Recently, news broke that China’s central bank, the People’s Bank of China (“PBoC”) increased its shareholding in India’s largest housing finance company– Housing Development Finance Corporation Limited (“HDFC”). The PBoC increased its shareholding from 0.8% in March 2019 to 1.01% in April 2020, on account of the deep dive in HDFC’s share prices in the past few months, due to Covid-19. The shares were purchased on behalf of China’s sovereign wealth fund– SAFE, one of many sovereign wealth funds that are used to invest in Indian companies.
Wary of the increase in foreign investments in Indian companies, particularly now, when valuations are at an all-time low owing to the pandemic, the Central Government, on April 18, 2020 introduced Press Note 3 (“PN 3”) amending the Consolidated FDI Policy 2017 (“FDI Policy”). As stated in the subject of PN 3, this amendment seeks to review the FDI Policy in order to curb opportunistic takeovers /acquisitions of Indian companies due to the COVID-19 pandemic.
In this note (“Note”) we talk about the relevant provision as it stood pre-amendment, the changes introduced by PN 3, and we delve into the consequent impact of these changes on Indian companies, particularly startups.
Pre-Amendment
As per Para 3.1.1 of the FDI Policy, a non-resident entity can invest in India, subject to other provisions of the FDI Policy, except in prohibited sectors (specified in Para 5.1 of the FDI Policy). However, it carves out exceptions in case of investments by citizens or entities (incorporated) in Bangladesh and Pakistan, on account of the history shared by India with these countries.
Exceptions
a. Citizens and entities (incorporated) in Bangladesh and Pakistan can only invest in India through the Government route under the FDI Policy, i.e., with prior government approval; and
b. Citizens and entities (incorporated) in Pakistan cannot invest in the following sectors, even with prior government approval – defence, space, atomic energy, other sectors prohibited for foreign investment (as specified in the FDI Policy).
Post-Amendment
PN 3 has retained the restriction specific to investments by citizens and entities of Pakistan (read above). However, it has introduced a requirement for prior government approval for investment by the following entities:
a. An entity of a country, which (i) shares a land border with India or, (ii) where the beneficial owner of an investment into India is situated in or is a citizen of any such country; and
b. Where subsequent changes in beneficial ownership, by way of direct or indirect transfers of any existing or future foreign direct investment (“FDI”) would result in such beneficial ownership falling within the purview of the first restriction.
When does PN 3 come into effect?
These changes will come into effect when notified in the form of an amendment to the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (“FEMA Notification”).
Analysis of the Press Note
1) Impact on new and follow-on investments into start-ups:
Once notified, PN 3 is likely to have far-reaching effects on companies of all sizes. Firstly, PN 3 extends the restrictions to investments from all countries that “share land borders with India”, i.e. Pakistan, Afghanistan, Nepal, Myanmar, China and Bhutan. While China is not specifically named in PN 3,
the policy will inevitably strike hardest at Chinese investing arms, given its apparently aggressive business interests and acquisition strategies in Indian companies. Capital-strapped entities looking forward to raising funds from Chinese investors will now have to factor in prolonged time windows to close such transactions, to account for the approval process, which is uncertain in addition to being time-consuming.
Secondly, PN3 appears to impact follow-on investments also, as it does not differentiate between new investments and follow-on rounds of investment by existing investors. A majority of Indian unicorn start-ups are currently backed by Chinese institutional investors as well. This list includes Oyo Rooms, Ola, PayTM, SnapDeal, Zomato and Swiggy, to name a few. Follow on investment rounds into such companies , will also require the prior approval of the Government, even though they were not required to seek such approval when they first invested in the start-up.
2) Broad scope of ‘beneficial ownership’
PN 3 also mandates that Government approval will be required for any transfer of ownership that results in the ‘beneficial ownership’ being situated in a country which shares a land border with India. The term ‘beneficial ownership’ is not defined under PN 3, or under the FDI Policy. Hence, it is unclear if this refers to immediate beneficial ownership of the shares of the Indian company, or ultimate beneficial ownership, which needs to be traced over several layers of holding companies, etc.
The Companies (Significant Beneficial Owner) Rules, 2018 (“SBO Rules”) define a ‘significant beneficial owner’ with respect to a company, as an individual acting alone or together, or through one or more persons or trust, possessing any one or more of the following rights or entitlements in such company:
(i) Holding not less than 10% of shares directly or indirectly;
(ii) Holding not less than 10% of voting rights, directly or indirectly;
(iii) Has the right to receive or participate in not less than 10% of the total
distributable dividend, or any other distribution, in any financial year;
and
(iv) Has the right, or actually exercises, significant influence or control, in any manner other than through direct shareholding.
It remains to be seen whether the FEMA Notification giving effect to PN 3 contains similar definitional clarity.
Further, PN 3 does not specify a shareholding threshold or control test to determine who a beneficial owner is. This may cover in its scope any transaction which results in an indirect ownership by a resident or citizen of a country that shares a land border with India, even to the extent of one share or a small
percentage of shares. This would include:
(i) FDI by an entity with an individual shareholder resident in China;
(ii) Investment transaction between two Indian entities, where one entity has Chinese investors, such as Ola;
(iii) Change in the capital structure of a holding company of an investor, such that a minor percentage of beneficial ownership is situated in China; and
(iv) Indirect acquisition of shares in an Indian company by a strategic investor, with Chinese shareholders, taking over global operations of a conglomerate.
Thus, there are multiple transactions where beneficial ownership may be situated in the countries covered by PN 3. Identification of such ownership may require a high level of data collection, of all shareholders of any party involved in a potential offshore transaction.
3) International Shift to Protectionism:
PN 3 comes close on the heels of the PBoC increasing its stake in HDFC – this may or may not be a coincidence. Since the outbreak of the COVID-19 pandemic and the corresponding lockdown that has ensued, the global economy has faced a slowdown and companies around the world have faced disruption in their operations, leading to a steep downfall in valuations, and thus offering huge opportunities for investors to pick up significant stakes at throwaway valuations.
Nationalism manifests itself in protectionist measures, and is not new. In the recent past, leading governments have taken steps to ensure that companies within their jurisdictions do not fall prey to hostile takeovers or lose controlling interest to foreign entities, particularly in sensitive or strategic sectors. Some examples are:
- Last week, in the wake of the Covid-19 pandemic, the European Union’s Competition Commission suggested that its member countries consider taking stakes in domestic companies to avoid the threat of hostile takeovers, specifically by China.
- Similar to the approval route in India’s FDI Policy, the UK updated its foreign investment laws in 2018 to allow for government scrutiny in acquisitions into specific sectors such as defence, computing hardware and quantum technology.
- The US actively screens takeovers by foreign entities on the grounds of national security. In a noteworthy decision in 2019, the Committee on Foreign Investment in the United States (CFIUS) cited national security concerns and mandated that a Chinese mobile gaming company reverse its acquisition in the dating app Grindr.
- In light of the above, the PN 3 is the latest and arguably one of the broadest in a growing line of protectionist measures to combat opportunistic takeovers.
Our Take
The measures detailed in the Press Note are crucial in ensuring that India’s strategic interests are preserved during this economic downturn. However, it is a double edged sword, as measures such as this will inevitably cut off liquidity channels for investment-starved companies who have a dire need for investment to even survive the current crisis. To offset this negative impact, the Government may want to consider offering business aid packages to struggling companies, either directly, through subsidies on wages or service payments, or indirectly, through temporary relaxation of statutory requirements.
PN 3 shall come into effect from the date of its FEMA Notification. Until such time, Indian companies which have fundraising options in the pipeline may consider expediting closure of such transactions at the earliest. Going forward, companies must be diligent in identifying the beneficial owners of their
shareholding so that they do not fall foul of PN 3 and the broader FDI regime. To avoid uncertainty for companies, and to ensure effective compliance, it is crucial that the FEMA Notification giving effect to PN 3 defines the scope of ‘beneficial ownership’ clearly and to prescribe a threshold of such restricted beneficial ownership.
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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.