Until very recently proposals for foreign direct investment in India triggered the requirement to seek prior Government approval depending on the sector in which the investment was proposed to be made. The list of these “approval route” sectors was progressively liberalized and as a result the requirement to seek prior Government approval for any foreign investment was triggered only in case of a handful of sensitive sectors. There were only a couple of exceptions to this general rule, which required foreign direct investment coming from Pakistan and Bangladesh to be subject to prior Government approval. However, in April 2020, with the onset of the Covid 19 pandemic in India and the growing geopolitical issues with China, the Government of India announced a change which would have a far reaching and long lasting impact on the foreign direct investment regime in India. The Government announced that investments from an entity based in a country which shares a land border with India, or where the beneficial owner of the investment in India is situated in a country which shares a land border with India, will require prior Government approval. In addition to primary investments, the restriction would also apply to secondary transfers of existing foreign direct investment in an Indian entity to an acquirer which meets this condition.
This requirement is primarily aimed at foreign direct investment from China as investments from other neighboring countries was either negligible and/or already regulated. China has traditionally not been a major source of foreign direct investment in India with some records suggesting that the aggregate amount of foreign direct investment from China over the last 20 years has only been around USD 2.5 billion. Having said that, a majority of these inflows have occurred over the last few years primarily in the Indian technology sector. The trigger for introducing this approval requirement was seemingly the increase by the People’s Bank of China of its stake in India’s largest private sector bank HDFC to 1%. On the face of it, the requirement was introduced with a view to “curbing opportunistic takeovers/acquisitions of Indian companies”. However, the broad brush nature of the language unfortunately, does not correspond with this stated intent and applies even to acquisition of minority stakes and funding to wholly owned entities. It does not even distinguish between “national champions” such as HDFC and emerging startups and tech companies which are keen to attract foreign capital.
The key issue with the requirement is that the Government has not provided a definition of the term “beneficial owner”. There have been several reports of the Government considering introducing a definition, but four months later, clarity is yet to emerge. This is possibly by design as the Government has probably realized the challenges in arriving at a precise definition. Given the way most of the leading Chinese entities are structured (with holding companies and/or listings outside of the PRC), any definition could well end up being less than perfect. The absence of a precise definition has resulted in the Indian authorized dealer banks, who act as gatekeepers for foreign investment inflows and outflows, adopting their own interpretations or variations of the existing rules which are not entirely fit for purpose. The tests being applied by banks range from evaluating whether the investor has any PRC shareholder who holds more than a 5%, 10% or 25% stake, and/or whether any senior managing official of the investor is a PRC national. Since the onus of complying with the foreign exchange regulations is primarily on the Indian investee companies, the investee companies are in turn requesting for contractual protections in terms of warranties and indemnities from a potential investor with a PRC connection. However, given the lack of clarity, potential investors are being put in a rather difficult situation of being required to warrant that their investment will not be subject to this requirement without knowing precisely what the requirement is, and who is it aimed at.
The other area of overreach has been the attempt to transpose this requirement to apply to investments in AIFs and other local platforms by LPs which, in theory at least, ought to be exempt from this requirement as it only applies to investments made under the foreign direct investment route. It remains to be seen whether such investments are ultimately kept out of the purview of this requirement or whether the Government goes for the jugular and restricts any inflow of capital from China be it under the traditional foreign direct investment route or under any of the recently emerging alternative investment routes.
The introduction of this approval requirement is likely to impact the capital raising efforts of several big Indian technology companies. Unlike the manufacturing sector, the Indian technology sector has been one of the bigger success stories in its ability to continue to attract the big and mighty of the world. The change in work cultures is likely to give a further fillip to the Indian technology sector. However, given the inroads made by several Chinese investors in the technology sector, future fund raising efforts are likely to be hampered as a result of this requirement. There are already reports of Indian companies being unable to drawdown on committed funds proposed to be invested by companies with a PRC connection. For now, North American tech conglomerates and tech focused funds seemed to have stepped into the breach as the number of multi billion dollar investments in Jio Platforms, a digital services company, by North American investors suggests.
Whilst India is not an outlier in its attempt to closely regulate investments from China, there is a need to clarify the scope as well as to crystallize the interpretation of the term “beneficial owner” in order to reduce the uncertainty around its application.