The article seeks to analyse the recent amendments made to FEMA 20 in order to regulate and permit, subject to certain limits and conditionalities, transactions in securities involving deferred payment of consideration, escrow arrangements and indemnity payments The Reserve Bank of India (“RBI”) has been progressively liberalising the legal regime regulating foreign investment into India under the Foreign Exchange Management Act, 1999 (“FEMA”) by amending the regulations made thereunder from time-to-time. Though the powers of RBI to regulate capital account transactions not involving debt instruments under FEMA were sought to be transferred to the Government of India as part of the Finance Act, 2015, the necessary notification for effectuating that shift has not been issued yet. RBI therefore continues to retain the power to regulate capital account transactions, including those involving debt instruments.
The Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 (hereinafter referred to as “FEMA 20”), as the title suggests, regulate the issue and transfer of securities of Indian companies to or by persons resident outside India. This article seeks to analyse the recent amendments made to FEMA 20 in order to regulate and permit, subject to certain limits and conditionalities, transactions in securities involving deferred payment of consideration, escrow arrangements and indemnity payments.
Hitherto, as per the provisions of Regulation 10 (A) (d) of FEMA 20, transfers of shares or convertible debentures or warrants of an Indian company by a person resident in India to a person resident outside India on deferred payment basis required the special permission of the RBI. Similarly, establishment of escrow mechanism was permitted in connection with issue of shares or convertible debentures to a person resident outside India for a period up to 180 days without RBI permission. Further, FEMA 20 did not have any provision regulating payment of indemnity in respect of a transaction involving issue or purchase of shares between a resident and a non-resident.
The Reserve Bank of India has, by notification no. FEMA. 368/2016-RB dated 20th May 2016, amended the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000 (the “Notification”), to permit:-
a) sale of shares by a non-resident to a resident and versa with up to 25% of the total consideration being paid on deferred payment basis, within a period not exceeding 18 months from the date of the transfer agreement
b) establishment of escrow mechanism for the above purpose within the above-said limits
c) the seller to furnish indemnity to the buyer for an amount up to 25% of the total consideration for a period not exceeding 18 months from the date of payment of full consideration if the full consideration has been paid by the buyer to the seller at the time of transfer of shares.
The above relaxations are subject to the condition that the total consideration finally paid must be compliant with the applicable pricing guidelines.
Transactions involving deferred payment of consideration, escrow arrangements and indemnity obligations which do not meet the above requirements will require special permission of RBI.
The Notification has significant implications for both foreign investors and Indian corporates, key amongst which are summarised below:
Deferred Payment Transactions: Hitherto, whilst Regulation 10 (A) (d) of FEMA 20 permitted transfer of shares or convertible debentures by a non-resident seller to the resident purchaser on deferred payment basis with RBI approval, the permissibility of such structure for transfer by resident seller to non-resident purchaser was not addressed therein. The Notification now permits transactions for secondary sale and purchase of shares between resident buyers and non-resident sellers and vice versa involving deferred payment of the consideration and establishment of escrow mechanism for that purpose, within the above-said limits. To that extent, the Notification is a welcome development. It may however be noted that this dispensation does not appear to extend to other types of securities such as convertible debentures and warrants.
Escrow Arrangements: The second proviso to para 8 of Schedule 1 to FEMA 20 mandates obtaining of special permission of RBI for establishing an escrow account for a period beyond 180 days in relation to a transaction involving issue of fresh shares or convertible debentures to a person resident outside India investing under the FDI route. That provision continues to remain unchanged. Thus, as regards escrow arrangements, there now appear to be two dispensations – one applicable to issue of fresh securities and the other applicable to secondary sale of securities – which do not make sense, since the effect of both kinds of acquisitions is essentially the same. One hopes that the RBI will rectify this dichotomy at the earliest.
Indemnity Payments: There has been a view prevailing amongst the legal fraternity that payment of indemnity under a share purchase agreement / share subscription agreement to a non-resident is in the nature of a current account transaction and therefore permissible without any restrictions. The Notification appears to suggest that the RBI would view indemnity payments, made in connection with transactions involving issue and transfer of securities, to be capital account transactions. That the RBI chose to amend FEMA 20 rather than the Foreign Exchange Management (Current Account Transactions) Rules, 2000 for this purpose is of significant importance in this regard. One would also be forgiven for questioning the inclusion of indemnity payments in FEMA 20 considering that it is not, strictly speaking, in the nature of a capital account transaction which is defined in Section 2 (e) of FEMA as follows:
2 (e) “capital account transaction” means a transaction which alters the assets or liabilities, including contingent liabilities, outside India, and includes transactions referred to in sub-section (3) of section 6. Indemnity does not fall within any of the categories of transactions listed in Section 6 (3) of FEMA which, in any event, is due to be repealed from a date yet to be notified.
Further, it would have been preferable if the RBI had refrained from prescribing time-limits on indemnity payments and left it to the commercial wisdom of the parties to the transaction, considering that it is customary for foreign investors to seek indemnities with respect to the title, tax and certain business-related warranties for longer periods of time than the period of 18 months permitted under the Notification.
While the Notification applies prospectively (in the absence of specific language to the contrary therein), it will impact past as well as future FDI transactions. Firstly, the Notification cramps the negotiating elbow room for foreign investors in relation to deferred payment, escrow and indemnity clauses in investment agreements going forward. The Notification is also likely to affect future remittances of indemnity payments under agreements entered into prior to the date of the Notification. Foreign investors would be well-advised to revisit the investment agreements entered into by them and seek legal advice to determine how far they stand exposed to the possibility of not being able to receive payments due to them under indemnification clauses in such agreements.
The last couple of years have witnessed a significant increase in FDI inflows into India. Although, the abovereferred amendments impart the much desired flexibility and certainty in structuring of transactions involving foreign investment into India, the aspects highlighted in this article need to be addressed expeditiously – else it would be a case of ‘one step forward, two steps back’. The march of law needs to be in tune with commercial realities, if the Government of India’s flagship ‘Make in India’ and ‘Ease of Doing Business’ initiatives are to succeed.
Disclaimer – The views expressed in this article are the personal views of the author and are purely informative in nature.