Changing guidelines for defence sector

By Rajat Sethi, S&R Associates
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The current policy of the government of India in respect of foreign investment in the defence sector is set out in Press Note 2 of 2002 issued by the Ministry of Commerce and Industry, and is reflected in the Foreign Exchange Management Act, 1999, as amended (FEMA) and the regulations and notifications issued under FEMA.

Press Note 2 of 2002 permits foreign investment of up to 26% in an Indian company in the defence sector with the prior approval of the Foreign Investment Promotion Board (FIPB), and sets out other conditions of such investment:

Rajat Sethi Partner S&R Associates
Rajat Sethi
Partner
S&R Associates

(1) Licence applications are considered by the Department of Industrial Policy and Promotion, Ministry of Commerce and Industry, in consultation with the Ministry of Defence; (2) The applicant should be an Indian company or partnership firm; (3) The management of the applicant company should be in “Indian hands”, and majority representation on the board as well as the chief executive of the applicant company or partnership firm should be resident Indians; (4) There is a three-year lock-up in respect of transfer of equity from one foreign investor to another; (5) Arms and ammunition must be sold to the Ministry of Defence (although they may be sold to other government entities and state governments with the prior approval of the Ministry of Defence) and not to any other person or entity in India, while exports are subject to applicable government policy; (6) Non-lethal items can be sold to persons or entities other than the central or state governments with the prior approval of the Ministry of Defence.

Also relevant for foreign suppliers is the “offsets clause” in the Defence Procurement Procedure (DPP), the most recent version of which was issued by the Ministry of Defence in July 2008. The offsets clause applies to all procurement proposals where the indicative cost is Rs3 billion (US$61 million) or more. A 30% minimum offset is prescribed by the DPP 2008; a higher offset may be set, or the offset requirement waived in specific cases. The offset obligation can be discharged by the following methods: (1) purchase of, or executing export orders for specified products or services of the Indian defence industry; (2) foreign investment in the Indian defence industry (whether product manufacture, service provision or research and development); and (3) offset programmes in anticipation of future obligations (the DPP 2008 introduced detailed guidelines for this option).

The offset obligations must be fulfilled coterminus with the main contract. Quarterly compliance reports must be submitted, and penalties for non-fulfilment of the offset obligation include disqualification from future defence contracts.

In February the government issued new guidelines for the calculation of foreign investment in Indian companies, in Press Note 2 of 2009. These provide that foreign investment in Indian companies that are owned (indicated by ownership of more than 50% of equity) and controlled (indicated by having the power to appoint a majority of the directors) by resident Indian citizens, and which in turn invest in a second Indian company, will not be considered for calculation of foreign investment in the second company.

In respect of the defence sector, Press Note 2 of 2009 also requires the equity interest of the “largest Indian shareholder” to be at least 51% of the total equity. The “largest Indian shareholder” may be an individual shareholder, a relative of the shareholder as defined under the Companies Act, 1956, or a company/group of companies in which the individual shareholder has management or controlling interest (or a combination); or it may be an Indian company/group of Indian companies under the same management and ownership control.

Comparatively low levels of foreign investment in the Indian defence sector suggest that investors have found the 26% cap unviable and the offsets clause unduly restrictive, with foreign suppliers perceiving insufficient opportunities in the Indian defence sector to discharge their offset obligations. The Indian government must also balance the concerns of foreign investors and suppliers with national security concerns and the need to develop a strong defence industrial base in India. Reports indicate that the government is considering increasing the limit to 49%, although it is unclear whether this will be implemented.

Press Note 2 of 2009 allows a foreign investor to invest at two levels simultaneously: (1) at the level of an Indian holding company in which the foreign investor holds up to 49% equity interest (with the remaining 51% or higher equity interest held by a single Indian shareholder or group which also has the power to appoint a majority of the directors); and (2) at the level of a subsidiary of the Indian holding company (i.e., the operating company engaged in the defence sector) in which the foreign investor holds an equity interest within the 26% limit.

Such a structure would provide a foreign investor an aggregate direct and indirect economic interest in an operating company in the defence sector that is in excess of the 26% direct foreign investment limit. However, such a structure would require the prior approval of the FIPB and it will remain untested until the FIPB approves specific cases.

Rajat Sethi is a partner at S&R Associates. S&R Associates provides legal services in the areas of M&A, securities laws, financings, foreign direct investment, regulatory matters, general corporate counselling and arbitration and litigation. S&R Associates’ office is located in New Delhi and it currently has 25 lawyers, including five partners.

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