Introduction
Several
governments across the world have brought into force restrictions
on foreign investments. These restrictions are aimed at protecting
the companies from hostile takeovers/acquisitions at a time when
valuations have been significantly impacted due to the
ongoing COVID-19 pandemic.
The Indian Government, with the notification of Press Note No. 3
(2020 Series) on 17 April 2020, seeks to do the same.
Pursuant to the said press note, the government notified the
Foreign Exchange Management (Non-debt Instruments) (Amendment)
Rules, 2020 (New Rules). The New Rules are effective from 22 April
2020.
In this update, we have discussed the restrictions brought about
by the New Rules, the impact they might have and certain areas on
which there is a lack of clarity.
Restrictions under the New Rules
Under
the extant Foreign Direct Investment (FDI) regime in
India, non-resident entities are permitted to invest in various
sectors in India (for e.g., manufacturing, broadcasting, trading,
etc.). Investments in most of these sectors is permitted to be
undertaken without any approval from the government, i.e., under
the automatic route.
Bangladesh and Pakistan are the only countries from which all
investments into India require an approval from the government,
i.e., investments can only be made through the government route.
The New Rules add several countries to the list of those which
must now mandatorily adopt the government route. The provisions of
the New Rules are summarized below:
-
> Primary
investment: an entity of a country, which shares a
land border with India or where the beneficial owner of
an investment into India is situated in or is a citizen of any
such country, can invest only with prior government
approval.
> Secondary
investment: transfer of ownership of any existing or
future FDI in an entity in India, directly or indirectly, resulting
in the beneficial ownership falling to an entity of a
country which shares a land border with India, shall require
prior government approval.
Thus, the New Rules extend the requirement of prior approval from
the government to investments from entities residing in China,
Nepal, Myanmar, Bhutan and Afghanistan (all of which share a land
border with India) (Restricted Investors).
Impact
of the New Rules
A
quick look at the current status of investments in India from the
Restricted Investors indicates that investments from China
(including by financial investors having Chinese investments) are
likely to be the most affected by the New Rules. Chinese venture
capital funds and technology companies have significant stake in
Indian companies, especially in the Indian tech space.
With the notification of the New Rules, these companies and other
Restricted Investors, will need to take the following into
account:
-
> Time
taken to process an approval: Restricted Investors
contemplating to invest in Indian companies will need to keep
some time in hand as they are likely to devote some extra time
to obtain government approval before their investment.
> Restriction
on fresh infusion of funds to existing investments:
since Restricted Investors now need government approval prior
to undertaking further investments, there is likely to be a
delay in additional rounds of investment which might be in the
pipeline. This is also likely to further hinder the expansion
of their business operations in India.
> Limited
exit options: the New Rules also require Restricted
Investors to get government approval for transfer of
securities to other entities, where the beneficial ownership
of the buyer entity is with a Restricted Investor. This is
likely to restrict the range of potential buyers for
Restricted Investors at the time of exit from the Indian
company. It may also impact their bargaining power while
negotiating the exit price.
The impact of the New Rules is unlikely to be limited to
Restricted Investors alone. Investors and other shareholders in
companies having investment from Restricted Investors, may also
face difficulties in enforcing their rights under the transaction
documents. For e.g., exercise of a pre- emption right (as
available to all investors/shareholders) may prove to be
difficult.
New
Rules: grey areas
The
New Rules leave several points open to interpretation. Some of
these points are set out below:
-
> Beneficial
owner not defined: the New Rules prohibit investments
where the beneficial owner is a Restricted Investor. However,
neither the New Rules nor the Foreign Exchange Management Act,
1999 define beneficial owner. Given that various
Indian laws define the term differently, clarity on its
meaning in the context of the New Rules is much needed.
> Compliance
for existing investments: the New Rules are silent on
any compliance norms for existing investments made by
Restricted Investors in Indian companies. Given that the
intention behind the New Rules is to curb hostile takeovers,
it seems plausible that the government will seek details of
existing investments of the Restricted Investors. We are yet
to see whether the government requires any such reporting.
> Foreign
indirect investment (downstream investments): under
the extant FDI regime, investment by a non-resident in the
shares of an Indian company, which has an Indian subsidiary,
can be construed as foreign indirect investment (downstream
investment) in the Indian subsidiary. An Indian subsidiary
receiving such downstream investment is required to inter alia
comply with the entry route restrictions on foreign
investment. Prima facie, it appears that funding of an
Indian subsidiary by a holding company (which has investments
from a Restricted Investor), will also have to take government
approval even when the funds are in fact not being received
from outside India.
> Entities
in Hong Kong as Restricted Investors: the New Rules do
not specify the names of the countries from which investment
is restricted. This casts uncertainty on the status of
entities based in Hong Kong and investing in India. This is
because while Hong Kong is a Special Administrative Region of
the People’s Republic of China and recognized as one
country, two systems, the Indian Government has
recognized Hong Kong separately for certain aspects such as
having a separate tax treaty or for that matter recording FDIs
from Hong Kong separately in data sheets. On the other hand,
there are specific references to Hong Kong in the list of
countries (amongst others, including China) with respect to
provisions relating to setting up of a branch office/project
office in India or acquisition of immovable properties in
India.
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