The Narendra Modi regime’s bold new policy for foreign direct investment (FDI) from border sharing countries is now in force legally. The new law came into effect post a Foreign Exchange Management Act (FEMA) notification which was released late night on April 22. The government had announced its intentions a few days earlier via Press Note 3 of 2020, which had raised many eyebrows, as it mandated prior government approvals for FDI from India’s neighbours such as Pakistan, China and Bangladesh.
Interestingly, the policy added that such an approval would also be required for deals where the beneficial or the ultimate owner of the investment, whether directly or indirectly, is from these neighbouring countries.
Apart from investments in specific sectors, government nod was required only for investments originating from Pakistan and Bangladesh.
Post investment by the People’s Bank of China in domestic financial powerhouse HDFC, it wouldn’t be naïve to believe that through this revised policy, the government is keen to scrutinise capital flows from China into India and exercise discretion where deemed fit. Through this pre-emptive move, the government also wants to avoid predatory behaviour by companies or investors from bordering nations, especially China, who would be eyeing Indian targets, which are struggling at cheaper valuations after the novel coronavirus, or COVID-19, pandemic.
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Not surprisingly, there was an immediate debate in the M&A advisory world on the timing of the move and its impact on fund raising abilities of Indian companies. More so, because the sudden step by the government was applicable to all sectors and not the traditionally sensitive ones like pharma, banking, defence and others. In the past few years, sectors like early stage tech, consumer internet manufacturing, renewable energy and auto have seen heightened interest from the land of the dragon.
The Press Note 3 of 2020 also did not differentiate between majority and minority investments. Moreover, there were big question marks regarding the specific parameters based on which investors would fall within the purview of the law or be excluded. Thus, there was an opportunity to address multiple concerns in the fine print of the eagerly awaited FEMA notification.
But key stakeholders, including M&A lawyers and investment bankers, are sorely disappointed and say the FEMA notification has not moved ahead substantially on the burning issue and still lacks key clarifications and a robust methodology.
Revathy Muralidharan, Partner at Indus Law, who works with private equity funds, feels the wording of the FEMA notification is ambiguous and poses more questions than answers. “What constitutes ‘beneficial ownership’ lies at the heart of the matter. A threshold percentage or a test of control are possible yardsticks which can be used to determine beneficial ownership. The term has not yet been defined in the context of this new law and the government will need to clarify this as soon as possible,” she adds.
To be sure, beneficial ownership has been defined under the Prevention of Money Laundering Act (PMLA) and the Companies Act, but the government’s FEMA notification does not offer guidance on which one to follow.
Dealmakers fear that a whole bunch of transactions may unnecessarily come under the purview of the new law leading to inordinate delays.
“ Given that the Chinese have invested all over the world, in many cases as passive financial investors, this could effectively scale down the automatic route for FDI and subject many investments, particularly those by global funds that may have Chinese limited partners holding a minor investment, to government approval. The experience with government approvals for foreign investment, post closure of the Foreign Investment Promotion Board (FIPB), has been a time consuming exercise with approvals taking 6-12 months,” says Ashwath Rau, Senior Partner, AZB & Partners.
Rau believes the right balance between addressing the government’s concerns and ensuring that FDI is not prejudiced can be achieved by adopting the definition of ‘beneficial owner’ under PMLA. He added that the formation of a body like FIPB is critical to fast-track government approvals in such cases.
Under rule 9(1A) of the PMLA, 2005, the term ‘beneficial owner’ has been defined as: the natural person who ultimately owns or controls a client and/or the person on whose behalf the transaction is being conducted, and includes a person who exercises ultimate effective control over a juridical person.
Raghubir Menon, Regional Practice Head, Mumbai (M&A & PE) at Shardul Amarchand Mangaldas, highlighted the potential impact on existing minority Chinese investments in Indian companies, which are exploring further downstream acquisitions. “Many Indian unicorns and tech startups have minority Chinese investments. The rules should not be interpreted as implying that such Indian entities are prohibited from undertaking M&A or investments in their ordinary course, while driving their own internal growth strategies,” he warned.
Another topic of uncertainty is the status of investors from Hong Kong, which is governed under the principle of ‘one country, two systems’. According to an earlier regulatory update by Khaitan & Co, “The volume of applications from Chinese investors seeking the government’s approval is expected to rise exponentially, which could increase timelines for transactions in this corridor, apart from adding the obvious new layer of regulatory uncertainty. While investments from China are subject to the requirements of the new Press Note, it does not fully clarify the status of investments from Hong Kong, which is a special administrative region.”
Based on official FDI data available on the Department for Promotion of Industry & Internal Trade’s (DIPP) website, between April 2000 and December 2019, capital inflows from China stood at $2.3 billion while $4.2 billion came in from Hong Kong. One factor that needs to be kept in mind is that in many cases investments from China are routed through multiple, tax friendly jurisdictions like Singapore and Hong Kong. Interestingly, Singapore is India’s second largest source of FDI after Mauritius.
Experts feel there are scenarios other than plain-vanilla FDI investments, which may also prove to be tricky. “You need clarity on situations where Chinese investors are exercising pre-existing warrants or participating in rights issues of Indian companies to maintain their existing shareholding,” Sudip Mahapatra, Partner at S&R Associates, said.
The PBOC-HDFC example is not an isolated one. Globally, Chinese investors are on a buying spree and are beefing up their positions in the public equity markets in the US and Western Europe, much to the chagrin of local market participants in these regions.
Back home, investment bankers closely tracking the Indo-China corridor believe a balancing act needs to be pulled off here. Karan Sharma, Executive Director and Co-Head of Digital & Tech Investment Banking at Avendus Capital, is one of them. Though the government has been sensitive as well as strategic regarding the protection of interests in Indian firms, it can’t ignore the fact that Indian internet and tech companies are key generators of employment and overall economic push and would like to access global capital pools, including China.
“Business is getting back to usual in China and there is increased interest among Chinese investors, including strategic players and family offices, to diversify their portfolios towards India. The recent regulations will certainly extend timelines for deal approvals and mean higher information disclosure for potential investors. We expect the government to possibly continue this for a brief period , gradually ease it off as the Indian markets open up and limit such approvals to a few critical sectors,” says Sharma. For instance, The Committee on Foreign Investment in the United States (CFIUS) has adopted a sector-specific approach.In an interview to CNBC TV-18, Amitabh Kant, CEO of government think tank NITI Aayog said the relevant notification from the government does not even mention China and added that Chinese investments were welcome. But Deal Street is clearly not convinced and its feedback is loud and clear. Over to the Finance Ministry and the Reserve Bank of India, which administers FEMA.