on March 10, 2008; May 5,2008; June 2, 2008 and ]une3, 2008 respectively.

(ii) Reliance Communications Ltd. has allotted 27,694 equity shares of Rs. 5 each at a premium of Rs.475.68 on conversion of FCCBs on January 31, 2008.

CERTAIN At TERHATIVES THE ISSUER COMPANIES AY LOOK FOR IN CASE THE CONVERSION IS NOT TAKING PLACE

10. As the maturity dates advance, companies are left with the following options:

10.1 Look for tire resources to l'epay tile debt

• Raising additional debt - This can be done by plain vanilla bank funding or again an

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CORPORATE LAWS - [NOlAN FCCBs - CURRh"NTSCENARIO

BCB/FCCB. The demerits are high rates of interest adding to the existing debt burden. The companies with high debt equity ratio cannot go for it. Moreover, the current global turmoil is not conducive to raise ECBs or FCCBs over the coming few months.

• Additional Equity - In this period of weak capital market, raising fund through equity is very difficult. Higher eq uity dilution and larger equity base for service at the time of profit distribution is always there. Wockhardt's existing debt-equity ratio is a little higher than the standard 2:1. It is in the process of raising equity or equity equivalent to pay offFCCBs. In an extraordinary general meeting of the members of Wockhardt, held on Ianuarv 19, 2009, members have, inter alia, accorded for issue of redeemable preference shares of face value of Rs. 5 each at such price as may be decided by the Board total amount being raised not exceeding Rs. 500 crores.

• Internal accruals or sale of assets - It is dilemma for the companies, whether to use the accruals for growth plans or to serve the debt.

Amtek Auto Ltd. has obtained members' approval through postal ballot for authorizing its Board to sell or mortgage or lease or dispose its properties, up to a maximum limi t of Rs. 3000 crores, Am tek ha ving issued FCCEs ttp to USD 500 million, the purpose of abovesaid approval from members' could be a move towards clearing the outstanding FCCBs.

10.2 Reset the conversion clause to bring it closer to teality - As per the reset clause attached to the FCCBs, the conversion price can be revised downward when the company's share price falls below a predetermined level. But only a handful of companies have included this clause. Even this alternative comes with a cost. With the drop in conversion price, the dilution in equity will be much higher.

There are very few companies which have reset the conversion price at the rescue of reset clause. Pioneer Embroiders Ltd. has reset the conversion price downwards by 30 per cent to Rs. 155.92.

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10.3 Altering the terms of issue - Suzlon Energy has restructured its USD 500 million zero coupon FCCBs and reduced it to USD 389 million. It had given three options to the bond holders such as: the bonds can be swapped for new convertible bonds or premature redemption of bonds or can receive certain fees in lieu of consent to amend the terms and conditions.

Steel major Jindal Stainless is planning to ask its overseas bond holders for rescheduling the outstanding amount on its FCCBs that is due in December 2009.

10.4 Buy-back 0/ FCCBs

• A noble gesture of the Government. The Government has made a right move by allowing premature buy-back of FCCBs, enabling the corporate treasuries to actively manage their liability mix. The RBI has opened the window of premature buy-back of FCCBs using 'rupee resources subject to certain conditions. Otherwise most of the companies will have to buy foreign exchange from the markets to get rid of their liability, which would lead to depreciation of rupee and create more volatlllty in forex market.

However, this window is subject to the following conditions>

'" This provision of pre-payment (premature purchase) of existing FCCBs will be available up to December 31, 20~9.

• The initiation power/right of prepayment is vested with the issuer of bonds and not with the holder of bonds. However, the actual pre-payment is subject to the consent of the holder of the bond.

• The bonds purchased from the holders must be cancelled and should not be re-issued or re-sold.

'" This pre-payment scheme of FCCBs will not have any effect on the bondholders of Indian companies not opting this window or on the non-participating bond holders of Indian companies opting this window.

• Buy-back should be routed through the designated authorised dealer for the FeCB .

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• Companies should open escrow account with the branch or subsidiary of an Indian bank overseas or an international bank to ensure that the funds are used only for the buyback.

This scheme is available through both automatic route and approval route

10.5 Auto Route - Buy-back of FCCBs under the auto route is allowed for cases where:

• The funds used for the buy-back represent either existing foreign currency funds held abroad or in India or in EEFC accounts;

• And fresh ECBs are raised in conformity with the current BeB norms.

• Fresh ECB is co-terminus with the residual maturity of the original FeCB but is less than three years; the all-in-cest ceiling should not exceed 6 months Libor plus 200 bps, as applicable to short-term borrowing.

• There is minimum discount of 15 per cent on the book value of FeCB.

10.6 Appmval Route

• Indian companies are allowed to buyback out of rupee resources, representing

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internal accruals, subject to the following conditions:

(i) rupee resources represent internal accruals to be evidenced by chartered accountant's and designated AD's certificates; and

(ii) the amount does not exceed USD 100 million of the redemption value of the FCCB per company subject to:

• minimum discount of 25 per cent of book value for redemption value up to USD 50 million;

• minimum discount of 35 per cent of book value for the redemption value over USD 50 million and up to USD 75 million; and

• minimum discount of 50 per cent of book value for the redemption value of USD 75 million and up to USD 100 million.

• Though buy-back is a cheaper option than paying the full coupon and repaying the principal amount at the maturity, yet insufficientfunds refrain many companies to opt for it. Further, the fact that initially this

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CORPORATE LAWS - TNDIANFCCBs - CURRENT SCENARIO

window was open only for three months ending March, 2009, made buy-back nonsailable, However, now it is extended up to December 31, 2009.

• I t is useful for the com panies having surpl us cash in excess of operating cash, to use that cash for buying back their FCCEs by which they will cancel some of the debt:

• Companies which ha ve bought back FeCBs:

Reliance Communications Ltd. is the first to avail this option. It bought back FeCEs worth US $25 million on December 29, 200B and US $10 million on January 10, 2009.

Jubilant Organosys Ltd. has bought back part of the FCCB as follows:-

(i) On February 5, 2009, FCCBs amounting to US $ 11.1 million due in 2011.

(ii) Settled on February 23,2009, FeCBs amounting to US $ 3 million due in 2010 and US $ 45.3 million due in 2011.

In fact, Jubilant offered to buy-back its entire outstanding FCCBs of about US $248 million in the 2nd trench, but received a poor ·response and could purchase only US $ 48.3 million. It was because the tender offer was much below the conversion price. Orchid Chemicals & Pharmaceuticals Ltd. has bought back FCCBs of US $ 37.8 million and it may also purchase additional bonds from time to time.

The other companies which have exercised this oplionincludeMahindra & Mahindra, Tulip Telecom, Moser BOler, Radice Khaitan, Hotel Leela, Pidilite Industries and Uflex. Together, these firms have bought back bonds worth $ 240 million (around Rs .. 1,200 crore) at a discount of 30 to 50 per cent on the face value.

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Bharat Forge Ltd. is exploring the possibility of FCCB buy-back.

11. CONCLUSION

• The extension of buy-back date by nine months i.e., from March 31,2009 to December 31, 2009 is a very good opportunity for the companies wishing to opt for it. The Government has indeed made a good move by extending so. The capital gain, i.e., the difference between the bond conversion price and current m arket price should be anincentive for the companies. It is very much beneficial to the companies to buy-back FCCEs now as at the time of issuing they had done it at higher prices.

• Even resetting the conversion clause would relieve the companies to some extent. Promoters' equity dilution is not an issue to be bothered where promoters are holding maximum equity. Companies may utilize this option wherever possible.

• If the rupee strengthens and stock prices rise, nothing more than that, the FeeB market will revive and conversions wi II ta ke place.

• Overall, it is a great lesson to India Inc. for having not considered the risk of nonconversion of FCCHs. India Inc should accept this fault and be cautious of and prepared for the worst scenario, before taking up any new instrument. Further, the investment bankers and professional bodies should take the responsibility for making aware of key aspects of any new instrument, which otherwise are not easily known, before the India Inc acts on such new things and not while drowning.

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