Foreign Portfolio Investors (“FPIs”) are permitted to invest in corporate bonds and non-convertible debentures (“NCDs”) issued by Indian companies which are either listed or ‘to be listed’ on recognized stock exchange in India. The NCDs are essentially borrowings made by Indian companies from FPIs (by way of issuance of NCDs to FPIs). These NCDs can be secured or un-secured as agreed between the issuer company and the subscribing FPIs. FPIs are new avatar of FIIs, with all key conditions remaining the same.

Recently, in a stated objective to “harmonize” the investment requirementsfor Government securities and corporate bonds, the RBI has brought about certain changes with immediate effect in respect to investments by FPIs in corporate bonds, as recommended by the RBI in its Sixth Bi-Monthly Monetary Policy Statement, 2014-15. Now all future investments by FPIs in the debt market in India will be required to be made with a minimum residual maturity of three years of the listed debt instrument. This will include investment by FPIs in corporate bonds as well. There will, however, be no lock-in period and the FPIs shall be free to sell the securities to domestic investors.

The stated objective is certainly debatable; but nonetheless, even if there exists a very cohesive reason to harmonize the regulations for FPI investment in government securities and corporate bonds, the end result may not benefit Indian corporates proposing for a listed debt securities issuance. RBI issued Circular no. RBI/2014-15/448 A.P. (DIR Series) Circular No. 71 dated February 3, 2015 (“Circular”) for introducing certain key changes in the directions for FPI investments.

After receiving certain enquiries on the ambiguities in the Circular, the RBI issued certain clarifications on February 6, 2015 vide its notification no. RBI/2014-15/460 A.P. (DIR Series) Circular No. 73 (“Clarification”), on applicability of the new directions.

RBI has framed three questions based on the enquiries received mainly on applicability of the Circular to (i) investment by FPI in commercial papers; (ii) debt instruments having maturity of three years and over but with optionality clause of less than three years; (iii) amortised debt instruments having average maturity of three years and above. In respect of amortised debt instruments, the Clarification explained that “FPIs shall be permitted to invest in amortised debt instruments provided the duration of the instrument is three years and above.” Even though the RBI has issued this Clarification, there are no guidelines available for calculation of the average maturity for amortised instruments. If the ‘average maturity’ principle is applied in the same manner as it is applicable for the external commercial borrowing/ ECB guidelines, then a view may be taken that prepayment can start immediately after investment by the FPI, as long as the average maturity comes to three years. However, investments which fulfill the ‘average maturity’ principle may fall victim to such ambiguity since the authorized dealers have not been given any clarity on this issue by the regulator.

The said harmonization certainly requires another review, as there lacks rationale for some of these changes proposed by the RBI, particularly since a three year minimum maturity condition may prove to be counterproductive for the issuer company viz. the borrower. With these new conditions, even if the borrower Indian company (issuer of the NCDs) has adequate funds to repay the debt, which is quite expensive most of the time, such a company will not be allowed to do so now before minimum maturity period of 3 years. This will result in Indian companies being burdened with costly debt, even if they have the resources and the capability to repay all or part of such debt prior to the expiry of the three year tenure. If the objective was not to allow FPIs to seek redemption prior to three years period, then that should have been the condition. All what was required to be restricted was a “put option” in the hands of FPI whereby any FPI can seek an early exit, at its option, from the issuer company.

Ironically, the new regime permits an early exit prior to expiry of three years through sale of such NCDs by FPIs to any domestic buyer! It is difficult to comprehend why such a sale to a domestic investor is allowed which will result in a forex outflow while restricting the ability of the issuer Indian company to redeem the same debt instrument. In our view, there lacks a justification for not allowing Indian borrowing companies to do the same, viz. allow redemption or part redemption at “it’s will “prior to the expiry of three years particularly since when the same listed debt instrument is allowed to be sold another domestic buyer.

This change may also create complications when the same NCDs are held by both resident and not-resident investors, where the non-resident investors will be saddled with the three year lock-in and on the other hand, the domestic investors will be free to sell or seek redemption of the NCDs.

In light of these changes, there will be additional challenges or open issues like consequences of any event of default by the Indian borrower of the debenture terms. In such cases, surely foreclosure should be allowed, which will lead to ambiguities. If one argues that no early redemption or foreclosure or a forced redemption is allowed even if there is an event of default, then the foreign portfolio investor will be left with limited remedies and defenceless. Though, the FPI investor may have a put option against the Indian promoter of the issuer company, but the best recourse in default cases is to recover directly from the borrowing companies.

In conclusion, although these changes seem to have been made for attracting capital into the Indian debt market, however, the consequences are counter-productive for the eco system that exists for such investments.