The Department of Industrial Policy and Promotion (DIPP) of India’s Ministry of Commerce and Industry recently issued a discussion paper on the relevance of sectoral caps for inbound investment. As a result of these caps, foreign investors may hold only a limited percentage of equity in Indian companies that operate in certain sectors.
Currently, sectoral caps for foreign investment are set at four levels of shareholding: 26%; 49%; 51%; and 74%. In addition, foreign investment in certain sectors is completely prohibited.
Foreign investment in Indian companies is regulated by the Foreign Exchange Management Act, 1999, the foreign direct investment (FDI) policy of the government and the foreign investment regulations put in place by the Reserve Bank of India. Sectoral caps for foreign investment form part of the FDI policy of the government.
Significantly, the DIPP’s discussion paper acknowledged that indirect foreign investment in up to 49% of the equity share capital of a company is permitted in all companies operating in any sector in India. This follows from press note 2 of 2009, issued by the DIPP, which states that downstream investments by a company in which more than 50% of the beneficial equity and the right to appoint the majority of the board of directors is held by resident Indian citizens are considered to be “domestic” investments, even if the investing company has up to 49% FDI in it.
As a result, the paper questions whether “what can be done indirectly, should as well be allowed to be done directly”. While this may be an attractive argument in support of the elimination of sectoral caps on foreign investment, it is based entirely on the consequences of the rules for calculation of “domestic investment” for the purposes of the foreign investment regulations. It may, therefore, be useful to step back and analyse the rationale behind the sectoral caps.
Basis for caps
Identifying the rights of investors at each of the four levels of sectoral caps, the paper states: “any equity holding greater than 25% gives a right to block a ‘special resolution’, 49% equity represents a level just short of ownership, 51% signifies ownership and a right to pass all ordinary resolutions, 74% equity cap on FDI means that the Indian equity holders, acting in unison, can block a special resolution.”
Therefore, the caps appear to be aimed at limiting the level of foreign control in companies. This may be desirable from a national security perspective for certain sensitive or strategic sectors such as defence and telecommunications.
However, sectoral regulations and licensing conditions may be sufficient to protect national security interests in such sectors. For example, licences issued by the Department of Telecommunications typically contain restrictions on cross holdings in companies in the same sector and can be terminated on very broad grounds. Further, as any transfer in ownership requires prior approval, the government can limit investments from unfriendly nations.
Operational conditions such as these may be sufficient and possibly more effective in safeguarding national security interests, since these regulate the behaviour of enterprises, as opposed to mere allocation of corporate rights. Further, unlike sectoral caps, such conditions are applicable across the board to all market participants, and not only to enterprises with foreign investment.
Maintaining sectoral caps could also create inconsistencies in foreign investment policy, particularly as there could be different caps for broadly similar activities. For instance, foreign investment up to 74% is permitted in the telecommunications sector and up to 49% in cable networks and direct-to-home (DTH) services. However, due to developments in technology, telecommunications companies can now also provide broadcasting services such as internet protocol television services, which overlap with DTH activities.
The paper highlights that the sectoral caps could provide an opportunity for arbitrage for unscrupulous Indian partners in joint ventures with foreign investors. It also asks if investment by foreign institutional investors should be excluded from the purview of the sectoral caps.
Finally, the paper considers whether a better way to ensure Indian control over companies would be to require companies in certain sectors to make an initial public offering within a specific time. This could raise difficulties in terms of timing and strategy and may, in certain cases, make India an unattractive destination for foreign investors. Further, listing a company on an Indian stock exchange would not guarantee Indian control as the shares may be held by foreign investors. Also, it cannot be assumed that individual Indian retail investors would represent Indian interests.
Rajat Sethi is a partner and Simran Dhir is an associate at S&R Associates, a law firm based in New Delhi and Mumbai. They can be contacted at firstname.lastname@example.org and email@example.com respectively.
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