April 15, 2013

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Changes Impacting FDI: Recent And Imminent

- Arun Madhu, Senior Associate [ ]

Arun Madhu

Over the past few years, India has become the much-preferred global investment destination. With its economy racing ahead at a fervent pace and the stock market scaling new heights on a regular basis, India looks poised to take yet another impressive leap and cement its place amongst the world's most sought after investment hubs.

A key driver of this growth has been the dynamic evolution of the nation's legal and regulatory framework. Several far-reaching changes have recently been implemented on a broad range of issues and many other promising changes are in the offing. In this article, we examine some of the changes, which are likely to impact foreign investment in India.

Recoding The Takeover Code

In July this year, the Takeover Regulations Advisory Committee (TRAC), which was given the responsibility of reviewing the existing regulations governing takeovers of publicly-listed companies, has recommended a drastic overhaul of the over-adecade old law currently in force - the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997.

The report proposes that the trigger for a mandatory tender offer be increased to a 25% shareholding threshold from the 15% mark at present. This move has been long-awaited by investors as it addresses their repeated criticism that holding a 15% stake in a company does not result in acquisition of any meaningful control.

The report also recommends that the minimum offer size to shareholders of a target in the case of a takeover bid be increased to 100% from the current 20%. This would mean that an acquirer (i.e. a person who acquires more than 25%) will no longer have the luxury of making an open offer for a mere 20% of the remaining shares of the company and will be compelled to make an offer to buy out all the remaining shareholders of the company.

It is most likely that the biggest gainers, if these changes are implemented, will be the members of the PIPE or 'private investment in public equity' club as the otherwise cumbersome and expensive open offer process will be required only in select cases. The increase in the minimum offer size, however, is likely to cause a consequent rise in acquisition costs, which in turn is likely to ensure that the M&A market will be reserved only for the most serious players.


The Indian Government is presently weighing its options for allowing cashless consideration for shares in foreign direct investment. Thus far, the FDI policy has allowed companies to issue shares only through normal banking channels, with the two exceptions being, set offs against external commercial borrowings and royalty payments. While prior government approval is needed to utilise any other route, the excepted routes too are subject to strict eligibility and reporting conditions and therefore, available to very few companies and investors.

However, companies not falling under the automatic route have made numerous and repeated requests for permission to make use of this commercially attractive route in their transactions. In certain specific instances, the concerned government agency, the Foreign Investment Promotion Board (FIPB) has, on a selective basis, allowed the issue of shares against import of capital goods, transfer of technology, etc. Given the constant demand for liberalising this avenue for investment, the government has issued a paper inviting comments on the proposal for expanding the ambit of permissible transactions under the automatic route (Discussion Paper). We analyse below some salient features of the Discussion Paper.

Capitalising on Shares

Most often, start-up companies do not have access to adequate cash reserves to procure their capital goods. Sometimes, even companies that have been around for a while find themselves in a situation where they do not have sufficient funds for upgrading their machinery and equipment. If such companies are allowed to issue their shares against the import of such assets they will then have clear and easy access to cutting-edge equipment without any liquidity concerns gnawing at them.

As per the proposal, these transactions will be made subject to the Foreign Exchange Management Act, 1999 (FEMA), thereby making it possible for the fair value of such imported goods to be determined based on customs evaluation. Alongside this proposal, the matter of issuing shares against import of raw materials and trade payables has also been raised. The discussion paper further recognises the concern that allowing such transactions may lead to a distortion of FDI as they are essentially 'current account' transactions, which should ideally fall outside the purview of FDI.

Share-Service Swap

Traditionally, monetary payment for services has been a freely permitted 'current account' transaction (except in the case of consultancy payments, which when beyond specified monetary limits, require approval from the RBI). Issuance of shares for receipt of such services, however, is likely to give rise to numerous issues such as how to assign a specific value to intangible services, how to prevent possibilities of over invoicing and such other jugglery.

It has been suggested that the government should opt for a step-by-step approach in implementing this change. It should first allow the issue of shares only against services, the payment for which will not be a 'current account' transaction, and after the FIPB has had the opportunity to examine the manner in which companies take advantage of this, to extend the option to all other transactions that comply with applicable FEMA regulations. Despite narrowing the scope of the policy change at the first instance, implementation in this manner will ensure that the desired change is brought about with minimal adverse effects.

India's Window to the World

Over the past few years, global acquisitions and mergers by Indian companies have been on the rise. The present regulatory framework, however, made it impossible for a company to embark upon such an acquisition unless it holds huge financial reserves or leverages itself dangerously close to bankruptcy. If companies are allowed the share swap option, they can chase their growth aspirations unhindered by worries regarding their existing bank balances. However, it is likely that there will be no blanket change in this regard.

Instead, the discussion paper suggests that companies looking to make use of such an option must obtain government approval on a case-by-case basis guided by the dictates of India's Overseas Direct Investment regulations along with the FDI policy as well as the valuation norms applicable to overseas as well as inbound investments. Further, the proposal also recommends that standardised and transparent criteria must first be laid down in order to guide applicants while making their applications for approval before the FIPB.

No Shares for Intangibles

The discussion paper makes it clear that the government is not yet ready to allow the issuance of shares against intangible assets (e.g. franchisee rights). Fearing the inherent problems of such transactions, viz. the problems of valuation of intangibles and the subsequent litigation that is likely to follow, where parties may contest a mismatch between the shares issued and the assets received, the government has opted to not permit such transactions. The issue of shares for one-time extraordinary payments like arbitration awards is also considered undesirable at present, for similar reasons.

What You Give is What You Take

In most cases, the largest amount of investment is necessary at the time of incorporation of a company. Under existing policies, it is permissible for the expenses of incorporation incurred by Indian promoters to be set off against the issue of shares. This option was not available to foreign national promoters. The discussion paper proposes to do away with this distinction between Indian and foreign national promoters by bringing transactions under this head under the automatic route.

Further, it has been suggested that Foreign Inward Remittance Certificate be made mandatory in cases where shares are issued to foreign promoters. Lastly, in order to protect other shareholders of the company from any misdemeanours on the part of the promoters, stringent accounting and regulatory standards have also been prescribed.


The issuance of 'warrants' (i.e. instruments which are convertible into shares of a company at the option of its holder) to non-resident entities has been an issue that has long dogged the foreign investor community. Warrants are highly beneficial instruments to investors, offering them the ability to garner shares at a significant discount to the market price by merely making a part payment of the consideration upfront and in advance (this payment is not a premium for the option but is adjusted against the final purchase price).

Warrants and the foreign investors have had a chequered history. Prior to the release of the first consolidated FDI policy in March, 2010 (in the form of Circular 1), warrants were permitted to be issued to non-residents so long as the prior approval of the FIPB was obtained. However, Circular 1 categorically prohibited the issue of any instrument other than vanilla equity shares, compulsorily convertible debentures and preference shares. The document went on to give examples of such prohibited instruments (i.e. warrants, partly paid shares, etc.) effectively displacing a hitherto settled position.

However, despite the onpaper ban, investors continued to approach the FIPB for the issue of such instruments with the regulator obliging them with conditional approvals (e.g. foreign investors subscribing to warrants were necessarily required to pay a fair sum of upfront consideration and were required to convert the warrants within 18 months of their issuance, both conditions which were typically associated only with warrant issuances by publicly listed Indian companies). Circular 2 (which sets out the FDI policy effective from October 1, 2010) now crystallizes the position by expressly stating that warrants may be issued so long as governmental approval is obtained.

The Way Forward

Changing trends in the economy have put the law too on the anvil of change. Apart from the instances highlighted above, the age-old taxation, company law and antitrust statutes (legislations which are intrinsic to any investment in India) find themselves on the chopping block, with progressive bills likely to replace them comprehensively in less than a couple of years. It appears that exciting times await both investors as well as regulators. Needless to say, one hopes that the evolving legal scenario, in turn, gives a tremendous impetus to the cause of foreign investment in India.


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