“The times they are a-changin”, Bob Dylan sang in his famous song, which seems as apt for the current regulatory regime of foreign exchange laws as it did for the turbulent times in which he wrote it. At the same time as grappling with the effects of COVID-19 and preparing for its aftermath, the government has been proactive in reforming certain areas of exchange control provisions. A few weeks ago, ostensibly with a view to prevent Chinese takeovers of Indian firms in this volatile economy, the government subjected all foreign direct investment (FDI) from neighbouring countries (restricted countries) to the provisions of the prior approval route. While the ramifications of this development continue to be debated in relation to an amendment made to the Non Debt Instrument Rules which govern, among other matters, foreign investments in India, the government has also imposed pricing restrictions on non-residents acquiring shares in a rights issue.
FDI from neighbouring countries: Though it is in some senses a protectionist move, the objective of the government is to prevent the takeover of Indian firms at low valuations, particularly where they have been depressed by the COVID-19 crisis. The move has been lauded by practitioners. However, concerns have arisen over the ambiguities surrounding the decision. For example, while investments from entities beneficially owned by entities and citizens of restricted countries have been placed under the approval route, there is no guidance as to what is the mechanism to identify such beneficial ownership, given the differing provisions under company and securities laws. There is ambiguity surrounding funds where the investment managers may be based in a non-restricted country, while the investors may be entities or citizens of restricted countries. Most importantly, given the current financial crisis, with a potential economic worsening in the future, companies will be looking to raise funds. Most foreign investors, particularly in unlisted companies, have the benefit of contractual pre-emptive rights designed to maintain their shareholdings. Prior approval in these cases, without a change in the shareholdings among the parties, would impact even genuine fundraising, as such an approval would normally delay this an activity. In addition, the issue of approval for downstream investment, where the investor is owned or controlled by an entity or citizen of a restricted country, should be clarified.
Pricing in rights issue: To prevent non-resident investors from acquiring shares of an Indian company at an artificially low valuation through a rights issue, the government has imposed pricing restrictions. The amendment provides that any acquisition by a non-resident, following the renunciation of shares by a resident, is to be made at a price not less than the fair market value. Previously, unlisted companies in a rights issue were free to determine the price as long as the price offered to non-residents was not less than the price offered to residents. In the case of listed companies, the board had the discretion to determine the price. Commercially, the subscription price was lower than the trading or fair market price in order to attract more subscriptions due to the comparative discount.
Capitalizing on this free pricing regime, some foreign investors, in agreement with resident shareholders, used it as a means to increase their shareholding without paying fair market value. It has often been used to provide otherwise prohibited, assured returns to non-resident investors, with resident shareholders not subscribing to the rights shares, thereby enabling non-resident investors to acquire a larger stake. While the amendment is laudable, certain unintended consequences should be clarified. As an example, if an existing non-resident acquires shares in a rights issue, comprising his own entitlement as well as those acquired pursuant to renunciation by a resident, different pricing could lead to taxation and commercial complexities. This should be addressed. Uncertainty in price determination would also exist if a non-resident shareholder renounces its right to subscribe for shares and other non-resident shareholders choose to subscribe.
The amendments are welcome, aimed as they are at protecting domestic investors by imposing restrictions on foreign investments. They help to maintain the sanctity of the market. It is important to protect the domestic economy, given the existing global economic slowdown together with an all-time low projection of the economic growth of the country because of the ripple effects of COVID-19. However, these restrictions might act as further deterrents to attracting much needed foreign investment to India. Accordingly, it remains to be seen how these changes will be implemented and what overall effect they have on the economy as well as the ease of doing business.
Snigdhaneel Satpathy is a partner and Sanchita Kumari is an associate at L&L Partners.
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