1

Foreign Currency Convertible Bonds (FCCB)

SUBJECT: International Finance PROJECT GUIDE:

Contents:
1. Introduction to FCCB 2. Salient Features of FCCB 3. FCCB in India Guideline for issuing FCCBs in India 4. Modes of raising funds through FCCB. 5. Tax treatment on Foreign Currency Convertible Bonds in India 6. Case Study

Foreign Currency Convertible Bonds (FCCB)

Introduction: Foreign currency convertible bond (FCCB) is a convertible bond issued by a country in a currency different than its own currency. It's a quasi debt instrument that helps companies raise foreign currency funds at attractive rates. The bond acts like both a debt and equity instrument. FCCB are similar to bonds as they make regular coupon (interest) payments and also give the bondholder an option to convert the bond into stock. Coupon is the interest rate stated on a bond when it's issued. For example, a $1,000 bond with a coupon of 7% will pay $70 a year. It is called a "coupon" because some bonds literally have coupons attached to them. Holders receive interest by stripping off the coupons and redeeming them. This is less common today as more records are kept electronically.

FCCBs give holders the option to convert them into equity at some future dates, usually at a premium to the price of the company's share at the time of the issue. A lot of FCCB have been raised for pursuing acquisitions. These types of bonds are attractive to both investors and issuers. The investors receive the safety of guaranteed payments on the bond and are also able to take advantage of any large price appreciation in the company's stock. (Bondholders take advantage of this appreciation by means warrants attached to the bonds, which are activated when the price of the stock reaches a certain point.) Due to the equity side of the bond, which adds value, the coupon payments on the bond are lower for the company, thereby reducing its debt-financing costs. FCCB has become the most favored external commercial borrowing technique. There are two main reasons why would investor choose FCCB: This mix product offers many of 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.

3 Salient Features:

FCCB is a quasi-debt instrument, which can be converted into a company's equity shares if the investor chooses to do so, at a pre-determined strike rate. FCCB issues have a 'Call' and 'Put' option to suit the structure of the Bond. A call option entitles the issuer to Call" the loan and make an early redemption. On the other hand, a put option entitles the lender to exercise the option to convert the FCCB into equity; both the options are subject to RBI guidelines. The interest component or coupon on FCCBs is generally 30 per cent - 40 per cent less than on normal debt paper or foreign currency loans or ECBs. This translates to cost saving of approx 2-3 per cent p.a. The coupon on bonds can also be zero as in case of zero coupon Bonds (ZCB) in view of its attractiveness of options attached to them. In case of ZCB, the holder is basically interested in either conversion of the bonds in equity or capital appreciation. The redemption of FCCB can be made at a premium or at par or even at a discount depending upon the coupon offered. The Present value of overall remaining cash flow determines the valuation of Bonds e.g. out of 3 series of FCCN issued by Tata Motors Limited, 1 per cent FCCN of 2003 are redeemable on July 31 2008 at 116.824 per cent of Principal, whereas Zero Coupon FCCN of 2004 will be due for redemption at 95.111 per cent of principal. The Yield to Maturity (YTMs) in case of FCCB's normally ranges from 2 per cent to 7 per cent. FCCB are generally issued by Corporate, which have high promoter shareholding and hence do not perceive any risk of losing management control even after exercise of conversion option. The pricing of the FCCB options is generally between 30 per cent - 70 per cent premium over the Current Market Price giving sufficient cushion to the issuer. The FCCB holder opts to convert the FCCB, in case the market price exceeds the option price or if there is intent to make strategic investment by the lender irrespective of the stock price in market. In many cases, the FCCB issuer as well looks forward to exercise of option by lender, so that there is no fund outflow on redemption. Instead the issuers reserves are inflated by receipt of premium. If however, the FCCB holders do not opt for conversion, the Issuer has either to reissue the bonds to same holder or scout for a new lender. This also gives an opportunity for debt restructuring. The foreign holder of FCCB can trade the FCCB in part or in .full. That is to say, the holder can sell the debt part while holding the Option; or vice versa. For example, if the holder is a mutual fund, interested only in equity, it may retain the conversion option and sell the Bond, with a call option to, say. a bank who does not want to take equity risk. The Bank thus buys

4 debt portion of the FCCB and draws a fixed income till the bond is called up. The seller still retains the benefit of equity and can call up when stock price is substantially less than the conversion price without sacrificing the liquidity.

The issuance of FCCB like any incremental borrowing invariably requires the approval of existing consortium of lenders. FCCB can be secured as well as unsecured. Most of the FCCB issued by Indian Companies are generally unsecured. FCCB can be subordinated to existing debts or they can be unsubordinated on case to case basis depending upon the structure of the deal, its timing and the present gearing. FCCB can be converted into Indian Shares or American Depository Shares (ADS). The allottee is free to dispose of the shares so received upon conversion any time after allotment, if there is no lock in clause. FCCB issue expenses as well as premium on redemption of FCCB are generally charged to Securities Premium Account. While a credit rating of Bonds is not mandatory, since Bonds are mostly issued by top corporate having excellent track record. rating definitely helps to price the Coupons competitively. The issuing company needs to hedge its forex exposure arising out of FCCB, till the time of redemption or conversion. The right to convert the FCCB into equity can arise any time starting immediately after allotment and can vest for 2-3 years. FCCB carries fewer covenants as compared to a syndicated loan or a debenture, hence these are more and more convenient to raise funds. FCCB are generally listed to improve liquidity generally Indian issuer have listed at Singapore Stock Exchange and in many Cases also on Luxembourg Stock Exchange.

Limits of foreign investment in the issuing company The Ordinary shares and Foreign Currency Convertible Bonds (FCCB) that are issued against the Global Depository Receipts are treated as Foreign Direct Investment (FDI). However total foreign investment made either directly or indirectly shall not exceed 51% of the issued and subscribed capital of the issuing company.

5 FCCB in INDIA According to it Ministry of Finance government of India FCCB is defined as: "Foreign Currency Convertible Bonds" means bonds issued in accordance with this scheme and subscribed by a non- resident in foreign currency and convertible into ordinary shares of the issuing company in any manner, either in whole, or in part, on the basis of any equity related warrants attached to debt instruments; " FCCB became quite popular due to its inherent nature of optional convertibility, low interest rates and easy access to funds. Many Indian companies in the past two-three years raised capital by issue of FCCBs. Primarily FCCBs have a fixed tenure, they are convertible on the option of the issuer or investor, as the case may be and are either interest-bearing or in case they are interest-free or low rate, a premium on redemption is payable if not converted. Guidelines for issuing FCCBs In India FCCB are issued in accordance with guidelines and regulations framed under FEMA Act by the RBI and schemes notified by the Ministry of Finance, Government of India. An FCCB issue by a company is governed by FEM (Transfer or Issue of any Foreign Security) Regulations, 2004 (hereinafter Regulations) and Issue of Foreign Currency Convertible Bonds and Ordinary Shares (through Depository Receipt Mechanism) Scheme, 1993 (hereinafter the Scheme). The comprehensive guidelines issued on External Commercial Borrowings (ECB) vide A.P. (DIR Series) Circular No. 5 dated August 1, 2005 (hereinafter ECB Guidelines) are also applicable to FCCB issue. In other words the FCCB are required to be issued in accordance with the Scheme. Further they must be meeting the requirements of the ECB guidelines. Any company who wish to raise the foreign funds by issuing FCCB, require prior permission of the Department of Economic Affairs, Ministry of Finance, Government of India. The company issuing the FCCB should have the consistent track record for a minimum period of three years The Foreign Currency Convertible Bonds shall be denominated in any freely convertible foreign currency and the ordinary shares of an issuing company shall be denominated in Indian rupees The issuing company should deliver the ordinary shares or bonds to a Domestic Custodian Bank as per regulation. The custodian bank on the other hand instructs the Overseas Depositary Bank to issue Global Depositary Receipt or Certificate to non-resident investors against the shares or bonds held by the Domestic Custodian Bank. The provisions of any law with regard to the issue of capital by an Indian company will also be applicable the issue of Foreign Currency Convertible Bonds or the ordinary shares of an issuing company. The company issuing FCCB shall obtain the necessary permission or exemption from the appropriate authority under the relevant law relating to issue of capital.

6 Modes of raising funds through FCCB in India

According to the Scheme (as amended in August 2005 and subsequently) an Indian company which is registered under Companies Act is eligible to make an issue of FCCBs provided the company is not ineligible to raise funds from the Indian capital market or has been restrained by the SEBI in accordance with the Foreign Currency Convertible Bonds and Ordinary Shares (Through Depositary Receipt Mechanism) Scheme, 1993. Raising of funds through FCCB can be done through two modes Automatic route and Approval Route. 1) Automatic Route: FCCB through automatic route does not require any approval from government or RBI. Eligibility: A company registered under the companies act is eligible to raise funds through FCCBs. However financial intermediaries such as banks, financial institutions (FIs), housing finance companies and NBFCs are not eligible for FCCB. Individuals, Trusts and Non-Profit making Organizations are also not eligible. But all the companies have not been permitted to raise funds through automatic route. Only the companies engaged in real sector i.e. industrial sector especially infrastructure in India are eligible under automatic route. Rest of the companies has to follow approval route and take permission from RBI before going for FCCB issue. Lenders: Eligible companies can raise fund only from internationally recognized resources such as international banks, capital markets multilateral financial institutions, export credit agencies, suppliers of equipment, foreign collaborators and foreign equity holders (other than OCBs). A "foreign equity holder" to be eligible as recognized lender under the automatic route would require a minimum holding of equity in the borrower company as set out below: (i) For FCCB up to USD 5 million - minimum equity of 25 per cent held directly by the lender, (ii) For FCCB of more than USD 5 million - minimum equity of 25 per cent must be held directly by the lender and debt-equity ratio should not be exceeding 4:1 (i.e. the proposed ECB not exceeding four times the direct foreign equity holding). An overseas organization and an individual can also lend to a company on FCCB provided they have obtained due diligence certificate from an Overseas Bank in accordance with conditions stipulated in the Guidelines.

2) Approval Route: Eligibility: following have been permitted under approval route to make an FCCB issue:1. Financial institutions dealing exclusively with infrastructure or export finance 2. Banks and financial institutions which had participated in the textile or steel sector restructuring package as approved by the Government 3. FCCBs with minimum average maturity of 5 years issued by Non-Banking Financial companies (NBFCs) from multilateral financial institutions, reputable regional financial institutions, official export credit agencies and international banks to finance import of infrastructure equipment for leasing to infrastructure projects. 4. Housing Finance companies can also raise funds through FCCB subject to fulfillment of following conditions: i. ii. iii. iv. minimum net worth during the previous three years should not be less than Rs. 500 crore, should be listed on the BSE or NSE, minimum size of FCCB must be USD 100 million, the applicant should submit the purpose / plan of utilization of funds.

5. Special Purpose Vehicles, or any other entity notified by the Reserve Bank, set up to finance infrastructure companies / projects exclusively, is regarded as Financial Institutions and FCCB by such entities will be considered under the Approval Route. 6. Multi-State Co-operative Societies engaged in manufacturing activity satisfying the following criteria i) the Co-operative Society is financially solvent and ii) the Co-operative Society submits its up-to-date audited balance sheet. Lenders: Eligible companies can raise fund from internationally recognized resources such as international banks, capital markets multilateral financial institutions, export credit agencies, suppliers of equipment, foreign collaborators and foreign equity holders where the minimum equity held directly by the foreign equity lender is 25 per cent but debt-equity ratio exceeds 4:1.

8 Taxation on Foreign Currency Convertible Bonds Until the conversion option is exercised, all the interest payments on the bonds, is subject to deduction of tax at source at the rate of ten per cent Tax exercised on dividend on the converted portion of the bond is subject to deduction of tax at source at the rate of ten per cent If Foreign Currency Convertible Bonds (FCCB) is converted into shares it will not give rise to any capital gains liable to income- tax in India. If Foreign Currency Convertible Bonds (FCCB) is transferred by a non-resident investor to another non-resident investor it shall not give rise to any capital gains liable to tax in India. The foreign resident is not required to file any return before the Indian Tax Authorities, if its Indian taxable income contains only income from other sources

Concerns on FCCB Despite the all the positives linked to the instrument, what gets apparently ignored are some of the risks that are attached to it. For example, FCCBs do not portray the real extent of leveraging and do not divulge the exact date of conversion, as there is a reasonable time period available for investors to exercise the option. Usually, the companys ability to meet the repayment obligations if the issue does not get converted into equity - is not looked into. Also, the zero coupon FCCBs fail to factor in the cost of servicing the debt (the promised yield to maturity) in case of non-conversion. Example of a Debt obligation if FCCB is not converted to equity: Subex has FCCB worth $180 million outstanding. The company's 2006-07 cash flow was Rs.25 crore, while the interest payment on the FCCB works out to roughly Rs.58 crore per annum. This raises questions over firm's ability to pay for the interest. Since the FCCB were issued, the firm's stock has slid 78% from Rs.577.45 per share to Rs.142. The FCCB will mature in 2012. If its stock price does not rise substantially, Subex will have to redeem this debt The first batch of these FCCBs, which corporate India raised at a very high premium on the back of the big Bull Run, will start coming up for redemption by October 2009. This means the companies have to prepare now. In the last five years, over 130 Indian companies have raised more than $20 billion (Rs 80,000 crore) in FCCBs. Companies like Subex Azure, Aurobindo, Wockhardt, Bajaj Hindustan and First Source run an FCCB project that is large in comparison with their size and cash flows. Subex, Aurobindo Pharma, Hotel Leela Venure, HCC and Bajaj Hindustan all have FY09 debt /EBITDA of over four times, with Subex topping the list at 11.25(x) debt/equity. It remains to be seen in 2009, which would be the first year when large FCCBs start coming up for redemption if they do not convert and the trend accelerates in 2010 and 2011. Subex, Aurobindo Pharma, Orchid Chemicals, HCC, Hotel LeelaVenure and Bajaj Hindusthan are some companies with deeply out of money FCCBs and these companies face high liquidity risks once FCCBs come up for redemption (unless there is a significant rally in stock prices). In contrast, companies like Tata Motors, M&M and Ranbaxy, which also have large amounts of FCCBs, have far less worry because of their large market caps.These corporation should not have liquidity problems when FCCBs come up for redemption, reported earnings are likely to be hit 510% as FCCBs are replaced by debt, one of the study states. Wockhardt: The $110-million issue raised by Wockhardt is the first to come up for redemption, in October 2009. The company had offered a conversion price of Rs 629.80. The shares on May 16 traded at Rs 308.60, resulting in a difference between conversion and current price of 104%. Given its total net debt of $630 million, including the FCCB component, the debt-to-Ebitda ratio was 3.32.

10 Subex Azure: For its $180-million FCCB, Subex Azure offered a conversion price of Rs 897.60, while its share was priced at Rs 141.15 on May 16a difference of 535.91%. On a total debt load of $225 million, the debt-to-Ebitda ratio stands at 11.25. Aurobindo: The Companys FCCB of $200 million will come up for redemption in May 2011. But as of now, against a conversion price of Rs 1,483.4 for the bigger issue, the shares are traded at Rs 347.20. That yields a difference of 327.25%. Here, too, on a net debt of $615 million, the companys debt-to-Ebitda stands at 5.86. However, all is not lost for Indian companies gone for FCCBs. There have been companies, which are fundamentally good, whose current market price have neared and also crossed the conversion price level. Case Study: Subex Systems Subex Systems has raised $ 10 million through an issue of foreign currency convertible bonds, FCCBs. The five-year bonds carry a coupon of two percent above the six month London inter-bank offer rate (LIBOR). The bonds are due for redemption on December 31, 2009 at par value, if not converted into ordinary equity shares. The initial conversion price of the bonds is Rs 300 per share. The bonds are being listed on the Luxembourg Stock Exchange and the proceeds of the issue would be utilized towards primarily funding the overseas acquisitions announced by the company recently, according to the company. Meanwhile, Intel Corp's venture capital arm has acquired a 5.67 percent stake in Subex Systems. This takes Intel Capital Corp's total holding to 10.73 percent. The mode of acquisition is conversion of preference shares. Intel has acquired 4,79,500 shares amounting to 5.67 percent of the paid-up capital of Subex Systems. The shareholding of Intel Capital Corporation after the acquisition in Subex is 9,59,000 shares amounting to 10.73 percent