Demystifying FEMA - Part 4.1

PART – 4.1

Foreign Long Term Investors[1]

Investment by Foreign Long Term Investors (FLTIs) refers to an investment made to acquire lasting or long-term interest in enterprises operating outside of the economy of the investor. There are strategic FLTIs and financial FLTIs. 

Strategic FLTIs

These investors are operating companies that provide products or services and are often competitors, suppliers or customers of investee companies. Their goal is to identify companies whose products or services can synergistically integrate with their existing product line to create incremental long-term shareholder value. These investors actively participate in management of Investee Company. Degree of participation in management depends upon extent of investment, regulatory framework, and business considerations, for e.g. - if there is complete buyout by these investors than the earlier board of the investee company will get dismantle, and a new board will be constituted having directors appointed by the strategic investors. A strategic investment may result in:

            ·    Wholly Owned Subsidiary (WOS);
           ·     Joint Venture undertaking (JV), where an Indian investors setup new a new company with                   collaboration of foreign investors. For e.g. Vistara airlines is a JV between Tata sons and                     Singapore airlines; or
           ·  Stake buy in an existing Indian company. For e.g. Etihad Airways bought 24% stake in Jet                  Airways.

Financial FLTIs

These investors include private equity firm, venture capital firms, hedge funds etc. These firms are in the business of making investments in companies and realizing a return on their investments. Their goal is to identify private companies with attractive future growth opportunities and durable competitive advantages, invest capital, and realize a return on their investment with a sale or an IPO. These investors, like portfolio investors, are not interested in management’s affairs of the investee company, but unlike portfolio investors, these investors can appoint their representatives on the board of the company under investment agreement. In case these investors choose to appoint their director/s on the board of the investee company, he/they will not be actively participating in managements’ affairs of the company. Exit routes are extremely important for these investors. After the expiry of the investment horizon, these investors will encash their holding making huge capital gains on their initial investment. The main source of ROI for these investors is in the form of capital appreciation, whereas the profits earned by the company is the main source of ROI for portfolio investors.

This distinction between strategic and financial investors has major impact on the ways how FDI transactions are structured. It has major impact on scope of due diligence, terms and conditions of shareholders’ agreement etc. It will also help to appreciate various provisions of foreign direct investment regime. It would be worth noticing that in the life cycle of a company, strategic investment comes after financial investment. Strategic buyout is most preferred exit route for financial investors. Before strategic buyout of Whatsapp by Facebook, there were venture capital investments in Whatsapp[2].

FOREIGN DIRECT INVESTMENT SCHEME (FDI SCHEME)

Every year Department of Industrial Policy and Promotion (DIPP) issues consolidated FDI policy. Schedule 1 to FEMA 20 contains mechanism to operationalise the FDI policy issued by DIPP. There are automatic route and approval route through which FDI can come into India. Under automatic route, there is no need to take prior approval from govt. before receiving FDI and, in return, to issue equity shares or convertible securities to foreign investors. Under approval route, there is need to take approval from Foreign Investment Promotion Board (FIPB) before any investment from foreign investors. FDI can result into two types of investment.

• ·                     Greenfield Investment – Under this route, FDI results into setting up or expansion of      business activities by the companies. There is a direct flow of money to the companies providing resources to expand or setting up of the businesses. FLTIs subscribe to unsubscribed capital of the companies, and, in return of investment, the companies issue fresh equity or convertible securities to the FLTIs. FLTIs may also get management rights to have a say in the matters related with the management of the company. All foreign direct investments by financial FLTIs result in Greenfield investment.

• ·                     Brownfield Investment - Under this route, the existing shareholders sell their stake to FLTIs. Since, there is no fresh issue of securities by the companies to FLTIs, There is no fund flow to the companies enabling them to set up or expand business activities. Instead, promoters of the companies get money from FLTIs. FLTIs also get management rights through representation on the board of the company. Some foreign direct investments by strategic FLTIs may result in Brownfield investments. Strategic investment could also be hybrid i.e. strategic FLTIs can subscribe to the fresh share capital (Greenfield) and, at the same time, they can buy shares from existing shareholders (brownfield). Acquisition of Ranbaxy Laboratories by Daiichi Sankyo in 2008 was an example of strategic acquisition which was hybrid in nature. Daiichi purchased entire shareholding from promoters of Ranbaxy, and, at the same time, Ranbaxy issued additional shares and warrants to Daiichi.

    

Eligible Securities for FDI[3]

Indian companies can issue following securities to receive FDI:

• ·         Equity shares;
• ·         Partly paid equity shares and warrants[4];
• ·         Fully, compulsorily and mandatorily convertible debentures (CCD);
• ·         Fully, compulsorily and mandatorily convertible preference shares (CCPS); and
• ·         American Depository Receipts (ADRs), Global Depository Receipts (GDRs), and Fully Compulsorily Convertible Bonds (FCCBs).

Non-convertible, optionally convertible or partially convertible debentures and preference shares will not be counted towards FDI, and the same will be treated as ECBs.

Strategic FLTIs prefer to acquire equity shares to gain immediate control/active management rights over the investee company. On the other hand, financial FLTIs prefer to acquire CCDs and CCPSs so as to get preference over promoters of the investee company in assets distributions in the event of winding up of the company. In early stages of the companies, there is high risk of failure of the startups companies. To contain the possible loss arising due to failure of the investee company, financial FLTIs subscribe to CCPSs and CCDs.

Pricing of Securities under FDI scheme[5]

1)      Listed Companies – Generally, FDI in listed companies is in the nature of strategic investment because these companies can easily raise funds from other routes, and, also because, there is very limited scope of getting high returns from capital appreciation in listed companies therefore these companies are not investment’s target of financial FLTIs. FDI in these company can be Greenfield or/and brownfield investment.

·         Private Investment in Public Equity (PIPE) – As the term itself suggest, it is private investment in public company. In company law and securities laws term, it is preferential allotment of specified securities[6] regulated by ICDR Regulations, 2009. Under this, companies issue fresh securities to foreign investors (Greenfield). RBI mandates that pricing of securities in PIPE transactions shall be done in accordance to the SEBI’s regulations i.e. pricing guidelines of preferential allotment in ICDR regulations.

·         Transfer of shares (Brownfield) - The price of shares transferred by way of sale shall not be less than the price at which a preferential allotment of shares can be made under the SEBI Guidelines, as applicable.

2)      Unlisted Companies – FDI in unlisted companies can be both: strategic and financial investment. For fresh issue of securities as well as transfer of shares the valuation will be done as per any internationally accepted pricing methodology for valuation of shares on arm’s length basis, duly certified by a Chartered Accountant or a SEBI registered Merchant Banker.

Pricing of securities of listed companies has always been an easy affair from regulatory point of view. RBI made SEBI’s pricing guidelines applicable wherever the issue of pricing of securities of listed companies came up. Pricing of securities of unlisted company saw changes of pricing methodology. Earlier for issue and transfer of securities from resident to non-resident under FDI, the prices of securities were determined on the basis of Discounted Cash Flow (DCF) method. Now, the pricing can be done on the basis of any internationally accepted pricing methodology. This gave more freedom of negotiation to parties.

Optionality Clauses while Issuing Securities

In financial management terms, Options are derivative[7]. Options are traded on F&O section of stock exchanges. FEMA is not concerned about their tradability, but their impact on capital control mechanism. Generally, there are ‘call[8]’ and ‘put[9]’ options in shareholders' agreement. Call options are used by strategic FLTIs to raise their holding in companies in future in certain events such as if the sectoral caps of FDI have been raised by the govt. than strategic investors would like to raise their holding to consolidate their positions. Put options are used by the financial FLTIs as an exit route after the expiry of investment horizon. Foreign investors by exercising put options sell their shares to promoters of the investee company. These are put options which faced regulatory frown in the past. RBI was of the view that securities issued with put options gave investors assured returns which were like debt financing and hence should come under much stricter regime of ECB. But in January, 2014, RBI allowed issuance of securities with options subject to certain conditions[10]. The emphasis of RBI was to eliminate the scope of ‘assured return’. Circular issued by RBI ensures that put options cannot be exercised atleast for a minimum period of one year. There is a minimum lock-in period of one year or a minimum lock-in period as prescribed under FDI Regulations, whichever is higher. The lock-in period shall be effective from the date of allotment of such shares or convertible debentures.

Circular has prohibited to issue securities with put options of which exercise price (not formula) has been decided at the time of issue of securities. The exercise price of options will be decided at the time of exercise of that options. The non-resident investor shall be eligible to exit from the investment in equity shares, Compulsorily Convertible Debentures (CCDs) and Compulsorily Convertible Preference Shares (CCPS) of the unlisted investee company at a price not exceeding that arrived at as per any internationally accepted pricing methodology on arm’s length basis. The guiding principle would be that the non-resident investor is not guaranteed any assured exit price at the time of making such investment/agreements and shall exit at the fair price computed as above at the time of exit, subject to lock-in period requirement, as applicable[11].

Exercise price of put options to sell equity shares of listed companies will be the prevailing price in stock market. The exercise price for transferring CCD and CCPS issued by listed companies will be a price worked out as per any internationally accepted pricing methodology at the time of exit duly certified by a Chartered Accountant or a SEBI registered Merchant Banker.

The regulatory regime on the pricing of options has been in state of flux since last few years. Initially, RBI completely prohibited options in investment agreement, but in January, 2014, it allowed the put options attached to equity shares of unlisted companies to be exercised on the price determined as per Return on Equity formula, which took away the element of assured return[12]. In July 2014, RBI again changed its stance and gave more freedom to determine exercise price of options attached to equity shares of unlisted companies to be fair price determined according to any internationally accepted formula at arms-length basis. Now, in January, 2015, RBI has allowed to Tata to pay pre-agreed price to DoCoMo. It is highly recommended to read articles provided in footnote[13]. Regulatory regime for exercise price of options attached to listed equity shares, CCD, and CCPS (of both listed and unlisted companies) has been constant since RBI allowed options in January, 2014.

Eligible Foreign Investors

Investment under FDI scheme is not regulated on the basis of classes of investors like under PI scheme. Any non-resident entity can invest under FDI scheme. However, if the origin of the entity is in Bangladesh or Pakistan than depending upon the sector in which investment is to be made, approval from govt. has to be obtained.  

There exist considerable ambiguity on the investment by FII under FDI scheme. As learned earlier that an individual FII cannot hold maximum 10% of paid-up share capital of the company. If an individual FII holds more than 10% of the paid-up share capital of a company, than investment above 10% will be considered as FDI, and the same will be counted toward FDI cap[14]. There may be a situation in which a company requires funds, and a FII is willing to invest the money, it can be done in the following ways:

• If individual FII’s holding is less than 10% - than the company can issue shares against the investment made by FII under private placement mechanism allowed under PIS in schedule 2 to FEMA 20. This can be done till the individual limit does not go beyond 10%.
• If Individual FII’s holding is at 10% - still the company can issue shares against the investment made by FII under private placement mechanism, but this will be done under FDI scheme and such investment will have same restriction as are applicable on FDI by any other non-resident Indian.

As noted in an earlier part that FIIs can invest in unlisted companies under PIS in schedule 2 to FEMA 20. It was also noted that new RFPI regulations, 2014, prohibited investment in unlisted companies under FPIS by FPIs. Now, both RFPI regulation and Schedule 2A to FEMA 20 stipulate that if FIIs do not exit the unlisted public company at the time of listing of such company than investment under PIS will be considered as FDI and the same will be subjected to capital control measures under FDI scheme.

Composite Sectoral Caps

As noted earlier, investment in equity shares of a company can either be made under PIS or FDI scheme. While under PIS, portfolio investors get only voting rights, but, under FDI scheme, foreign investors may also get management rights besides voting rights. In strategically important sectors such as banking, insurance, telecom and real state, total foreign investment (PIS + FDI) cannot exceed sectoral caps. Acquisition of voting rights is threshold for stricter regulation of these sectors. In other sectors, investment under PIS and FDI scheme remains separate, and investment in one scheme does not decrease the limit of investment under other scheme. But in sectors with composite cap, investment under one scheme will eat up the space of investment under other scheme.

This part has covered various aspects relating to FLTIs under FDI scheme. There are various other sector specific requirements in FDI policy.  Foreign Venture Capital Investors (FVCIs) has one other route to make investment into Indian companies. This scheme is contained in schedule 6 to FEMA 20. In next part (4.2), scheme for FVCI will be discussed.

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[1] The term is coined for the purpose of this article. FEMA regime does not mention this term anywhere.

[2] Sequoia Invests $8 Million In Messaging App Maker WhatsApp <http://techcrunch.com/2011/04/08/sequoia-whatsapp-funding/, Last accessed at February, 14, 2015>

[3] Consolidated FDI policy dated April, 17, 2014.

[4] RBI/2014-15/123 A.P.(DIR Series) Circular No.3

[5] RBI/2014-15/129 A. P. (DIR Series) Circular No. 4

[6] Specified securities has been defined by ICDR Regulations, 2009 to mean equity shares and securities convertible in equity shares.

[7] A derivative is a contract between two parties which derives its value/price from an underlying asset.

[8] A call option confers a right on investor to buy shares in future.

[9] A put option confer a right on investors to sell their shares in future.

[10] RBI/2013-2014/436 A.P. (DIR Series) Circular No. 86.

[11] RBI/2014-15/129 A. P. (DIR Series) Circular No. 4

[12] RBI/2013-2014/436 A.P. (DIR Series) Circular No. 86.

[13] RBI eases fair value buyout norm, allows Tatas to pay DoCoMo previously agreed price for Tata Tele stake < http://articles.economictimes.indiatimes.com/2015-01-14/news/58065915_1_tata-sons-ntt-docomo-central-bank/2, Last accessed at February 14, 2015>

[14] Investment by FIIs under the FDI route would not be reckoned towards the 10% limit provided for investments under the FII route < http://www.indialawjournal.com/volume4/issue_2/special_report.html, Last accessed at February, 13, 2015>