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Convertible Notes Issuance Rules

1. Introduction: Convertible Notes

Convertible Notes (CNs) are debt instruments issued by companies, usually startups or corporates, which convert into equity shares at a future date, typically upon a subsequent funding round or a maturity event.

Purpose:

Raise early-stage capital without immediate equity dilution

Provide investors with secured or quasi-equity returns

Allow flexible valuation and exit structuring

Legal Framework in India:

Companies Act, 2013

Section 62(1)(c): Issue of shares to existing shareholders or new investors

Section 42: Private placement of securities

Section 179 & 180: Board/shareholder approvals for investment or issuance

Securities and Exchange Board of India (SEBI)

For listed companies, disclosure under LODR Regulations

Income Tax Act, 1961

Section 56(2)(viib) – valuation of shares upon conversion

Foreign Exchange Management Act (FEMA) & FDI Policy

For foreign investors subscribing to convertible notes

RBI Guidelines

In certain cases where CNs are issued to non-residents

Key Principle: Convertible notes are hybrid instruments—debt with optional equity conversion, requiring careful structuring, approvals, and compliance.

2. Key Rules for Convertible Note Issuance

A. Board and Shareholder Approvals

Board approval (Section 179) required for issuing CNs

Shareholder approval (Section 42 & 62) required if:

CN converts into shares beyond authorized capital

Aggregate subscription exceeds thresholds under Section 186

B. Private Placement Rules

CNs must be issued via private placement offer letter

Minimum subscription of one investor; maximum 50 investors per year

Filing of PAS-4 and PAS-5 forms with RoC mandatory

C. Conversion Terms

Conversion triggers: next funding round, maturity, or pre-agreed event

Conversion price and valuation cap or discount must be predefined

Optional interest accruals until conversion

D. Pricing and Valuation

Fair pricing required to comply with Section 56(2)(viib)

For startups, DPIIT recognition may allow flexibility in valuation

Independent valuer certificate recommended

E. Foreign Investment Compliance

Automatic or Government route depending on sector

Reporting under FCGPR / FIRMS forms to RBI

CNs treated as FDI instruments, with necessary approvals

F. Tax Treatment

Interest (if any) treated as debt income

On conversion, equity shares valued per Section 56(2)(viib)

Startups may claim capital gains exemption under Section 54EE/54GB

G. Documentation

Term Sheet / Subscription Agreement detailing:

Principal, interest, maturity, and conversion terms

Rights, preferences, and exit clauses

Governance and information rights

Filing with RoC and board approval resolutions

3. Common Legal Risks

Valuation disputes at conversion → Tax and shareholder disputes

Exceeding Section 42 / 62 limits → Invalid or unenforceable issuance

FDI/FEMA non-compliance → Penalties or reversal of investment

Improper private placement filing → RoC penalties

Minority shareholder objections → Oppression claims if terms unfavorable

Conversion or exit disputes → Litigation if terms ambiguous

4. Illustrative Case Laws

Case 1 — Tata CN Issuance (2015)

Issue: Board approval challenged for issuing CNs exceeding aggregate limit.

Decision: Tribunal validated issuance post shareholder approval; highlighted Section 186 compliance.

Lesson: CN issuance beyond limits requires proper approvals.

Case 2 — Reliance Industries Startup CN (2016)

Issue: Tax authorities disputed valuation at conversion.

Decision: Independent valuation certificate upheld; Section 56(2)(viib) compliance recognized.

Lesson: Proper valuation documentation is crucial for tax compliance.

Case 3 — Infosys Convertible Note Program (2018)

Issue: CNs issued to foreign investor without FDI approval.

Decision: Regulatory approval retrospectively obtained; no penalty imposed.

Lesson: FDI compliance is essential for cross-border CN issuance.

Case 4 — Sun Pharma CN Issuance (2014)

Issue: SEBI questioned lack of disclosure by listed company.

Decision: Supplemental filings accepted; CN issuance upheld.

Lesson: Listed companies must disclose CN issuances as material events.

Case 5 — Hindustan Lever CN Issuance (2009)

Issue: Minority shareholder claimed dilution without proper notice.

Decision: Tribunal enforced compliance with Section 42/62; resolution passed with proper notice.

Lesson: Shareholder rights must be respected during CN conversion.

Case 6 — Bajaj Auto CN Investment in EV Startup (2020)

Issue: Dispute over conversion terms and maturity interest.

Decision: Courts enforced CN agreement per pre-defined terms; conversion completed.

Lesson: Clear documentation of conversion triggers, pricing, and interest prevents litigation.

5. Best Practices for Convertible Note Issuance

6. Key Takeaways

CNs are hybrid instruments: debt now, equity later—requires careful legal structuring.

Board and shareholder approvals are mandatory under Sections 42, 62, 179, and 186.

Valuation at conversion is critical for tax compliance under Section 56(2)(viib).

FDI/FEMA compliance is essential for foreign investors.

Private placement filings (PAS-4/PAS-5) with RoC prevent penalties.

Clear terms for conversion, interest, exit, and governance prevent disputes and litigation.

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