The curious case of ‘composite caps’

By Vaibhav Kakkar and Sahil Arora, Luthra & Luthra Law Offices
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In a press release dated 16 July, India’s cabinet said that in an attempt to ensure that “uniformity and simplicity are brought across the sectors in the FDI policy for attracting foreign investments”, it had approved a proposal by the Department of Industrial Policy and Promotion (DIPP) to introduce “composite caps”. Composite caps envisage that the sectoral caps specified in the FDI policy would be “composite” for all forms of foreign investments and that there would no longer be any sub-caps for foreign investments.

Vaibhav Kakkar
Vaibhav Kakkar

The press release was cheered by the industry and markets, with the expectation that composite caps would mean the obliteration of sub-limits across the board. However, the jubilation was short-lived, and a closer examination of the fine print suggested that the composite caps framework was applicable “unless provided otherwise” by the sectoral policy.

Coupled with Press Note No. 8 of 2015 issued by the DIPP soon after, it became apparent that composite caps would not be applicable to the defence and private-banking sectors, which would have immediately benefited from the amendment by virtue of having a relatively large number of listed companies and therefore the ability to access foreign portfolio investment (FPI).

The defence sector is starved for FDI, and requires a substantial inflow of investment in order for defence manufacturing in India to achieve any discernible level of success. The sector is also a vital cog in the government’s “Make in India” campaign, and the removal of sub-limits across all sectors would have been in line with the government’s policy in this regard. Instead, the decision to retain the sub-limits for FPI and investments by foreign venture capital investors at 24% in the defence sector – where foreign investment is permitted up to 49% with prior approval of the Foreign Investment Promotion Board (FIPB) – will prevent composite caps from having any real impact in this sector.

The retention of the sub-limit for portfolio investment (up to 49%, with FDI permitted up to 74%) in the private-banking sector is also unfortunate. The fear of “fly-by-night operators” or “hot money” entering the sector and causing havoc on exit due to any negative global sentiment is mitigated by the stringent regulatory oversight exercised by the Reserve Bank of India (RBI) on this sector. In addition to the individual sub-limit of 10% for each portfolio investor (as per the Securities and Exchange Board of India rules and the FDI policy), the RBI has “fit and proper criteria” in place for such investors. It also limits shareholding and voting rights at 10%, with the requirement of prior RBI acknowledgment if any single investor (along with persons acting in concert) holds more than 5%. Thus, considerable checks and balances are already in place to prevent concentration of ownership, and eliminate any risk of “foreign control”.

Sahil Arora
Sahil Arora

The introduction of composite caps in the private-banking sector assumes even greater importance against the backdrop of the government’s stress on financial inclusion, combined with BASEL III upping capital requirements for banks. The removal of individual sub-limits would have gone a long way in providing flexibility for private sector banks to raise institutional capital to meet the expected credit growth. Private sector banks which have exhausted their FPI limit but have FDI headroom now have no option but to raise funds through American or global depository receipts, which is a relatively more expensive proposition than domestic capital offerings.

Recent reports suggest that the government is considering allowing 100% FDI in the private-banking sector. However, given the limited options available for many banks to raise capital, it remains to be seen whether the move would have any real benefit without the sub-limit for FPI being removed.

Even with these limitations, the introduction of composite caps in the FDI policy is still a laudable step in the right direction. Investors who were previously subject to sub-limits in the sectoral policy can now invest in these sectors up to the sectoral cap for FDI. The amendment also provides greater clarity and legal certainty, and should lower transaction costs by doing away with compliances with multiple sets of regulations.

Hidden away in the press release and subsequent press note is another major amendment to the FDI policy. FPI up to an aggregate of 49% or up to the sectoral cap (whichever is lower) is now permitted without FIPB approval or compliance with FDI sectoral conditions, if such investment does not lead to change of ownership/control of the investee company from resident Indian citizens to non-resident entities. This is arguably a real “big-bang reform” and would allow a number of listed companies, previously not allowed by the regulator to raise funds through the FPI/qualified institutional placement route (due to inability to comply with FDI policy conditions), to now unlock value. Sectors such as brownfield pharmaceuticals and multi-brand and single-brand retail, which have onerous sectoral conditions, should be able to reap immediate benefits from this change. Policy initiatives such as these are crucial in order to fulfil the government’s avowed policy objective of 8% economic growth.

Luthra & Luthra Law Offices is a full-service law firm with offices in New Delhi, Mumbai and Bangalore. Vaibhav Kakkar is a partner and Sahil Arora is an associate at the firm. This article is intended for general informational purposes only and is not a substitute for legal advice.

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