A press release from the Ministry of Finance dated 16 April has modified the 2017 foreign direct investment (FDI) policy by reintroducing the concept of minimum capitalization norms for the financial services sector. The FDI policy sets out the rules in respect of FDI in regulated and unregulated financial services. Regulated financial services are those regulated by a financial services regulator and unregulated financial services are those that are not regulated by any financial sector regulator, or where only part of their activity is regulated or where there is doubt regarding the regulatory oversight of such services.
Up to 100% FDI is permitted in regulated financial services under the automatic route and is not subject to minimum capitalization norms. In unregulated financial services, FDI is allowed up to 100% with prior government approval and is subject to conditions including minimum capitalization norms.
The rationale for the distinction seems to be that if a financial service is under the regulatory oversight of a sector-specific regulator, the government does not need to have a “look-in” at the entity providing the service before it receives FDI.
The press release has reinstated the pre-October 2016 position by requiring minimum capitalization of US$20 million for “fund-based” and US$2 million for “non-fund based” activities. Fund-based activities include merchant banking, underwriting, portfolio management, asset management, etc. Non-fund-based activities include investment advisory, financial consultancy, forex broking, credit rating and money changing.
An “explanatory note” in the press release has created some confusion by stating that unregulated financial services will include entities which are not registered with the concerned sector regulator and entities and activities that are exempt from registration under the concerned sector regulations.
This expands the definition of unregulated activities. For instance, an alternative investment fund (AIF) has to be registered with the Securities and Exchange Board of India, but its foreign-owned investment manager (IM) does not. IMs would be covered under the expanded scope of unregulated non-fund-based activities, and thus subject to minimum capitalization norms. The norms would also apply to portfolio management services and investment advisory arms of foreign private equity funds.
The minimum capitalization requirements introduced by the press release are more onerous than the pre-October 2016 requirements. A bare reading of the press release indicates that even a minority FDI participation in an entity in the financial sector would require the specified capitalization. Consequently, the press release has effectively made joint ventures in the financial sector between a non-resident and an Indian partner unviable.
A large number of IMs, portfolio managers and investment advisory entities were set up under the previous regulations, which required a minimum capitalization of US$500,000. It is unclear whether these structures would be grandfathered. If these entities are required to infuse additional capital, then effectively the press release is a regressive step being applied retrospectively – one that chips away at “regulatory certainty” and does not bode well for India’s ease of doing business rankings.
The press release also creates an incompatibility between the FDI regime and the legal structures used by IMs, asset management companies (AMCs), portfolio managers and investment advisers. Several prominent service providers in the financial services sector offer their services through a limited liability partnership (LLP). This allows them to benefit from having limited liability, separate legal entity status and tax efficiency. At present FDI in LLPs is permitted only for LLPs operating in sectors under the automatic route that are not subject to any FDI-linked performance conditions. As FDI in unregulated financial services is subject to government approval and not under the automatic route, IMs, AMCs, portfolio managers and investment advisers that are planned to be set up with foreign equity participation can no longer be organized as LLPs.
The explanatory note to the press release has created more confusion than clarity. It has led to a situation where a press release has reversed or confused certain clear policy-level relaxations brought in October 2016. The financial sector will have to await clarification from the government and the Reserve Bank of India as the resultant position seems to be inconsistent with the government’s stated objective of bringing more sectors under the automatic route, providing regulatory certainty and promoting ease of doing business.
Shinoj Koshy is a partner at L&L Partners. The views expressed are personal and intended for general information purposes. They are not a substitute for legal advice.
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