Compulsorily Convertible Debentures: Whether ‘Debt’ or ‘Equity’?

INTRODUCTION:
A Compulsory Convertible Debenture (CCDs) is a type of financial instrument
which must be Converted into equity share by a specified date. For Companies,
it allows for repayment of debt without spending cash. It helps companies to
increase Equity and decrease Company Debt. Compulsorily Convertible
Debentures (CCDs), a hybrid instrument, has gained prominence in the last two
decades. However, its classification as equity or debt has been the subject of
discussions, mainly due to conflicting perspectives under different laws. This
initial divergence surfaced from the framework of guidelines under the Foreign
Exchange Management Act, 1999 (FEMA), which deemed CCDs as equity.
However, in the realm of tax jurisprudence, CCDs have been treated as debt
until the point of conversion. This conflict arises due to the hybrid nature of
CCDs having the essence of both debentures and equity.
In November 2023, the Supreme Court of India delivered its judgment in IFCI
Limited v. Sutanu Sinhai that dealt with the question whether CCDs are to be
treated as ‘debt’ or ‘equity’ in a different context. This analyses the Supreme
Court judgment and the ‘repayment of principal’ test that courts have
consistently applied to determine whether convertible debt instruments are
regarded as ‘debt’ or ‘equity’.
IFCI Limited demanded corporate insolvency resolution process (“CIRP”)
under the Insolvency and Bankruptcy Code, [Link] context is that IFCI
Limited, an Indian company, made an investment in IVRCL Chengapalli
Tollways Limited for constructing a highway by subscribing to CCDs of ICTL.
Subsequently, the highway project ran into financial difficulties and CIRP
proceedings were initiated against ICTL. By this time, the CCDs had matured
and were automatically convertible into equity shares of ICTL. Even then, IFCI
claimed that its investment in the form of CCDs constituted debt and hence, it
should be treated as a ‘financial creditor’ in the CIRP. IFCI argued that the
resolution professional treated IFCI neither as a ‘shareholder’, nor a ‘financial
creditor’, thereby leaving it without a remedy.
Both the National Company Law Tribunal and the National Company Law
Appellate Tribunal (“NCLAT”) disagreed with IFCI. In its judgment, the
NCLAT reasoned that since CCDs do not contemplate repayment of the
principal amount, they must be regarded as equity and not debt. To reach this
holding, the NCLAT relied on the ‘repayment of principal’ test laid down by the
Supreme Court in Narendra Kumar Maheshwari v. Union of India.
The NCLAT also relied on the Reserve Bank of India’s master direction on
foreign investment in India to rule against IFCI. The master direction expressly
states that “debentures which are fully, compulsorily and mandatorily
convertible are treated as equity instruments.”
IFCI filed an appeal against the NCLAT’s judgment before the Supreme Court.
The Supreme Court upheld the NCLAT’s ruling and, in doing so, affirmed the
‘repayment of principal’ test laid down in Narendra Kumar Maheshwari.
REPAYMENT OF PRINCIPAL DOCTRINE:
In Narendra Kumar Maheshwari, the Supreme Court came up with a test to
determine whether a convertible debenture would be regarded as ‘debt’ or
‘equity’.ii The test is simple which says: Do the terms of the convertible
debenture postulate repayment of the borrowed principal amount? If the answer
is yes, then the convertible debenture is treated as a debt instrument, even
though such repayment may be optional and may not occur upon maturity.
Conversely, if the convertible debenture’s terms do not contemplate repayment
of the principal amount (i.e. conversion into equity shares upon maturity is
mandatory), it is to be regarded as an equity instrument. Applying this test, the
Supreme Court observed that CCDs must be converted into equity shares upon
maturity and therefore, the possibility of repayment of the principal amount
does not arise. Consequently, the Supreme Court held that CCDs would be
treated as equity and not debt.
CCDs under FEMA:
Under the Foreign Exchange Management (Non-Debt Instruments) Rules of
2019, the term “equity instruments” means “equity shares, convertible
debentures, preference shares, and share warrants issued by an Indian
company”. “Convertible debentures” within this framework pertains to
debentures that are fully, compulsorily and mandatorily convertible. Therefore,
under FEMA, CCDs are regarded as “equity”.
CCDs under Insolvency and Bankruptcy Code:
The determination of whether CCDs are debt or equity plays a vital role in the
Code. Firstly, under CIRP, creditors form a part of the Committee of Creditors
(CoC) which takes all decisions on behalf of the corporate debtor during CIRP.
On the other hand, equity investors neither have any representation in the CoC
nor is their consent required for any actions taken on behalf of the company
once it is placed under CIRP. Secondly, during liquidation of a corporate debtor,
proceeds from the liquidation estate are distributed among stakeholders based
on an order of priority known as the waterfall mechanism. As per the Code,
creditors are ranked higher than equity investors. Equity investors are the last in
line to receive the residue of proceeds after distribution to all stakeholders
mentioned section 53 of the [Link]
Various NCLT and NCLAT judgments have dealt with this issue with a common
ratio coming out that the treatment of CCDs and accrued interests as a financial
debt under the Code is to be determined on the facts of each case. One of the
key factors determining the nature of the CCDs is the treatment in the financial
statements, if the CCDs are termed as a debt (long term borrowings), then such
CCDs are required to be treated as debt and not equity.
Conclusion:
CCDs as a hybrid instrument has seen a challenging journey, considering its
nature has been subject to varied interpretations under different legislations.
Each legislation had a different intent in treating CCDs in a particular manner.
For FEMA, the reasoning was to exercise control on future repayment
obligations. It can be stated that the nature of CCDs depends on the contractual
terms, a fact-finding exercise of such terms and accounting treatment. Rather
than terming difference of treatment under various laws as contradictory. A fact-
centric approach is imperative for a comprehensive understanding of the nature
of CCDs. CCDs may appear to be a lucrative instrument the exact terms of
CCDs will determine where an investor and creditor will stand in an insolvency
proceeding. Documentation plays a significant role in determining the outcome
on the nature of CCDs.
i
CIVIL APPEAL NO.4929/2023
ii
Manu/SC/0388/1989
iii
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