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SEPTEMBER 2013

SPECIAL EDITION

STRICTLY FOR PRIVATE CIRCULATION

New denition of Control for FDI

Inter aliais a legal newsletter published by AZB & Partners for a select list of clients and colleagues. Published every quarter, it aims to provide a snapshot of recent legal developments in certain critical areas: infrastructure, foreign direct investment, securities law, exchange control regulations, corporate law, media and entertainment, intellectual property and banking. When a significant development demands it, Inter alia is published as a Special Edition to provide an in depth analysis of that development. We hope you will find the content informative and useful. If you have any questions or comments, please email us at: editor.interalia@azbpartners.com or call AZB & Partners.

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Introduction
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The Department of Industrial Policy and Promotion, Ministry of Commerce and Industry, Government of India (DIPP), has issued Press Note 4 (2013 Series) on August 22, 2013, which amends the existing definition of control under the terms of the Consolidated Foreign Direct Investment Policy dated April 05, 2013 (FDI Policy). Prior to the amendment, the definition under the FDI Policy, of an Indian company controlled by resident Indians was as follows: A company is considered as controlled by resident Indian citizens if the resident Indian citizens and Indian companies, which are owned and controlled by resident Indian citizens, have the power to appoint a majority of its directors in that company. Pursuant to this amendment, control has now been defined as follows: 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. (Emphasis Supplied). The definition of being owned by resident Indian entities in the FDI Policy continues to be as follows: A company is considered as owned by resident Indian citizens if more than 50% of the capital in it is beneficially owned by resident Indian citizens and / or Indian companies, which are ultimately owned and controlled by resident Indian citizens. The revised definition of control, therefore, expands the existing definition to also include control which is exercised through management and policy decisions, shareholding, management rights, and shareholder or voting agreements.

Control under the FDI Policy

The key implications of the amended definition of control under the extant FDI Policy are discussed below:

1. Downstream Investments
If an Indian company is concluded to be foreign owned or foreign controlled for the purposes of the FDI Policy, any downstream investment by that Indian company in another Indian company is required to be in compliance with the relevant sectoral conditions on entry route, conditions and caps with regard to the sectors in which the latter Indian company is operating. For example, prior to this amendment, in the case of an Indian investee company A (Company A) which has foreign direct investment (FDI) of less than 50% of the share capital and where the foreign investors do not have the right to appoint majority of the directors on the board of directors of Company A, one was not required to examine the other rights exercised by such foreign investor as the erstwhile definition of control clearly stated that an Indian company would be considered as Indian owned and controlled if the FDI in Company A is below 50% of the share capital and the foreign investor does not have the right to appoint majority of the directors on the board of directors of Company A. Therefore, prior to this amendment, where a foreign investor held less than 50% in Company A and Indian resident shareholders had the power to appoint majority of the board of directors of Company A, an investment by Company A, in another Indian company B (Company B), would not have been treated as indirect foreign investment by virtue of Company A having received FDI. However, pursuant to the amended definition of control, the nature of rights exercised by the foreign investors in Company A would need to be examined (irrespective of the quantum of foreign investment and even if the right to appoint directors is in favor of the Indian resident shareholders) and if Company A is considered to be foreign owned or foreign controlled, the entire downstream investment by Company A in Company B will be considered as indirect foreign investment even if Company A itself has minimal foreign investment (except where Company A owns 100% of Company B on which case indirect foreign investment in Company B is limited to the percentage of FDI in Company A) and would need to be in compliance with the conditions under the FDI Policy applicable to the specific sector in which Company B is operating. A diagrammatic representation of this illustration is set out below: INDIAN PROMOTER
90% ownership plus right to appoint majority board of directors

FOREIGN INVESTOR
10% ownership plus minority protection rights

COMPANY A

Indian owned and Indian board controlled but potentially foreign controlled

80%

COMPANY B

Entire shareholding will now be considered as foreign investment

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Prior to the amendment of the definition of control, such FDI in Company A would not have been considered for the purposes of calculating indirect FDI in respect of the downstream investments made by such Company A into Company B (irrespective of the sector that Company B is engaged in, except for insurance for which there exists a specific carve-out) if Company A is owned and controlled by Indian residents. However, pursuant to this amendment, even where the foreign investor exercises minority protection rights, it will be necessary to examine whether such rights amount to control even if the Indian resident shareholder has the right to appoint majority directors on the board of directors of such company. This is relevant specifically in the context of downstream investments in companies engaged in sectors with sectoral caps on FDI. For example, if Company B was a ground handling company in which FDI is capped at 74%, any downstream investment by Company A (even if such investment is out of its own internal accruals) in Company B will prohibit Company B from raising any direct foreign investment. Therefore, the FDI Policy which previously provided an objective definition of control, has, pursuant to the amendment to the definition of control, become subjective.

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2. Investment in sectors with Sectoral Caps

As per the FDI Policy, in sectors with caps on FDI, prior approval of the Foreign Investment Promotion Board (FIPB) will be required in all cases where the control of an existing Indian company (Company X), which is, for example, a credit information company, currently owned or controlled by resident Indian citizens and Indian companies, (which are, in turn owned or controlled by resident Indian citizens), is being transferred to a non-resident entity as a consequence of transfer of shares and/or fresh issue of shares to non-resident entities inter alia through amalgamation, merger/demerger, and/or acquisition. Therefore, in cases where even a minority stake of, for example, 10% is being acquired in Company X, if the foreign investor has certain veto rights over the affairs of Company X which, if construed as enabling such foreign investor to have control over Company X, approval of the FIPB will be required, prior to making such an investment; even if such foreign investment in Company X is otherwise under automatic route.

3. Treatment of Existing Investments

The amended definition of control will apply prospectively. This effectively means that, while the existing foreign investments in Indian companies with sectoral caps and having downstream investments in other Indian companies, which are engaged in restricted / prohibited sectors, will be grandfathered, any further rounds of investment by the foreign investor into such Indian company or any new downstream investments by such Indian company, is likely to require a fresh examination of the rights of the foreign investor in such Indian company in order to determine if the same is in compliance with the FDI Policy by virtue of the new definition of control. For example; while an existing minority investment by a foreign investor (without the right to appoint majority of directors) in an Indian company which has downstream investment in another Indian company engaged in construction and development of townships (a sector which has conditionalities applicable to FDI) is not required to comply with the conditions set out the FDI Policy in relation to FDI in township construction and development, there is ambiguity on whether any further funding by such foreign investor in such an Indian company would require the construction development of township activity, undertaken by the downstream company to comply with the applicable conditions under the FDI Policy if the foreign investor has minority protection rights in the first Indian company.

Scope of Control under the Takeover Regulations Parallel Interpretation?

The press release notifying the amended definition of control, states that the amendment will ensure alignment of the scope of control with the definition of control as per the Substantial Acquisition of Shares and Takeovers Regulations, 2011 (Takeover Regulations) and the definition proposed in the Companies Bill, 2012. It may be noted that the definition of control as per the Takeover Regulations has already given rise to considerable uncertainty on the issue as to whether contractual rights, especially in the nature of affirmative voting rights granted to minority shareholders, amount to control. Such affirmative voting rights generally provide negative rights to such minority shareholders which enable the investors to prevent a company from taking certain actions without approval of the foreign investor, as opposed to exercising any positive control over the actions of the company. Such rights are commonly granted to investors generally with a view to protect the investments by such investors. Subhkam Ventures In the well-known dispute between M/s Subhkam Ventures India Private Limited (Subhkam) and the Securities and Exchange Board of India (SEBI), the Securities Appellate Tribunal
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(SAT) disagreed with the position adopted by SEBI that affirmative voting rights conferred on an acquirer, would result in the acquirer having acquired control over the target company. In this matter, SAT observed that control is a proactive and not a reactive powerit is a power by which the acquirer can command the target company to do what it wants to doPower by which an acquirer can only prevent a company from doing what the latter wants to do is by itself not control. In other words SAT construed the term control under the Takeover Regulations to mean a positive power and not a negative or preventive power. The decision of SAT was challenged by SEBI in the Supreme Court. However, while a decision of the Supreme Court was eagerly awaited on this issue, the parties to the dispute, viz. SEBI and Subhkam, entered into a settlement as a result of which the Supreme Court observed that the question of law as to whether negative control amounts to control remained open and that the SAT decision in Subhkam would not be treated as a precedent. As a result, the issue of whether or not affirmative voting rights conferred on an investor would amount to the investor having acquired control or not, remains an open one. Consequently, at present, there is no clear guidance available from the decision in Subhkam as to the manner in which the new definition of control will be interpreted under the FDI Policy. However, it may be observed from SEBIs stance in Subhkam that SEBI has been interpreting control in a broad manner to even include negative rights which are in the nature of protective rights and do not confer any positive control on the investor to direct the management and policies of the company1. In light of the above, the issue as to whether acquisition of affirmative voting rights or other customary minority protection rights by investors would amount to acquiring control under the Takeover Regulations continues to be a vexed issue.

Jet Etihad Deal

Regulators recently raised concerns over the terms of the agreement between Etihad Airways PJSC (Etihad) and Jet Airways (India) Limited (Jet) in relation to the acquisition of a minority stake by Etihad in Jet. It was reported that concerns were raised by regulators that control of Jet could pass into foreign hands because of the manner in which the deal had been structured, despite Etihad acquiring a minority stake in Jet. While the deal has been approved by FIPB, approvals from certain other regulators are awaited. Accordingly, it remains to be seen how the deal will be finally executed, addressing the concerns of the relevant Indian regulators. Further, it will need to be examined whether or not the position taken by the various regulators in the Jet-Etihad deal will serve as a precedent to determine what constitutes control for all sectors or whether such concerns are more relevant for heavily regulated sectors such aviation where the substantial ownership and effective control is required to be vested with Indian nationals.

Concluding Remarks
The amended definition of control, will therefore: (i) lead to a situation where an Indian owned and Indian board controlled company with even a minimum shareholding held by foreign investors (including foreign private equity investors) having certain veto or customary affirmative vote rights, may be categorised as a foreign controlled company; (ii) lead to a situation where an Indian owned and Indian board controlled entity with much higher foreign ownership (assuming foreign investors are willing to invest significant capital without rights to protect their investments) will continue to be classified as Indian owned and controlled merely because minority protection rights are not given to its shareholders2; (iii) result in the entire downstream investments made by Indian companies (which are classified as foreign controlled) into other Indian companies being foreign investments, despite the minimal foreign shareholding in itself and also require them to comply with the sectoral caps, valuation guidelines, minimum capitalisation norms etc.; and (iv) require fresh examination of the rights of a foreign investor where the foreign investor proposes to make further investments in an Indian investee company even where the original investment by such foreign investor in the Indian investee company is grandfathered. While there is no bright line test to determine control, and the interpretation of control may be case specific, foreign investors will now have to exercise caution with regard to the nature of rights acquired when they invest in Indian companies and whether such rights may be construed as them having acquired control. Further, it remains to be seen whether DIPP and FIPB would adopt a similar interpretation of control as SEBI since, as stated above, the new definition of control is similar to the definition of control under the Takeover Regulations.
1 The issue of whether affirmative voting rights would constitute control under the Takeover Regulations was also considered by SEBI in a recent matter of Clearwater Capital Partners, which is currently pending before SAT. 2 It would be very unlikely for such foreign investors to commit large amounts of capital without adequate rights to protect their investment.

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The fact that there is no settled judicial decision with regard to what constitutes control is likely to add to the already existing ambiguity. In any event, it is unlikely for there to be any one size fits all solution and the test of control will end up being a look and feel test taking into account various factors such as the nature of rights of the investor, the stake held by the investor, the rights enjoyed by other parties in the company, etc.

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For further information on this Special Edition, please contact: v

mumbai

Zia Mody zia.mody@azbpartners.com Darshika Kothari darshika.kothari@azbpartners.com v

new delhi

Ajay Bahl ajay.bahl@azbpartners.com Anil Kasturi anil.kasturi@azbpartners.com v

bangalore

Srinath Dasari srinath.dasari@azbpartners.com

september 2013

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6september 2013