CAN OPTIONALLY CONVERTIBLE PREFERENCE SHARES BE CONSIDERED AS A DEBT OR AN

EQUITY?

One of the types of shares which a company can issue is Preference Shares. However, they
are not used as commonly as equity shares. This is unlike in the USA, where preference
shares or preferred stock is an extremely popular means of capital structuring. Preference
shares offer a lot of flexibility in transaction structuring and hence, they are very attractive.
As stated earlier, preference shares are distinct from a preferential issue of shares and the two
should not be confused. Nowadays, several companies have issued bonus preference shares to
their equity shareholders. They are also increasingly being used in joint ventures, foreign
collaborations, private equity/ venture capital funding, etc.

Optionally Convertible or Compulsorily convertible: Optionally convertible preference shares

are those preference shares which carry an option to be converted into equity shares. The
option of conversion may be given either with the company or with the shareholder or it may
be a combination. Compulsorily convertible Preference Shares are those shares, which once
the shares are converted, there is no obligation on the part of the company to redeem them
since they are no longer preference shares.

If we have a look at the features of a OCPS one can say that it’s a mix of both a debt and an
equity.

It has features of an equity for the following reasons:

 Conversion Option: The key equity feature of OCPS is the conversion option.
Holders have the right, but not the obligation, to convert their preference shares into
equity shares. This conversion feature provides investors with an opportunity to
participate in the company's growth and benefit from potential capital appreciation.

 Voting Rights: While not always the case, some OCPS may also carry voting rights if
converted into equity. This aligns with the equity shareholders' ability to participate in
corporate decision-making.
  Participation in Capital Appreciation: By converting to common shares, OCPS
holders gain ownership rights and can benefit from any increase in the company's
overall value.

While OCPS have certain debt-like features (such as fixed dividends), their equity
classification is primarily based on the conversion feature, which allows investors to
participate in the ownership and potential success of the company.

Debt-like characteristics:

 Fixed Dividend Payments: Like traditional preference shares, OCPS typically offer a
fixed rate of dividend. This fixed payment resembles the interest payments associated
with debt instruments.

 Priority in Liquidation: In case of bankruptcy or liquidation, preference

shareholders, including OCPS holders, have a higher claim on the company's assets
compared to common equity shareholders. This priority is more akin to debt holders
who are higher in the capital structure.

But according to Indian Law, its not this way.

According to Foreign Exchange Management (Overseas Investment) Directions, 2022 1,

an “equity capital” means equity shares or perpetual capital or instruments that are
irredeemable or contribution to non-debt capital of a foreign entity, which is in the nature of
fully and compulsorily convertible instruments. Accordingly, any instrument which is
redeemable or non-convertible or optionally convertible shall be treated as debt for the
purpose of OI Rules/Regulations/Directions.

The key factor is the "optionally convertible" aspect of preference shares. If the preference
shares are optionally convertible, it means that the holder has the choice to convert them into
equity shares. The fact that the conversion is optional, as opposed to fully and compulsorily
convertible, introduces an element of uncertainty. The holder may choose not to convert, and
as such, the instrument does not represent a fully committed equity interest.
1
https://rbi.org.in/Scripts/NotificationUser.aspx?Id=12381&Mode=0#PartI Direction 1(vii)
While the paragraph doesn't explicitly mention redemption in the context of OCPS, it does
mention that any instrument that is redeemable shall be treated as debt. If the OCPS have a
provision for redemption, meaning they can be repurchased by the issuing company at a
predetermined price or on a specific date, this redemption feature aligns with debt
characteristics.

In summary, the definition in the Foreign Exchange Management (Overseas Investment)

Directions, 2022, treats instruments that are optionally convertible, redeemable, or non-
convertible as debt for the purpose of those rules. Optionally Convertible Preference Shares,
given their optional conversion feature, may be considered as debt under this definition, as
they do not represent a fully committed equity interest until the conversion option is
exercised.

Even under the Foreign Exchange Management (Transfer or Issue of Security by a

Person Resident Outside India) Regulations, 2017 2 Capital instruments shall include non-
convertible/ optionally convertible/ partially convertible preference shares issued as on and
up to April 30, 2007 and optionally convertible/ partially convertible debentures issued up to
June 7, 2007 till their original maturity. Non-convertible/ optionally convertible/ partially
convertible preference shares issued after April 30, 2007 shall be treated as debt and shall
conform to External Commercial Borrowings guidelines regulated under Foreign Exchange
Management (Borrowing and Lending in Foreign Exchange) Regulations, 20003.

2
https://rbi.org.in/Scripts/BS_FemaNotifications.aspx?Id=11161
3
2(v) of the 2017 Regulations