Raising The Wall – No Entry Without Approval

To say that the Covid-19 has unleashed unprecedented times is an understatement. Every country, every government, every regulator, and every 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 – save lives or 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 it can mitigate supply chain disruptions caused by the current Covid-19 pandemic. To this end, Japan had announced its 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 in the home country or to diversify their production bases into Southeast 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 the 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 the Ministry of Commerce & Industry) issued press note 3 of 2020 (PN 3), announcing the 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 takeover/acquisitions of Indian companies due to the current Covid-19 pandemic. Hence, there is no doubt of 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 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.

2. 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 above-mentioned 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 by the Reserve Bank of India 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 down the countries, which share a land border with India. Hence, these countries would be 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 PRC is not named, the intention that one may gather is that the limitation applies to China only (shares physical border with India) and not to Hong Kong. Thus, 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.

B. Beneficial ownership threshold: The PN 3 does not define “beneficial ownership”; nor is this term defined under the 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 the 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 the Companies 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[1] 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 the Companies 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 the RBI while issuing the notification under the Non-Debt Rules clarifies the threshold of beneficial ownership of citizens of land-border nations, 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. RBI may consider the 25% and 15% ownership thresholds under the PMLA.

C. Exemptions: As per the Companies (Significant Beneficial Owners) Rules, 2018, (as amended) (SBO Rules), investment vehicles registered with the relevant regulator are exempt from complying with the SBO Rules. Hence, it would be helpful if the RBI, while issuing the notification under the Non-Debt Rules, clarifies whether investment vehicles regulated by SEBI and RBI (or any other regulator) would be exempt from the requirement of determination of beneficial ownership for the proposed FDI Policy purposes.

D. Retroactive effect: PN 3 provides that the proposed FDI policy will apply to “transfers” in “existing” investments. Hence, this effect would have a retroactive effect. So does it mean that 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, the 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 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 investment in insurance companies, the Insurance Regulatory and Development Authority of India (IRDAI) has issued its guidelines, which deal with examination of ownership vesting with Indians. Hence, it would be helpful if RBI, while issuing the notification under the Non-Debt Rules, clarifies the interplay between the proposed FDI policy requirements and guidelines issued by industry regulators.

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 clarify the ministry that will be responsible for granting such approvals and whether approval of the Ministry of Home Affairs would also be required. 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 the land-border nations. In order to ensure that PN 3 and the eventual amendment to Non-Debt Rules do not destabilize fundraising 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.