The Indian Regulators’ New Rules Tightening Norms for Foreign Investment in Corporate Bonds

In a major blow to foreign investment in bonds issued by corporates in India (“Bonds”), the Reserve Bank of India (“RBI”), by way of a circular dated February 3, 2015 (“RBI Circular”), and the Securities and Exchange Board of India (“SEBI”), by way of a circular dated February 3, 2015 (“SEBI Circular”) (together, the “Circulars”), have restricted the ability of foreign portfolio investors (“FPIs”) to invest in Bonds having a residual maturity of fewer than three years.

Background

FPIs are permitted to invest in government securities (“G-Secs”) and Bonds. To encourage more patient capital, RBI had previously restricted FPIs from investing in G-Secs having a minimum residual maturity of fewer than three years. No such restriction had been imposed on FPIs’ investments in Bonds issued by corporates.

However, the RBI Governor, in the Sixth Bi-Monthly Monetary Policy, dated February 3, 2015, announced that, to harmonize the rules, FPIs henceforth would be permitted to invest in Bonds only with a minimum residual maturity of three years.

The Circulars were introduced in line with the above-mentioned policy. They were followed by a SEBI clarification dated February 5, 2015 (“Clarification”) with respect to investments by FPIs in Bonds.

Changes

• FPIs are now permitted to invest in/purchase corporate Bonds only with a minimum residual maturity of three years. This applies to all future investments by FPIs in Bonds.

• However, FPIs do not have any lock-in for such investments, and are free to sell them at any time, provided, however, if fewer than three years remain to maturity, FPIs can sell the Bonds only to persons resident in India.

• FPIs are now not permitted to invest in liquid and money market mutual fund schemes.

• FPIs cannot invest in Bonds with a maturity of more than three years but having optionality clauses exercisable within three years.

Analysis

Contractual Arrangements Difficult

The imposition of a minimum three-year residual maturity requirement will not only impact shorter term loans, it will also restrict various contractual arrangements such as call/put options vis-à-vis the issuing company, part redemptions, etc., to be exercised prior to the expiry of three years. For an issuer company which is contemplating having a prepayment clause in the terms of its Bonds, this may be a major deterrent for it to raise monies from FPIs.

Also, in many cases, especially in the real estate sector, where payments are linked to an agreed distribution waterfall, or where Bonds were structured from a tax perspective so that payments on them are attributed towards principal in the beginning and the premium is back-ended, this new requirement will significantly hinder such structures.

Optionality Clauses

The Clarification has made it clear that any investment in Bonds having a residual maturity of more than three years, but having optionality clauses exercisable prior to three years, will also not be permitted for investment by FPIs. This will prevent structuring by FPIs to exercise put option and sell the Bonds. This may be against the intent of RBI to attract patient, long-term capital.

Default

The Circulars do not clarify whether, in case of default, the Bonds can be redeemed prior to three years upon enforcement of security. In the absence of such clarification, even redemption upon enforcement prior to three years will require regulatory approvals. However, if the application for approval is coupled with a court order, regulatory approvals for prior redemption may be granted. Alternatively, the FPI may transfer the Bonds to a domestic counterparty prior to enforcement, in which case this three-year requirement will not apply.

Grandfathering

The requirement of a minimum three-year residual maturity is only for new investments by FPIs. Existing holdings of Bonds by FPIs can continue to have call/put options and be redeemed prior to three years.

Possible Structures

Considering that a principal moratorium of more than 18 months may not be amenable, warehousing in India by FPIs and sale to promoters without any optionality clauses in the terms of the document of the Bond issuance seem to be possible structuring options open to FPIs. However, each of these options will have its own set of regulatory and tax considerations which may need to be analyzed in detail on a case-by-case basis.

Conclusion

The Indian corporate bond market is a highly underdeveloped market in comparison to that in other countries. At approximately U.S.$242 billion, India’s corporate bond market lags far behind those in China (U.S.$1,651 billion), South Korea (U.S.$1,014 billion) and Japan (U.S.$786 billion), according to a June 2014 report by Credit Analysis & Research Limited (see http://www.careratings.com/upload/NewsFiles/Studies/Indian%20Bond%20Market-%20Striking%20a%20Chord%20with%20Asian%20Peers.pdf).

In 2013, the government substantially reduced the withholding tax for corporate non-convertible debentures (“NCDs”), which seemed to indicate that it intends to encourage foreign debt. However, the introduction of the minimum three-year residual maturity requirement for Bonds is a major dampener for FPIs and corporates.

Although the aggregate limit for all corporate NCDs is U.S.$51 billion, of which 90 percent is available on an on-tap basis, a substantial portion is still yet to be utilized.

The Circulars and the Clarification do not augur well for the intention of the government to encourage debt.

Abhinav Harlalka is a Member of the Private Equity and Private Debt Practice Group of Nishith Desai Associates, Mumbai. Deepak Jodhani is a Senior Member of the Private Equity and Private Debt Practice Group of Nishith Desai Associates, Mumbai. Ruchir Sinha is Co-Head of the Private Equity and Private Debt Practice Group of Nishith Desai Associates, Mumbai. The authors may be contacted at abhinav.harlalka@nishithdesai.com, deepak.jodhani@nishithdesai.com and ruchir.sinha@nishithdesai.com.