Convertible Debentures: New Rules

The MCA has recently released the Draft Public Companies (Terms of Issue of debenture and of raising loans with option to convert such debentures or loans into shares), 2011. The rule if and when becomes effective will supersede the Public Companies (Terms of Issue of debenture and of raising loans with option to convert such debentures or loans into shares), 1977. 

The 2011 rules are more or less similar to the 1977 rules albeit one significant difference. As per the 2011 rules a public financial institution or a bank can now only convert all or any part of the debentures, if (a) the company has defaulted in the repayment of, or payment of interest on, such loans and debentures; and (b) the bank or public financial institution has given the company a notice of its intention to convert the debentures at least 30 days prior to the intended date of conversion.     

Pledge of Shares, FDI

In recent times Government/RBI has made several attempts to liberalize, rationalize and simplify the processes associated with FDI flows to India and reduce the transaction time. In furtherance of this, the RBI vide a circular dated May 2, 2011 has delegated its powers to AD Category-I banks to allow non resident investors to pledge their shares held in an Indian Company, subject to certain conditions. The conditions prescribed are as follows:

In case shares are pledged in favour of an Indian bank the following conditions are applicable:

1. In case of invocation of pledge, the transfer of shares should be in accordance with the FDI Policy existing at the time of creation of pledge.
2. A declaration from the statutory auditor that the loan proceeds would be applied for the declared bona fide  business purpose.
3. The Indian company whose shares are pledged will have to comply with the SEBI disclosure norms. In other words the Indian Company would have to comply with Regulation 8A of the Takeover Code and Clause 35/41 of the Listing Agreement.  
4. The lender bank will have to comply with the provisions of S. 19 of the Banking Regulation act, 1949. In other words the lender bank cannot hold shares as a pledge of an amount exceeding thirty percent paid up share capital of that company or thirty percent of its own paid up share capital and reserves, whichever is less.

In case shares are pledged in favour of an overseas bank the following conditions are applicable:

1. Loan is utilized for genuine business purpose overseas and not for any investments either directly or indirectly in India.
2. Overseas investment should not result in any capital inflow into India.
3. In case of invocation of pledge, the transfer of shares should be in accordance with the FDI Policy existing at the time of creation of pledge.
4. A declaration from the statutory auditor that the loan proceeds would be applied for the declared bona fide business purpose.

A VCCIRCLE article analyzes the effect of the circular in detail. On a parting note though, the circular comes at a time when pledging of shares may not be commercially viable due to the prevailing market prices of these shares.

Rights Issue, Unsecured Loan Adjustment

In SRM Energy Limited v. SEBI, SAT has adjudicated upon the issue of adjustment of unsecured loans against the price to be paid for the shares allotted in the rights issue. The brief facts of the case are as follows. The appellant company borrowed a certain sum of money from the promoter group upon an oral understanding that if and when the appellant company came out with a rights issue, the unsecured loans would be adjusted against the share price. Subsequently, the appellant company came out with a rights issue and further sought to give effect to the aforementioned oral understanding entered into with the promoter group.

SEBI objected to such an adjustment on the ground that the unsecured loan advanced by the promoter group did not comply with the conditions prescribed u/s 81(3) of the Companies Act, 1956 [hereinafter “the Act”]. On the other hand the appellant company argued that shares were proposed to be allotted in accordance with the provisions of S. 81(1) of the Act and that the conditions incorporated in S. 81(3) were not applicable to the dispute in question. Before discussing the ruling of SAT, it is only appropriate to discuss the relevant provisions of the Act.

S. 81(1) of the Act empowers the Board to issue shares to the existing body of shareholders of the company in the same proportion in which they already hold shares of the company, without any special resolution or government approval. S. 81(1A) further empowers the Board to issue shares to non existing shareholders. However, as a condition precedent, such an issue has to approved by the shareholders vide a special resolution. S. 81(3) stipulates that S. 81 would not apply (a) to a private company (b) when the loans/debentures have a stipulation attached thereto that the lender will be entitled to exercise an option to convert the loans/debentures into shares at a future date. Such a conversion is however subject to two conditions (a) the terms of the loan has to be approved by the central government or is in conformity with the rules made in this behalf; and (b) a special resolution has to passed by the shareholders sanctioning the terms of the loan. 

SAT, while taking a pragmatic view allowed the adjustment. The reasoning adopted by SAT was that the entire transaction fell within the purview of S. 81(1) of the Act in that the additional shares were sought to be issued to the existing body of shareholders in the same proportion and that the transaction was not a mere conversion of debt into equity in the strict sense. Additionally, SAT noticed that as per the terms of the loan it was open for the promoter group to demand the immediate payment of the loans from the appellant company and hence, it was meaningless for the promoters to first demand the payment of the loan and then forward the very same amount towards the price of the shares allotted in the rights issue.