[Ayush Mehta and Navya Bhandari are students at National Law University, Jodhpur.]
Recently, Donald Trump was heard accusing China of “spreading” the Novel Coronavirus (COVID-19). Of late, there are sources which show that China initially hid information about the virus, which arguably strengthen the claim that it is a Chinese virus. COVID-19 has changed all dimensions of business, making it all the more uncertain. With crashing markets, stagnant growth and job layoffs, the global economy is hard hit. Among such business uncertainties, it seems that China has emerged as the winner. The strength of this statement lies in the fact that while nations all over the world are at an all-time low, the Chinese economy has started to recover to an extent that 96.6% of China’s large and medium sized firms have resumed operations.
In such a scenario, the Department for Promotion of Industry and Internal Trade, Ministry of Commerce and Industry, Government of India, with a view to curbing “opportunistic takeovers/acquisitions of Indian companies due to the current COVID-19 pandemic,” took a strong step and recently amended paragraph 3.1.1 of the Consolidated FDI Policy 2017. This article analyzes the said change in the law and its repercussions thereof.
What strained the government to take this step?
On 12 April 2020, the Chinese Central Bank increased its stake in HDFC bank by 1%. This led to widespread uproar among Indian investors and public, and the Indian government was driven to the realization that Chinese firms may take advantage of India’s fragile economic condition and undertake similar actions. Taking hands on approach, the government, forced by the fears of hostile takeovers, decided to change the existing norms related to foreign direct investments to protect investor interest.
Since a lot of sectors in India are open to 100% foreign investment, it compelled the government to act preemptively. Though the change has been made for investments from all land neighbours of India, it mainly hints at hijacks by Chinese firms.
Changes in the legal position regarding FDI norms
Through a Press Note, the government introduced strategic changes in the FDI policy to curb takeovers and acquisitions of Indian companies in view of the falling stock prices on account of the COVID-19 pandemic. Do note that this amendment in norms is yet to be confirmed by the Reserve Bank of India (RBI) under the Foreign Exchange Management Non-Debt Instruments Rules 2019 which govern foreign investments in India. It is pertinent to note that under the rules, only RBI has been vested with the power to make regulations. Therefore, because the aforesaid notification was given out by the Ministry of Commerce, its confirmation by the RBI is pertinent.
FDI policy in India
As per the FDI policy in India, foreign investments can be done via two routes:
Automatic route - Under the automatic route, the threshold for investments has been capped as per different sectors and it can be done without prior government approval.
Government route - Under the government route for foreign investment, governmental approval is required.
Non-resident entities can invest in India subject to the FDI policy, except in those sectors/activities which are prohibited. However, a citizen of Bangladesh or an entity incorporated in Bangladesh can invest only under the Government route. Similar restrictions are also placed on Pakistani entities and individuals.
The revised policy is designed taking cue from other European nations like France, Italy and the United Kingdom. Under the revised policy, the government has narrowed the scope of investment by placing it under strict governmental scrutiny in order to protect Indian interests.
Under Para 3.1.1 (a), “A non-resident entity can invest in India, subject to the FDI Policy, except in those sectors which are prohibited.” The change in the policy now brings investment from all those countries which share land borders with India or where the beneficial owner of an investment is situated in any such country or is a resident, under the government route. Government approval is required not just for the future investments but also for the transfer of ownership of existing FDIs.
Paragraph 3.1.1 (b) reads, “In event of transfer of ownership of any existing or future FDI in an entity in India, directly or indirectly, which results in beneficial ownership falling within the restriction of clause (a), such subsequent change shall also require prior government approval." The use of the word ‘or’ between ‘directly’ and ‘indirectly’ in the norm makes the amendment inclusive and covers all modes through which any investment may be made.
While this decision will help India monitor hostile and opportunistic takeover of Indian companies, the fear of such takeovers is not just from neighbouring countries but from the world at large. The change in policy, which is narrowly focused on China, still leaves room for such actions from other parts of the world, though they are highly unlikely.
Analysing the amendment - is it foolproof?
It is pertinent that the above changes have been made to the FDI regime and not to the Foreign Portfolio Investment (FPI) regime. Interestingly, the recent HDFC bank stake increase was made through the FPI route.
In October 2019, the Securities and Exchange Board of India had reclassified FDI and FPI with a view to widening the scope of the regulation. The new rules state that any investment below 10% stake through any route will be classified as FPI. This means that even direct investments below 10% stake will be classified as FPI, thus escaping the change in paragraph 3.1.1, which is only for FDI.
Moreover, there are certain aspects in which the norms are unsettled. The norms do not define what “beneficial ownership” means. Neither is the term defined in the FEMA or the Companies Act, 2013. Adding on, the regulation does not list the countries in particular. This leads to ambiguity regarding the fact that, whether investments from Hong-Kong will be treated differently or same as the investments from mainland China. Foreign Exchange Management (Establishment in India of a branch office or a liaison office or a project office or any other place of business) Regulations, 2016 treat the two differently.
After the dissolution of the Foreign Investment Promotion Board, it is also unclear as to who will be responsible for granting the required permission for foreign investments.
Impact of the amendment on the economy
These pre-emptive changes have been made to take care of round - tripping of investment. However, there will be other significant impacts of the decision, especially on startups.
While the move to prevent China from taking advantage of the economic predicament is welcome, it may have far-reaching implications on Indian startups for which Chinese investment has been paramount. Chinese investment is the stimulus for the impressive growth of Indian startups, and of late, Chinese venture capital funds and giants like Alibaba and Tencent have ramped up their investment in this sector to an extent that without their investment the future of Indian startups looks bleak. Currently at least 18/23 Indian unicorns (such as Paytm, Snapdeal, OYO and OLA) are backed by Chinese investors.
The notification can be an impediment to growth. The new policy would force companies who depend on investments from China, to find new investors in this time when there would be none. The flow of capital from Europe and the US would also dry up due to their own economies heading towards a recession. The change in policy will not only affect the growth-stage startups but also unicorns who depend on such investment to keep the cash flowing.
While we agree that some measures are necessary to prevent China from taking advantage of India in the deteriorating economic conditions, a sectoral implementation of the policy would have been better. Given the plight of the start-up industry in India in COVID-19 times, a liberal approach for this sector of the economy would have been more beneficial.
The restriction on investments will also impact the Make in India plan, as it had been luring Chinese manufacturers to set their units in the country and reducing imports to reduce the balance of trade deficit. However, as there are no exemptions mandated by the government in this regulation, it could very well dampen such initiatives.
China and WTO - the new conundrum
A Chinese spokesperson claimed that the barriers India has set would violate WTO’s principles of non-discrimination and are in contravention with the general trend of liberalization and facilitation of trade and investment.
However, China’s claims can be refuted by the fact that there is no denial of permission to invest; rather it is a change in the approval process. The policy does not result in any restriction of Chinese investment and hence cannot be considered as an impediment to facilitation of trade.
Way ahead - suggestions and concluding remarks
It is the government’s duty to take every possible step to protect the interest of Indian companies. While the prompt actions of the Indian government are appreciated, it is expected that another notification by the government clears the ambiguity in relation to the list of countries, who a beneficial owner is and which is the relevant authority for granting permissions.
Another aspect that has to be taken care of is the booming startup industry in India, which is heavily dependent on Chinese firms for funding. In the already collapsing economy, smaller startups who are not financially strong need more capital injection to stay afloat. Whilst altering rules for FDI and FPI, the government should lay a clear roadmap and provide some relief or alternate measures.
The government should also consider excluding sectors which have prospects of creating a huge number of jobs and companies with existing 100% Chinese ownership. An exemption of investments by ‘pooled companies,’ in which Chinese companies do not have controlling capacities, would also be beneficial.
India being an attractive investment destination for Chinese investors, is vulnerable to hostile takeovers at this point. Therefore, although this decision hinders all such investments, it surely will go a long way to protect hostile takeovers. In toto, the regulation is a welcome move.