The Department for Promotion of Industry and Internal Trade (DPIIT), Government of India (GOI) has issued Press Note 3 dated April 17, 2020 (PN#3) to curb opportunistic acquisition of Indian entities during COVID-19 pandemic.
PN#3 comes as no surprise considering the recent acquisition by the People’s Bank of China (PBC) of a toehold stake (1.01 percent) in HDFC. The timing of PBC’s purchase – when HDFC’s share price was on a decline – had ignited fears of high performing Indian companies with strong business fundamentals, and affected by COVID-19 pandemic falling easy victims to opportunistic acquisitions. India Inc.’s concerns were exasperated with reports of leading Chinese companies with deep pockets and the backing of the Chinese state vigorously scouting for investment opportunities in India and elsewhere. No wonder, the representatives of the Indian medium and small industries made an urgent appeal to the Indian Prime Minister to halt foreign direct investments (FDI) from China. Their apprehensions were also echoed by prominent Indian opposition leaders who also urged the Indian government to come up with laws to stem the possibility of the discounted opportunistic sale of Indian companies.
The global narrative against opportunistic acquisitions
COVID-19 pandemic and the unprecedented decline in global economic activity has resulted in several countries asserting their economic sovereignty to shield domestic companies from opportunistic buys. The European Union (EU) guidelines of March 25, 2020, recommends member states to adopt screening mechanisms for shielding critical health infrastructures, research establishments, and technology companies from perverse foreign investments of companies of strategic value. Italy has recently authorized mandatory pre-governmental clearance for mergers, joint ventures, stock or asset purchases by foreign investors into defence, energy, transportation, communication, technology, and other strategic sectors. Spain, too, has introduced temporary measures mandating prior governmental authorization for non-EU/EFTA entities proposing to acquire control or equity stake over 10% in Spanish companies engaged in energy, healthcare, and sensitive sectors. Germany has proposed amendments to the (German) Foreign Trade and Payments Act, 2013, to facilitate governmental scrutiny of foreign investments on a case by case and prohibit deals that may interfere with German public policy or public security. Even the French Monetary and Financial Code has brandished the requirement of prior approval from the Minister of Economy for foreign investments that jeopardize public order, public safety, or national defence interests. Media reports indicate that the United Kingdom proposes new legislation to implement foreign investment screening measures to dispel opportunistic acquisitions.
The US government has followed a protectionist policy to shield companies from the increasing onslaught of Chinese acquisition. The (United States) Foreign Investment Risk Review Modernization Act, 2018, has empowered the Committee on Foreign Investment to scrutinize foreign investments into US technology and real estate companies by entities controlled/funded by foreign sovereign states. With the US economy increasing affected by CODID-19 pandemic, foreign investments into US companies operating in strategic sectors may witness increased governmental scrutiny. The US states, including Delaware, also have evolved jurisprudence on takeover defences, which entitle US companies to deploy poison pill structures to thwart hostile acquisitions. Deal Point Data report of April 1, 2020, mentions that an overwhelming number of US-listed companies have used poison pills during the global pandemic.
Australia has also amended the Foreign Acquisitions and Takeovers Act 1975 to require mandatory clearance of the Foreign Investment Review Board for foreign investments into Australia. Japan has earmarked USD 2.2 billion packages for assisting Japanese companies in shifting production lines from China, signalling its concerns on its companies operating in China.
The ambit of PN#3 – Demystifying the Indian position
Mandatory government approval
PN#3 prescribes mandatory governmental approval for FDI into Indian investee entities (primarily companies and LLPs) from countries that share a direct land border with India – China, Pakistan, Bangladesh, Nepal, Afghanistan, Myanmar, and Bhutan (Restricted Countries). Mandatory governmental approval would apply to both direct and indirect FDI investments from Restricted Countries and includes primary investments and secondary transfers of shares of listed and unlisted Indian investee entities. PN#3 suggests that direct FDI investments would comprise of investments received from citizens or entities incorporated in a Restricted Country (Restricted Persons). Indirect FDI investments would cover FDI investments received by Indian investee entities from intermediate foreign entities beneficially owned by Restricted Persons.
No distinction between ‘strategic’ and ‘financial’ investors
PN#3 makes no distinction between Restricted Persons that are purely financial investors and those that are strategic investors. Further, though not clarified, the expression ‘investment’ used under PN#3 suggests that the mandatory governmental approval would apply to FDI through all equity instruments – equity shares (including partly paid), convertible preference shares, convertible debentures, and warrants.
Meaning of ‘beneficial owner’
PN#3 also does not elaborate on the meaning of ‘beneficial owner.’ The Foreign Exchange Management Act, 1999, and its regulations also do not define ‘beneficial owner.’ While both the Reserve Bank of India (Know Your Customer (KYC)) Directions, 2016 (KYC Guidelines), and The Prevention of Money Laundering Act, 2002 defines the expression ‘beneficial owner,’ DPIIT is more likely to adopt the RBI interpretation in construing ‘beneficial owner’ under PN#3.
The KYC Guidelines prescribe the twin tests of ultimate ownership of over 25 percent shares (or profits) in an Indian investee company or the right to make majority board appointments, which includes de facto control of the Indian investee company through contractual arrangements. The test prescribed for partnership firms and unincorporated entities is the ownership of/entitlement to over 15 percent of the capital or profits of the entity.
Treatment to FPIs
PN#3 excludes existing and future portfolio investments (FPIs) by Restricted Persons into Indian companies. However with media reports of SEBI – the Indian securities market regulator – closely monitoring share acquisitions by Chinese entities into Indian listed companies, urging custodians to monitor investments at depressed valuation by Chinese entities into listed Indian companies, and seeking details on FPI composition, the possibility of tweaks to the FPI framework on the lines of PN#3 cannot be ruled out.
Grey areas – awaiting clarity
PN#3 does not clarify whether the conditions specified under PN#3 would apply to entities domiciled in Hong Kong. Although Hong Kong is under the political control of China, it also maintains limited self-government and a separate legal system and immigration channels. This would be an important clarification as an increasing number of private equity and venture capital funds domiciled in Hong Kong frequently invest in Indian companies. DPIIT should also clarify the applicability of PN#3 to downstream acquisitions by Indian investee companies funded through internal accruals. It is also unclear whether the subscription to, transfer of convertible notes issued by Indian start-ups would require governmental approval at the stage of subscription or their conversion into equity shares. The clarity on the definition of ‘beneficial owner’ would also enable a better understanding of the prescription of PN#3.
PN#3 will be effective from its notification and on being incorporated into The FEMA (Non-debt Instruments) Rules, 2019.
Impact of PN#3 on deal-making in India
On-going deals:
Restricted Persons involved in on-going FDI transactions or proposing to embark on one would need to be mindful of the requirement for pre-governmental approvals for share transactions. Historically, Indian regulators (the erstwhile FIPB, RBI, and DPIIT) have shown caution in approving FDI from China into sensitive sectors – pharma, telecom, and financial services. Therefore, timely closing of the on-going deals involving FDI from Restricted Countries will hinge on the time taken by the Indian regulators in approving the transactions. Though DPIIT approval typically takes six to eight weeks, the likelihood of enhanced governmental approval for FDI investments by Restricted Persons into sensitive Indian sectors cannot be ruled out. Extension in deal timelines may also result in cost escalation and even impact the deal valuation of Indian investee entities. Deal participants will also need to factor the additional reporting and intimation requirements to lenders, employees, vendors/suppliers, and other third-party stakeholders if delays occur. Further, where on-going deals are third party financed, financing gaps may also emerge because of prolonged delays in obtaining the government’s approval.
Parties will also need to consider changes required to the pre-closing covenants under the existing deal documents. If on-going deals have defined timelines that cannot be extended (mainly, global restructurings involving ancillary Indian entities), Restricted Persons may need to evaluate extending the deadlines for closing / post-closing divestments and integrations involving India. In exceptional cases, contractual parties may even evaluate aborting transactional agreements involving investment into, or purchase of shares of an Indian investee entity. Naturally, this would depend on the scope and ramifications of a material adverse clause under deal documents. Further, the implications of break fee commitments, if agreed, would also have to be factored into before aborting a deal. Given the uncertainty around the approval process and the timelines for FDI by Restricted Persons in sensitive sectors, there may also be increased instances of parties reopening pricing discussions or attempting to renegotiate the deal terms.
In listed company acquisitions, the requirement of pre-governmental approval may not have been specified in the detailed public statement and the letter of offer before making an open offer. In such cases, Restricted Persons would need specific dispensation from SEBI to withdraw from the open offer process. SEBI would be guided by principles laid down by the Supreme Court in Nirma Industries (Civil Appeal no. 6082 of 2008 – judgment dated September 9, 2013), and SEBI’s ruling in Jyoti Limited (WTM/SR/CFD/39/08/2016).
Existing deal documents:
PN#3 would require mandatory pre-governmental approval for subscription by Restricted Persons to new shares offered upon exercise of pre-emption rights, bonus issuances, and anti-dilution rights. If a down round occurs, tweak in the conversion ratio of existing convertible instruments in favour of a Restricted Person – standard protection given to financial investors by Indian companies and start-ups – may also require government approval. Even transactions undertaken for benefiting only non-Restricted Persons, which increase a Restricted Persons’ beneficial ownership in the Indian investee companies, for example, buyback or selective reduction of capital would also require governmental consents. So would be the case for secondary transfers, including the exercise of call and put options.
New Deals
Restricted Persons would need to be alive to the changes introduced by PN#3 and evaluate the timing of their overall India investment strategy, including recapitalization of Indian joint ventures/subsidiaries that have suffered during the lockdown and greenfield investments. It would also be prudent to engage with the Indian regulator early in the deal-making process so that the regulator’s approach to the investments is better understood, and parties can structure investments more appropriately, minimizing the risk of delays.
In the short run, Indian companies – notwithstanding cash-starved – may be hesitant in entering into potential fundraising and acquisition transactions with Restricted Persons until sufficient clarity emerges on the Indian regulator’s approach in approving FDI deals from Restricted Countries. Given that, PN#3 does not mandate governmental approval for transferring business or assets to an Indian subsidiary of Restricted Persons; parties may consider designing deal structures as asset/business sales to mitigate the rigours of governmental approval.
Conclusion
India’s strategy on ringfencing Indian companies weakened by the pandemic is aligned with the global move to restrict opportunistic foreign investments. This was a necessary step given that COVID-19 pandemic has eroded the revenues and share prices of several Indian companies. Further, given the near-absence of sophisticated takeover/acquisition defences in India, Indian listed companies in the absence of the safety net of PN#3 would have found it challenging to create any meaningful defences against opportunistic buys. Directors, bound by fiduciary duties to stakeholders (including shareholders) could have also not directly intervened in an acquisition process. Therefore a uniform pan-India policy against opportunistic buys of Indian companies is a welcome step. However, the Indian regulators (DPIIT or the Ministry of Finance) should provide more clarity on some of the grey areas in PN#3 – the meaning of ‘beneficial owner’, the applicability of PN#3 to Hong Kong, downstream investments structured with internal accruals and convertible loans.
Regarding the Indian deal ecosystem, PN#3 will have widespread ramifications for both strategic and financial investors and the Indian investee companies. It would force a re-evaluation of the immediately planned Indian entry/investment strategy and reopen for negotiations the entire pre-agreed matrix on the rights and obligations of parties under the existing investment/shareholders agreements.
It is equally imperative that PN#3 does not create unnecessary administrative bottlenecks in subverting genuine FDI into India, particularly FDI into greenfield and non-sensitive Indian sectors. In the post-COVID-19 landscape, the Indian economy would increasingly depend on FDI, and overprotection may do India more harm. While GOI has taken a bold step, it will be essential to assuage concerns of genuine investors from the Restricted Countries and roll out consistent parameters for screening FDI from Restricted Countries. Indian regulators would need to do a tough balancing act in avoiding needless overregulation.
This article represents the personal views of the author and is for general information only. It is not intended to constitute or be relied upon as legal advice. The discussions on the steps taken by countries other than India in regulating opportunistic acquisitions is solely based on a reading of publicly available reports and the author’s common sense understanding of foreign laws.