Barbarians at the gate – no entry without approval

To say that the Covid-19 has unleashed unprecedented times is an understatement. Every country, government, regulator and citizen across the globe is trying to come to terms with the implications of this deadly virus and surviving it. It is indeed a Hobson’s Choice – to save lives or to save the economy. But several countries, in said and unsaid words, have expressed vulnerability to the corporate raiders from China! They are literally at the gate and it has become a cause of worry for most governments and corporations.

Japan has proposed building an economy that is less dependent on China, so that Japan can mitigate supply chain disruptions caused by the current Covid-19 pandemic. To this end, Japan announced an emergency economic package on April 7, 2020, earmarking 240 billion yen (approximately USD 2.2 billion) for fiscal 2020 to pay  Japanese manufacturing firms to leave China and relocate production either to their home country or to diversify their production bases into South East Asia. Australia, Italy, Spain, and Germany have announced amendments to their respective foreign investment laws to make acquisitions and takeovers by foreigners much harder. So has the European Union. The Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA) of the United States has seen increased review of foreign investments under the Trump administration due to security and national interest concerns.

The sentiments echo in Sansad Marg (Parliament Street) in India. On April 17, the Department for Promotion of Industry and Internal Trade (under Ministry of Commerce & Industry) issued press note 3 of 2020 (PN 3), announcing Government of India (GoI)’s decision to review the foreign direct investment (FDI) policy.

The objective behind issuing PN 3 is stated in the press note itself, viz. curbing opportunistic takeovers/ acquisitions of Indian companies due to the current Covid-19 pandemic. Hence, there is no doubt about the urgency on the part of GoI to immediately put the checks and balances in place, especially considering the fact that several sectors and industries are open to 100% foreign ownership under the current FDI policy without the need for any prior scrutiny or regulatory approval.

The restrictions stipulated under PN 3 are as follows:

  1. Primary investments: A non-resident entity, being an entity of a country, which shares a land border with India or where the beneficial owner of an investment in India is situated in or is a citizen of any such country, then such entity can invest in India only with prior government approval. The other conditions as applicable under the extant FDI policy (such as permissible and prohibited sectors/activities, pricing norms, eligible instruments, etc.) will continue to apply.
  1. Secondary investments: Transfer of ownership in any existing or future FDI in an Indian entity, whether directly or indirectly, which results in the beneficial ownership falling in the hands of entities/ citizens of the abovementioned restricted countries shall also require prior government approval.

It would be pertinent to note that the aforesaid revisions to the FDI policy await formal notification under the Foreign Exchange Management (Non-Debt Instruments Rules), 2019 (Non-Debt Rules), being the relevant rules applicable for foreign investments into India under the Foreign Exchange Management Act, 1999 (FEMA).

While the timely intervention of the GoI is appreciated, the PN 3 is unclear on several aspects:

A. Land-border nations: The PN 3 does not list the countries that share a land border with India. Hence, these countries would include Pakistan, Bangladesh, China, Nepal, Myanmar, Bhutan and Afghanistan. Not naming the countries may be intentional.

In 1997, Hong Kong became a Special Administrative Region of the People’s Republic of China (PRC) and as per its constitution (the Basic Law), it became “one country, two systems”. Since countries (including PRC) are not specifically named, can one gather the intention is to apply the limitation to China only (since it shares physical border with India), and not to Hong Kong? If yes, entities set up in Hong Kong may not be impacted by PN 3, unless such entities are directly or indirectly (beneficially) owned by Chinese citizens/entities. If no, then this could have unintentional consequences since Hong Kong is a leading holding company and fund management jurisdiction and thus will lead to disruption w.r.t. compliance with the proposed FDI policy, especially in the case of existing structures.

B. Beneficial ownership threshold: The PN 3 does not define “beneficial ownership”, nor is this term defined under Non-Debt Rules or FEMA.

The Prevention of Money-Laundering Act 2002 (PMLA) defines ‘beneficial owner’ to mean an individual who ultimately owns or controls a client of a reporting entity or the person on whose behalf a transaction is being conducted and includes a person who exercises ultimate effective control over a juridical person. The thresholds as prescribed under the Prevention of Money-Laundering (Maintenance of Records) Rules, 2005 (PMLA Rules) are 25% for a company and 15% for non-corporates (such as partnerships, trust, etc.). These thresholds for determination of beneficial ownership are applied by Reserve Bank of India (RBI) and Securities and Exchange Board of India (SEBI) for entities under their respective jurisdiction.

The Indian Companies Act 2013 (Cos Act), under Section 89, defines the term “beneficial interest” and includes, directly or indirectly, through any contract, arrangement or otherwise, the right or entitlement of a person alone or together with any other person to:

    1. exercise or cause to be exercised any or all of the rights attached to such shares, or
    2. receive or participate in any dividend or other distribution in respect of such share.

Section 90 of Cos Act defines “significant beneficial owner” (SBO) as every individual who acting alone or together, or through one or more persons or trust, including a trust and persons resident outside India, holds beneficial interests of not less than 25% or such other percentage as may be prescribed in shares of a company or the right to exercise or the actual exercising of significant influence or control as defined under Section 2(27) of Cos Act over the Indian company. It would be pertinent to note that as per the Companies (Significant Beneficial Owners) Rules, 2018, as amended (SBO Rules) the threshold for SBO is 10%.

Hence, it would be helpful if GoI while issuing the notification under the Non-Debt Rules clarifies the threshold of beneficial ownership of entities / citizens of land-border nations (individually or at an aggregate level), which will trigger the need for prior government approval. In the absence of such clarity, it appears that any percentage of beneficial ownership, including a single share would require prior government approval under the proposed FDI policy. Hence, it would be preferable if GoI links the thresholds to existing legal and regulatory provisions as per Cos Act and PMLA, which would also facilitate ongoing reporting under the existing reporting formats. The existing format may also be amended to include any additional information that GoI deems appropriate in light of the objective of the proposed FDI policy.

C. Exemptions: As per the SBO Rules, investment vehicles registered with the relevant regulator are exempt from complying with the SBO Rules. Hence, if GoI, while issuing the notification under the Non-Debt Rules, aligns the determination to SBO Rules, the exemptions would become applicable. The rationale behind aligning the exemptions would be that the relevant regulator (be it SEBI or RBI or IRDA etc.) would be in a position to monitor and seek information on beneficial ownership, as well as take the necessary actions as per the relevant regulations.

D. Retroactive effect: PN 3 provides that the proposed FDI policy will apply to “transfers” in “existing” investments. Hence, to this effect, it would have retroactive effect. So, does it mean that the existing investments stand automatically grandfathered? And only the existing investments, which will have any change in ownership thresholds in the future, are intended to make themselves compliant with the proposed FDI policy? Accordingly, it would be helpful if GoI clarifies the nature of reporting (if any) required for existing investments where the beneficial ownership already includes entities/ citizens from land-border nations. Furthermore, threshold for determination of beneficial ownership becomes critical as there is no clarity on what is expected from the existing structures to ensure that these are considered as “compliant” under the proposed FDI policy. Also, the applicability of the revised FDI policy for pipeline investments (closing pending) and committed investments (e.g. investments committed to be made in tranches) would need to be assessed for which clarity in scope becomes critical.

 E. Conflict resolution: With respect to private equity investments in insurance companies, the Insurance Regulatory and Development Authority (IRDA) of India has issued detailed guidelines, which deal with the examination of ownership vesting with Indians and has the ability to seek information and monitor beneficial ownership – and if required make further edits to its guidelines if so deemed necessary. Hence, it would be helpful if GoI while issuing the notification under the Non-Debt Rules clarifies that such regulators will continue to be the relevant authority for the purposes of the revised FDI policy.

F. Approval process: With the disbanding of Foreign Investment Promotion Board, the approval process is split between relevant ministries, Department of Economic Affairs, etc. Hence, GoI must shed light on the ministry that will be responsible for granting such approvals and whether approval of Ministry of Home Affairs would also be required. In fact, with respect to regulated entities, “single window” clearance before the concerned regulator should be permitted to ensure no delays or hassles by being made to run to multiple counters for approval. Hence, clarity on format of application and expected timelines would also be relevant.

PN 3 appears to be a step in the direction to protect national interest and prevent hostile takeovers from land-border nations. In order to ensure that PN 3 and the eventual amendment to Non-Debt Rules do not destabilise fund raising efforts of Indian corporates and do not lead to  confusion around which investing entities will get covered under the beneficial ownership of land-border nations, the final word of GoI on this proposed amendment to FDI policy shall be awaited eagerly.

Covid-19, like the Trojan Horse, has surreptitiously unleashed its terror on the nations – the war it seems has just begun.