Tough regulations' on retail -- finding an opening to invest

Much has been said on the actual impact that the retail foreign investment policy has had, since it was announced last year. Some traction has been seen on the single brand side, while multi brand retailers have chosen to sit on the sidelines. The overall feeling seems to be that the policy is 'tough', the political environment uncertain and a cautious wait and watch approach is wise in the current circumstances. This wait will only get longer as India goes through general elections next year and MNCs wait to see the new government’s direction with respect to retail trade.

In our earlier editions of BMR Point of View on retail[#_ftn1]^[1], we have talked about the levers that the Government has, to channelize much needed foreign investment in this space. In this sixth edition, we discuss some alternate strategies that investors can follow within the framework of the current regulations.

This window arises from the Government’s recent articulation of how it reckons sectoral caps for permissible foreign capital in layered investment structures. This clarity has finally been provided by the Government under the indirect foreign investment and downstream investment guidelines, which were formally notified by the Reserve Bank of India (“RBI”) recently. The guidelines are general in nature and can be used across most sectors - in this edition, we analyse how they may be relevant in the context of retail.

Analysis of the recent notifications

The 2009 position

Indirect foreign investment and downstream investment guidelines are formulated to govern investments made by an Indian company, which has received foreign capital. In 2009, the Government[#_ftn2]^[2]had for the first time laid out a clear principle – that, in reckoning whether investments made by such an Indian company are to be viewed as FDI or not, consideration must be had not to the economic rights enjoyed by the foreign and Indian parties, but only to the control that is exercised by the foreign investor. Thus, these guidelines clarified as below:

If a non-resident (ie Ain the diagram below) beneficially holds more than 50% in B or otherwise exercises control over B, the investment made by B in C will be regarded as indirect foreign investment. Such indirect foreign investment has to satisfy sectoral caps and other guidelines prescribed by the government with regard to downstream investments and indirect foreign investment.

On the other hand, if (a) A beneficially holds < 50% in B and (b) also does not exercise control over B, the investment made by B in C will be outside the purview of indirect foreign investment, and investment by A will not be subject to any regulatory approval[#_ftn3]^[3].

RBI nod to the 2009 Union Government policy

Even as the Government notified this principle through the relevant Press Notes in 2009, actual implementation of this could not take off in a big way as RBI did not notify the relevant changes under the Foreign Exchange Management Act (FEMA). Structures based on this principle were therefore, viewed as aggressive and bore the risk of scrutiny.

The speculation surrounding these guidelines is over as the RBI has now, in 2013, formally notified these principles. This step is forward thinking - it acknowledges that where the foreign investor holds less than 50% and does not exercise control over the Indian company – the Government need not regulate further investments made by such an Indian company.

New definition of “control”

Simultaneous to the notification of these guidelines, the Government has also widened the definition of ‘control’, the criteria for determining whether a downstream investment by an Indian entity (having foreign capital) may be viewed as indirect foreign investment or not. The erstwhile definition of control was restricted to the right to appoint a majority of directors in a company, which typically went hand in hand with holding majority stake in a company. The new definition[#_ftn4]^[4]however, takes cognisance of control exercised on management and policy decisions through shareholder agreements, even without having a majority on the Board.

The new definition of control reads as " 'Control' shall include 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." This definition has been largely aligned with that contained in the new Companies Act, 2013 and the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011.

In order to avoid any misuse of the policy, it is prescribed that in sectors where government approval is required for foreign investment and where the shareholders enter into inter-se agreements, the same would need to be furnished to the government for consideration/ approval. These changes suggest that the government is likely to take a more informed and realistic view to investigate the extent of control exercised by the foreign shareholder, as recently witnessed in the Jet-Etihad deal.