By Vaibhav Kakkar, L&L Partners

A Government which had made it its habit to announce big bang policy reforms to attract foreign investors, on April 17, 2020, took what could possibly go down as its boldest foreign policy decision. By issuing Press Note 3 of 2020 (Press Note), the Modi Government has made all foreign direct investment (FDI) from countries sharing a ‘land border’ with India subject to prior Government approval. Previously, apart from investment in select sectors, the requirement for prior government approval arose only for investments originating from Pakistan and Bangladesh.

While the intent to prevent ‘opportunistic’ investment from Chinese sources in a domestic market (which has seen a fall like no other) is clear, the Government’s move has raised more questions than they have provided answers for. The Press Note would only become effective once a formal amendment is made to the rules issued under FEMA, and it would be imperative for the Government to address some crucial aspects.

What provoked the Government?

Owing to Covid-19 and the ensuing nation-wide lockdown, there has been absolute mayhem at the stock market with Sensex having reported its sharpest fall in the previous quarter. Out of 538 stocks from BSE500 and Nifty 500, 114 stocks have seen their price halved with 221 stocks having fallen between 30% to 50%. In this backdrop, the Government appears to have been particularly spooked by the People’s Bank of China raising its stake in India’s largest non-banking mortgage provider, HDFC, and amid warning calls by MSMEs to prevent a ‘shopping spree’ by Chinese investors of heavily discounted Indian companies.

The Indian Government is not alone. With valuations world-over being severely hit and in an attempt to prevent predatory behaviour by Chinese companies, the Australian, Spanish and German governments have all tightened rules around foreign takeover, without specifically singling out China, much like has been done by the Indian Government.

Coverage over Foreign Portfolio Investment?

The language in the Press Note covers only FDI from Chinese sources and does not impose any restrictions on foreign portfolio investment from China. That is, once the FEMA notification is issued, investments in unlisted companies and investments in excess of 10% in listed Indian companies would require prior Government approval. However, foreign portfolio investments i.e. investments of less than 10% in listed Indian companies are not impacted by the Press Note.

Given that the roots of the Government’s concern lie in potential hostile takeovers of listed Indian companies, SEBI would certainly look at this aspect closely and one could expect either formal restrictions on foreign portfolio investment from Chinese sources or SEBI being conservative in giving a nod to foreign portfolio investors from China.

In fact, reports suggest that SEBI has asked depository participants regarding details of offshore funds whose ‘beneficial ownership’s is from China, Hong Kong and other countries that could have a Chinese link such as Pakistan, North Korea, Taiwan, Iran and Myanmar.

Question of Beneficial Ownership

Apart from entities registered in China and Chinese citizens, the Press Note also covers investment from entities where are ‘beneficially owned’ by such Chinese entities or citizens. However, the Press Note has not clarified the manner in which ‘beneficial ownership’ would be determined. Given that most large funds may be substantially funded by, or be controlled by, Chinese entities or citizens, yet not majority owned by them, the rules to determine ‘beneficial ownership’ would be crucial. This assumes special importance since most Chinese sourced investment reaches India through funds in Singapore and Mauritius.

Special Administrative Regions (SARs) of China

In the past, when the Government has prohibited Chinese investors from acquiring immovable property in India without prior approval from Reserve Bank of India, they have also specifically called out Hong Kong and Macau (separate from China) within such restrictions, owing to them being SARs of China. However, the Press Note currently only places these restrictions on China, and it remains to be seen whether they would paint Chinese SARs with the same brush, especially given the extent of investment emanating from Hong Kong.

Worry for Existing Chinese Investors

The Press Note and the impending FEMA notification would, in all likelihood, be prospective in nature. Accordingly, existing investments from China (such as Alibaba and Tencent’s investment in e-commerce companies) would be grand-fathered and should require no post-facto Government approval. However, given that most Indian companies are in need of a fund raise, the Government would need to clarify whether a rights issue wherein Chinese investors are only acquiring pro-rata shareholding and thus not increasing their percentage shareholding in the company, would also require prior Government approval. The requirement of prior Government approval in such cases could significantly impact even bona fide fund raise by Indian entities given that any Government approval would normally delay the fund raise by months.

What Next?

While the Government would term the move as an act of self-defence and one that follows a global pattern, this pre-emptive economic strike would certainly impact foreign investment inflows in India and could follow a Chinese retribution against Indian companies with investments in China. However, in times of a global pandemic where survival is king, one can hardly cast shadows on the Government’s motive or second guess their intentions. Given that a close examination reveals that the prime motivator for the Government appears to be HDFC where the People’s Bank of China raised its stake only marginally from 0.8% to 1.01%, it is only hoped that the Government’s decision is backed by empirical evidence and not mere apprehensions.

As the country braces for the fall-out of this decision, it is imperative for the Government’s bold move to be immediately followed by a comprehensive FEMA notification and SEBI clarification that addresses the above concerns.

Vaibhav Kakkar is a Partner, and Sahil Arora is a Senior Associate at L&L Partners, Delhi (formerly, Luthra and Luthra Law Offices). The views of the authors are personal.

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