FDI in NBFC Sector Relaxed

Foreign direct investment (FDI) in non-banking finance companies (NBFCs) has been subject to minimum capitalisation norms. For example, any foreign investment of more than 75% in an NBFC requires a minimum capitalisation of US$ 50 million through foreign inward remittances.

As far as downstream investments are concerned, the Conslidated FDI Policy Circular provides that the relevant caps and conditionalities shall apply to downstream investments as well. However, there is a specific exception for 100% foreign-owned NBFCs where there is no restriction on establishing downstream subsidiaries without further capitalising each subsidiary with the minimum required foreign investment. However, this specific dispensation was not available to NBFCs where foreign investment is between 75% and 100%. By way of a Press Note No. 9 (2012) Series, the Government has now brought such NBFCs on par with 100% foreign-owned NBFCs, whereby they can also set up downstream subsidiaries without further capitalising each one of them with the requirement minimum amount.

A reportin the Business Standard sets out some of the advantages of this change:

The rule has made the business very capital intensive for companies that have FDI, as most of them prefer a subsidiary structure to carry out different types of businesses.

This was not the only problem. Norms say that a NBFC has to set up separate arm for different set of activity. It means a NBFC who is in the business of custodian service and then it decides to go into leasing and finance, it needs to set up a different arm.

Previous regulation meant such a NBFC, if having more than 75 per cent FDI but less than 100 per cent and a capital base of $50 million, it would need to bring another $50 million. Now this will not be required.

• Update (October 11, 2012): The above amendment has also been implemented by the Reserve Bank of India through a Circular.

FDI Reforms Take Effect

We had earlier discussed the key aspects of the FDI reforms proposed by the Government. Unlike the previous occasion where the Government had to keep the FDI reforms in the retail sector in suspended animation, this time it was quick to notify the reforms that have now taken legal effect, as follows:

Press Note No. 4 (2012 series): FDI in single-brand product retail trading;

Press Note No. 5 (2012 series): FDI in multi-brand retail trading;

Press Note No. 6 (2012 series): FDI in the civil aviation sector;

Press Note No. 7 (2012 series): FDI in the broadcasting sector; and

Press Note No. 8 (2012 series): FDI in power exchanges.

These changes have taken into effect from September 20, 2012.

A Comment on the New FDI Reforms

The Government has attempted to stem the trend of economic policy paralysis by announcing a slew of measures yesterday with a view to enhancing foreign direct investment (FDI), including in some sensitive sectors which had witnessed political deadlock over the last year or so. The new measures relate to multi-brand retail, single-brand retail, civil aviation, power trading exchanges and broadcasting.

Multi-brand Retail

The most prominent (and even emotive) sector relates to multi-brand retail. After the Government had to call of its proposed opening of the sector to FDI last November, it has sought to resuscitate its policies, this time with some modifications in an apparent effort to cushion its impact and to enhance its acceptability to various stakeholders. However, given this is a political hot-potato, the extent to which it receives acceptances remains to be seen.

The Government’s new proposal is contained in its press release. First, the Government’s balancing act is evident from that fact the states are provided significant powers. Multi-brand FDI can be carried out in specific states only if that is permitted by the relevant state governments. This is driven by both legal and political compulsions. The legal compulsion, which is expressly stated by the Government, is that the retail sector is regulated under the Shop & Establishments Act, which is essentially within the domain of the states. This legislation touches upon governing the working conditions of personnel employed within the sector. From a political standpoint, this involves some tight-rope walking so as to initiate FDI in states which are amenable to this policy, without confronting those that are against. While some states have taken a liberal view on the issues, several states continue to oppose FDI in the sector. The Times of India lists out the approaches adopted by some of the key states on the issue.

Second, the retail outlets must be set up in urban agglomerations with a population of more than 10 lakhs. In states with no such cities, specific dispensations have been made. This is to ensure that the impact of the proposal can be contained to urban areas, without any impact on the rural areas.

Third, a minimum of 50% of the FDI is to be utilised in “backend infrastructure”, which includes “capital expenditure on all activities, excluding that on front-end units; for instance, back-end infrastructure will include investment made towards processing, manufacturing, distribution, design improvement, quality control, packaging, logistics, storage, ware-house, agriculture market produce infrastructure etc.” This is a significant condition as it generally well-accepted that there is a dire need for funding to develop such backend infrastructure in India. The arguments in favour of liberalisation of FDI in the multi-brand sector have been premised on the need for such funding. Specifically, the press release also states that land cost and rentals will not be counted towards that purpose.

In all, while this move is expected to please the markets and demonstrate the Government’s aim to create a more conducive investment environment, a lot will depend on the acceptability of such a policy to the states. To that extent, while the Government’s policy is merely enabling, the ball now lies in the individual states’ court.

Single-brand Retail

The Government’s approach on single-brand retail has been bolder. The effort has been unequivocal in terms of reducing the burden on foreign players in being able to meet with investment conditions. When the Government allowed 100% FDI in single-brand retail earlier this year, it imposed several conditions, including the requirement for local sourcing from micro, small and medium enterprises (MSME). However, this was considered to be restrictive, and many single-brand retailers including Ikea made representations to the Government to ease the process. The Government, in its new proposal, agreed to relax two significant conditions.

The first relaxation pertains to the condition that the foreign investor must be the owner of the brand. It was felt that this does not recognise group holding structures whereby for reasons of commercial exigency the entity that makes the investments into the Indian company may be different from the entity that holds the brand. Therefore, the new condition simply provides that any non-resident entity, “whether owner of the brand or otherwise”, may make the investment. A protective measure, however, has been introduced to state that only one investment will be permitted for a specific brand. This change is understandable, and can at best be said to be procedural rather than any substantial overhaul.

The second relates to the domestic sourcing condition, which was found to be onerous. The previous condition stipulated that where the FDI were to be in excess of 51%, then a mandatory domestic sourcing was required to the extent of 30% of the value of products sold, and such sourcing was to be from small industries (which were defined as industries where investment in plant and machinery did not exceed US$ 1 million). Representations were made to the Government that this was not practicable for high value goods, and that even where industries may have satisfied the requirement as the commencement of supply to the single-brand retailer, they would soon outgrow their “small” industry status. The Government has favourably addressed these concerns by removing the mandatory nature of the local sourcing norms. The new requirement states that single brand retailers may source their needs locally, and “preferably” from MSMEs, village and cottage industries, craftsmen and artisans “where it is feasible”. The only mandatory part relates to geographical element, i.e. the fact that 30% of the sourcing must be done locally, from India. The rest of the requirement seems to be merely a “good faith” effort on the part of the retailers, and there appears to be no immediate attempt to enforce this so as to invite legal consequences upon retailers who may not source from MSMEs or the village or cottage sectors.

Aviation

The liberalisation of FDI in the aviation sector, although not unexpected, is interesting for different reasons. In case of the retail sector, there has been significant pressure from the multinational players to open up the sector. However, in the aviation sector, the trigger appears to have emerged from within, due to the domestic circumstances. Foreign airlines have been seeking a share of the domestic aviation pie for over a decade now. But, the Government has been steadfast in its resolve not to open up the sector for foreign strategic players. However, the recent economic fractures in the domestic aviation industry have necessitated a change in approach. With the domestic industry being competitive, and with several players facing dire financial circumstances, the new FDI measures appear to be a way of preventing further downturn in the domestic sector in the hope that foreign airlines would be interested in infusing the much needed funds into the domestic aviation sector.

Under the new dispensation, foreign airlines will be permitted to invest in “scheduled and non-scheduled air transport services” that were hitherto out of bounds for them. The investment will be allowed under the Government (approval) route up to a maximum of 49%. The investment cap and other related measures are to ensure that control of the domestic company remains in Indian hands. The proposal also addresses some of the security concerns involved in the industry.

Others

In the broadcasting sector, changes have been made to bring the key services within the scope of FDI to the extent of 74%, so as to confer similar treatment as the telecom sector. Separate regimes continue for cable networks and news (and current affairs) broadcasting services. A limit of 49% has been set for FDI in power trading exchanges.

In a related move, the Cabinet has also announced disinvestments in some key public sector undertaking, which may in turn boost the capital markets.

To conclude, these proposals appear to be an attempt to boost the economy and address the concerns of policy paralysis that have afflicted the country more recently. While it will certainly have the effect of altering the perceptions among investors in the markets, it might be too early to determine the impact of these reforms on the ground. The FDI in multi-brand retail is left to be determined by the states, many of whom continue to reject the idea. Moreover, there could also be a political backlash from the opposition and other regional parties to the idea of liberalisation in that sector, the effect of which will be known only in the coming days and weeks. From a technical standpoint, the current decisions have been taken by the Cabinet, but there appears to be no formalisation in terms of changes to the FDI Policy, which might soon follow nevertheless. But, until these formal legal changes are effected, concrete steps towards investment may have to wait. That would be a prudent approach considering the previous experience where the proposal to open up the multi-brand retail sector last November generated great enthusiasm, only to be soon followed by the proverbial “slip between the cup and the lip”. 

Liberalisation of FDI from Pakistan

Hitherto, a person resident in Pakistan or an entity incorporated in that country was not allowed to purchase shares or convertible debentures in an Indian company. This was by virtue of Regulation 5 of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000.

By way of a circulardated August 22, 2012, the Reserve Bank fo India (RBI) has partially removed this prohibition. Now, a person who is a citizen of Pakistan or an entity incorporated there may invest in an Indian company under the approval route, i.e. with the prior approval of the Foreign Investment Promotion Board (FIPB). However, investment is not permitted in specific “sectors/activities pertaining to defence, space and atomic energy and second/activities prohibited for foreign investment”.

The blanket ban has given way to a more restricted avenue for investments.

Revised FDI Policy

The Department of Industrial Policy and Promotion (DIPP) has issued the new Consolidated FDI Policy Circular 1 of 2012 that is effective from today. An accompanying press release lists the key changes.

Some of the key changes relate to sectoral issues:

- relaxation for foreign investment in commodity exchanges whereby FII investment may be brought in through the automatic route; and

- clarification regarding the scope of ‘leasing’ for investment in non-banking finance companies (NBFCs).

Others relate to the imposition of additional restrictions on foreign direct investment (FDI):

- unavailability of share issuance option for purchase of second hand machinery from foreign suppliers; and

- the need to make prior intimation to the Reserve Bank of India (RBI) while increasing the limit of 24% foreign institutional investments (FIIs) in a single company.

The remaining changes formalize previous announcements that were already made by the Government:

- investments by foreign venture capital investors (FVCI) through private arrangements and purchase on stock exchange (discussed here);

- investments by qualified financial investors (QFI) (discussed here);

- liberalization of policy on transfer of shares in the financial services sector; and

- changes to sectoral policy in pharmaceuticals and single-brand retail trading.

In terms the periodicity of changes to the FDI policy, a decision has been taken to review the policy annually rather than to follow the current practice of bi-annual changes. In the interim, changes will be effected by way of press notes.

Although these are only the highlights of the policy, other issues might likely arise based on a detailed reading of the new policy, especially on matters of interpretation.

Outbound FDI and M&A

The Reserve Bank of India has published a paper/address titled “Outward Indian FDI – Recent Trends & Emerging Issues” that examines various regulatory aspects of outbound FDI by Indian companies. It considers various business aspects and comments upon regulatory issues and concerns.

The latest issue of The Economist also looks at outbound M&A from India, and analyzes the level of success that Indian outbound deals have achieved. While some deals have indeed been profitable, others may not have achieved the expected success for several reasons, including the global financial crisis that emerged at the peak of the Indian outbound M&A boom. Part of the issues identified relate to complexity in Indian corporate structures, and possible regulatory obstacles. For example, the article notes:

But to do more jumbo deals in a tougher world, Indian firms need to tackle a glaring area of weakness. This is their complex structures, which mean cash flows are spread thinly, and their dislike of issuing equity for fear of diluting their controlling shareholders. Both factors combined make it hard to marshal resources without resorting to risky levels of debt.

Nevertheless, it appears that the deal-flow on outbound Indian M&As have continued even into 2012 although the sizes of the deals have dropped in comparison with those witnessed during the boom.

Liberalisation of Foreign Investment in Single-Brand Retail

Although the proposed policy changes on foreign investment in multi-brand retail had to be put on hold due to stiff resistance, the Government has issued Press Note No. 1 (2012 Series) to increase the limit of foreign investment in single-brand retail from 51% to 100%. Such foreign investment would continue to require the approval of the Government of India (acting through the Foreign Investment Promotion Board). For investments beyond 51%, a new condition requiring domestic sourcing has been inserted as follows:

In respect of proposals involving FDI beyond 51%, mandatory sourcing of at least 30% of the value of products sold would have to be done from Indian 'small industries/ village and cottage industries, artisans and craftsmen'. 'Small industries' would be defined as industries which have a total investment in plant & machinery not exceeding US $ 1.00 million. This valuation refers to the value at the time of installation, without providing for depreciation. Further, if at any point in time, this valuation is exceeded, the industry shall not qualify as a 'small industry' for this purpose. The compliance of this condition will be ensured through self-certification by the company, to be subsequently checked, by statutory auditors, from the duly certified accounts, which the company will be required to maintain.

FDI in the Civil Aviation Sector

With the civil aviation industry in India facing concerns on the financing front, calls are being made to liberalise the foreign investment rules in the sector. Of course, that stance has been subjected to criticism on the ground that the foreign direct investment (FDI) policy should not be utilized to bail out certain players in the industry.

In any event, there are a couple of issues to be considered from an FDI standpoint. The proposal doing the rounds (although there is no formal announcement from the Government) is that foreign airlines will be permitted to hold up to 24% in Indian airline companies. The reason behind such a cap is to ensure that the foreign airline does not obtain negative control by being able to block special resolutions in the company. Given that this would be a strategic investment rather than a financial or portfolio investment, it is not clear if foreign airlines will be willing to take up such a low stake in Indian ventures. Moreover, it is likely that even if its stake is 24% or below, the foreign airline would insist on significant affirmative voting or veto rights (in addition to other customary rights granted in such types of investment), and it remains to be seen whether the regulatory proposal would also take into account the grant of such rights to foreign airlines and, if so, to what extent. 

At a broader level, the discussion of imposing a cap of 24% on foreign airlines appears to run contrary to the intention of the Department of Industrial Policy and Promotion, Government of India, to streamline foreign investment caps such that all limits below 49% would be abolished, as stated in a discussion paper issued in June this year. The current proposal in the airlines sector goes against the streamlining effort.

FDI – Transfer of Shares

The Reserve Bank of India (RBI), through a circular issued last week, curtailed its own approval powers involving transfers of shares of Indian companies between residents and non-residents.

Previously, certain specific transactions required the prior approval of the RBI, and these included (i) transfers not compliant with RBI’s pricing norms, (ii) those that required prior approval of the Foreign Investment Promotion Board (FIPB), (iii) where the investee company was in the financial services sector and (iv) where the transfer was within the purview of the SEBI Takeover Regulations.

In the recent circular, the requirement for approval of the RBI in these cases has been done away with so long as the transfer is otherwise in accordance with the FDI policy. Where the pricing is not in accordance with the RBI regulations for transfer, transactions will nevertheless be permitted if the pricing follows the norms of other relevant regulators such as SEBI (for takeovers, public offerings, buybacks, etc.). As regards companies in the financial sector, no prior approval of the RBI is required if no-objection certificates are obtained from the sector regulators.

The effect of the new regime is that it not only liberalizes the procedural requirements for transfers between residents and non-residents making them far easier, but it also cedes RBI’s approval powers on pricing to regulators such as SEBI which also impose pricing norms on specific securities transactions.

Reversal of FDI Policy on Options

Exactly a month ago, the Government announced its updated FDI policy which treated foreign investments in Indian securities as external commercial borrowings (ECB) in case such investments conferred options on the foreign investors. The wide amplitude of the restriction on options gave rise to significant concern among the corporate and investment community, and it has been the subject matter of criticism among practitioners and commentators alike.

However, this concern has been assuaged by a clarification issued by the Department of Industrial Policy and Promotion (DIPP) today which deletes the relevant clause (para 3.3.2.1) of the Consolidated FDI Policy that outlaws options in securities. While this new pronouncement seems unequivocal and the alacrity with which the Government reacted is indeed remarkable, it remains to be seen whether the Reserve Bank of India (RBI) will also now adopt a more liberal approach to options and modify their prevailing position (that the existence of options in securities will convert investments into those under the ECB policy rather than the FDI policy). Moreover, it is certainly not the end of the debate regarding the enforceability of options in securities of Indian companies which continue to encounter issues under companies and securities legislation, namely the Companies Act and Securities Contracts (Regulation) Act respectively.

Revised FDI Policy: Options Outlawed

In the comments section to my previous post on the new FDI policy, reader Menaka highlights another important clarificatory change regarding the policy stance of the Government that now clearly outlaws options in securities held by foreign investors in Indian companies. The relevant clause in Circular No 2 of 2011 is as follows:

3.3.2.1 Only equity shares, fully, compulsorily and mandatorily convertible debentures and fully, compulsorily and mandatorily convertible preference shares, with no in-built options of any type, would qualify as eligible instruments for FDI. Equity instruments issued/transferred to non- residents having in-built options or supported by options sold by third parties would lose their equity character and such instruments would have to comply with the extant ECB guidelines. [emphasis supplied]

Although the Reserve Bank of India has been adopting this stance lately (as discussed here), it is now well-etched in the policy of the Government of India as a formal matter, and not just in the form of interpretation of the regulations. This suggests that the Government has taken strong exception to the use of put options in equity investments as a method of guaranteeing returns to foreign investors and providing financial protection against their investments. It is bound to curtail investments in certain sectors and by specific types of investors (e.g. financial investors such as private equity funds) who tend to rely upon put options in securities as an essential component of the transaction structure.

Another aspect to consider is that even though the concern of the foreign investment regulators arises in the context of a “put” option as that may provide the investment with the character of an external commercial borrowing (ECB), a plain reading of the clause in the new FDI policy quoted above is wide enough to extend it to “call” options as well. This would lead to the result that foreign investors holding call options will also fall within the proscription contained in the new policy, although it does not carry the same reasoning for a ban as that of put options.

Revised FDI Policy

It is that time of the year when the Government conducts its bi-annual review of the policy on foreign direct investment (FDI). Consistent with the previous trend over the last couple of years, it yesterday announced the Consolidated FDI Policy in the form of Circular No. 2 of 2011, which comes into effect from October 1, 2011.

The key changes announced are as follows:

1. Construction development activities: The education sector and old-age homes are exempted from the conditions that apply to construction-development activities in the real estate sector. These conditions include minimum built-up area, minimum capitalization and lock-in. 

2. Agriculture: Apiculture (bee-keeping) has been allowed under the category of permitted agricultural activities under controlled conditions.

3. Industrial Parks: Basic and applied R&D on bio-technology, pharmaceutical sciences/ life sciences has been allowed as ‘industrial activity’ for purpose of establishing industrial parks, where FDI is allowed up to 100% under the automatic route.

4. FM Radio: FDI has been increased from 20% to 26%.

5. Conversion of Advances into Equity: In case of conversion of imported capital goods/machinery and pre-operative/pre-incorporation expenses into equity instruments (which was permitted effective April 1, 2011), the application to the FIPB must be made within 180 days from the date of shipment of capital goods/machinery or retention of advance against equity.

6. Pledge/Escrow: Resident investors can pledge their shares in an Indian company against external commercial borrowings (ECB) raised by such company from foreign lenders. Moreover, several procedural aspects of equity investment have been eased: these include the ability of foreign investors to open escrow accounts towards payment of share consideration and for keeping securities to facilitate FDI transactions. 

Compared to the last round of changes in April 2011, the new policy appears to be lacklustre with largely incremental advancements and clarifications. It is devoid of any material changes in any sector that is of significance in the overall development of the economy. Although there was great momentum a few weeks ago towards liberalisation of the multibrand retail sector, and consequent anticipation of policy announcements, it appears to have slowed down lately.