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Change of Guard: FDI & ODI Transactions

Published on Sat, May 23,2015 | 12:14, Updated at Mon, May 25 at 22:19Source : CNBC-TV18 |   Watch Video :

For over a decade and more the RBI has played a key role in determining the rules of the foreign investment game. So while the Government decides on FDI limits and ownership and control thresholds, the RBI determines pricing thresholds for the entry and exit of foreign investment in Indian equity and debt. Well not any more! The Finance Act, 2015 deletes RBI’s control over FDI investements via equity. It says the Central Government may prescribe permissible classes of capital account transactions (not involving debt instruments) and the conditions that may be placed on such transactions. It’s a momentous change of guard and CNBC TV18’s Menaka Doshi discusses the implications with Ashwath Rau, Partner, Cyril Amarchand Mangaldas & Vivek Gupta, Partner – M&A, BMR.


FEMA, 1999

The Reserve Bank may, in consultation with the Central Government, specify
(a) any class or classes of capital account transactions which are permissible;


The Reserve Bank may, in consultation with the Central Government, specify

(a) any class or classes of capital account transactions, involving debt instruments, which are permissible


FINANCE ACT, 2015 adds new section in FEMA

(2A) The Central Government may, in consultation with the Reserve Bank, prescribe
(a) any class or classes of capital account transactions, not involving debt instruments, which are permissible
(b) the limit up to which foreign exchange shall be admissible for such transactions; and
(c) any conditions which may be placed on such transactions

Doshi: Section six of Foreign Exchange Management Act (FEMA) 1999 has been amended. Certain specific aspects of it have been deleted. But as yet, no government notification has come out suggesting what the new regime should be. What prevails right now?

Rau: Firstly the Finance Act has been passed as a result of which FEMA stands amended. But the Act itself in its language says that it will not become effective till the government notifies it. As far as I am aware, it has not yet been notified. But even assuming that it is notified without the government actually prescribing rules, the amendments to FEMA itself in section 47(3) very clearly say that until such time that the government supersedes it through rules or regulations and replacement, the current rules and regulations framed by the RBI and the FEMA will continue to apply.

Doshi: This applies to Foreign Direct Investment (FDI) and to Overseas Direct Investments (ODI). So all of that which was erstwhile under the control of Reserve Bank of India (RBI) will now hereon be under the control of the Government of India, specifically the finance ministry?

Gupta: Yes, that is right. So, the only thing that stays back with RBI is debt, and the power to define what is debt rests with the Central Government.

Doshi: So, the first tricky issue to deal with here is what is debt and what is not debt. And I suppose the two of you will agree with me that a bunch of convertibles, foreign currency convertible bonds (FCCB), etc. will probably qualify under the government’s definition as non-debt. So, it will be purely debt instruments like non-convertible debentures that will come under the gamut of debt?

Gupta: What I do expect is that the government will have to take a clear position on mezzanine or hybrid instruments; instruments that carry the character of both debt and equity. Till now the distinction that RBI has been maintaining has been very clear; anything which has any element of debt basically falls within External Commercial Borrowings (ECB) guidelines, unless it is compulsorily convertible. I expect the government to come out with a definition which addresses the issue of how hybrid like convertibles that you mentioned will get treated.

Rau: Let us look at it in two parts. One part of it is we do hope that the government does what Vivek just said they should do and I do hope they clarify that hybrids are possible under the category of permitted capital account actions. (Interrupted)

Doshi: Hybrids would come under the Government’s jurisdiction and not RBI’s debt jurisdiction?

Rau: Correct and that they will permit those instruments with whatever conditions they may think as appropriate, because one of the biggest problems that clients investing from overseas have faced while operating in the Indian market is, given the complexity of the commercial deals that are valid bonafide commercial deals and what they see in other markets, they need the flexibility to arrange the economics through those kind of instruments.

Doshi: The first test, of whether this momentous change of guard is going to be one that causes cheer or concern, will be how they define debt. The second test really is going to be, whether the Government is more conservative than RBI in the guidelines that it puts out or it is less conservative than RBI. It is really difficult to tell. I am going to ask both of you to speculate based on your past experiences on issues where the government and the RBI have disagreed. For instance, when it came to the 2009 Press Notes on how to define foreign ownership and control, the RBI took some 3-5 years to notify those changes in FDI policy…giving us all the impression that the RBI never agreed with the Government on those new definitions. So, that was one area of difference in opinion. The second area of difference in opinion has been Call & Put Options. RBI said Call & Put Options were not permissible, then they changed their mind half way through the Tata Docomo situation, but then they applied the old regulations to Tata Docomo. Then they promised in the Monetary Policy document that we will issue liberal guidelines. Now they have no control and the Government will have to do that.

Rau: I am optimistic on this one. I think the Government will be more liberal. The reason why they would be more liberal is the stated objective of this current government with the Prime Minister having said this in multiple venues on multiple occasions. So, they want to make the ease of business in India much better. They want to attract foreign investment.

Doshi: All that is good, but remember the confusion on Tata Docomo.

Rau: The point I was trying to make is if you look at it from a policy perspective the Government is a lot more aligned towards facilitating foreign investment than the RBI would be from a mandate perspective, because the RBI’s monetary policy perspective is entirely different.

Doshi: The RBI has often used this for exchange control, the Government will use this to make cohesive FDI policy?

Rau: Yes and that is the hope from a policy perspective. Getting into the specific of what you are saying, generally speaking if you look at the (Tata Docomo) objection that could have been there, there is a stated policy and if you are going to make exceptions from a stated policy there are legal ramifications, tomorrow somebody could take you to court and challenge it.

Doshi: Are you saying that the government agreed with the RBI (on allowing assured return on/of capital) but was just cautious about no diversion from extant policy? Or did you actually believe the Government disagreed with RBI? Because nobody knows what the governments real position is on this, therefore I am asking.

Rau: I don’t know either and there is speculation here.

Doshi: Vivek, what would you say, will the Government be more conservative than RBI?

Gupta: Conceptually I agree with Ashwath. It is the Government’s mandate to promote foreign investment. It is not the RBI’s direct mandate to do that. RBI is more of a regulator and the central bank. One would imagine, one would expect that the Government would be more liberal in prescribing these guidelines. I wonder though and this is all of course speculation, I wonder though whether there is an old RBI and whether there is a new RBI?

Doshi: The new RBI is the one that promised in the Monetary Policy liberal guidelines on Call & Put Options?

Gupta: Exactly. So, I would hope that the Government is more liberal, although I thought that we were seeing the beginnings of a new RBI which was in any case moving along a more liberal track. However as I said this is all speculation, at the end of the day we are sort of bothered about what the result is and we have a list of what we would want the Government to do.       

Doshi: Let us get down to that list because that is equally important. This is the time when you can be heard at the Finance Ministry while they are drafting these regulations. So, what is on your list of what you hope the government will tackle in these new regulations?

Gupta: There is a basic case to be made that where we stand in our investment cycle and what the needs of India are presently. We need definite flexibility in terms of recognising what I call mezzanine, hybrid capital. I fully understand the Government’s concerns around it, I fully understand the fact that we have seen the Asian crisis and we have seen currency crises and the Government has to guard against it. But, there are very many paths on which the government can move and start to bring in hybrid elements one by one, watch what happens and then open it up fully. So, for example, the Government could say for certain specified sectors, infrastructure, roads, ports, etc. we will allow hybrid elements for example. Certain categories of investors we will allow. We will allow things like liquidation preferences openly, we will allow call and put options in a more regular, commercial format without people like Ashwath having to resort to huge legal gymnastics to write it in legal documents.

Doshi: What is on your laundry list?

Rau: I agree with the primary point he has made, but just to give this a little bit of meat in the hope that people are listening, I would think the areas would probably be divided into two categories; some which fell in the RBI’s domain previously and others which actually fell already within the Government’s domain. Within what was in the RBI’s domain previously, one would, apart from instruments, look for flexibility as far as pricing is concerned. Today the RBI has taken it a long way to basically say get a valuation in an ‘internationally accepted methodology’ which is a big step for them to have taken, but that does not necessarily solve the problem for a foreign investor. Because, at the end of the day if there is a valuation that has to be put in place at the time of an exit and let us assume for a second that is an unhappy exit situation, there are many things that can be done to thwart that valuation. (Interrupted)

Doshi: So, you are saying do away with pricing thresholds altogether then?

Rau: Pricing altogether. You said it is a wish-list. So it is a wish.

Doshi: Go ahead. Next?

Rau: The other part of it is things like deferred consideration, escrow arrangements for hold-backs, indemnities, etc. all global practice. Today there are restrictions, there is need for getting approvals, etc. this complicates deals, creates a lot of frustration; indemnities are very common. To have a portion of the purchase consideration held back is something that is international market practice today, why not do it here as well, and allow that to happen?

Moving on quickly to the government’s bucket which I actually think has bigger items.

Doshi: This is the big one, right?

Rau: Absolutely. Today, ‘control’ is in a state of complete confusion.

Doshi: The definition of ‘control’ is confusing right now.

Rau: The definition of ‘control’. It is absolutely, I mean, the problem over here is whilst it has been aligned across statutes, which is a good thing, there is still no clarity in relation to what it really means. Does a person have control if they have veto rights? The old debate in relation to negative and positive control.

Doshi: But this is not just a foreign investment problem. This is a problem with even how Securities and Exchange Board of India (SEBI) looks at control and therefore how Competition Commission of India (CCI) looks at control and every other regulator in the country, that draws from capital markets regulations, looks at control. It is a qualitative threshold and not just a quantitative threshold.

Rau: I agree, but it hits us very badly in the context of foreign investment because it creates uncertainty in relation to what constitutes ‘control’ particularly since you have rules like the FOCC - foreign owned and controlled company rules, etc. which then impact what a foreign owned company can do on a downstream basis. You have a situation today where because of the control requirement being exercised in the context of insurance, there are bunch of people who have made investments and are holding 26 percent. And they have a set of rights which were actually approved by the Government and the Regulators when they made the investment. Are you going to go back and tell them now that you are going from 26-49 percent, you cannot have those rights? There is a clear distinction to my mind between what constitutes minority protection and what constitutes control.

We need that clarity can be spelt out from a legal stand point. Yes, it is always going to be debated, but the problem that you have today is from the stand point of how Regulators are approaching it. At least my sense is one feels there is no distinction between the two, between ‘control’ and ‘minority protection’. And let us be clear, investors are not going to invest billions of dollars of capital without being able to protect it. The second is the Foreign Investment Promotion Board (FIPB) approval process itself has to be simplified. Over the years, I remember when I started practising, it used to take eight weeks and if it was ten weeks, one felt that it had taken too much time. Today, you are talking about a minimum of about three to four months. Sometimes, it takes six months. I have had applications in some sectors (Interrupted)

Doshi: Be careful, you will be shouted down like Deepak Parekh was!

Rau: The limited point and the Government is already seized of this. The limited issue is that you have 13-14 ministries that need to comment on every single application, right? And the question is are you necessarily going to have to approve everything that is currently under the approval route or should the approval route only be limited top areas where you either have a sectoral problem or a national security consideration?

Doshi: Vivek, is there anything that Ashwath has not already asked for that is on your list?

Gupta: I would only say that a lot of what he said as a wish-list from the Government’s side, while I support it fully, is something that did not require a FEMA Section 6 amendment to happen.  

Doshi: Of course not, it is separate, as he pointed out.  

Gupta: So, that could have been done any way by the Government and hopefully Government will see it.


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