2019 Year in Review: Key developments that impacted startups

#1 How the FDI Policy changed the landscape for e-commerce platforms


India has the 3rd largest startup ecosystem in the world as well as the 3rd highest number of unicorns. In 2019, 7 companies have reached the esteemed unicorn status and 50 more were added to the soon-to-be unicorn list. During this time, the Government of India has introduced various legal and policy measures, which have had an impact on how startups operate. In the first of my posts on ‘Key developments that impacted startups in 2019’, I discuss the provisions of Press Note 2 of 2018 (which was issued by the Ministry of Commerce and Industry on December 26 last year) (“Press Note”) and which subsequently percolated into new rules formulated by the Reserve Bank of India i.e. the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (“NDI Rules”), as amended by the Foreign Exchange Management (Non-debt Instruments) (Amendment) Rules, 2019 (“Amendment Rules”), with specific focus on e-commerce entities.

The NDI Rules lay down guidelines, to be complied with by e-commerce marketplace entities (“Platforms”) once they have accepted foreign direct investment. Below is a discussion on the specific guidelines and how they have had an impact on these e-commerce entities.

a. Control over inventory:
In the marketplace model of e-commerce platforms, Platforms are not permitted to exercise ownership over the goods to be sold on their platforms. Doing so would render the same an inventory-based model, which would mean that they are not permitted to have foreign direct investment (“FDI”). If more than 25% of the goods/services of a particular vendor are purchased from the Platform or its group companies, it will be deemed to be an exercise of control over inventory by the Platform, rendering it an inventory-based model.

What is a marketplace model of e-commerce?
It is a model where an e-commerce entity provides a platform to act as a facilitator between buyers and sellers (Business to Business/B2B).

What is an inventory-based model of e-commerce?
It is a model, where the inventory of goods and services is owned by an e-commerce entity and is sold to consumers directly (Business to Consumer/B2C).

This restriction will impact Platforms such as Amazon, which while publicly have stated that they are marketplaces, but have been accused of functioning on an inventory-based model. While a majority of Platforms claim to be mere facilitators (and hence will be considered as a marketplace under the NDI Rules), in practice, many vendors selling on these Platforms are either controlled/owned by the Platform or its affiliates, or these vendors source most of their inventory from the Platform or its affiliates. Under these circumstances, the Platform should be considered to be following an inventory-based model, which is not permitted to receive FDI as per the existing framework. In addition to having an impact on such Platforms, these provisions will also have a detrimental effect on vendors dependent on the Platform or its group companies for acquiring their inventory, since they will now have to find other sources to acquire their inventory, which is a potentially burdensome and expensive task.

b. Equity stake in vendors:
If a Platform has an equity stake in a vendor/seller, or if it exercises control over its inventory, the vendor will not be permitted to sell its products on the Platform.

Neither the Press Note nor the NDI Rules as amended, specify whether equity participation in a vendor is required to be direct or indirect, to attract this restriction. In the absence of such a clarification, subsidiaries of a ‘Indian owned and controlled company’ where this parent company has a minority equity participation from a Platform or its group companies, can act as vendors on this Platform, potentially defeating the purpose of these provisions.

Platforms like Amazon that have forayed into the retail sector by launching their own private labels, such as Amazon Basics by Amazon, heavily lobbied against these changes, which led the erstwhile Department of Industrial Policy & Promotion (“DIPP”) (now renamed as the Department of Industrial Policy & Promotion (“DPIIT”)) to notify a clarification in this regard. On whether the Press Note prohibits the sale of private label products by e-commerce entities, the DIPP clarified that “this policy did not impose any restriction with respect to the nature of products which could be sold on the marketplace”. This contradictory clarification has given rise to a regulatory grey area as to whether or not it is safe for Platforms to continue to sell products through sellers in which they have an equity participation. In addition to launching their own labels, multiple Platforms have also entered into exclusive sale arrangements with various companies, like Amazon’s partnership with OnePlus to exclusively sell their smartphones. With the laying down of further restrictions against imposing exclusivity conditions by Platforms on vendors, this may also become an issue. This has been further discussed below.

c. Warranties:
Any warranty and/or guarantee for the goods and services sold on the Platform will be the responsibility of such seller/vendor, and the Platform will not have any role to play here.

d. Control over prices:
The Platform should not influence prices directly or indirectly and should offer a level-playing field to all vendors/players selling goods on the Platform.

e. Services on Arm’s length basis:
Ancillary services provided by the Platform or by entities in which the Platform has direct or indirect equity participation, to vendors or sellers should be on an arm’s length basis and in a fair and non-discriminatory manner. Provision of such services to any vendor on terms not applicable to other vendors in “similar circumstances” would be considered to be unfair and discriminatory.

However, the use of the term “similar circumstances” without specifying what would constitute such similar circumstances is problematic when it comes to compliance with such an obligation. Neither the Press Note nor the NDI Rules as amended shed any light on this. In the absence of a clarification by the DPIIT to this effect, compliance or non-compliance with the same cannot really be determined, which defeats the purpose of having a requirement of maintaining an auditor’s report to ensure compliance (discussed below).

What kinds of ancillary services can be offered by e-commerce platforms to their vendors?
Typically, Platforms provide services such as order fulfillment services, logistics related services, warehousing facilities, payment processing facilities and marketing facilities.

f. Exclusive dealing contracts:
Typically, an exclusive dealing contract is an undertaking between a producer and a dealer, where the dealer agrees to only make purchases from the producer and is prohibited from dealing with makers of competing products. The NDI Rules here specifically state that Platforms should not lay down any exclusivity restrictions mandating that any seller should only sell their products/services on that particular Platform.

However, the DPIIT’s failure to provide any guidance on how to identify such restrictions is problematic. Whether only affirmative contractual impositions of exclusivity attract this restriction, is a question remaining to be answered. Another question that this poses is whether a consensual arrangement between willing parties to exclusively sell certain products would indeed attract such a restriction. The use of the term ‘imposition’ could be construed to indicate a sense of compulsion, and the lack of clarity here is another gaping hole in the framework.

g. Compliance Report:
The Amendment Rules have now marked the calendar for Platforms, and September 30th of every financial year (“Deadline) is now a definite statutory deadline that all Platforms will be required to adhere to. All e-commerce marketplace entities having FDI shall be required to obtain and maintain a report by a statutory auditor by the Deadline, for the preceding financial year stating that they have complied with the e-commerce guidelines (“Compliance Report”) described above. This requirement had been introduced by the Press Note earlier, and has merely been reiterated in the Amendment Rules, possibly with the object to consolidate the compliances applicable to entities receiving FDI.
The auditor’s job will definitely be complicated by the vagueness of the provisions above, particularly in identifying whether the Platforms are truly providing services to their sellers on a non-discriminatory basis. Relying on an auditor to determine issues having legal import such as whether services are being provided by the Platform on an arm’s length basis, has been touted to be a gaping flaw in the existing framework. Though the Compliance Report requirement has been intended to bring greater transparency in the functioning of Platforms, it may not be sufficient to fulfill the intended goal.

Our Views
There has been a growing concern amid small business owners that the discounting practices of Platforms, have resulted in making ‘domestic’ brick and mortar businesses a less favorable option. Offering deep discounts is not a viable option for such domestic businesses that function without FDI, making them lose out in the race against the Platforms. The concept of deep discounts became common soon after e-commerce companies like Amazon forayed into India, when they opted for deep discounting to attract consumers to the new alternative – ‘online shopping’. Consumers benefitted from these practices, while the Platforms continued to spend investor funds to sustain the deep discounting model, leading to deep e-commerce penetration in India. This helped Platforms such as Flipkart and Amazon to carve a niche for themselves in the market. However, this also led to offline retailers and other e-commerce platforms, who were not as heavily funded as Flipkart and Amazon, being adversely affected by such deep discounting practices.

In an attempt to prevent domestic businesses from suffering due to these Platforms, the Press Note was introduced. Taking into consideration the government’s goal of facilitating ease of doing business in India, and the substantial burden imposed by the Press Note, it was made applicable only to FDI received by entities after February 01, 2019.

Platforms such as Amazon and Flipkart that have been employing deep discounting and exclusive partnerships as a means to attract and maintain their customer base have been greatly hit by the introduction of the Press Note and now the Amendment Rules. In spite of repeated requests by Platforms to postpone the deadline for the Compliance Report, the government has proceeded with its game plan to keep the Platforms in check.

These provisions will definitely increase the burden of acquiring foreign investment for startups in this business, as they will have to face these restrictions if they want to be able to compete with domestic behemoths like Reliance who are not reliant on FDI. On the other hand, well-established entities whose entire business model is structured on these exclusive partnerships and in-house labels will require a complete overhaul to ensure compliance with the NDI Rules, which will substantially increase the capital burden. In the case of Amazon, this may also entail divesting from the seller entities Cloudtail and Appario. Further, sellers who had exclusive arrangements with these Platforms may have to exit from such arrangements and sell their products on multiple platforms to refrain from violating these rules. However, this depends on the manner in which the DPIIT goes on to interpret this provision of the Press Note. Just as there exists a contradiction in the manner in which the restriction against private label products (discussed above) has been viewed by the DIPP, there could be a similar situation in this case.
On the other end of the spectrum are traditional brick and mortar businesses who will greatly benefit from this increased burden on their competitors who had attracted customers with various cashback offers and discounts. These rules will maintain a check on the discounts and cashbacks that Platforms tend to offer by restricting the Platform’s control over them. This will provide the brick and mortar businesses with an opportunity to catch up and win back their customers.

As far as the Compliance Report is concerned, we are yet to see how effective a mandated filing of the same is going to be, in ensuring that e-commerce marketplaces actually comply with these guidelines. Though the government’s efforts to consolidate the applicable compliances are appreciated and may well make things easier for those seeking to comply, it is yet to notify the actual filing and form requirements for the Compliance Report.

This situation has highlighted the need for a regulatory body to supervise these e-commerce entities and to ensure that they are compliant with the rules. The Draft E-Commerce Policy that is in the pipework will lay down how these e-commerce entities should operate, and only if there is some progress on that front will there be some clarity in the situation at hand. If these rules are implemented in their entirety, 2019 will go down as a year in which the Government of India has made significant strides in compelling the e-commerce big shots to fall in line and put an end to their allegedly anti-competitive practices.

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Disclaimer: This post has been prepared for informational purposes only. The information/or observations contained in this post does not constitute legal advice and should not be acted upon in any specific situation without seeking proper legal advice from a practicing attorney.


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