October 3, 2011

New Consolidated FDI Policy: Entry is welcome – Exit at our ‘option’!

Against the backdrop of declining foreign direct investments (“FDI”) in India, much was anticipated from the regulators on the mid year review of the policy on FDI in India i.e. the Consolidated FDI Policy. On September 30, 2011, the Department of Industrial Policy and Promotion (“DIPP”) from the Ministry of Commerce and Industry has released the revised Consolidated FDI Policy (Circular 2 of 2011) (“New FDI Policy”), which became effective from October 1, 2011. The New FDI Policy supersedes the erstwhile version of the policy that was made effective by DIPP on April 1, 2011 (“Erstwhile FDI Policy”).

The changes brought by the New FDI Policy are dreary and lackluster; however, on a minute reading of the policy, there may be a ground breaking impact on the inflow of foreign investments into India as the interests of the foreign investors may get a set back. This effect is due to introduction of a new clause under Chapter 3 (General Conditions on FDI) of the New FDI Policy whereby DIPP has restricted the exit avenues that may be available to a foreign direct investor. We hereby outline the key changes that this fourth edition of Consolidated FDI policy introduces, along with their implications.

A.      ‘Options’ to lose their equity character

Conspicuous by its absence from the list of major changes summed up in the Press Release dated September 30, 20111, that accompanied the release of New FDI Policy, is what it introduces under clause of the New FDI Policy. Despite the parties to the transaction negotiating certain exit options that may be available to the foreign investor, DIPP has now imprinted that any method of offering an exit to any foreign investor by way of use of ‘options’ will render any such equity instruments to be ineligible for FDI and to comply with the ECB guidelines, thus, losing their equity character.

Background: RBI’s words DIPP’s voice?

Perhaps, this doesn’t count as a change in the prevalent policy from the perspective of the Reserve Bank of India (“RBI”) as RBI has been raising objections to the widely opted exit mechanism in the form of ‘put option’ or ‘call option’. In July 2009, RBI had raised issues with the put option agreed upon between DE Shaw and promoters of DLF, owing to the price formula that assured the investor a given IRR within it3, however, the issue now no longer revolves around the timing of price determination. Reading together the letters that RBI has subsequently issued to other promoters and investors, at various points in time, pointing out the alleged debt-like nature of share purchase agreements that carry an option for the investor to sell (put), promoter to buy (call), or company to buy (buy-back), now the very option available to the parties is in issue; not the prior determination of pricing alone. Further, these options, while admittedly ‘in-built’ in the agreements, are also looked upon as ‘derivatives’ by the regulators, which do not fall under the category of permissible FDI instruments.

These options warranted investors a safe exit, on a specified event occurring (like an IPO failure) or after a specified period of time. Now that the New FDI Policy stands clarified, such arrangements will have to comply with the restrictions in terms of end-use, eligible borrowers and lenders, and cap under the extant ECB regime, and will no longer be considered FDI.

What are the implications?

The New FDI Policy restricts exit rights available to foreign investors and renders both, ‘put options’ and ‘call options’, as not eligible for FDI purposes. In a market where IPOs don’t remain commercially viable, put options, call options or buyback remained an exit option for foreign investors, especially for private equity funds, with limited capital interests.4 More often than not, their exercise had also been stipulated as contingent upon the occurrence of any event of default on part of the company or the promoters. By posing such a restriction, it would take away the obligation of performance from the promoters and the Indian company and will lead to be a mis-match of expectations. It is customary in private equity transactions for the promoters and the Indian company to attract foreign investments by making certain promises to the foreign investor; however, removal of such options available with the foreign investors could, in a distorted form, appear to be a protectionist approach of the regulators in favour of the Indian promoters and companies.

And this does not necessarily stop here – any joint venture or a strategic partnership arrangement would typically have provisions in relation to exit for either parties in case of breach, default or other such consequences as the parties may commercially agree. Further, it is a fairly common provision in such agreements to provide for a put or call option for either party to buy out the other so that the business does not suffer and there is a viable exit available for the outgoing party. All of these rights will now become impractical with the New FDI Policy.

Exits are an essential part of any Shareholders’ Agreement and making these provisions impermissible would take out the substance of such an agreement. How this change affects options in agreements that have been hitherto entered into remains to be seen and what will be the opportunities that will be available to the foreign investors is yet to be explored. With options being barred in either event, foreign investors, especially private equity funds, have little incentives to invest in to a country which is otherwise characterized by significantly high rates of inflation, corruption and political uncertainty.

B.      Exemption from otherwise applicable restrictions for construction-development activities in the education sector and in old-age homes

As a welcome move, construction development activities in the education sector and in respect of old-age homes have been exempted from conditions applicable to construction-development sector in general in terms of the minimum built area, minimum capitalization (USD 10 million for wholly owned subsidiaries and USD 5 million for joint ventures with Indian partners) and the lock-in period of three years from the date of completion of minimum capitalization. With this exemption available now, FDI is expected to flow in this sector.

C.      Relaxed timelines for conversion of imported capital goods/machinery to equity instruments and payment of pre-operative/pre-incorporation expenses

Following a discussion paper issued in September last year, effective from April 1, 2011 on ‘Issue of Shares for Considerations Other Than Cash’, conversion of imported capital goods/machinery and pre-operative/pre-incorporation expenses to equity instruments were permitted, subject to prior Government approval, under Clause 3.4.6. of the Erstwhile FDI Policy, which came into force on April 1, 2011.

The erstwhile FDI policy prescribed a time limit of 180 days from the date of shipment of goods within which such conversion into equity should be undertaken. The New FDI Policy now clarifies that it is the application for such conversion that has to be made within 180 days from the date of shipment of goods, and not from the date of the conversion.

Similarly, payment  for  pre-operative/pre-incorporation expenses can now be made  by  the  foreign  investor  to  the  company  directly  or through the bank account opened by the foreign investor in accordance with Foreign Exchange Management (Deposit) Regulations, 2000. Here again, the window of 180-days from the date of incorporation of the company is clarified as applicable to filing of application for conversion of such payment into equity (which under the earlier policy applied to conversion). However, it is not clear how such payments can be made to the company, when the company has not come into existence yet.

D.      Pledge of shares

Under the New FDI Policy, a promoter of an Indian company can pledge his shares to secure a loan obtained under ECB, provided that the Authorized Dealer (AD) is satisfied that certain conditions with respect to the loan agreement are met, Loan Registration Number has been obtained, and other specified conditions are satisfied. Further, a non-resident shareholder in an Indian company can also pledge his stake in the company in favor of the AD to secure a credit facility extended to such company. The lending bank then will have to comply with Section 19 of the Banking Regulation Act, 1949. The pledge may also be made in favor of an overseas bank to secure credit facilities extended to non-resident promoters or shareholders of the resident Indian company whose shares are pledged, provided, inter alia, such loaned funds are utilized for overseas business purposes.

E.      Escrow accounts

Opening and maintaining non-interest bearing escrow accounts in India on behalf of non-residents (denominated in INR) towards payment of share purchase consideration or for keeping securities earlier required RBI approval. Now such approval can be obtained from AD Category – I banks without the prior approval of RBI.

F.      Single brand product trading

Despite the very favorable recommendations of the Committee of Secretaries to open up multiband retailing, it remains a prohibited sector. The New FDI Policy, on the contrary and as a dampener, has only tightened its grip by introducing a condition that the foreign investor should be the owner of the brand into which the investment is made. This implies that brand licensees may no longer be allowed to make investments into retailing under this channel.

G.     Expansion of industrial activity under industrial parks

New FDI Policy has included ‘basic and applied R&D on bio-technology pharmaceutical sciences, life sciences’, as an ‘industrial activity’, under industrial parks, defined as “a project in which quality infrastructure in the form of plots of developed land or built up space or a combination with common facilities is developed and made available to all the allottee units for the purposes of industrial activity”.

H.      FM Radio- cap increased

FDI limit in terrestrial broadcasting / FM radio has been increased to 26% under the New FDI Policy, from the erstwhile cap of 20%.


Though the New FDI Policy states that the intent and objective of the Government of India is to attract and promote foreign direct investment into India, the change with respect to the prohibition of using ‘options’ as a means of exit mechanism may close the doors for a majority of investors across. It is appalling to see the regulators taking such a view against certain strategic or private equity investors, to whom such rights are very valuable, and such an attitude towards these foreign investor raises questions whether the approach of the regulators is appropriate in today’s circumstances. For e.g., recently, the RBI, vide its Master Circular on Foreign Investments in India dated July 1, 2011, had added a provision which prohibits a SEBI registered Foreign Venture Capital Investors (“FVCI”) from acquiring permitted securities by way of private arrangement with a third party. This, in effect, seems to restrict SEBI registered FVCIs from purchasing shares from existing shareholders of Indian portfolio companies. It may be noted that till date the issue pertaining to secondary purchase of shares by SEBI registered FVCIs was a grey area as the terminology used under the extant regulations did not specifically prohibit SEBI registered FVCIs from purchasing shares from existing shareholders.

While India can boast of strong regulatory fundamentals that can support such capital inflows, DIPP and the ministry must reduce regulatory uncertainty and chaos, and promote market instruments which can avert risks for foreign investors. However, rather than valuing the long term commitment, regulators seem to have looked at this with a suspicion and thus – ‘Entry is welcome but exit at our option’!



1 http://dipp.nic.in/English/acts_rules/Press_Release/pr30092011.pdf

2 Clause “Only equity shares, fully, compulsorily and mandatorily convertible debentures and fully, compulsorily and mandatorily convertible preference shares, with no in-built options of any type, would qualify as eligible instruments for FDI. Equity instruments issued/transferred to non-residents having in-built options or supported by options sold by third parties would lose their equity character and such instruments would have to comply with the extant ECB guidelines.”

3 See our Reality Check on ‘Funding Real Estate Projects: Exit Challenges’ here.

4 See Options, Puts and the Law, February 10, 2009 available at: www.livemint.com/2009/02/10221646/Options-puts-and-the-law.html, and Regulators frown at put option mode of exit, August 14, 2011 available at: http://www.livemint.com/2011/08/14230735/Regulators-frown-at-put-option.html





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