This article is written by Eshvar Girish, a student of School of Law, Christ University. This article discusses restrictions on foreign direct investments from countries that share their land borders with India.

Background

On April 17, 2020, the Department for Promotion of Industry and Internal Trade [DPIIT], announced a groundbreaking change to the consolidated Foreign Direct Investment [FDI] policy. Pursuant to the announcement, the amendment was notified by way of Press Note 3 [Press Note] on April 22, 2020. The regulatory body has imposed stringent restrictions on foreign direct investments from countries that share their land borders with India [border countries]. This includes 7 countries which are Pakistan, Bangladesh, China, Myanmar, Bhutan, Afghanistan, and Nepal. 

The amendment extends the scrutiny of the government to transfer ownership of any existing or future FDI in an entity in India. This can directly or indirectly result in beneficial ownership to be included within the purview of the regulations. The same will also be applicable in cases of a subsequent change in beneficial ownership. 

Furthermore, the new rules imply that investment in even a single share of an Indian company through the FDI route from the restricted countries will require the prior approval of the government. This approval is mandatory irrespective of the sector or the quantum of FDI involved.

Reasons for Amendment

The FDI regulatory norms were tweaked in order to deter predatory acquisitions and takeovers of Indian entities at low valuations due to the COVID-19 outbreak. There were similar restrictions that were already in place for Pakistan and Bangladesh but the new amendment is chiefly targeted at regulating and monitoring the inflow of funds from Chinese entities. All Chinese entities which could earlier invest in India via the Automatic Route can now only invest via the Approval Route.

The pandemic has led to a devastating effect on the economy of various countries in the world. Consequently, this has led to a drastic fall in the market valuation of companies due to which Chinese investors had bought out many businesses in Italy which was found to be unacceptable by many countries. This incident instigated various countries to amend their FDI policy with respect to China to avoid the same mishap from taking place in their respective countries.

Moving on to the Indian perspective, MSMEs in India had sought help from the government to temporarily halt FDI through the automatic route as production had come to a grinding halt in all their manufacturing facilities. Followed by this incident, on April 11, 2020, HDFC Ltd, India’s largest housing finance company revealed in a filing that the People’s Bank of China had increased its stake in the company from 0.8% to 1.01%. This sudden raising of stake by the bank in the company after the value of the stock market was eroded by 25% is what triggered DPIIT to modify the FDI policy. A similar action had already been taken up by countries like Spain, Germany, Australia, and the US before India. Although the Saudi Arabian Monetary Authority had also purchased a 0.7% stake in HDFC Ltd., it was not much of a concern because it requires at least a 1% trigger for a regulatory notification to surface. 

The Chinese Viewpoint

The restrictions imposed by the Press Note are applicable only to countries that share their land borders with India. Countries like Sri Lanka and Maldives which share water-borders with India are excluded from its ambit. The DPIIT Factsheet on FDI states that India has received FDI to the tune of $8.97 million from Myanmar, $3.25 million from Nepal, $2.44 from Afghanistan, $2,342.03 million from China and $4,224 million from Hong Kong during the period of April 2000 and December 2019. Although, China ranks only in the 18th position among the other countries who invest in India, the Press Note will still have a substantial impact on them.

China has claimed that the Press Note is violative of the World Trade Organization’s principle of non-discrimination and that it has led to the creation of an inequitable business environment. However, a point of debate arises whether India can invoke the ‘security exception’ clause under Article XIV of General Agreement on Trade in Services as the reason for tweaking the FDI norms was to protect itself from hostile takeovers.

The Press Note 3 is applicable only to foreign direct investments but not to foreign investments in the public securities market, that is, foreign portfolio investments. Having said that, the SEBI recently issued directions to custodian banks to disclose details of the ultimate beneficial owners of foreign portfolio investments made from China and Hong Kong. This instruction is also applicable for non-mainland China and funds based out of Hong Kong whose Limited Partners are from China. 

Implications of the Amendment

Geographical Impact

In the wake of the Covid-19 pandemic, it is essential to keep a check on the amount of FDI received from neighbouring countries. Although India shares a cordial relationship with Afghanistan, Bhutan, and Nepal, the robust bilateral trade and investment ties with them will be strained as the FDI from these countries now fall under the Approval Route.

It is pertinent to note that India keeps track of FDI from Hong Kong SAR of China and Taiwan separately from that of FDI received from the Republic of China. However, it remains to be seen whether Taiwan and Hong Kong who happen to be significant investors in India will also fall under the bracket of ‘border country’ as it has not been specified under the Press Note 3.

Beneficial Ownership 

The definition of the term ‘beneficial owner’ is absent in the Press Note 3 due to which reliance needs to be placed on the interpretation of this term under pari materia statutes. The definitions of ‘significant beneficial ownership’ and ‘beneficial interest’ as specified under the Companies Act, 2013 is not taken into consideration by the RBI in the interpretation of Press Note 3 as it would lead to a conceptual disparity from a FEMA perspective. 

The RBI has laid emphasis on the Prevention of Money Laundering Act, 2002, and the RBI (Know Your Customer) Directions, 2016 as they specify the criteria which are necessary to determine a beneficial owner. Pursuant to the PMLA, the KYC Directions which were issued provide the definition of ‘beneficial owner’ in a detailed manner. 

Furthermore, the SEBI (Foreign Portfolio Investors) Regulations, 2019 determines the beneficial owner of foreign portfolio investors in accordance with the PMLA read with the KYC Directions. The authorized dealer banks conduct a KYC check for all the remittances received from non-resident investors as mandated by the reporting requirements of foreign investments in India. However, it is not clear whether the same procedure will be followed to determine a beneficial owner for the purpose of Press Note 3.

Ramifications on External Commercial Borrowings

Press Note 3 does not specify whether External Commercial Borrowings will also be included under its purview. Eligible border investors can take the ECB route in sectors as prescribed under the ECB framework. Additionally, such investments must be made with caution as ECB regulations might be amended in the near future to suit the needs of Press Note 3.

Even though, conversion of ECB into equity does not involve fresh infusion of funds, such a conversion leads to the re-categorization of ECB as FDI. Consequently, such transactions may be prohibited due to which Indian companies might be unable to carry out their conversion obligations under such loans. This existing grey area in the amendment concerning ECB will eventually result in defaults.

No minimum threshold on the quantum of investment

The Press Note 3 is silent on the minimum quantum of investment which would be covered under the Approval Route. It must have included only investments that grant direct or indirect ownership or investments that grant control over the affairs of an Indian entity or beneficial owners within the realm of the Approval Route. 

A rigid FDI regime that excludes even minor investments or passive investments can lead to an overwhelmingly low inflow of FDI into India. India is still a developing country and such harsh measures can substantially retard the growth of the economy.

Impact on the transfer of investments

Share transfers by non-residents to border investors now require the prior approval of the government. Indian companies must employ circumspection before making share transfers in the favour of border investor due to the absence of reporting requirements in such transactions. However, border investors who transfer existing instruments to investors other than border investors do not have any restrictions. 

Furthermore, any indirect investment made by a Border Investor into Indian companies will also need to follow the Approval Route once they fit the criteria of a ‘beneficial owner’. For instance, a special purpose vehicle set up by a fund situated outside India will need the approval of the government.

Existing transactions 

The sudden announcement of Press Note 3 has caused the Indian companies amid ongoing transactions to go into a frenzy. The investors involved in such transactions will become wary of investing more in the same transaction as it will require government approval. This can lead to an unintended stagnancy in the existing transactions which is counterproductive for Indian Investees.

Moreover, the duration of restrictions imposed by Press Note 3 is not specified. In such an event, the border investors who invest in multiple tranches in an Indian entity will now apply for government approval for all tranches simultaneously instead of applying separately for each tranche of investment. While seeking approval, the sectoral caps must also be taken into consideration by the investors. 

Conclusion

The revised FDI policy has been brought into force mainly due to factors that can be attributed to the COVID-19 crisis. However, the Press Note fails to mention if this revised policy is a permanent measure or an interim measure. It also remains to be seen whether sunset conditions will be introduced in order to determine the duration until which the requirement of prior approval will exist. 

Additionally, the new regulatory norms are aimed at the protection of Indian entities from predatory takeovers and ‘vulturism’. However, there are a lot of practical concerns that emanate from the application of the same. For instance, the tracing of beneficial ownership of FDI on the basis of the nationality of promoters, directors, etc. will be a strenuous challenge for the regulatory bodies.

Furthermore, the approval route deals with foreign investments from border countries on a case to case basis which will tantamount to greater scrutiny. The pre-requisite of approval even for minuscule investments might be unsympathetic towards legitimate investors but in the due process, hostile takeovers can be curbed while genuine investments can still be made.

---