SPECIAL ARTICLE

Foreign Direct Investment Caps in India and Corporate Control Mechanisms

K S Chalapati Rao, Biswajit Dhar

While India has generally been following an open door policy in foreign direct investment, a few areas are still subject to caps on fdi. The need to retain a degree of control over the operations of the investee companies in Indian hands is one of the justifications for the caps. In early 2010, the government specified the methodology for calculating indirect foreign equity in order to remove ambiguities in calculating the extent of fdi in a company. This paper argues that the percentage of shares or proportion of directors on the board does not necessarily represent the extent of control and therefore more direct intervention would be required if the policy objectives are to be achieved.

ver the past several years, India has progressively liberalised her foreign direct investment (FDI) policy. As a result, in most sectors, foreign investors can hold 100% of the equity in firms registered in India. Restrictions that remain on foreign ownership are imposed in two ways. One, foreign investors are not allowed to invest in 11 sectors,1 and two, some sectors (mostly in services) are subject to ceilings on FDI and/or specific government approval. The justification for so doing varies depending upon the sector, but includes inter alia the desire to retain a certain degree of control over the operations of the investee companies in Indian hands and possibly to give time to the domestic entrepreneurs to gain strength so as to withstand competition from foreign companies.2 Notable among the areas subject to caps are defence industries, insurance, civil aviation, print media, broadcasting, telecom, banking and single brand product retail trade.3 The caps are generally placed at 26%, 49% or 74%. In order to prevent foreign investors from breaching the ceilings by investing through other companies incorporated in India which they either own or control, the government has spelt out the methodology for calculating direct and indirect foreign equity in Indian companies.4 This methodology has been elaborated in the Consolidated FDI Policy (CFP 2010) that became effective from 1 April 2010. Of late, however, the government has indicated its intent to relax the caps in a number of sectors, including defence and retail trade.5 Besides, the proposal to increase the FDI limit from 26% to 49% in the insurance sector is pending. Given that the increase in foreign participation is now being proposed in sensitive sectors, and in reversal of the policies wherein the government was reluctant to cede control to foreign entities for fear of marginalisation of the Indian entities, it is imperative to understand the manner in which the caps on FDI are being applied. In our view, corporate control is a phenomenon that seems easy to perceive, but can manifest in several different ways in its actualisation, which can easily cause a gap between ex ante and ex post. This paper is an attempt to contribute to the ongoing discussion on FDI policy and is based on Indias recent experience in implementing the caps on FDI.

The views expressed here are personal and do not necessarily reflect the official policy or position of the institutes the authors are associated with. K S Chalapati Rao (rao@isid.org.in) is with the Institute for Studies in Industrial Development, and Biswajit Dhar (biswajit@ris.org.in) is with the Research and Information System for Developing Countries, New Delhi.

Corporate Control
Hymer (1993) had argued that corporate control is not an easy thing to define, and the dividing line between some control and no control is arbitrary. Legal provisions can only provide some broad parameters. Ownership of majority equity is generally taken as a sufficient condition for unambiguous control because
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under company law most decisions taken in general meetings and election of directors are based on simple majority of the shares represented by those participating in the meeting. However, special provisions can bestow control of varying degrees even on those owning minority shares (see Table 1 for the significance of different shareholding levels). For example, a minimum of 26% would not only give the minority shareholder greater bargaining power but under the Indian company law it would also enable him to effectively oppose special resolutions (which require the support of shareholders owning at least 75% of the shares) thus limiting the freedom of the majority to carry out all their plans. Also, if the equity capital consists of shares with differential voting rights some having no voting rights at all
Table 1: Significance of Various Levels of Equity Shareholding
Share in Equity (%) Significance/Implications

then simple majority in equity may not work out to majority in voting rights. Further, and even more importantly, minority investors can insist on special rights which give them disproportionate control disproportionate both in terms of voting rights, representation on the board and the boards functioning. This phenomenon was noted by Goyal (1979, 1982) in case of companies compliance with the Foreign Exchange Regulation Act, 1973 (FERA). Significantly, for a sample of 56 companies whose prospectuses were available, Dhar (1988: 28) found:
... in 32 companies foreign partners kept control over the board of directors with a 26% or less share. In one instance, involving the cosmetics manufacturing company, Ponds India (...an affiliate of Chesebrough Ponds Inc of US), the foreign partners could control the board by being only a member of the company, i e, even by owning a solitary share of the company (emphasis added).

10

Usually taken as the minimum share required to exercise control/ influence. Identification of FDI relationship is based on this perperception. Under Sections 397 and 398 of the Indian Companies Act (1956), those holding a minimum of 10% share capital can approach the Company Law Board against suppression of minority shareholders and mismanagement. Securities and Exchange Board of India (SEBI) Takeover Code applies when this share is reached by the acquirer. International Accounting Standard 28 assumes that the investor exerts significant influence if it holds, directly or indirectly, 20% or more of the voting power at stake. Proposed by SEBI (2010) for application of the Takeover Code. Based on the shareholding pattern of listed Indian companies, the Committee felt that 25% is the level at which promoters would be capable of exercising de facto control. Earlier, RBI classified an Indian company in which at least 25% shareholding was held by a foreign company as a Foreign Controlled Rupee Company. A major FDI cap. The minimum shareholding required to get special resolutions passed at company general meetings being 75%, those controlling 26% shareholding can block any special resolution, if they so desire. According to Companies Bill 2009, this percentage reflects significant influence. The Industrial Licensing Policy Inquiry Committee (ILPIC defined it as effective equity for classifying a company into a business group (calculated after excluding the shares held by public financial institutions from the total) Under FERA, foreign branches and subsidiaries were asked to reduce the level of foreign equity to 40% thereby implying companies with up to 40% foreign equity would be treated as domestic companies. Another important cap on FDI in certain restricted sectors. The objective is to have majority shares (51%) in Indian hands. Simple majority. Sufficient to get through all ordinary resolutions as also in the absence of proportional/cumulative voting, can elect all the directors open for election. Minimum government shareholding required under the Companies Act (1956) to be classified as a government company. This is the upper limit allowed where 100% FDI is not permitted. This is the counterpart of 26%. Indian shareholders with 26% shareholding will be in a position, if they so desire, to block special resolutions. Wholly-owned. (i) Special rights can change the relationship in favour of minority shareholders irrespective of the extent of their voting rights. (ii) Another manner in which the percentages can lose their significance is the deployment of differential voting rights. (iii) The situation would also be dependent upon the distribution of remaining shareholding. This is more so in case of listed companies.
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If such agreements, coupled with dependence on the foreign investor for technology, brand names and market development (including buybacks which could be a very important consideration in case of the defence sector) are entered into, then the control implied in the majority equity and majority in the board may have little relevance in practice. This has been a well-established practice in international business as explained in Schaffer et al (1999: 581).
Even if a foreign entity cannot own a majority of a joint venture, it may be able to legally obtain operational control through other means. One may surround the joint venture with contractual obligations to the foreign venturer. For example, if the joint venture is to assemble components manufactured in the US, the US investor retains significant control over the joint venture regardless of how many shares the investor owns or how many directors it can name to the board because it controls the supply of components. Similarly, a US investor can exercise control through supply contracts, marketing agreements, management contracts, and veto power in the joint venture agreements (emphasis added).

25

26

33.33

40

49 50.01

51 74

Let us examine the CFP in the light of the above. According to the CFP, further investments in other Indian companies by all those Indian companies which are owned and controlled by Indians will be treated as fully Indian; otherwise their entire holding would be treated as indirect foreign investment. For this purpose, the main criteria adopted are that (i) the Indian company should be a majority owned by Indians6 (who should also act in concert),7 and (ii) Indians should have the right to appoint majority of the directors. This is irrespective of the fact that the investing company might have foreign equity up to 49.99%. The CFP does recognise the possibility of differential voting rights and special rights enjoyed by certain shareholders affecting the election of directors at annual general meetings when it states:
In any sector/activity, where Government approval is required for foreign investment and in cases where there are any inter-se agreements between/amongst shareholders which have an effect on the appointment of the Board of Directors or on the exercise of voting rights or of creating voting rights disproportionate to shareholding or any incidental matter thereof, such agreements will have to be informed to the approving authority. The approving authority will consider such inter-se agreements for determining ownership and control when considering the case for granting approval for foreign investment (emphasis added).

100 Some distorting factors

Although the approach of the CFP is better than the one that looks merely at simple majority in equity shares, it nonetheless

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suffers from the limitation that it still relies on majority in the board. It does not address the second and more critical question of how a companys board, which is the main operational body, functions. Boards determine the policies, strategies and operational matters. Hence in more ways than one, the boards role is more decisive than that of the general body of shareholders. The following cases help to understand the role of special powers which distort the control implied in the relative shares of joint venture (JV) partners.

matters listed in Article 172(3) hereof (AXA Reserved Matters), unless approved by a majority of the directors, including the affirmative vote of the AXA director.

The 46 AXA Reserved Matters include, among others:

(pp) Any appointment, nomination and removal of any SPV Co Nominee Director on the board of directors of JVCo. (qq) Utilisation of any proceeds received by the Company from the sale/transfer of its shareholding in the JVCo.11

Case 1: Max New York Life Insurance

Under the existing provisions, foreign equity is restricted to 26% in the insurance sector. In the equity share capital of Max New York Life Insurance Co (MaxLife), Max India has 74% share and New York Life International (NYLI) of the United States has the remaining 26% stake thus conforming to the FDI cap applicable to the insurance sector. The Articles of Association (AoA) of MaxLife stipulate that out of the total 10 directors of the company, Max India is entitled to appoint seven directors to MaxLifes Board, NYLI two (non-retiring) directors and the remaining one will be filled up by MaxLifes chief executive officer. Thus, Max India has a far larger number of directors on MaxLifes board who also constitute majority. However, in the board meetings of MaxLife, a quorum is deemed to have been formed if only one director nominated by each of the partners is present. Moreover, the AoA of the company provides that certain decisions taken by MaxLife and any of its subsidiaries (each a Relevant Company)
...shall require prior approval by a majority of the board of directors of the Relevant company, which majority must include at least one (1) director appointed by Max India and one (1) appointed by NYLI ...(emphasis added).8

The JVCo under reference here is BhartiAXA and the SPV is First American Securities. Since AXA can decide whom to nominate to BhartiAXAs board, the representatives of the SPV on BhartiAXA can, in effect, be AXA representatives. The 90% shares held by the Bharti entities in the SPV are thus of no consequence. AXA seems to have paid a heavy premium for acquiring the shares of the SPV while the Bharti entities obtained the shares at the face value of Rs 10. Between 5 July 2006 and 26 February 2010, AXA paid Rs 406.38 crore for acquiring 43,48,973 shares of Rs 10 each at an average premium of Rs 924.44 while Bharti entities were allotted 4,79,80,848 shares at par for Rs 47.98 crore. These figures suggest that the 10% share of AXA had cost it far more than what the 90% acquired by Bharti in the SPV. On paper, the combined direct and indirect share of AXA in the JVCo works out to 25.9998%.12 Since the SPV is majorityowned and controlled by Indians, as per the CFP, foreign share in the JVCo would only be 22.2%. However, as the SPV, in practice, is foreign-controlled, the effective share of AXA works out to 60% (22.2 directly and 37.8 through the SPV), far in e xcess of the stipulated limit. The emphasis on acquiring a higher share formally in the JVCo by AXA is further evident from the following:
Notwithstanding anything to the contrary contained in these articles, if and on each occasion that the laws or regulations of India are changed so that AXA is permitted to hold, directly or indirectly, more than 26% of the shares, AXA shall have the right to increase its holding of shares either by acquiring any or all of the Non-Disposal Shares from Bharti SPV or by subscribing for new shares... (emphasis added).

These conditions thus nullify the majority enjoyed by Max India in the board of MaxLife and make NYLI an equal partner in decision-making. The 26% cap on foreign equity has therefore little relevance and MaxLife effectively operates as a 50:50 JV. This also implies that acquisition of additional equity, if any, by NYLI through indirect means by itself is not going to change the position as far as control of MaxLife is concerned.

An inescapable conclusion, therefore, is that the SPV has been created to get around the existing regulations and AXA was not prepared to settle for the 26% share.

Case 2: Bharti AXA Life Insurance

A more interesting case is that of Bharti AXA Life Insurance Co (BhartiAXA) in which AXA India Holdings, Mauritius (AXA) has 22.2% stake, Bharti entities have 40% and Bharti SPV (First American Securities Pvt Ltd)9 37.8%. In this case, [T]he quorum for the transaction of business at a general meeting shall be five members present, of whom one shall be AXA (duly represented) and, for so long as Bharti holds not less than 12.5% of the shares, one shall be Bharti (duly represented).10 There are similar clauses in respect of representation on the board as also how the shareholding of Bharti SPV should be transferred whenever official FDI policy is modified to allow higher foreign share. The AoA of Bharti SPV states:
...no obligation of the company shall be entered into and no decision or determination shall be made and no action shall be taken by the Board with respect to the company or JVCo (...) in respect of any of the

Case 3: Tata-AIG General Insurance

In yet another case of Tata-AIG General Insurance Co, the 26% FDI limit has no operational significance as the articles give the foreign investor special rights. Interestingly, subsequent to a news report on the special rights enjoyed by foreign investors in insurance JVs, based on our ongoing study of FDI,13 it was reported, in the context of formulating guidelines for insurance IPOs, that ...no joint venture will be able to go public without the foreign partner losing its veto power in the joint venture.14 However, it is not clear how such rights will be treated in case of unlisted JVs. Another relevant issue is whether the Indian partner will be allowed to sell his entire stake in the open market after the company is listed and the lock-in-period, if any, is over leaving the foreign investor as the single largest investor. In any case, one wonders why the CFP missed this important and well-known aspect of corporate control.
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Veto Rights of Minority Shareholders

That the interpretation of veto rights, which are an important means of control by minority shareholders, has become contentious is evident from the fact that the issue is currently engaging the attention of the highest judicial body of the country. The case concerns the veto powers held by Subhkam Ventures (I) (Subhkam), a minority shareholder of MSK Project (India) (MSKP). The SEBI had earlier held that since Subhkam has the right to appoint a nominee on the Board of MSKP and that the affirmative vote of the nominee shall be required in dealing with a large number and variety of matters as long as Subhkam holds at least 10% of the share capital of MSKP, it amounts to control of Subhkam over MSKP. When Subhkam went for appeal against this ruling, the Securities Appellate Tribunal (SAT) observed that the matters over which Subhkam holds veto power were not in the nature of day-to-day operational control over the business of MSKP. They were also not in the nature of control over either the management or policy decisions of MSKP and they merely enable Subhkam to protect its interests.15 While the SAT did not deem the veto powers to amount to control, there is every possibility of such powers amounting to some sort of control. It is relevant to refer in this context to the European Commissions competition policy which states:
Joint control exists where two or more undertakings or persons have the possibility of exercising decisive influence over another undertaking. Decisive influence in this sense normally means the power to block actions which determine the strategic commercial behaviour of an undertaking (emphasis added).16

It would also be relevant to refer to SEBI (2010) which refrained from interpreting veto powers amounting to control because the existence or non-existence of control over a listed company would be a question of fact, or at best a mixed question of fact and law, to be answered on a case to case basis (p 29). A case-bycase approach while advisable is open to a high degree of subjective interpretation. One can expect considerable litigation by the interested parties if the decisions go against them as has been the case with Subhkam.

Summing Up
The issue of indirect foreign equity came into focus because of the possible circumvention of the caps on the extent of foreign equity imposed for certain sectors. The caps imply a JV framework as the remaining equity is expected to be held by local partners. The CFP lays emphasis on majority ownership and right to appoint majority directors for defining domestic shareholding. Evidence shows that the sectoral caps aimed at restricting the extent of control yielded by foreign investors as a means of protecting national interest/ objectives, may not work in practice. It is the relative strengths of the partners which determine the extent of control in JVs and the dominant partner can leverage control in several different ways, most notably through shareholder agreements/rights written into the AoA. Even in cases where foreign participation in the risk capital of a company is 26%, the Indian partners may opt for the JV mainly to secure intangibles such as technology, managerial skills and goodwill, from their JV partners. In such cases, the Indian partners are likely to cede control over operations of the
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JV because they lack the necessary experience. In fact, the two cases discussed above involve Indian partners that did not have any past experience of insurance business. The foregoing suggests that realisation of the twin objectives of attracting FDI along with the attendant benefits of technology, while simultaneously retaining control in Indian hands, is fraught with difficulties. In this context, the point made in the Discussion Paper of the Department of Industrial Policy and Promotion regarding increasing the cap for the defence sector from 26% to 74% as higher FDI limit would also provide a significant incentive for transfer of know-how/technology to the country, makes somewhat of a strange reading. This brings one to the fundamental question: what is the objective of allowing FDI in sensitive areas? Indeed if the objective is to attract foreign capital and technology so that the sectors would grow fast and efficiently, then sectoral limits on FDI could obviously act as a deterrent for foreign investors.17 As regards imposition of sectoral caps, the key motivation seems to be to retain some control in Indian hands. Given that no explicit restriction on the extent of foreign control is imposed whenever FDI is allowed to enter through the automatic route, subsequent efforts at limiting control through monitoring indirect foreign equity would be of little consequence. Even in the case of the defence sector, for which the governments approval is mandatory, the CFP, while elaborating on the indirect foreign equity, only says that the present limit of 26% is subject to the condition inter alia that, [T]he management of the applicant company/partnership should be in Indian hands with majority representation on the Board as well as the chief executives of the company/partnership firm being resident Indians, thus relying on the nationality of the directors and their majority in the board. By simply looking at the nationality of the directors, one is likely to misjudge the character of a companys board of directors and be oblivious to the constraints under which they could be working. The critical issue that this paper has tried to highlight is that control over enterprises in sensitive sectors cannot be achieved through setting limits on percentage of equity holding, or proportion of directors in the board. The minimum that should be done is to disallow veto powers, withdraw the automatic route option for such sectors and follow a case-by-case approach. The government should also consider holding golden shares in all companies operating in sectors considered highly sensitive from national security and public health point of view. There is obviously a need for the government to specify the objectives in placing caps in each sector and also to study how the present caps are working in practice at all stages. The CFP should elaborate on this in its next revision and before attempting to relax the existing caps.
Notes
1 These are agriculture (except floriculture, horticulture, development of seeds, animal husbandry, pisciculture, aquaculture and cultivation of vegetables and mushrooms) retail trading (except single brand product retailing), lottery, gambling and betting, chit fund, mutual benefit financial companies, trading in transferrable development rights, real estate, manufacturing of cigars, cigarettes, tobacco or tobacco substitutes, atomic energy, and railway transport (other than mass rapid transport systems). See Consolidated FDI Policy (Effective from 1 October 2010) of the Department of Industrial Policy and Promotion, available at http://www.dipp.nic.in/FDI_Circular/FDI Circular_02of2010.pdf.

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2 For example, restrictions are imposed on the entry of foreign firms in defence with a view to strengthening self-reliance in defence preparedness. For details, see DIPP (2010), paragraph 3.1. 3 Supra note 2. 4 The methodology was unveiled in Press Note No 2 (2009 Series), available at http://siadipp.nic.in/ policy/changes/pn2_2009.pdf. 5 There has also been external demand to raise the caps. See Economic Times (2009) and The Telegraph (2010), where insurance, banking and defence were reported to be the focus. 6 Excluding the shares held by public sector banks and public financial institutions. 7 This is to avoid the possibility of splitting of Indianowned votes which could give the foreign shareholder upper hand in spite of being in minority. 8 See the AoA of MaxLife (downloaded from the website of Ministry of Corporate Affairs (MCA)). 9 It is reported that First American Securities, is 90% owned by Bharti and 10% by AXA. See: Bharti-AXA finalise equity holding in insurance venture at http://www.siliconindia.com/show news/BhartiAXA_finalize_equity_holding_in_ insurance_venture-nid-30617.html 10 See the AoA of Bharti AXA Life Insurance Co Ltd (downloaded from MCAs website). 11 See the AoA of First American Securities Pvt Ltd (downloaded from MCAs website). 12 22.222 directly and 37.778 x 0.10=3.7778 indirectly through the SPV. 13 Joe C Mathew (2010). 14 http://www.lifeinscouncil.org/media-centre/latest-news/521-stakeholders-of-ipo-bound-cos-mustsell-stake-equally. 15 Before the Securities Appellate Tribunal, Appeal No 8 of 2009. Date of Decision: 15 January 2010, available at http://www.sebi. gov. in/satorders/ subhkamventures.pdf. 16 Point 19 of the European Commission Notice on the Concept of Concentration under Council Regulation (EEC) No 4064/89 on the control of concentrations between undertakings available at http://eur-lex.europa.eu/LexUriServ/ LexUriServ.do?uri=CELEX:31998Y0302(01):EN: NOT. 17 Over the years, foreign investors have not only been reluctant to accept conditions, they have, in fact, been able to secure a more investor friendly regime in which only the minimum restrictions are imposed. Two agreements under the World Trade Organisation provide evidence as to how this has happened. The Agreement on Trade Related Investment Measures (TRIMS) prohibits host countries from imposing any performance clauses (such as export requirements and import balancing) on the foreign investors. Similarly, the General Agreement on Trade in Services (GATS) prohibits countries that have taken commitments to allow foreign investment in their service sectors to impose limitations on the participation of foreign capital in terms of maximum percentage limit on foreign shareholding In other words, caps on foreign investment cannot be imposed. Department of Industrial Policy and Promotion (2010): Discussion Paper: Foreign Direct Investment (FDI) in Defence Sector, Ministry of Commerce and Industry, available at http://dipp.nic. in/ DiscussionPapers/ Discussion Papers_ 17 May 2010.pdf. Goyal S K (1979): Impact of Foreign Subsidiaries on Indias Balance of Payments, a report submitted to the UN ESCAP, Bangkok, Indian Institute of Public Administration, New Delhi. (1982): The New International Economic Order and Transnational Corporations, Corporate Studies Group Working Paper, Indian Institute of Public Administration, New Delhi. Hymer, Stephen (1993): On Multinational Corporations and Foreign Direct Investment in John Dunning (ed.), The Theory of Transnational Corporations, UN Library on Transnational Corporations (London and New York: Routledge), Vol 1, pp 23-43. Mathew, Joe C (2010): Foreign Firms Call the Shots in Several Insurance JVs, Business Standard, 28 September. Schaffer Richard, Beverley Earle and Filiberto Agusti (1999): International Business Law and Its Environment, 4th Edition Cincinnati: West Educational Publishing. Securities and Exchange Board of India (2010): Report of the Takeover Regulations Advisory Committee, 19 July. Chairman: S Achutan. Economic Times (2009): US to Ask India to Raise FDI Limit in Insurance, Defence: Assistant Secretary of State Wants Sectoral Cap to Move Up to 49%, 20 November. The Telegraph (2010): UK Team to Push for Easy FDI, 27 July, available at http://www.telegraphindia. com/ 1100727/ jsp/ business/story_12730405.jsp

References
Dhar, Biswajit (1988): State Regulation of Foreign Private Capital in India, Corporate Studies Group Working Paper available at http://isid.org.in/pdf/ statreg.PDF.

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