Navigating Indian insolvency for structured products

As any foreign investor will know, India has an ever-changing regulatory framework, as well as a currency, which is not freely convertible. The result of this is that the markets and investors have developed various hybrid instruments with contractual rights to provide desired returns and economic requirements, while being compliant with Indian regulations. Partially convertible instruments, which were originally equity from a foreign investment perspective, have for a long time now been regarded as debt. Therefore any instrument which fixes the return, or exits pricing, also runs into regulatory issues. A permitted and popular instrument is compulsorily convertible debentures (CCDs) from a foreign direct investment perspective. These are routinely used by private equity firms, hedge funds and structured investors investing in India.

So, how does this instrument fare under the Insolvency and Bankruptcy Code (IBC), one of India’s most significant pieces of legislation in the last few years? The IBC is a consolidated time-bound legislation intended to efficiently enable insolvency resolution or liquidation of companies, and maximises recoveries to lenders. The legislation was enacted against a macroeconomic context of Indian promoters having leveraged their company and personal balance sheets to unprecedented levels, leading to significant non-performing assets and stress in the Indian banking industry.

‘Financial debt’ under the IBC comprises any debt along with interest, if any, which is disbursed against the consideration for the time value of money. It is clear that a debenture falls within this and therefore a creditor can commence proceedings under the IBC where there has been a failure to pay a debt. Convertible debentures are debentures under the Indian Companies Act and interest is payable whether there are profits or not. There has been unending litigation under the IBC. However, the fundamental question of whether an instrument that is compulsorily convertible into equity can constitute a claim, and classify the holder as a ‘financial creditor’ under the IBC remains unclear. There is case law to support optionally convertible instruments constituting debt.

While the raising of funds by means of CCDs creates the existence of a debt that remains a debt until it is repaid or discharged, raises additional questions. Does it cease to be debt merely because the CCDs are redeemed not by returning the money but by getting shares of the equivalent value? Does convertibility of debentures affect the characteristics of debt and transform it into something else? The mode of discharging the CCD is by issuing equity shares in lieu of payment in cash, but does not detract from its legal character as a debt. From an accounting perspective, it is also recognised in the financial statements of a company as debt prior to conversion. However, if the conversion is into equity shares of a company under the IBC, those shares are of limited economic value and have almost no rights under the IBC.

It could well be argued that the repayment is through the issue of equity shares and therefore there is no right of payment in monetary terms, which is what is required for a debt to be construed as financial debt under the IBC. Also the typical rights granted in investment documentation to the holder of the CCDs such as veto rights, or a right to appoint a nominee are more similar to equity investor rights, and may tilt a courts’ view in favour of CCDs being more in the nature of an equity instrument with debt-like features. However, this would depend on the facts and circumstances.

While drafting investment documentation, CCD investors may use various structural enhancements to mitigate this risk to create a claim such as a buyback obligation. Considerations need to be made regarding the timing of enforcement options available to CCD holders. This can be before an application has been filed to commence an insolvency resolution process, but not admitted (which can be several months) moratorium provisions preventing the institution of any suits against the insolvent corporate debtor. In addition to contemplating the effects on a CCD holder’s contractual rights under a shareholders agreement, and the articles of association.

In the IBC process, the fate of the corporate debtor ultimately lies in the hands of the committee of creditors, which comprises only financial creditors. If CCDs are considered equity investments then the potential for downside protection or risk mitigation for the holders stands considerably reduced as such a holder would most certainly not fall within the definition of financial creditors. The issue is still untested under the IBC and it will be interesting to see how this unfolds over time.

By ZBA partner Niloufer Lam, consultant Rukmini Roy Chowdhury, and associate Yash Kahandole