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.

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).

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.

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.