Revised FDI policy in defence: Cause for cheer

By Mohit Saraf and Hemant Krishna V, Luthra & Luthra Law Offices
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The percentage of foreign direct investment (FDI) to be allowed in the defence sector has long been a bone of contention among industry players with conflicting business interests. Focus on real consequences of increased FDI is often drowned by undue alarmism that India will forfeit its strategic interest to foreign players. Meanwhile, India has not only become the world’s largest arms importer, but its arms imports are almost three times those of the second and third largest importers – China and Pakistan. This has impaired India’s capabilities of repair, maintenance and upgrade of defence equipment.

Mohit Saraf
Mohit Saraf

This dependency on imports also sits awkwardly with the new prime minister’s oft-repeated dream of transforming India into a manufacturing powerhouse. Therefore, despite stiff opposition from certain camps of the industry, the government has cleared the decks to raise the FDI cap from 26% to 49% under the approval route.

At first blush, this move may seem too coy to change the import-manufacturing equation since 49% does not allow a foreign shareholder to have majority voting rights. However, the revised policy retains that proposals for FDI beyond 49% will be considered by the Cabinet Committee on Security based on recommendations from the Ministry of Defence and the Foreign Investment Promotion Board (FIPB), on a case-to-case basis, if they are likely to bring access to modern and “state-of-the-art” technology.

This, when read in tandem with the government’s “come and make in India” call to investors, creates significant new room for investor optimism.

‘Red carpet, not tape’

Back in 2010, when the Department of Industrial Policy and Promotion floated a discussion paper on increasing the FDI cap in defence, international arms majors made a strong pitch for raising the cap to at least 74%. While the government has not granted their wishes (yet), raising the cap by 23% presents foreign investors an ineluctable opportunity to realize greater economic benefit and augurs well for domestic enterprises involved in manufacturing activity.

Since defence production is interconnected with several other sectors, increased investment in defence is bound to have a desirable multiplier effect on ancillary industries such as automotive, precision machining, heavy and light engineering, earth moving, plastics, automotive components, machine tools, communication, etc.

The policy also offers international players that own “state-of-the-art” technology a chance to invest up to 100% in the sector. While the revised policy specifies that proposals beyond 49% would require recommendations from the Ministry of Defence and FIPB, and cabinet committee approval, given the prime minister’s direct appeal to foreign manufacturers to “sell anywhere but manufacture here” and his assurance of all cooperation, potential investors should not be deterred by the approval process.

Legal quicksand

This said, foreign investors would do well to seek sound legal guidance on certain aspects of investment in the sector. The new policy lays down a condition that the company applying for government permission for FDI up to 49% should be an Indian company “owned and controlled” by resident Indian citizens. This means that more than 50% of the applicant’s capital should be beneficially owned by resident Indian citizens, who would also have the right to appoint a majority of the directors or to control the management or policy decisions, including by virtue of their shareholding or management rights or shareholders agreements or voting agreements.

Hemant_Krishna_V_-_Phoenix_Legal_new
Hemant Krishna V

This casts a shadow on certain types of affirmative or veto rights which are popular in investment agreements. Moreover, the Companies Act, 2013, contains provisions on related-party transactions which restrict the ability of interested directors and members to be present and vote at meetings at which a contract or arrangement with a “related party” is discussed as the subject matter of a resolution. This may impact a foreign investor’s ability to influence the terms on which its proprietary technology is licensed to or shared with its Indian joint venture company.

Foreign investors entering into technology licensing arrangements should also be mindful of India’s intellectual property regime and dispute resolution processes. The dispute resolution forum picked by the parties can have significant bearing on the length of proceedings. Once a dispute goes into litigation in India, obtaining the right interim relief is often half the game won. Confidentiality is also a concern. Indian procedural law does not specify procedures and mechanisms for protection of confidential information produced before courts. This is left to the ingenuity of lawyers and the discretion of the court.

While exercising legal finesse will continue to be central to sound investment strategy, the revised policy provides enough grist to the investment mill to cheer about.

Luthra & Luthra Law Offices is a full-service law firm with offices in Delhi, Mumbai and Bangalore. Mohit Saraf is a senior partner and Hemant Krishna V is an associate at the firm. This article is intended for general informational purposes only and is not a substitute for legal advice.

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