In another major policy reform, the foreign direct investment (FDI) norms have been relaxed. It is expected that this move will not only promote the competitiveness of India as an “investment destination”, but will also boost the FDI and technology inflows into the country. Some concerns, however, remain. The revised policy does not address anticipated changes such as permitting FDI in LLPs, Multi-Brand Retail Trading etc. amongst others. Lex Witness Bureau brings you the highlights of the third edition of India’s revised Consolidated FDI Policy…
For emerging economies, conducive Foreign Direct Investment (FDI) policies play a crucial role in the growth since they facilitate the inflow of foreign capital and funds, in addition to transfer of skills and technology. Even the developed economies seek FDI by incentivising overseas investors, particularly for capital-intensive and technology related industries. Primarily, FDI policies aim at creating a friendly business environment so that the foreign investors are at ease with the legal and financial framework of the host country. The rationale being that foreign investors look for stable and predictable environments where the decision-making processes are rationalized, and the regulatory procedures are non-onerous. At the same time, these policies should be able to offer growth opportunities and profits which in turn encourage further capital inflows across a wide array of industries. Thus, the need for effective policies which help in injecting significant FDI into a growing economy cannot be over-emphasised! Having said that, at times it has also been felt that certain FDI policies are not appreciated within the host country. For instance, FDI flows enable a handful of trans-national giants to set up monopolies in highly profitable sectors where domestic businesses were already meeting the demands of the market, thereby wiping out the latter. Infact, in some cases, the overseas players may not bring in any valuable new technology. Expectedly, critics of such FDI inflows raise eyebrows on the merits of such foreign investment.
The advocates for FDI, on the other hand, argue that for attracting FDI in some critical sectors, the host/recipient nation must permit FDI in industries where it may not be beneficial.
The data released by the Department of Industrial Policy and Promotion (DIPP) reveals that India attracted FDI equity inflows to the tune of USD 2,014 million in December 2010 and the cumulative amount of FDI equity inflows from April 2000 to December 2010 stood at a whopping USD 186.79 billion. It is, therefore, not surprising that the United Nations Conference on Trade and Development (UNCTAD) Report on world investment prospects, “World Investment Prospects Survey 2009-2012”, ranks India at the second place in global foreign direct investments. It is also estimated that India will continue to remain among the top five attractive destinations for international investors during 2010-12 period. How has India assumed the position of a key international trading partner on the world canvas? Most experts largely attribute it to implementation of the Consolidated FDI Policy which compiles together in one document all previous Acts, Regulations, Press Notes, Press Releases and Clarifications issued by the DIPP as well as the Reserve Bank of India where they relate to FDI. The Consolidated FDI Policy was first introduced with effect from April 1, 2010 (known as Circular 1 of 2010), with a view to reflecting the current ‘policy framework’ on FDI. Needless to say, DIPP’s consolidation initiative has been commended as a meritorious exercise. Particularly, the decision to endorse the practice of making bi-annual amendments to the policy (as opposed to the previous practice of implementing ongoing notifications) has been welcomed by all quarters. Another critical factor responsible for the rise in FDI inflows has been the recent authority granted to the Foreign Investment Promotion Board (FIPB), under the Ministry of Commerce and Industry, to clear FDI proposals of upto USD 258.3 million. Earlier all project proposals that involved investment of above USD 129.2 million had to be put up before the Cabinet Committee of Economic Affairs (CCEA) for approval.
Circular 1 of 2011 is the third edition of the Consolidated FDI Policy and is part of the ongoing exercise of simplification and rationalisation of FDI procedures. With the FDI inflows into India during the 11- month (April-February) period this fiscal year, declining by 25 per cent to USD 18.3 billion, the timing for further liberalisation could not have been better!
Through the new edition of the Consolidated FDI Policy (Circular 1 of 2011) the government has simplified the joint venture norms in order to liberalise foreign investment in India. In 1998, the Secretarial for Industrial Assistance issued a Press Note No.18 whereby there was complete ban on all new foreign direct investments by foreign investors who had previous joint venture or technology transfer or trademark agreement in Indian companies. This imposition proved very burdensome and impractical. In order to relax such imposition another Press Note No. 1 of 2005 was introduced which said that prior approval of Government would be required only in cases where foreign investor had an existing joint venture or technology transfer or trademark agreement in the same field. Looking at the impracticality of such norms the Government has now with this new FDI Policy of 2011 done away with such restriction and has allowed the foreign firms in existing joint ventures to function independently in same business sector.
Another relevant amendment introduced in the new Policy is regarding convertible instruments which states that the Indian companies can issue equity shares, fully, compulsorily and mandatorily convertible debentures and fully, compulsorily and mandatorily convertible preference shares subject to pricing guidelines/valuation norms prescribed under FEMA Regulations. The price at the time of conversion should not in any case be lower than the fair value worked out, at the time of issuance of such instruments, in accordance with the extant FEMA regulations. One can clearly see the efforts of the Government to change the investment policy and make it more investor friendly by removing several non-encouraging conditions that have held back foreign investment in various sectors in India. Considering the profitability of the business, the financial investors are generally very keen on investing in convertible instruments (such as preference shares or debentures) because the conversion price can be linked to future performance of the company, thereby incentivising the management and promoters to make the business more profitable. Commercially, for the investor it would always be better to determine the conversion rate upfront at the time of subscription to minimise the risk and ensure definite returns on its investment. However, at the same time there was no flexibility whatsoever regarding the conversion price and so would also lead to lessening the profits of the investor.
The amendment in the new policy will definitely encourage the investment by the investors since though the conversion price will be determined upfront at the time of investment, it will ensure that the investor also gets the benefit of the profitability of the company flexibly. This will secure the investment of the investor and will also ensure proportionate benefit to the investor in case of profits to the company. This may likely increase the use of such instruments while investing into India.
The erstwhile Consolidated Policy of 2010 provided that Indian companies can issue equity convertible instruments, ie, debentures and preference shares, subject to pricing guidelines/valuation norms prescribed under FEMA Regulations. More importantly, the pricing of the said capital instruments had to be “determined upfront at the time of issue of the instruments”. As is evident, there was no flexibility regarding the conversion price, which had to be determined upfront by the issuing company and investors. It is widely believed that this approach effectively curbed the market for convertible instruments. Now, with a view to providing better valuation based on performance, the revised Policy allows the option of using a conversion formula for such convertible instruments, subject to relevant FEMA and/or SEBI guidelines on pricing. There are some notable benefits of this revision. Firstly, since the parties can now agree upon a pricing formula, it will bring the convertible instruments in India in line with normal market practice. Secondly, it will enable companies to realize the full potential of their businesses in future. Even the investors will be only limited by the minimum regulatory pricing. It is, thus, felt that these changes will go a long way in helping convertible instruments assume their usual character, without being restricted by pricing restrictions! However, the new policy only deals with matters of pricing. There are no changes vis-a-vis the fundamental character of convertible instruments. For instance, only
“Compulsorily convertible instruments” continue to be treated as FDI, while “non-convertible and optionally convertible instruments” continue to be treated as ECBs.
The FDI policy traditionally allows issue of shares by Indian companies to foreign investors only against cash remittances received through normal banking channels, subject to a few exceptions, viz., conversion of external commercial borrowings outstanding; and payment obligations towards lump sum fee or royalty for technical collaborations. All other transactions involving issue of shares to foreign investors for consideration other than cash required approval of FIPB. In order to provide more investment options, the Government released a Discussion Paper in September 2010 considering additional methods of issue of shares for consideration other than cash. Now in this edition of the revised policy, the following additional methods have been accepted for issue of shares for consideration other than cash:
The chief benefit of this revision is that it will enable Indian companies to procure equipment and services from foreign enterprises/collaborators, when they are unable to pay cash, or when a cash transaction is not financially viable. Besides, such a method also ensures that foreign collaborators have an interest in the success of the Indian company’s business by picking up a stake in it.
Perhaps the most important change in this edition of the FDI Policy is the removal of the prior approval requirement for new ventures/collaboration by non-residents who had existing joint ventures/technical collaboration in the “same field”. Thus, Press NoteNo. 1 of 2005 has been finally struck down! This condition undoubtedly restricted foreign investments as FIPB while considering applications required a no-objection letter from the previous joint venture partner, thereby giving substantial leverage to the Indian partner. Subsequently, with time the requirement was diluted. To begin with, several exceptions were built into the condition, first, it was made inapplicable to certain sectors, e.g. the IT industry; and then specific investors were not bound by it, e.g. multilateral institutions. The next major watering-down was in the form of introduction of a cut-off date providing that the condition henceforth applied only to “existing ventures” as of January 12, 2005 (the date of the policy revision). In other words, it was not applicable to ventures that were established after that date. Nevertheless, calls for total elimination of this requirement continued unabated, pursuant to which the Government issued a Discussion Paper in late 2010, discussing the total abolition of the condition. It was noted therein that such a restriction does not exist in the foreign investment regulations of a host of other emerging economies, including Brazil and China, and that its abolition would increase the inflow of FDI. It is against this backdrop that the condition has now been completely removed.
The latest FDI Policy of India effective 1 April 2011 (Policy) has some areas of concern. The Ministry of Corporate Affairs vide series of statutory Notifications dated 4 March 2011 has announced that “Regulation of Combinations” under the Competition Act, 2002 (the Act) would become effective from 1 June 2011. Though as of now, the supporting regulation of the Competition Commission of India (CCI) is yet to be, but the latest consolidated FDI Policy of the Government of India may come in conflict with some of the concepts of the Act. Needless to mention that whenever conflicts arise between an administrative policy and law, the latter prevails. Not going into great details, the Joint Venture (JV) activities under the Act may have several meanings and unless a reasonable carve out is made, uncertainty between an administrative policy and law would continue to cause hardships to business enterprises. The JV has been defined in the Policy as “an Indian entity incorporated in accordance with laws and regulations in India in whose capital a non-resident entity makes an investment”. On the contrary, JVs in competition law space worldwide over the years are kept in two distinct baskets – (1) “full-function JVs”; and (2) “partial-function JVs”. Full-function JVs are those which are considered to function independent of parent enterprises as a separate autonomous economic entity and are established on a lasting basis. Such JVs come mostly within the ambit of the merger control provisions resulting thereby that parties to the JV have to comply with the mandatory merger filing formalities under the Act. Partial-function JVs between enterprises in the same kinds or levels of business are potentially risky business arrangements and unless the JV entity, post its formation, can adduce evidences by empirical data showing enhancement of economic efficiencies in the market may come within the mischief of prohibitory category under the Act.
The Court approved acquisition of shares under Scheme of Merger/Demerger/Amalgamation could be another area of overlap between the Act and the Policy. Any transaction of Merger or Amalgamation in excess of statutory thresholds prescribed under the Act if decided to be given effect to by the parties without the approval of the CCI shall be declared void. Besides being declared void, the CCI under its suomotu powers may reopen such closed transactions and before proceeding with the investigation will have statutory powers to impose a pecuniary penalty to the tune up to 1% of combined turnover or assets of the parties, whichever is higher. The Policy at paragraph 3.5.4 has omitted to indicate the overlap with the Act.
In view of foregoing, it is suggested that the Board in terms of paragraph 4.8.2 of the Policy may consider co-opting Secretary, Ministry of Corporate Affairs and Chairperson, CCI and other professional experts, experienced in competition law space, as and when necessity arises so as to ensure harmonious construction between the Act and the Policy.
The new provisions allowing flexibility to determine the price at the time of conversion would meet foreign investors’ preference to invest through convertible instruments to bridge the valuation gap, as well as to insulate against anti-dilution. This will also help the Indian companies and the investors to get right valuations depending on investee company’s performance at the time of conversion.
Liberalisation of the conditions for conversion of non-cash items into equity will offer a value added proposition to foreign companies proposing to or doing business in India as the same would allow them to deploy their non-cash resources for taking equity positions in India.
The abolition of the condition to obtain prior approval in case of existing joint ventures and technical collaborations in the ”same field” is a welcome change as the same would curb not just government intervention, but also manipulation by earlier joint venture partner. I am confident that in times when the competition to get larger pie of global capital is intensifying, such liberalization and simplification will attract more funds and technology into the country and would make India a competitive investment destination.
Down-stream investments, ie, indirect foreign investment into Indian companies, have always been a subject matter of ambiguity in the FDI Policy. Vexed issues like if an Indian company (having foreign investors) makes investments into another Indian company, will such downstream investment be treated as domestic investment or foreign investment, arose often. With a view to streamline the policy, the Government had issued Press Notes 2, 3 and 4 of 2009 to clear the confusion on downstream investments. However, the policy continued to be complex, particularly because of myriad types of intermediate companies, viz., operating company; operating-cuminvesting company; investing company. For simplifying the process further, the third edition now eliminates the differences arising out of the three different types of intermediate company, and applies uniform set of principles as long as the Indian intermediate company is “owned and/or controlled” by non resident entities. Thus, henceforth there are only two categories of Companies – ‘companies owned or controlled by foreign investors’ and ‘companies owned and controlled by Indian residents’. Investments by such an intermediate company would be considered foreign investment for the purpose of sectoral caps and other requirements. But some distinctions have been maintained regarding foreign investment into the intermediate company itself depending on its nature. For instance, if that is an investing company, then foreign investment is allowed into it under the approval route only. Furthermore, if theintermediate company does not have any operations or investments yet, then foreign investment is permissible only under the approval route.
The current round of policy review, fails to make definitive pronouncements in certain important areas, despite the fact that these areas/ sectors have been under active consideration for a while now. We take a quick glance at a few of the hotly debated sectors from FDI perspective:
Famously referred to as “the next big thing in reforms”, the significance of FDI in multi-brand retail trading was highlighted in the Economic Survey 2010- 11 tabled in Parliament in February this year, in the following words: “Permitting FDI in retail in a phased manner beginning with metros and incentivizing the existing retail shops to modernize could help address the concerns of farmers and consumers. FDI in retail may also help bring in technical know-how to set up efficient supply chains which could act as models of development.”
The existing Policy allows for 100% FDI in cash & carry and wholesale trading, ie, business-to-business; and 51% in single brand retail stores such as Gucci or Apple, subject to specified conditions. FDI in retail trading is permitted in several countries, including Brazil, Argentina, Singapore, Indonesia, China and Thailand without limits on equity participation. Will India join this long list of countries? Will the Walmarts and the Carrefours enter the Indian market? Industry watchers point out that since this sector needs funding, and FDI is a good source of funding, the permission for FDI will eventually come, albeit in phases. For now, the Government after having received representations from trade bodies and investors for allowing FDI in multi-brand retail, has released a Discussion Paper and has also received views thereof from various stakeholders.
Limited Liability Partnership (LLP)- the fast-emerging form of business structure- is a hybrid of companies and partnership firms, which allows unlimited number of partners in an entity, although their liability is restricted to the extent of the stake held by them. The concept is a new entry into the Indian corporate world, with the Limited Liability Partnership Act being passed in 2008 and coming into force as recently as on April 1, 2009. It is well-known that the Government has been considering allowing FDI in LLP firms. Towards this end, in 2010 DIPP circulated a note across various ministries and stakeholders to discuss the possibility of allowing FDI in LLPs. It is widely felt that FDI in LLPs could go a long way in lending flexibility to these firms and it would also make them more competitive globally. Besides it would also encourage more partnership firms to convert into LLPs. However, the Government is reportedly debating upon whether FDI should be allowed through automatic route because the structure of LLPs is notcertain. In other words, after FDI is allowed and foreign investors start to invest in sensitive sectors like defence, it might lead to security concerns. Consequently, deliberations are on regarding the limit of FDI as well as the sectors in which foreign investment should be allowed in LLPs. Interestingly, recent news reports indicate that the Ministry of Corporate Affairs has “in-principle” given its nod to allow FDI in LLPs.
The real estate sector had eagerly expected liberalised FDI norms and relaxation of rules for external commercial borrowings (ECBs). Although foreign investors have been contributing significant capital into India’s real estate sector, in the recent past, there has been a growing demand to remove the three-year lock-in period for FDI investments in realty. It was anticipated that the revised FDI Policy would give relaxation from the lock-in requirements which would bring some relief to foreign investors. Further, the current FDI policy does not allow ECB for real estate sector, except in case of integrated townships, due to end-use restrictions. It is believed that this has led to an increase in cost of fund as well as the cost of land, resulting in properties being priced unrealistically high. It is time to deliberate upon whether permitting ECB in real estate sector will help in reducing the cost of funds as well as property prices.
For the foreign investor, the third edition of revised Consolidated FDI Policy has many positives and no apparentnegatives. Particularly the removal of “Press Note 1 condition”, restricting the foreign partner of a JV from setting up another joint venture in the same field, is being hailed as a bold and impactful move. Undoubtedly there is a hint of disappointment as well, since some areas have been kept at bay for now. More wide-ranging reforms were being anticipated, chiefly permitting foreign investment into LLPs and multi brand retail; liberalization of the policy on investment into real estate; clarifications on the current policy regarding lock-in on original investment. Industry watchers are hopeful that in the months to come the Government will embark on more far-reaching reforms to address these issues as well. But the crucial question is will this edition of the FDI Policy prove to be a game changer in boosting investor confidence? Only time will tell. What does stand out is the intent of the Government, that of promoting FDI through a policy framework which is predictable, unambiguous and reduces regulatory burden pursuant to periodic consolidation and updation exercise. And this intent deserves to be applauded.
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