• Dev Agrawal

Press Note 3 (2020): Deconstructing Foreign Investment By Bordering Countries

[Dev is a student at Jindal Global Law School, Sonipat.]

The private equity (PE) industry has contributed to nation building through investments that have helped Indian businesses to become better, both in size as well as in quality. 2021 was been one of the best years for the PE and venture capital (VC) industry with a post-pandemic overhaul in of investments worth $77.1 billion in India. With over 2000 deals, the value of which has tripled since 2016, there were 11 investments of more than $1 billion and alternative investment funds (AIFs) contributed $11.2 billion in investments[1]. There has been a growing trend of investments into consumer tech and alternative formats of commerce such as video commerce, direct to consumer brand aggregators and short-form videos. There has been an increasing shift towards ‘control’ deals by the PE/VC industry – with PE/VC funds showing growing enthusiasm for the growth of Indian assets by being part of key-decision making to foster profitability.

As of May 2022, more than $24 billion in PE/VC investments were seen across 630 deals. There has been a lot of early-stage deals, in total crossing $500 million in NFT marketplaces, and areas associated with cryptocurrency trading platforms. An emerging trend across 2021 was several employee stock option (ESOP) liquidity events with more than 30 start-up companies announcing ESOP buyback schemes, which has been encouraging for the Indian workforce. Notably, PE/VC investors have placed a prime focus on environmental, social and governance (ESG) criteria in their investment strategies and are viewing ESG practices as essential elements of value creation and as a key theme to drive value across the full investing value chain. PE/VC funds are increasingly adopting ESG-related goals by embedding such practices through the investment lifecycle.

Press Note 3 of 2020: Concerns and Way Forward

Press Note 3 of 2020 dated 17 April 2020 (PN 3) provides that “an entity of a country, which shares a land boundary with India or the beneficial owner of an investment into India who is situated in or is a citizen of any such country, can only invest under the government route”.

Defining 'Beneficial Ownership'

At the current juncture, the expression 'beneficial ownership' has not been clearly defined. The lack of a clear definition has created uncertainty for investors as the phrase 'beneficial ownership' is understood in differing ways across India’s present regulatory landscape. Under the Reserve Bank of India’s KYC directions, as well as the Prevention of Money Laundering (Maintenance of Records) Rules 2005, 'beneficial ownership' has been pegged to a threshold of 25%. Similarly, under the Ministry of Finance’s General Financial Rules (GFRs) in relation to restrictions concerning public procurement from land-bordering countries, 'beneficial ownership' is defined as “ownership of, or entitlement to, more than twenty five percent of shares or capital or profits of the company”.

On the other hand, the Department for Promotion of Industry and Internal Trade (DPIIT)’s Standard Operating Procedure in relation to the filing and examination of FDI approval applications refers to the threshold set under the Companies Act 2013, which in turn prescribes a threshold of 10% for the determination of significant beneficial ownership. A fixed threshold for determination of 'beneficial ownership' would greatly benefit investors and clear the current anomaly, where divergent positions are taken by different agencies. This is especially important in the context of PE/VC players, which are essentially vehicles to pool investment from various small investors (i.e., LPs) who do not have any ability to control or direct the operations of the PE fund.

Going forward, as long as beneficial ownership of such PE/VC funds held by investors in land-bordering countries is below 25%, a framework may be considered where investments by such PE/VC funds are allowed under the automatic route, basis a declaration from the fund that its GP/ Manager is not in a land-bordering country and that the control of the fund is not held by an investor in a land-bordering country. In fact, this approach would also be in line with the ownership-control test under the present guidelines governing foreign direct investment.

Pendency of Applications and Delays in Approval Process

We understand through media reports from June 2022, basis an RTI application, that only 80 out of 382 proposals submitted by investors from land-bordering countries have received government approval, and investments worth billions of dollars remain stick in the pipeline. Currently, the approval process under PN 3 entails long delays on account of applications being considered and evaluated on a case-by-case basis. To promote ease of doing business, the regulatory framework should stipulate a clearly defined process which could be under the aegis of the DPIIT, and set out an expedited timeframe for processing of approval applications for PN 3 in the same manner as is provided for other approval applications.

To further simplify the process, specific parameters should be provided for the evaluation of applications. For instance, the applicant’s past investment profile, the nationality and credibility of the directors, sensitivity of the specific sector into which investment is being made and whether the applicant is proposing to enter into ‘control deals’ could be considered while assessing proposals from a PN 3 standpoint. It is also observed that different ministries of the government have adopted different approaches in respect to approval applications. In order to ensure that no specific sectors are unfairly impacted on account of such different approaches, it would be beneficial for the DPIIT to spearhead the process of alignment and coordination among the Ministries and officials to further streamline the approval process.

Implications of PN 3 on Downstream Investment

Currently, the applicability of PN 3 in respect of downstream investment by foreign owned and controlled companies (FOCCs) is unclear, and the government has not provided guidance on the relevant threshold to be considered for requirement of approval for downstream investment. Notably, at present, portfolio companies (whether FOOC or Indian owned and controlled) that may have minority investments from investors in land-bordering countries are required to seek approval for downstream investment under PN 3, due to lack of regulatory clarity. In order to encourage investment and facilitate ease of doing business, the government should consider an approach: where approval under PN 3 should not be required in cases where aggregate beneficial ownership held by investors in land-bordering countries is within the permissible threshold of 25%, unless the investor from a land-bordering country has actual control.

Additionally, in cases where investment has been received by an Indian entity pursuant to a PN 3 approval from the government, downstream investment in other Indian investee companies, under the automatic route, should not be subject to a fresh PN 3 approval requirement. Given that fund infusion in India have been made a requirement for a fresh approval is an unnecessary hardship for investors. As such downstream investment, after scrutiny of the investor’s profile by the government and after receipt of government approval, it would not entail any fresh infusion of funds into India by investors in land-bordering countries – the requirement of a further PN 3 approval should be done away with at the stage of such entities making further downstream investment in other Indian entities.

Foreign Portfolio Investment (FPI) in Listed Companies

Basis detailed consideration, the policy pronouncements were made by the government wherein it was announced that investment by a non-resident in a listed company for a stake below 10% shall be regarded as a foreign portfolio investment (FPI). However, when the entire gamut of exchange control regulations and FDI policy are viewed in depth, it is clear that the enabling framework in relation to the FPI route, as set out under the Foreign Portfolio Management (Non-debt Instruments) Rules 2019 (NDI Rules) is only prescribed for foreign portfolio investors that are registered with SEBI, and not for non-residents in general who hold less than 10% in a listed entity. Consequently, even investors (who are not registered as foreign portfolio investors with SEBI) with sub 10% investments are required to ensure compliance with the various FDI related norms and sectoral conditionalities.

In order to give full effect to the government’s vision in relation to the liberalisation of this policy, the scope of the enabling framework under NDI Rules should be enlarged to cover non-residents in general (i.e., investors who are not SEBI registered foreign portfolio investors) so that they can invest via the FPI route. Thus, given that such non-residents would have their demat account in India, their KYC would already have been undertaken. This approach would go a long way in fostering investment in listed companies as non-residents would be able to make investment without the requirement to comply with sectoral caps and conditionalities that are provided under the FDI policy in so far as passive investments (sub 10%) are concerned.

[1] Sources: India Private Equity Report 2022, Bain & Company, 16 June 2022; India Venture Capital Report 2022, Bain & Company, 30 March 2022; IVCA-EY; PE/VC Agenda- India Trend Book 2022, March 2022.


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