Business Laws

A case for hybrid instruments

For over a decade now, hybrid instruments have not been used for cross-border investments into India

For over a decade now, hybrid instruments have not been used for cross-border investments into India. Hybrid instruments combine certain characteristics of equity and debt, for example, optionally convertible preference shares (OCPS), debentures (OCD) and redeemable preference shares (RPS).

Till 2007, the foreign investment using hybrid instruments was permitted under the FDI route. Hybrid instruments are now classified as debt, governed by the ECB framework of the RBI. The ECB regime presents several restrictions resulting in it being used primarily for pure debt and making this route unviable for growth capital investment. The RBI’s reasoning is that these instruments can give investors assured returns, a strict no-no in the RBI’s eyes, and secondly, that they can act to remove equity risk. However, this reasoning is perhaps too binary.

Infusing capital

The purpose of hybrid instruments is to permit the infusion of equity-like capital into a company with capital protection and returns. These elements are flexible and the capital protection aspect primarily works towards risk mitigation. With the pandemic and the consequent disruptions, the valuations are affected. Indian companies seek to uphold their pre-Covid numbers while foreign investors seek to mitigate risk and provide low valuations. Due diligence are often of limited value, given the source of information. With few methods of risk mitigation available, the foreign investors are practically incentivised to hit at the valuations rather than mitigate risk in some other manner.

Hybrid instruments afford a longer-term prospect of risk mitigation. They do not necessarily have to provide uncapped returns. Here, it would be useful to de-link capital protection and assured returns. The latter presents a situation where debt with high returns can be disguised as equity. However, permitting capital protection of the principal amount seems rational, especially when such protection can otherwise be structured through liquidation preferences.

While the RBI remains insistent on prohibiting assured returns, the courts are not necessarily in agreement. Various decisions have displayed a ‘pro-enforcement’ bias towards capital protection provisions in investment contracts. This includes the landmark NTT Docomo Inc. Vs Tata Sons Limited matter, where the Delhi High Court held that the alleged violations of the Foreign Exchange Management Act do not prevent the enforcement of an arbitral award on grounds of the public policy. This principle was upheld by the SC in Vijay Karia Vs Prysmian Cavi E Sistemi, and also by the Bombay High Court in Banyan Tree Growth Capital LLC Vs Axiom Cordages.

These decisions underscore the importance of capital protection through enforcement of contract. They imply a liberalised outlook, with respect to capital protection under the Indian foreign exchange laws. The decisions have also been hailed as a marked improvement in India’s treatment of foreign investors, possibly helping ‘Doing Business’ rankings. However, the RBI continues to adopt a restrictive stance on hybrid instruments, which will only hinder foreign investments when they are most needed.

There also remain some contradictions in the law. The FDI Policy defines ‘hybrid instruments’ without actually using the term. It does not restrict limited returns on compulsorily convertible instruments. The RBI itself was considering permitting some degree of assured returns as early as October 2014. To a pandemic-hit economy, permitting hybrid instruments could present a path to increasing foreign investment into India. Opening up this route with suitable limits could also be considered. The risk of early redemption can be mitigated through lock-in periods. This route may also be limited to certain sectors which are in dire need of investment.

(The authors are with L&L Partners, New Delhi)

Published on May 02, 2021

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