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FDI: At the mercy of lawmakers

March 12, 2012 10:31 IST

MoneyWhen it comes to investments, certain assumptions are made at any level, whether by an individual or any other form of common or sophisticated entity.

The very basic assumptions are that the investment is within the contours of law and that there will be no inability in seeking a return in respect of the investment amount.

Take these assumptions away and there would be no investments forthcoming or at least expectation that there would be any.

One of the routes for investment into the country is foreign direct investment.

The manner in which the policy governing investment and repatriation by foreign investors has undergone a change seems encouraging, but on deeper analysis it seems to be lacking in clarity.

One of the encouraging steps was permitting transfer of shares between residents and non-residents under the automatic route, subject to pricing guidelines.

This step was taken towards the end of 2004, to simplify the process. But in 2012, we still seem to be awaiting clarity in the policy, as is evident from the following:

Transfer process and pricing methodology: Before liberalising the transfer process in 2004, transfer of shares between residents and non-residents required approvals from the Reserve Bank of India and the Foreign Investment Promotion Board.

The guidelines governing pricing were the ones prescribed by the controller of capital issues, which dates back to the pre-liberalisation era.

These guidelines were religiously followed, even though the very office of the controller of capital issues ceased to exist, until April 2010 when the discounted cash flow methodology was introduced.

However, the manner in which the new pricing methodology will be applied is unclear and the possibility of two independent experts coming up with a similar valuation is unlikely.

It is imperative, therefore, that the policy maker formulates rules for the DCF method of valuation.

Type of instruments: The type of instruments to which a non- resident investor could subscribe previously was equity shares, optionally convertible preference shares and optionally convertible debentures.

In June 2007, this was revised to only permit foreign investments in equity shares; fully, compulsorily and mandatorily convertible preference shares; and fully, compulsorily and mandatorily convertible debentures.

The intention behind this was to ensure that investment is made only into 'equity' instruments and not into 'debt like' instruments.

What, however, is not clear is whether, based on any specific rights attached to a security that is held by a non-resident investor, the instrument will cease to have an equity character and hence be impermissible.

In September 2011, when the current consolidated policy was updated, one of the surprising provisions was the inclusion of language that if equity instruments that are issued/transferred to non-residents have any in-built options or supported by options sold by third parties, they would lose their equity character and hence require compliance with guidelines governing external commercial borrowings.

This provision created enough anxiety to be withdrawn in four weeks.

It is, therefore, important to clarify what specifically is permitted.

This is easier said than done, but there should be a continuing attempt to clarify and freeze the position.

Lock-in provisions: There are sectors in which the policy stipulates a lock-in period for foreign investment -- for example, investment into townships, housing, built-up infrastructure and construction development projects.

The policy, when the famous Press Note 2 was announced in 2005, was that only minimum capitalisation would be locked in for a three-year-period.

Minimum capitalisation was an amount of $10 million for wholly-owned subsidiaries and $5 million for joint ventures with Indian partners.

As it currently stands, the policy stipulates that the lock-in period of three years will be applied from the date each installment/tranche of FDI is received, effectively discouraging investments towards project completion.

One way to approach this could be to prescribe that the three-year lock-in will not be applicable beyond a maximum tenure, say five years, calculated from the original date of investment, based on the size and nature of the project, and prescribing a minimum tenure of, say, one year.

Mixed regulatory views: Every primary investment by a non-resident triggers a filing requirement at the time the investment is received and securities allotted.

On the one hand, the policy is clear that where non-resident investment is in the form of convertible capital instruments, the conversion price of such security should not be lower than the DCF value of the share as on the date of issue of the instrument.

Accordingly, the policy stipulates that either the price or the conversion formula of such instruments should be determined upfront.

On the other hand, the RBI has had its own reservations over a formula-based conversion -- with the consequence that with every filing made specifying a conversion formula for a convertible capital instrument remains the risk of how the regulator will react.

It is time that the government and the RBI adopted a common position on this.

With clarity in policy and ease of process, investors will possibly utilise their time and effort deciding where to invest rather than if and how to invest.

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The author is partner, J Sagar Associates. These views are personal

Raj Ramachandran
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