Negotiating joint ventures in FDI restricted sectors

The foreign direct investment (FDI) policy announced by the Department of Industrial Policy and Promotion regulates the extent of FDI permitted across various sectors in India. While due to progressive liberalization in the FDI policy a majority of sectors are now under the automatic investment route, certain sectors deemed sensitive remain partially restricted, with FDI permitted under the automatic route only up to certain thresholds and beyond that with prior government approval, subject to various conditions. FDI caps in such sectors necessitate the setting up of joint ventures (JVs) as a mode of doing business. Further, investment conditions attached to such regulated sectors significantly impact the foreign parties’ ability to negotiate rights in a JV arrangement.

Negotiating JVs in restricted sectors is particularly challenging since the buyout option, typically used in the event of a breach/dispute or deadlock may not be available to a foreign shareholder. Therefore, the JV agreement should be carefully drafted to give the foreign investor flexibility on this issue.

The situation is a bit different in the case of joint ventures in 100% FDI sectors, where the foreign investor is evenly placed in terms of its ability to acquire the Indian partner’s shareholding in the event of a breach/dispute or deadlock or sell its equity stake to the Indian partner. However, in such a stake sale, the share pricing/valuation guidelines would need to be adhered to. As per the current pricing guidelines, a foreign shareholder cannot sell its stake to the Indian partner at a price more than the fair value despite having a put option under the JV agreement. However, where the foreign shareholder has a call option, the price payable can be equal to or more than the fair value.

A case in point is the JV dispute between Tata Sons and the Japanese company DoCoMo. Under the JV agreement between Tata and DoCoMo, DoCoMo was entitled to sell its shares at the fair value or half the subscription price (whichever is higher) to the Indian partner. A dispute arose since the pricing guidelines did not permit sale of DoCoMo’s stake at a price more than the fair value.

DoCoMo alleged breach of contract by Tata for failing in its obligation to find a buyer for DoCoMo’s stake. The arbitral tribunal ruled in favour of DoCoMo, finding that Tata Sons had breached its contractual obligations, which were legally capable of performance in ways that did not require permission from the Reserve Bank of India or Ministry of Finance.

The government is reported to have taken a view that there is no case for any relaxation in rules to allow DoCoMo to exit its JV with Tata at a pre-determined price. It is therefore important that the prevailing regulations be kept in view while negotiating and drafting cross-border JV agreements as there are certain ways in which the interests of the parties, commensurate with their investment in the joint venture, can be ensured and protected.

Some aspects which consume substantial negotiation time in joint ventures are management rights and call options. For restricted sectors, the FDI caps are typically set at 26%, 49% and 74%. A 26% stake implies the ability to block a special resolution; at 49%, a party can block a special resolution but not an ordinary resolution; while at 74%, it cannot pass a special resolution.

Given that a 49% stake offers no benefits under Indian company law over a 26% stake, a 49:51 JV is usually a compromise, due to regulatory constraints, by parties that commercially intend to form a 50:50 JV. While the monetary contribution of the parties is virtually equal, regulatory restrictions make it hard to achieve equal management rights, unless some innovation which can withstand legal scrutiny is made to the management structure. Further, for JVs involving licensing of technology by the foreign partner, such a partner may justifiably seek reasonable control over the JV company. In such cases, the 50:50 split of the parties’ decision making rights in the JV can be preserved through board committee mechanisms, right to appoint key managerial personnel, veto rights, specific quorum requirements and cross-default provisions in the licence agreement, JV agreement, etc.

A foreign partner that already has the maximum permitted FDI will find it difficult to enforce a call option, commonly used to allow a party to acquire the company in a default or a deadlock situation. Thus, such an investor, despite having the financial wherewithal to take over the JV entity, may find itself stuck in a JV that has become unviable, with exit being the only option. Therefore, certain flexibilities should be negotiated by the foreign party which can provide more freedom to the foreign partner in such situations.

Sunil Seth is a senior partner and Amit Mehta is a partner at Seth Dua & Associates.