Typically, there are two kinds of financing transactions handled by Indian finance lawyers on a daily basis:

1. Off-shore to off-shore borrowing (secured by Indian assets): In such cases, a foreign entity/corporation borrows money from an off-shore lender. To clarify, in this situation, no money is remitted into India. Typically, as part of the security package offered to the lender, the borrower entity requests its Indian subsidiary or group company to provide security to secure such borrowing.

2. Off-shore to on-shore borrowing: In such cases, an Indian entity/corporation borrows money from an off-shore lender (an ‘eligible foreign lender’). This is done under the external commercial borrowing (ECB) route in accordance with the Indian foreign exchange control regulations of India. To clarify, in this situation, the loan proceeds are remitted into India, and hence, there is an inflow of foreign exchange. The creation of security and the procedure involved therein to secure such ECB borrowing is governed by the ECB Regulations issued by the Reserve Bank of India (RBI) and managed via the designated authorized dealer bank of the borrower.

In this short post, I will cover point 1 above and attempt to set out the regulatory framework and challenges faced while creating security over Indian assets and equity to secure a completely off-shore borrowing.

Broadly, off-shore lenders request for the following types of security – (a) a corporate guarantee by the Indian subsidiary or the group company of the off-shore borrower; (b) a pledge over the equity interests held by the off-shore borrower in the Indian entity; (c) a non-disposal undertaking from the off-shore shareholder (borrower) over its shareholding in the Indian entity; (d) security over bank accounts, receivables and intellectual property rights owned by the Indian entity.

As a prelude, it is imperative to note that India has established a strict regulatory regime in relation to foreign exchange transactions. By way of example, any lending or borrowing transactions, investments or liabilities undertaken (such as investments, loans, guarantees, creation of security) by an Indian entity on behalf of an offshore entity, are regulated by the RBI through the Foreign Exchange Management Act, 1999 (FEMA) and any regulation or rule framed pursuant to it.

Every cross-border transaction must be classified either as a capital account or a current account transaction under FEMA, which defines a ‘capital account transaction’ to include “a transaction which alters the assets or liabilities, including contingent liabilities, outside India of persons resident in India or assets or liabilities in India of persons resident outside India”. The thumb rule under FEMA is that if it is a ‘current account transaction’, it is permitted unless prohibited or specifically regulated by FEMA, and ‘capital account transactions’, unless specifically permitted under FEMA or by the RBI, are prohibited.

With that background, let us examine from a regulatory perspective whether the creation of the above forms of security is permissible under the Indian regulations:

I. Cross-border Guarantee

• A guarantee on behalf of an off-shore parent/holding company is not expressly permitted under FEMA and hence, requires prior RBI approval;

• A guarantee on behalf of off-shore joint ventures/wholly owned subsidiaries is permissible, subject to compliance with the Foreign Exchange Management (Transfer or Issue of any Foreign Security) Regulations, 2004 and the RBI Master Direction on ‘overseas direct invest’

• A guarantee on behalf of a first level step down operating JV/WOS (set up by their direct JV/WOS) operating as either an operating unit or as a Special Purpose Vehicle (SPV) is permissible under the automatic route, subject to compliance with all other conditions under the ODI regulations.

• A guarantee on behalf of a second level step down operating subsidiary will require prior RBI approval, provided that the guarantor indirectly holds a minimum of 51 per cent shareholding in the overseas subsidiary.

• Issuance of any guarantee must also comply with the provisions of Companies Act, 2013 (particularly sections 185 & 186).

II. Pledge over Indian shares

Under the Foreign Exchange Management (Non-debt Instruments) Rules, 2019, a person resident outside India holding any equity interest in an Indian company is permitted under the automatic route to pledge such interest/shares in favour of an ‘overseas bank’, to secure the loan being extended to such person (or a person resident outside India) who is the promoter of such Indian company or the overseas group company of such Indian company.

III. Non-disposal undertaking (NDU) from the off-shore shareholder over its Indian shareholding

Commonly, in a cross-border financing transaction, an NDU is executed by an offshore shareholder (of an Indian company) where it contractually agrees to not dispose of its shareholding until the final settlement of the loan. As a standard market practice, execution of NDUs is typically followed by filing of Form 39 (in case of filings with the National Securities Depository Limited) by such offshore shareholder for creation of a ‘hold’ on the shares of the Indian company with the depository participant (DP) in favour of the lender. Once the relevant filings are completed, the shares are marked by the DP. This operationally means that without obtaining the prior consent of the lender, the shareholder would not be able to transfer such shares to a third-party.

Once there is a freeze over the shares with the DP, the DP shall not facilitate any transfer, and this, in my view, is akin to ‘constructive possession’ (as there is no alternative way of taking possession of dematerialized shares, even in the case of a general lien) and creation of a ‘negative lien’. The term ‘negative lien’ is not formally defined in any Indian legislation, however, as commonly understood, interpreted and judicially acknowledged, a negative lien restricts a person from creating any kind of encumbrance over its assets or otherwise disposing them without the prior consent of the lender. In other words, the lender does not take actual possession of the property on which the lien has been obtained. However, the right to deal with (or transfer) the assets over which a negative lien is created, would be contingent and conditional upon the lender's consent. In terms of FEMA, a lien amounts to a “transfer”, as the definition of the term “transfer” is an all-encompassing and includes a "lien".

Currently, in the finance market, there is lack of legal certainty on this issue and till date there does not exist any RBI circular expressly prohibiting or permitting such an NDU arrangement. However, such a security structuring is always vulnerable to scrutiny by the RBI, where it might consider such NDU arrangement akin to creation of a security interest. Hence, it is recommended to take a conservative view, and apply for prior RBI approval for creation of security by way of NDUs (which is to be followed by filing of FORM 39).

IV. Security over bank accounts, receivables and intellectual property rights owned by the Indian entity

These forms of security would require prior RBI approval.

To conclude, there are still huge gaps in the regulatory framework governing cross-border finance in India, and hence, this is an ever-evolving space. One will notice the RBI issuing new notifications and amendments to existing regulations on a very frequent basis. It is also arguable that the time has come for India to adopt a pragmatic approach by systematically re-thinking the design of the current regulatory framework and bring about immediate reforms.

Anubhav Khamroi is an LL.M. Candidate at the New York University School of Law and a Former Associate (Banking & Finance) at a Tier-1 law firm in India.