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The What And How Of Convertible Notes

The Indian economy started with a miniscule size of just 2.7 lakh back in 1947. Today it wears the crown of the world's fifth largest economy. Estimates of the Bank of America claim that in no longer than 10 years, India will become the world's third largest economy, only behind the US and China.

The economic reforms, that introduced liberalization in 1991 have been a watershed moment for the Indian economy. However, the game of numbers is deceptive sometimes. Despite being the fifth largest economy, the per capita GDP stands at less than USD 2000, which tags India as a struggling lower middle-income country.

As an economy advances with time, promotes entrepreneurship and startups, innovative methods of allocating funds, that prove beneficial not just to the company but also to the investors, start shimmering and gain momentum quite at a fast pace. One such innovative method of fund allocation is by way of convertible notes.

In India, convertible notes were introduced through a notification in 2016, that was aimed at amending the Companies (Acceptance of Deposits) Rules, 2014. In simple terms, a convertible note is an instrument, which acts as an evidential receipt of a money that an investor invests in a company, which is repayable as per the wish of the investor and also consists of an option of converting the money into the shares of the company, as per the terms and conditions decided upon earlier.

The above-mentioned notification also added that, "an amount of twenty-five lakh rupees or more received by a start-up company, by way of a convertible note (convertible into equity shares or repayable within a period not exceeding five years from the date of issue) in a single tranche, from a person", to be considered as exempted deposits.

Also, the RBI made amendments in the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2016 and introduced convertible notes under FEMA. Convertible notes can only be held for a maximum period of 5 years from the day of issuance. After the same is completed, it has to be repaid or converted into shares.

Convertible notes can be issued to people residing outside India, except for individuals who are citizens of Pakistan or Bangladesh, and the entities which are registered or incorporated in Pakistan or Bangladesh. NRIs and OCI cardholders are also eligible to acquire convertible notes, subject to terms and conditions as specified in the NDI Rules (Non-debt Instruments).

For startup companies, issuing convertible notes to people residing outside India, they must receive the consideration amount, by way of inward remittance or by debit to the NRE/FCNR account, maintained by the investor as per the FEMA Regulations. Schedule 4 of the RBI regulations allow an NRI to acquire convertible notes on a non-repatriation basis.

The finance ministry, by way of a notification made an amendment in Rule 6a of the NDI Rules, which said that investments coming from countries sharing a land border with India will compulsorily require government approval for the same. The question left unanswered was whether entities registered in the bordering countries would need government approval even for making investments by way of convertible notes in the Indian market.

Another loophole in the regulation of convertible notes is evident in the fact that only recognized start-ups are permitted to issue convertible notes, as per the RBI regulations, which implies that non-recognized start-ups, even if they are carrying enough growth aspects, would lag behind due to their incapacity to issue convertible notes. In the regulatory process of convertible notes, which are issued under section 42 of the Companies Act of 2013, a mandatory provision which asks for the disclosure of the valuer's details who has performed such valuation, along with the justification for the price, usually goes unnoticed by the companies.

The regulations around Convertible notes still lack the proper execution of the laws on the ground level. Many of the mandatory provisions of the same are not complied with, which implies an inefficient awareness regarding the same. As the concept of convertible notes is gaining momentum in the Indian market, a more detailed and comprehensive legislation is required for the fair and justified regulations of the same.

Law Referred To:
  • Companies (Acceptance of Deposits) Amendment Rules, 2016
  • Companies (Acceptance of Deposits) Rules, 2014
  • Foreign Exchange Management Act, 1999
  • Foreign Exchange Management (Non-debt Instruments) Rules, 2019
  • Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments), Regulations, 2019

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