LOOPHOLES IN DIPP’S PRESS NOTE – CURBING THE OPPORTUNISTIC TAKEOVER OF INDIAN ENTITIES BY CHINESE PART I OF RESEARCH UPDATE

1. INTRODUCTION

• With a view to curb the opportunistic takeovers / acquisitions of Indian companies due to the current Covid-19 pandemic, the Department for Promotion of Industry and Internal Trade has amended the extant Consolidated Foreign Direct Investment Policy, 2017 (“FDI Policy”) to the effect that an entity of a country, which shares land border with India or where the beneficial owner of an investment into India is situated in or is a citizen of any such country, can invest only under the Government route (i.e. approval of Government is required to be obtained before making such investment).
• Further, in the event of the transfer of ownership of any existing or future FDI in an entity in India, directly or indirectly, resulting in the beneficial ownership falling within the aforesaid restriction/purview of the aforesaid amendment, then such subsequent change in beneficial ownership will also require Government approval.
• While the Press Note 3 does not specifically mention China (of the other neighbouring countries), in background of the pandemic, it is obvious that the intention of the Government of India is to specifically target and prevent the Chinese from making opportunistic takeovers / acquisitions of Indian companies. The Press Note will only take effect after the requisite amendments to Rule 6 of the FEMA (Non-Debt Instruments) Rules 2019 are notified.
• Now, while the amendments prima facie seem to be unambiguous, the lack of clarity on the concept of “beneficial owner” and a closer look at the FDI Policy in the context of “ownership” / “beneficial ownership” and “control” would go to show that there are numerous questions left unanswered. This is particularly when one has to determine the ultimate beneficial owner in different cases where there are multi-layered corporate structures.
• The absence of definition of the term “beneficial owner” in the FDI Policy may give an opportunity to circumvent the FDI Policy because transactions can be structured in such a manner where an Indian resident can hold more than 50% of the capital of the ultimate holding entity of the Indian entity, however, the control of this ultimate holding entity may be given to a Chinese by way of highly confidential shareholders agreements / voting trust agreements or the like.
• As a part of our Corporate Law Practice, we are pleased to share with you Part I of this Research Update which deals with the following questions:
• What is the capital threshold limit on the basis of which a Chinese Investor be regarded as the “beneficial owner” of an Indian Company or a LLP?
• Is the beneficial ownership to be determined on the basis of shareholding only or can it be determined on the basis of “control” also?
• Can a Chinese investor be considered to be an indirect and ultimate beneficial owner if he / it does not hold majority capital of the Indian entity but nevertheless exercises “indirect” control in the Indian Company or LLP?
• Can ‘control’ be deemed to have been exercised by way of affirmative voting rights, i.e. can ‘negative control’ be regarded as ‘control’ for the purpose of the aforesaid amendment?
• The Chinese Investor may not hold majority capital in an Indian Company or a LLP or exercise control in the Indian Company or LLP individually but it may do so by acting in concert with other Investor. In such case, can such Investor be regarded as a beneficial owner of such Indian entity?  
•  Can a Chinese be deemed to be a beneficial owner of an Indian Company / LLP if he / it does not hold majority capital / profit share in the Indian Company / LLP but nonetheless exercises direct control in the Indian entity?
• OUR ANALYSIS

What is the capital threshold limit on the basis of which a Chinese Investor be regarded as the “beneficial owner” of an Indian Company or a LLP?

• As per the FDI Policy, 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. Likewise, a Limited Liability Partnership will be considered as owned by resident Indian citizens if more than 50% of the investment in such an LLP is contributed by resident Indian citizens and/or entities which are ultimately ‘owned and controlled by resident Indian citizens’ and such resident Indian citizens and entities have majority of the profit share.
• The term ‘Capital’ means equity shares; fully, compulsorily & mandatorily convertible preference shares; fully, compulsorily & mandatorily convertible debentures and warrants. [Side Note: if the Chinese Investor subscribes to any optionally convertible debt instruments, it will be regarded as an external commercial borrowing and not an investment]
• Therefore, in absence of the definition of the term ‘beneficial owner’ in the Press Note / FDI Policy, the meaning of it may be inferred from the FDI Policy that, – a Chinese Investor may be considered to be a beneficial owner in an Indian Company if the said Investor holds more than 50% of the capital in the Indian entity either directly or indirectly (i.e. through step down entities). [Side Note: We will deal with indirect holding in the 2^nd part of our Research Update]
• [Side Note: In our preliminary view, considering that the term “owned” is defined in the FDI Policy, one cannot look at the Companies (Significant Beneficial Owners) Rules, 2018 or the and/or the Prevention of Money-laundering (Maintenance of Records) Rules, 2005 for determining the meaning of “beneficial owner” for the purpose of FDI Policy / FEMA even when Companies Act, 2013 or Prevention of Money-laundering Act may be considered to be in pari-materia with FDI Policy and FEMA for this specific purpose]

Is the beneficial ownership to be determined on the basis of shareholding only or can it be determined on the basis of “control”?

• As per the FDI Policy, a company is considered as ‘Owned’ by resident Indian citizens if:-

1. more than 50% of the capital in it is beneficially owned by resident Indian citizens and / or
2. more than 50% of the capital in it is beneficially owned by Indian companies, which are ultimately owned and controlled by resident Indian citizens.

• Likewise, a Limited Liability Partnership will be considered as owned by resident Indian citizens if:-

1. more than 50% of the investment in such an LLP is contributed by resident Indian citizens; and/or
2. more than 50% of the investment in such an LLP is contributed by entities which are ultimately ‘owned and controlled by resident Indian citizens’ and such resident Indian citizens and entities have majority of the profit share.

• Further, as per the FDI Policy, the term ‘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. For the purposes of Limited Liability Partnership, ‘control’ will mean right to appoint majority of the designated partners, where such designated partners, with specific exclusion to others, have control over all the policies of the LLP.
• Therefore, it may be inferred that, – the beneficial ownership can be determined not only on the basis of shareholding but it can be determined on the basis of “control” also. [Side Note: Pls. see the below mentioned question and answer for further understanding of the highlighted portion]

Can a Chinese investor be considered to be an indirect and ultimate beneficial owner if he / it does not hold majority capital of the Indian entity but nevertheless exercises “indirect” control in the Indian Company or LLP?

• As per the FDI Policy, 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. Likewise, a Limited Liability Partnership will be considered as owned by resident Indian citizens if more than 50% of the investment in such an LLP is contributed by resident Indian citizens and/or entities which are ultimately ‘owned and controlled by resident Indian citizens’ and such resident Indian citizens and entities have majority of the profit share.
• It can be inferred from the above that, – unless the ultimate Holding Company of the Indian entity is both owned and controlled by a Indian resident, the Indian entity cannot be regarded as being beneficially owned by non resident investor. In other words, if the Ultimate Holding Company is “controlled” by a Chinese, the Chinese may be regarded as a beneficial owner of the step down Indian entity.
• For example, – ‘A’ is an Indian entity in which ‘B’, a Mauritius based entity holds 51% capital. More than 51% of capital of ‘B’ is held by ‘C’, another Indian entity. Now, assuming that despite ‘C’ holding majority capital in ‘B’, the control of ‘C’ is with ‘D’, a Chinese entity, In such case, ‘C’, the Indian entity may not be considered to be a beneficial owner of ‘A’ because the control of ‘B’ is with ‘D’ the Chinese Investor and not with ‘C’.
• The absence of definition of the term “beneficial owner” in the FDI Policy (dealing with the aspect of indirect control) may give an opportunity to circumvent the FDI Policy because transactions can be structured in such a manner where an Indian Investor can hold more than 50% of the capital of the ultimate holding entity of the Indian entity, however, the control of this of the ultimate holding entity may be given to a Chinese by way of highly confidential shareholders agreements / voting trust agreements or the like.

Can ‘control’ be deemed to have been exercised by way of affirmative voting rights, i.e. can ‘negative control’ be regarded as ‘control’ for the purpose of the aforesaid amendment?

• In most of the investment transactions, the investors nominate non-executive directors on the Board who are given affirmative voting rights wherein certain important financial / operating decisions cannot be taken without the prior written consent of such Investor nominee director. Most investors consider these rights critical in order to have some level of supervision over the target company’s operation and management.
• In such cases, a question arises that if a Chinese is having ‘Reserved Matters Rights’ / ‘Affirmative Voting Rights’ in the ultimate holding company of the Indian entity, can the Chinese considered to be having “control” over the concerned entity?
• In such cases, there can be two views as under:

1. Affirmative voting rights signify a ‘negative’ control and not an active controlling power to drive the affairs of the Company. Inference can be drawn from the judgment by the Hon’ble Securities Appellate Tribunal (SAT) in the case of Shubhkam Ventures, wherein it was held that, – “control”, as per the definition of the term in the Takeover Code, was a proactive and not a reactive power. The SAT in its order held that control really means creating or controlling a situation by taking the initiative. Power by which an acquirer can only prevent a company from doing what the latter wants to do is by itself not control. Considering that the definition of the term “control” as given under FDI Policy is identical as the definition given under the Takeover Code, the two statutes may be read as being pari materia with each other and accordingly, basis the aforesaid judgment, one may argue that the “control” inferred under the FDI Policy signifies ‘positive’ control and not ‘negative’ control.
2. A converse view may also be taken that, – the intention of the Press Note is very strict. Therefore, having ‘indirect negative control’ also would mean that Chinese is the ultimate beneficial owner of the Indian entity.

The Chinese (Investor) may not hold majority capital in an Indian Company or a LLP or exercise control in the Indian Company or LLP individually but it may do so by acting in concert with other Investor. In such case can such Chinese (Investor) be regarded as a beneficial owner of such Indian entity?  

• As per the SBO Rules prescribed under Companies Act, 2013, an individual will be considered to be a “significant beneficial owner” not only when he indirectly holds majority stake or exercises significant influence or control in the reporting company alone but when he is acting “together”. Such individual shall be deemed to be ‘acting together’ if he / she acts with a common intent or purpose of exercising any rights or entitlements, or exercising control or significant influence, over a reporting company, pursuant to an agreement or understanding, formal or informal, such individual, or individuals, acting through any person or trust, as the case may be. Unlike the Takeover Code (i.e. SEBI SAST Regulations), the SBO Rules however do not list the relationships which are regarded as “Deemed Persons Acting in Concert”. However, some guidance may be taken from the Takeover Code to interpret the term “acting together”. For example, individuals having blood relationship / immediate relatives having right to control the management or policy decisions of the Indian Company may be deemed to be persons acting together to have “significant influence” or “control” over the Indian Company, unless there is evidence to show otherwise.
• While the Press Note 3 / FDI Policy do not explicitly mention that beneficial ownership can be established not only by virtue of single handed control but also when investor is “acting together”; but given that the intention of the amendment is to protect the Indian entities from being taken over by the Chinese, in most likelihood this interpretation will be taken by the judicial authorities.

Can a Chinese be deemed to be a beneficial owner of an Indian Company / LLP if he / it does not hold majority capital / profit share in the Indian Company / LLP but nonetheless exercises direct control in the Indian entity?  

• As per the FDI Policy, 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. Likewise, a Limited Liability Partnership will be considered as owned by resident Indian citizens if more than 50% of the investment in such an LLP is contributed by resident Indian citizens and such resident Indian citizen(s) have majority of the profit share.
• Again, in absence of definition on what is a ‘beneficial owner’, there may be two interpretations. On one hand, it maybe interpreted that, – as long as more than 50% of the capital of the Indian entity is held by a resident Indian, even if the Indian entity is controlled by the Chinese, the Chinese may not be considered to be a beneficial owner of the Indian entity. On the other hand, a strict interpretation may also be taken that the Indian entity must not only be owned but also controlled by an Indian resident only to be considered to be beneficially owned by an Indian.

-TO BE CONTINUED IN PART II–