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Guarantee Structures! Do They Work?

Published on Mon, Feb 24,2014 | 16:48, Updated at Mon, Feb 24 at 16:48Source : Moneycontrol.com 

By: Raj Ramachandran, Partner, JSA

While structuring cross border joint venture transactions, many a times we come across non-resident parties being hesitant to support any financing that the Indian investee company may require to avail for its business. While some of these may be driven by commercial considerations and investment/ funding pattern, there is also, in certain cases, a lack of clarity as to what would be the recourse available to a non-resident guarantor should the guarantee be invoked. Quite surprisingly, the provisions under the foreign exchange regulations seem clear on this point.

A guarantee by a person resident outside India in favour of a person resident in India is a permitted capital account transaction. The provisions also specifically permit a person resident in India to make payment to a person resident outside India who has met the liability under a guarantee. What is contemplated under the regulations to come within its purview, is that the principal debtor and creditor should be Indian parties, and the guarantor a non-resident party. These conditions being satisfied, payment is allowed by way of reimbursement of the amount paid under the guarantee. There may only be the exchange risk to be factored in, but that is not too dampening in the larger scheme of things. Hence the providing of the guarantee, as well as the payment by the Indian company to the non-resident guarantor are permissible transactions, particularly where there is no credit enhancement pursuant to the guarantee provided.

As regards outbound guarantees, a guarantee by a person resident in India in favour of a person resident outside India is a permitted capital account transaction. The foreign exchange regulations specifically permit an Indian company to give a guarantee to a joint venture entity (into which it has contributed equity capital) or a wholly owned subsidiary, outside India, in connection with its business. The guarantee limit forms part of the total investment limit permissible under the regulations.  The total overseas direct investment limit permitted previously for an Indian company was 400% of its net worth. 100% of the value of any guarantee provided was taken into account while computing such 400% limit. Currently however, the total overseas direct investment limit stands reduced to 100% of the net worth of the Indian company to apply on a prospective basis for fresh overseas direct investment proposals.

What adds to the challenge with the reduced ODI limit is the guarantee provision under the new Companies Act of 2013. Under the 1956 Act a holding company could provide a guarantee for the benefit of its subsidiary taking the benefit of certain exceptions. The 2013 Act has no such exceptions, although there is generally enabling provision (under a yet to be notified section) to provide guarantees within the limits specified. Further, a strict reading of another section (which has been notified), conveys that such a guarantee cannot be provided if it triggers the criterion of a “person in whom the director is interested”. Merely having one common director triggers this criterion, thereby restricting such an arrangement inter se even private limited companies. While the provision under the 1956 Act allowed the making of an application to the appropriate authority seeking permission for certain arrangements, under the 2013 Act there is no such provision. A strict interpretation of this provision caused enough anxiety with even banks refusing to accept corporate guarantees from holding companies for the benefit of their subsidiaries, which resulted in the ministry issuing a clarification in this regard.

It remains to be seen how this provision gets relaxed for holding companies to be able to support their subsidiaries or other related entities in their business operations.

In conclusion, inbound guarantee structures seem feasible, but outbound and domestic guarantee structures will require facing the challenges of not only foreign exchange regulations but also the newly enacted company law provisions.

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