The Reserve Bank of India (RBI) has proposed banning the use of compulsory convertible debentures (CCDs) in the real estate sector. The central bank feels that these instruments are more in the nature of debt rather than equity until converted into equity (when the put option is invoked), and thereby they circumvent external commercial borrowing (ECB) guidelines applicable for the real estate sector.
The current norms do not allow ECBs in the sector except for projects with a minimum size of 100 acre.
CCDs are usually considered similar to equity and are structured in a manner that makes them akin to debt.
This is because in many cases there are contractual agreements allowing Indian realty players to buy back the shares from foreign investors at a fixed price after conversion. In other words, the foreign investor has a put option. Thus, for the foreign investor, a CCD is similar to a debt instrument with a fixed rate of return rather than an equity investment. For instance, a local property firm raising $30 million by issuing CCDs will give an undertaking that it will buy back the securities after two years for $33 million.
While real estate companies are barred from tapping debt through ECBs (except for the 100-acre or more projects), there is no restriction on pure equity investment, subject to certain conditions such as minimum capital requirement and a three-year lock-in. RBI officials believe that many realty companies have been issuing CCDs with a buyback option to foreign funds at a price that is fixed when the deal is struck, which sections of the government and RBI say is overseas debt masquerading as FDI.
CCDs are treated as FDI, so essentially there is nothing that contravenes the regulations. But what has rung alarm bells is the underlying structure (put option), as this makes it similar to debt.
?Put option on CCDs has the potential of being misused unless it is exercised post-conversion into equity. Buyback by Indian shareholders is also subject to the pricing regulations. Any restraint on exercising a put option post conversion into equity could be a bit onerous and tracking such transactions may also be an administrative hassle,? said Upendra Sharma, partner at law firm J Sagar Associates.
Analysts say CCDs are a financial innovation resorted to by companies to bring in foreign loans masquerading as equity. The option is used to sell securities to international investors who, in turn, are promised an assured return and an easy exit.
According to market estimates, more than $1 billion has been raised through this route in the past one year. What?s interesting is that such CCDs (unlike partly-convertible instruments) are shown as FDI, even though the underlying structure is no different from a pure loan.
More so because issuers are also giving a fixed interest return (just in case of loans) to foreign investors.