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Key takeaways:

• India has announced new restrictions on foreign investment from neighbouring countries, covering China and possibly Hong Kong.
• The restrictions extend to beneficial ownership, which may have far-reaching consequences for global M&A.
• A formal notification detailing the scope of the restrictions is expected in the coming weeks.

Like many countries, India announced new constraints on foreign direct investment (“FDI”) to curb opportunistic takeovers or acquisitions of Indian companies in light of the Covid-19 pandemic. A press note issued on 17 April 2020 (the “Press Note”)—just days after China’s central bank increased its stake in one of India’s largest private sector banks—restricts investments from China, possibly including Hong Kong, and other neighboring states without prior governmental approval.  The restriction covers direct and indirect investments from these countries and could result in unintended, far-reaching limitations on global M&A activity.

The policy change will take effect from the date on which the Indian government makes a formal notification under the Foreign Exchange Management Act. The notification is expected to provide further details on the scope of the restrictions. We understand that many market participants are now in dialogue with the government to ensure that implementing regulations temper the more concerning applications of the new restriction.

This note provides an overview of the potential implications.

• Changes in beneficial ownership are captured: The restriction extends to circumstances where the beneficial owner of the investment is based in any Neighboring Country (see below). The Press Note also provides that transfers resulting directly or indirectly in a change in beneficial ownership are impacted. It is not clear what “beneficial ownership” means in this context. Current definitions of beneficial ownership under different Indian laws vary, with thresholds ranging from 10% to 25%. This could mean that any of the following transactions could be caught:
• Purchase of an Indian target (or a non-Indian target with an Indian subsidiary) by a fund with any Chinese LPs.
• Purchase of an Indian target (or a non-Indian target with an Indian subsidiary) by a public or private company with significant Chinese investors.
• Transfer to a Chinese LP of a fund interest in a fund (wherever domiciled) that owns an Indian portfolio company.
• Transfer to a Chinese investor of shares of a non-Indian public or private company with an Indian subsidiary.

Some local sources indicate that many of these outcomes would be limited, e.g., where the Indian assets constitute a material part of the company’s business or where the Chinese ownership is significant.

• Across sectors: The restriction is not targeted at any specific sectors, and the requirement for prior governmental approval will likely apply across all sectors. This comes at a time when India has recently, prior to the Covid-19 pandemic, been streamlining its FDI process and easing investment restrictions across sectors.
• Existing investment commitments: The current FDI policy permits investments in tranches subject to a single regulatory approval. Unless the Indian government’s forthcoming notification makes specific exceptions for these situations, impacted foreign investors may need to seek additional governmental approvals for subsequent investment tranches under existing approvals. Given that existing investment commitments could also be impacted, affected investors may need to obtain approvals or clarifications from the government prior to completing their investments, and investors may even need approval to take up pre-emption rights.
• New restrictions cover China and may also cover Hong Kong: The new FDI restriction covers investment from entities based in countries which share land borders with India. These are China, Bangladesh, Pakistan, Afghanistan, Nepal, Myanmar and Bhutan (the “Neighboring Countries”). Certain news reports note that government sources have indicated that investments from Hong Kong (as a Special Administrative Region of China) are also intended to be covered by the restrictions, but this is currently unclear based on the Press Note. In many other areas of Indian regulation, Hong Kong is treated separately from China. 

The impact and effectiveness of the new FDI restriction will depend largely on the exact wording of the notification. Until it is clarified, some Indian deals may be paused. Similar restrictions are also expected to be announced by India’s market regulator, the Securities and Exchange Board of India, which regulates foreign portfolio investments in listed companies in India. Investors and entities potentially impacted by the restrictions may need to consider seeking clarifications from the government on a case-by-case basis.

The immediate impact of the new restriction is likely to affect companies that are already financially strained due to the Covid-19 pandemic. The change is likely to affect companies with existing investments from the Neighboring Countries that are looking for follow-on or rescue funding, as well as companies looking for fresh capital from investors with beneficial owners in these countries. Existing investors in Indian companies seeking options for transfers and exits will also potentially be affected. In addition, investors and fund managers based in Hong Kong with interests in India may need to consider whether governmental approvals are required. The governmental approval requirement and beneficial ownership restrictions will likely increase due diligence and KYC requirements in potential transactions, leading to an overall increase in costs as well as funding timelines.   

While the change has been welcomed by some as a tactical move to avoid distressed buyouts of vulnerable Indian companies, it has already drawn criticism from China, who referred to the restrictions as “discriminatory” and “against WTO principles”. India and China were parties to a bilateral investment treaty which was terminated by India in October 2018. However, the treaty contains a sunset clause which provides protection for investments existing prior to termination. It remains to be seen if investors and entities affected by the new FDI restriction will use this avenue for potential redress.