FDI To JV: Long Winding Road!
After 8 years of waiting, we had a one week blitz. From proposal to notification in 5 days...that's a record of sorts for any FDI policy liberalization in India. So the doors are now wide open for foreign direct investment in multi-brand retail, aviation, some aspects of broadcasting and power exchanges.
But its not yet time to pop the champagne – because FDI policy may have opened up but the doors to operationalising joint ventures with foreign partners are still jammed. Lawyers tell me the supporting legal framework is beset with ambiguities and JV negotiations go on for months. Two such lawyers are here with me today – Bharat Vasani of the Tata Group and Ashwath Rau of Amarchand Mangaldas- to tell you why from FDI to JV is a long winding road!
Doshi: Why is it that JV negotiations have become tougher? Is it simply because business has become so complex?
Vasani: I would say my first JV in my career I negotiated in 1987 and today when I am negotiating something in 2012, the complexities have increased many fold and the deals which we used to complete in 2-3 months takes several months, almost 3-4 times the time they originally took and many times the negotiation of JV goes on for years and eventually the JV may not last even that longer.
Rau: I think it is not a question of the rules having become very complex; I think the rules haven’t kept pace with the pace at which business has moved. As a result of which you have a set of rules which don’t necessarily take into account how business is done globally today and a variety of things and we can talk about them which actually are common place in any joint venture anywhere in the world. The sanctity of enforcement of your underlying legal agreement knowing that if you have committed to something you can call up on the party who is committed to it to perform- things like pricing adjustments etc which are bona fide commercial transactions, giving affect to them in the Indian context with the current frame work does pose a challenge, the rules really haven’t changed. It is the manner in which those rules are being interpreted and applied which is creating uncertainty.
Doshi: I know that the two of you have identified for me a list of issues that you believe are key to burdening JV negotiations so I want to start with what you would rate or what you would list as the biggest hurdle when it comes to JV negotiations and then we’ll go down that list one by one.
Vasani: I will answer it in slightly different way. When you negotiate a JV, when you are about to sign a JV agreement, in-house lawyers like me are called upon to explain and justify on a written opinion that the provisions of the JV agreement are completely enforceable and I have to prepare my written opinion. Sometimes an external opinion is also taken and the first thing which we do is that the agreement is in accordance with Indian law, its enforceable but as far as share transfer restrictions are concerned we have a section 111 A which says that it may not be enforceable, there are some conflicting judgments of the high court, there is no final word from Supreme Court as of now.
Companies Act, Sec 111 A: Shares or debentures and any interest therein of a company shall be freely transferable
Messrs Holding Judgement: Bombay HC upheld validity of pre-emptive rights including ROFRs
Next Put and Call options- yes they are there but there is some ambiguity in the Securities Contract Regulation Act. There is a long awaited notification of SEBI. As of today RBI is taking different kinds of views on put options. But non-compete clauses which are very standard in JV agreement, we have Section 27 of the Indian Contract Act which had no business to be on a statute book for so long, it was drafted in 1872 on a different premise and those premises are not valid today. And yet I have to say that is not enforceable and of course now there is a Competition Act adding to the complications.
SCRA: Contracts in derivative shall be legal and valid if such contracts are traded on a recognised stock exchange
Indian Contract Act, Sec 27: Every agreement by which anyone is restrained from exercising a lawful profession, trade or business of any kind, is to that extent void
Then I say that okay when I go out of the country will I get the right price and whether I will be able to take out the money and I’ll say sorry but we have a cap in terms of the FEMA pricing guidelines for non-residents where you can't take higher than what is the DCF value. And if there is a contentious exit which is nine out of 10 cases it is, then the Indian partner would try to ensure that the DCF price is the price he would like to pay rather than what the foreigner is entitled to. But the foreigner believes that I contributed to the success of this JV so when I exit I should be able to reap the benefit of my contribution and here is an RBI FEMA pricing guideline, one size fits all. Same pricing guideline irrespective of the sector of the industry to which your JV belongs and finally says if I have a dispute with an Indian partner, can I take him to arbitration and whether that arbitration award will be enforceable in the India? I would say yes. But there is a Venture Global judgment of the Supreme Court which says that even foreign awards are challengeable in India. It is only recently just on 6th of September Supreme Court corrected that anomaly. But Supreme Court judgment is applicable prospectively for agreements signed after 6th of September and not before. So you caveat your opinion to such an extent that once I got a response from the council on the other side that 'please tell me which clauses are enforceable now?'
FEMA: Price of shares issued/transferred to person resident outside India be determined by DCF in case of unlisted companies
SC on Foreign Arbitration: Indian courts cannot intervene & grant interim relief if seat of arbitration is outside India
Doshi: So I get the issue on share transfer restrictions, I get the issue on call and put options, to some extent I get it on non-compete. These are issues that we have debated on this show. Let me come to the issue that you raised that we have not yet had an opportunity to discuss – the exit pricing problem. What is this issue, we move from CCI (Controller of Capital Issues guidelines) to DCF (Discounted Free Cashflow method) and everybody at that time thought it was a good move simply because CCI was too outdated. Also in DCF there is the flexibility when you actually do that discounted cash flow for it to be altered or for it to suit different kinds of industries.
Rau: Effectively the law as it stands today basically says that you cannot exit at higher than the DCF price. Now you are familiar with the DCF, it is ultimately at some level the valuation for business plan. The business plan has to come from the company so one of the first questions is who is in control of the company?
Doshi: The Indian partner, depending…(Interrupted)
Rau: If the Indian partner is in control of the company, effectively the starting point of the entire valuation exercise is a business plan provided by that partner. That will say what I think at some level the partner wants it to say. Look at the basic understanding here, as Mr. Vasani said, a foreigner partner comes in, contributes to the growth of the company. It is only fair that when he exits, he is able to take fair market value and walk away.
Doshi: I know but I have two issues with what both of you have raised. On one hand Mr. Vasani is saying the DCF cap does not allow the foreigner partner to get the right value that he wants. On the other hand you are telling me that the Indian promoter in contentious issues can alter the DCF value to mean whatever he wants it to mean to cheat his foreign partner. The second problem is a problem between partners; regulators and governments can't fix that if two partners cannot work within a trustworthy environment. And if the second exists that is that if a DCF valuation can be shifted or changed to suit ones requirements, then why is it that foreign partners feel helmed in by the cap that DCF has provided because at the end of the day, there isn’t any constricting list of formulae that apply saying you must calculate the DCF only in this fashion. So there is a degree of freedom and flexibility right?
Vasani: What I am saying is that the DCF is not the right valuation for every sector of the industry- that’s where I am coming from and that is where I think this would not have gone on one size fits all approach.
Doshi: So it was anticipated- DCF would not suit holding companies and that’s the problem that you face when it comes to holding companies?
Vasani: Normally it won't even suit insurance companies where the concept is of embedded value.
Doshi: Attempt to make one size fit all is what bothers you in DCF.
Vasani: And I will tell you the connected problem there with. You know now the RBI says as far as foreign partner is concerned, he can come at the DCF price or he can exit it at DCF price. When he comes, DCF is the floor; when he goes DCF is the cap. Now in this years budget they introduced a new Section 56 (2) vii (b) in the Income Tax Act which says that if an Indian partner contributes his share in the JV company, if it is at a premium and the premium is higher than the fair market value of shares worked out as per the formula to be still prescribed by the Income Tax rules, then the difference will be treated as an income in the hands of the JV company and will be taxed as income from other sources. Now the problem which I face is that the foreign partner comes with DCF, income tax department if you see the scheme of the Act which is proposed is that it would be asset base valuation, so it will be net asset based. For example, what would happen to a situation like Facebook where the entire income will be taxed away. Now if a foreign partner is compelled to come at a market related price in a running joint venture, you have a preferential issue, where foreign partner says I cannot commit lower than DCF price and Indian partner says that I cannot commit higher than income tax denominated price and so dichotomy and the entire amount is taxed in the hands of a joint venture company where the penalty is also suffered by foreign partner to the extent of his shareholding. So this kind of dichotomy in consistency can be straightaway removed if both the regulators in the tax authorities say that this is the formula of valuation of share.
Income Tax Act, Sec 56 (2) vii (b): Consideration above fair market value of shares of non-public company chargeable to tax as 'Income from other sources'
Doshi: This is to cover your pricing challenging aspect?
Rau: You yourself said that there is so much flexibility that is given in a DCF valuation.
Doshi: That is what I am told, I do not do DCF calculation.
Rau: And it is true. There was a lot of flexibility in a DCF calculation. If there is so much flexibility, what is the point in having it there when in reality there is enormous scope for…(Interrupted)
Doshi: You are talking of an ideal world where we should not have any prescribed method at all.
Rau: The overriding question here is what do we need to do to attract foreign investors and I think one of the basic principles for a foreign investor is that if he is going to come, make the investment, grow the investment, there cannot be regulatory challenges potentially that allow for an erosion of that value for reasons he cannot understand.
Doshi: We have covered I think the top four issues that Mr Vasani listed with regards to restrictions on securities, we have covered exit pricing, what else would you like to add to the list before I come to arbitration and tax?
Rau: One each on securities and exchange control. I think as far as securities is concerned, the definition of a control is big one because there is so much ambiguity, Subhkam went all the way to Supreme Court- essentially the law has not been laid down because the fact decision has in that sense been stated as having no precedent value.
Subhkam Judgment: SC allowed case to be withdrawn
Now if there is basic ambiguity in relation to whether you are in control or not, every joint venture negotiation that we have, there are concerns about what kind of right you should be taking and going one step further now in the context of what rights you can be taking to give affective and commercial understanding, there is exchange control. Now exchange control today because of the various limitations that are there consideration having to come in upfront etc, limitations on your ability to take deferred consideration, needed to go back to the regulator in the event of indemnity payments, these are all factors that ultimately impede the commercial flexibility of parties. One can certainly argue that you need those various regulations, restrictions etc, I am not trying to make the policy debate of whether we should have exchange control restrictions or not…(Interrupted)
Doshi: Yes, don’t because that is a different conversation.
Rau: I am not even getting into that but the fact that they are there effectively are limiting the ability of a foreign partner.
Vasani: If the joint venture company with the minority foreign partner were to IPO the company whether the foreign partner would be treated as a promoter for the purpose of SEBI ICDR regulations, which accompanies with it host of issues including the lock-in and including the liability issues for misstatements in the offered document. So they are uncomfortable on this issue as what is my status and that is where – also I find that we are changing the rules of the game midcourse many times and that is what irritates them the most.
Rau: I think if you look at the overall theme of FDI rules have now changed, there is major reforms that has happened, is that reform going to translate into the kind of investment that we need to…(Interrupted)
Doshi: Not going by the description both of you are laying out.
Vasani: Even some mundane issues that the joint venture agreement, the stamp paper on which it should be executed itself is an issue in the state of Maharashtra that what should be the stamp duty applicable on a joint venture agreement.
Doshi: I have two issues that I want to very quickly bring up, arbitration because we have just had a recent Supreme Court (SC) judgment that sets the record straight I think to a large extent when it comes to the non-interference of Indian courts in foreign arbitrations but you all still seem to be unhappy with the outcome of that judgment, so I want a quick response on that?
Vasani: If the foreign partner is looking forward to some kind of interim relief in the event of any dispute and as you know India works on interim relief, it is virtually…(Interrupted)
Doshi: Cannot get it under the new rules of the game.
Vasani: It is out so they have virtually thrown the baby out with the bathwater; so now what government of India needs to do is to immediately amend the Arbitration and Conciliation Act of 1996 to provide a provision for interim relief for foreign seated arbitrations also and for which the SC itself has said that we are not going to do it, it is the duty of the parliament to change the law.
Doshi: Let me come to you with tax indemnities.
Rau: Today thanks to everything that has been happening on the tax front in our country, most negotiations, I think the good news is we rush through 99 percent of all the other issues and we made tremendously fast progress but we spend the rest of the negotiation and oodles of time on the tax indemnity. The reason why that kind of time is being spent is when you are entering into the joint venture, there is no tax unless it is a secondary transfer etc, there isn’t a tax issue but people are getting stuck on what will happen ultimately when one of the parties wants to exit etc. The questions are which country are you coming from, what kind of substance are you setting up in that particular country, what is GAAR going to do to the entire proposition. If I am going to buy it and there is an exit formulation- whether it is preemption right or an option or whatever it maybe- ultimately when you as the foreign partner sell to me, how much tax should I withhold, what kind of an indemnity are you going to be giving me, what kind of certification are you going to be giving me and we have 195 certifications. We have had a case where there was 195 certifications given which was then sort of backtracked on. So firstly getting the 195 certificate itself is difficult. Effectively, post Vodafone, if you want an Indian party to make a payment to you of consideration, you either have to give them an indemnity if it is comfortable to give the indemnity, sometimes discussions go into escrow and bank guarantees or effectively allow him to withhold the entire tax and even in cases, there is one negotiation currently where that is happening, even in cases where the entire tax is being paid, we are not talking about making use of the Mauritius or the Singapore treaty where entire tax is paid simply because of the fact that there is so much concern about what the tax department will and will not do, they still are asking for uncapped, unlimited indemnities.
Income Tax Act, Sec 195: Tax must be withheld on payment made to non-resident
Vasani: One more complication which has come from the Finance Act in 2012- they have introduced a new provision now in Section 112 which deals with long-term capital gains tax, they have now said that unlisted companies and the most of the joint ventures are infact in unlisted space, the cap has been reduced to 10 percent. Now the tax rate will be 10 percent but because of the drafting lacuna that is meant for unlisted space- they have said securities has defined in SCRA which effectively means marketable securities though lawyers are not able to give opinions on whether the shares of an unlisted company will be eligible for that 10 percent tax rate.
Income Tax Act, Sec 112: 10% Long Term Capital Gains Tax payable on transfer of listed securities