Authored by Abhishek Tripathi & Narayan Gupta

Background

The Government of India (“GOI”) through Ministry of Commerce & Industry vide Press Note No. 3 (2020 series) dated April 17, 2020 (“PN 3”) amended the Consolidated Foreign Direct Investment (FDI) policy to require any investment from a country which shares a land border with India to require prior Government approval. This was followed by notification of Foreign Exchange Management (Non-Debt Instrument) Amendment Rules, 2020 (“Amending Rules”) under Foreign Exchange Management Act, 1999 (“FEMA”) on April 22, 2020 to notify consequent amendments in the relevant rules.

PN 3 has come immediately after Chinese central bank bought approximately one percent shareholding in HDFC. This transaction probably cautioned the Government and the market watchdogs of the risks of  ‘opportunistic takeovers and acquisitions’. Chinese investment in India has reportedly reached USD 2,342 million over last two decades. Apart from investments in greenfield projects, Chinese investors have also invested in major unicorns of India, including Delhivery, Dream 11, Flipkart, Hike, MakeMyTrip, Ola, Oyo, Paytm, Quikr, Rivigo, Snapdeal, Swiggy. This follows similar steps by several other countries to restrict takeovers of their businesses.

Affected countries

Prior to PN 3, irrespective of the sectors, citizens or entities from Pakistan and Bangladesh could only make investment in Indian entities under the Government approval route. Through PN 3 and the Amending Rules, similar restriction has been extended to all countries that share a land border with India. According to Ministry of Home Affairs, these countries include Pakistan, Bangladesh, China, Nepal, Myanmar, Bhutan and Afghanistan (“Border Countries”). Effectively, this would also include Hong Kong which is recognized by India as part of China. An ambiguity may arise if Border Countries would also include Taiwan[1], although for foreign investment purposes, official reporting by the GOI show Taiwan to be a separate country.  It is unlikely that Taiwan will be included in the list of Border Countries, at least for FDI and FEMA purposes.

Extent of Beneficial Ownership

PN 3 and the Amending Rules also restricts investments whose ‘beneficial ownership’ lies with a person who is situated in or is a citizen of the Border Countries. FEMA does not define the principle of ‘beneficial ownership’. This principle exists in different forms in different laws. For instance, Companies (Significant Beneficial Ownership) Rules 2018 define ‘significant beneficial owner’ to mean a person who, directly or indirectly, holds at least ten percent of shares or voting rights or has significant control over the company.

On other hand, Know Your Customer directions issued by the RBI provide that in case of companies, a beneficial ownership is created upon ownership of more than 25% of shares, capital or profits of the company, for partnership firms, unincorporated associations and trusts the threshold is 15% interest in the relevant entity, including its capital, profits, property, as may be relevant.

The ambiguity in what constitutes direct and indirect beneficial ownerships raises concerns for funds based out of popular tax havens for Indian investments, such as Singapore, Mauritius, Netherlands, Cyprus and Dubai. Many such funds may have investments whose ultimate beneficiaries, directly or indirectly, may be Chinese citizens or entities based in China. Many such institutional investors may have to create India specific funds without Chinese investments to pass the muster, particularly for investments under the FDI route. This will potentially affect the availability of capital for investment into India.

Potential effect on investments

The immediate consequence of the decision is that any future investment in any Indian entity from China will have to go through the approval process of the Government. This may impact the following investments under the FDI route:

a) Infusion of further capital into wholly owned subsidiaries of Chinese entities, including in Chinese owned manufacturing units and infrastructure projects.

b) Private equity/ venture capital investments into Indian entities from Chinese companies or companies/ funds based in Hong Kong.

c) Private equity/ venture capital investments into Indian entities from offshore funds with significant Chinese investments.

d) Transfer of shares in Indian companies to Chinese entities, or offshore entities/ funds with Chinese investment.

It is normal for investment documents to provide the existing investors with the right to participate in future rounds of investments, through preferential investment rights. Companies with Chinese, direct or indirect, investments may face challenges in further fund raising if such investors create roadblocks in further investments by refusing to waive their rights if the Government approval is not forthcoming.

Uncertainties in what constitutes beneficial Chinese ownership may further restrain FDI investments into Indian companies, as it may narrow the pool of investors available for investments. Exits for existing investors too may be affected as potentially funds/ institutional investors with Chinese investments may be hesitant to go through the Government scrutiny of their ownership. However, since the relevant FEMA notification has limited the scope of the restrictions only to FDI investments, investments under other routes of foreign investment, such as investments by foreign portfolio investors under the portfolio investment route and investments by foreign venture capital investors, may not be immediately impacted. One may have to watch out for possible action by the Securities and Exchange Board of India to regulate portfolio investment and venture capital investments by registered foreign venture capital investors in the future.

Effects under Bilateral Investment Protection Agreements

Historically, since the onset of liberalization, Indian entered into bilateral investment protection agreements (“BIPA”) with various countries to attract more investments. Many of these agreements since then have been terminated. Amongst the countries that India shares its borders with, India has historically entered into BIPAs with China, Bangladesh, Nepal, and Sri Lanka, Myanmar. Of these, BIPA with Bangladesh alone is still [SAS1] in force, the remaining BIPAs have been terminated. It is also important to examine the scope of such agreements with countries other than the bordering neighbours, as many investments are routed indirectly through holding companies situated at tax favoring jurisdiction. Amongst other major investment destinations to India, India has had BIPA with Netherlands (terminated on September 22, 2016), Mauritius (terminated on March 22, 2017), and Cyprus (terminated on March 22, 2017). Comprehensive Economic Cooperation Agreement between India and Singapore contains provisions ordinarily contained in BIPA for investment protection.

Most BIPAs continue to apply even after termination in respect of investments made or acquired before the date of termination of the agreement. For example, Clause 16(2) of the India China BIPA, makes it applicable for a period of 15 years from the date of its termination, while Cyprus and Mauritius limit it to 10 years after termination[2].

BIPAs normally contain provisions on ‘National Treatment’ and ‘Most Favoured Nation Treatment’. These provisions, amongst others, provide that the treatment accorded to the foreign investments and foreign investors should not be inferior to the treatment given to the domestic investors or foreign investors from any other country. There is some legal basis to suggest that Most Favoured Nation obligations under BIPAs apply only to existing investments, and not to pre-investment measures. In fact, the Joint Interpretative Statement executed between India and Bangladesh, clearly acknowledges in the definition of investment that the BIPA does not apply to pre-establishment or pre-investment activities. Therefore, India may be able to avoid consequences under the BIPAs, in so far as PN 3 and Amending Rules apply as restrictions to future investments and not to existing investments. However, to the extent that PN 3 and Amending Rules limit the ability to invest of those investors who have existing contractual rights pursuant to their existing investments, a case for breach of BIPA may still be maintainable. In the context of expired or terminated BIPAs, it may need to be seen if the investor possessed contractual rights to make future investments or purchase shares prior to the termination of the relevant BIPA. For an analysis of India-China, BIPA, you may refer to this post.

Conclusion

The Government may have had the best intentions in protecting Indian businesses from an opportunistic takeover, but it could have avoided selective targeting of Chinese investments. Many other countries which have taken similar steps have avoided selective targeting of countries. Unlike hot money in stock markets, FDI needs to seen through a different glass. A sweeping restriction on Chinese investments, which is a major source of funds, is likely to create panic. Many companies facing distress due to Covid-19 which genuinely need equity funding could be starved off this source, thereby impacting economic recovery of such units. Many greenfield projects and under development projects which have commitments from Chinese investors would also face unnecessary hardships and delays, as they may have to go through bureaucratic hurdles to fund those commitments. In the process, many such commitments may fall through, creating adverse economic consequences. Clarity is also required on what constitutes beneficial Chinese ownership. Till such time that the ambiguity prevails, innocuous investments may fall foul of the beneficial ownership restrictions because a Chinese entity indirectly owned some interests in the investor.

[1] The official position of India is ‘Taiwan’ is not an independent country and is a part of the mainland China.

[2] The India-Mauritus BIPA extends the period beyond 10 years if a longer period has been provided for or agreed in the relevant contract or approval granted to the investor.