Pakistan’s Foreign Exchange Regulation Act, 1947 (“FERA 1947”) requires that no person resident in Pakistan shall buy or borrow any foreign exchange from or make any payment to or for the credit of, any person resident outside Pakistan except with the previous general or special permission of the State Bank of Pakistan (“SBP”). The FERA 1947 furthermore requires no person resident in Pakistan shall issue or transfer any security or create or transfer any interest in a security in favour of a person resident outside Pakistan without the SBP’s general or special permission.
From time to time, SBP grants general permissions under various provisions of the FERA 1947. These general permissions are contained in the Foreign Exchange Manual (“FE Manual”) issued by SBP. If a matter is not covered by general permission given in the FE Manual, it will require special permission from SBP. However, the process of obtaining special permission from SBP is very slow and bureaucratic, and, in practice, SBP rarely grants special permissions.
Chapter 20 of the FE Manual contains general permissions granted by SBP, inter alia, for the issuance of shares of Pakistani companies to foreign investors. Likewise, Chapter 19 of the FE Manual contains general permissions granted by SBP, inter alia, to Pakistani companies to obtain foreign currency loans from abroad under various categories listed therein, subject to compliance with the legal requirements laid down by SBP for each category. Until recently, SBP did not allow Pakistani companies to avail convertible debt financings from abroad. Besides, a majority of foreign investors (including venture capital firms) were not eligible to offer finance to companies operating in Pakistan.
To support the startup ecosystem in Pakistan, SBP has now allowed startup companies to avail convertible debt financing from abroad. For this purpose, a new category of loan has been created by incorporating a new paragraph 7(vii) in Chapter 19 of the FE Manual through FE Circular No. 4 of 2021 dated 26 May 2021. This paragraph also sets out various parameters subject to which Pakistani startup companies may raise convertible debt from abroad.
Who is eligible to avail convertible debt finance from abroad?
To be qualified to avail convertible debt finance from abroad under paragraph 7(vii) of Chapter 19 of the FE Manual, the Pakistani borrowing company must fulfill the below conditions:
- It is incorporated in Pakistan as a private or a public company for not more than 7 years;
- it is not formed by splitting up, or reconstructing a business already in existence;
- it has annual revenues below PKR 2 billion (approximately USD 12,860,000) since its incorporation; and
- it has equity (including retained earnings) below PKR 300 million (approximately USD 1,930,000) as per its latest audited financials.
Are there any qualification requirements for foreign lenders?
Yes. any of the following entities may be an eligible foreign lender:
- A foreign bank;
- international capital market;
- multilateral financial institutions such as IFC, ADB, etc.;
- foreign government-owned development financial institution;
- foreign export credit agency;
- foreign supplier of plant & machinery;
- a foreign parent or associated company
- a Pakistan national resident outside Pakistan;
- a person who holds dual nationality including Pakistan nationality, whether living in or outside Pakistan;
- a foreign national, whether living in or outside Pakistan; or
- a company or firm (including a partnership) or trust or mutual fund or private fund incorporated, registered, and functioning outside Pakistan, excluding entities owned or controlled by foreign governments.
To be an eligible foreign lender, the relevant entity must comply with the international standards of Anti Money Laundering (AML) & Combating Financing of Terrorism (CFT) i.e., Financial Action Task Force Guidelines.
Is there any maturity period requirement?
Yes. The maturity period of convertible debt finance may be between 1 year to 5 years. The loan may be rolled over provided that its total tenure does not exceed 5 years.
Is there any borrowing cost ceiling?
Yes. The borrowing cost ceiling will depend upon the maturity period of the convertible debt finance facility and will be as under:
- 250 bps above the relevant benchmark rate where the maturity period of the facility is between 1 year to 3 years; or
- 350 bps above the relevant benchmark rate where the maturity period of the facility is above 3 years, and up to 5 years.
The above borrowing cost ceilings include spread over the relevant benchmark rate, loan-related insurance premium, and other loan-related fees payable in foreign currency. However, it does not include any commitment fee, and any costs, expenses, and fees payable in local currency.
Is there any restriction on the conversion of a convertible debt finance facility into equity?
Depending upon the terms and conditions of the relevant finance agreement, the outstanding loan amount (including any accrued profit or mark-up) may be converted into equity of the borrowing company on or before the maturity of the convertible debt finance facility. Furthermore, the shares will be issued to the foreign lender after complying with the requirements laid down under the company law and will be registered with SBP as a repatriable investment under Chapter 20 of the FE Manual.
Will a foreign convertible debt finance transaction require registration?
Yes. The foreign convertible debt finance transaction will require registration with SBP through a designated local bank called the “authorized dealer”. The designated local bank will register the transaction after making sure that it complies with the applicable requirements laid down in the FE Manual.
Following documents will be required to be submitted to the designated local bank for registration:
- The foreign convertible debt finance agreement between Pakistani borrowing company and the eligible foreign lender;
- a list of directors of the Pakistani borrowing company;
- information about the beneficial ownership of the Pakistani borrowing company; and
- an authenticated copy of the final repayment schedule.
The designated local bank will prepare a proceed realization certificate (PRC) after full disbursement of the loan amount in foreign exchange by the foreign lender to the borrowing company in Pakistan. A copy of the PRC, a certificate confirming the applicable benchmark rate, and a certificate confirming payment of applicable taxes will be submitted by the designated local bank to SBP along with the relevant statutory return.
Will fresh permission from SBP be required for any repatriation under a registered foreign convertible debt finance transaction?
No. After the foreign convertible debt finance transaction has been registered, the designated local bank may affect the remittance of principal, interest, and other fees as per the agreed repayment schedule without the SBP’s permission.
Will fresh permission from SBP be required for the conversion of debt into equity under a registered foreign convertible debt finance transaction?
No. However, the designated local bank will be required to report any conversion of outstanding loans into equity to SBP. Besides, as explained above, the shares issued to the foreign lender will be required to be registered with SBP as a repatriable investment under Chapter 20 of the FE Manual.
Is there any restriction regarding the issue price of shares in case the foreign lender decides to convert its debt into equity?
Yes. The issue price of the shares should not be below the latest break-up value of shares of the Pakistani borrowing company as determined by its external auditors. The name of such external auditors should be borne in the SBP’s approved list of auditors.
The rupee liability of the borrowing company (including accrued profit/mark-up) will be determined by converting the foreign currency loan amount, outstanding as per last month-end or, where last month-end figures are not available, quarter-end financial statement, into PKR by using the prevalent mark-to-market exchange rate (mid-rate) announced by SBP.
The latest amendment in the FE Manual is a continuation of the SBP’s drive to support the startup ecosystem in Pakistan and to boost foreign direct investment into the country. Previously, SBP had allowed local startup companies to incorporate holding companies abroad. SBP had also allowed resident individuals to acquire equity stakes in companies incorporated abroad. Likewise, the export-oriented companies were allowed to incorporate subsidiaries and to establish branch and liaison offices abroad.
A typical foreign convertible debt finance transaction involves securing debt finance by a Pakistani borrowing company from a foreign lender and the issuance of shares of the Pakistani borrowing company to such a foreign lender. Hence, such a transaction will attract the application of both Chapter 19 and Chapter 20 of the FE Manual.
While the required changes have been made by SBP in Chapter 19 of the FE Manual to enable the Pakistani startup companies to avail convertible debt financing from the eligible lenders abroad, SBP has not yet made the required changes in Chapter 20 of the FE Manual to enable a Pakistani borrowing company to issue shares to an eligible foreign lender, should the foreign lender choose to exercise the option of conversion of its debts into equity.
Given the lack of capacity of the designated local banks and their reluctance to facilitate similar transactions, it will be desirable that appropriate corresponding amendments are made in paragraph 7 of Chapter 20 of the FE Manual to streamline the process of issuance of shares under a registered foreign convertible debt finance transaction.
Majeed & Partners, Advocates & Counsellors At Law is a full-service commercial law firm based in Lahore. Our lawyers have represented many growth-oriented companies from inception and throughout a full range of complex transactions. We have helped several young entrepreneurs in setting up companies and advised them during early-stage fundraising as well as subsequent funding rounds. For further details, please feel free to Contact Us.