Non-residents can pledge shares of Indian company

By Mohit Gogia, S&R Associates
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Recent changes introduced in the foreign direct investment (FDI) policy of the government of India and the introduction of the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (takeover code), enable non-residents to secure their payment obligations by creating a pledge over shares held by them in an Indian company (including a listed company), subject to certain conditions.

FDI policy

On 30 September, the Department of Industrial Policy and Promotion issued circular 2 of 2011, which outlines the consolidated FDI policy in India with effect from 1 October. A significant change in the FDI policy is the introduction of provisions permitting the creation of a pledge over shares of an Indian company by a non-resident.

Mohit Gogia Lawyer S&R Associates
Mohit Gogia
Lawyer
S&R Associates

The change was made to incorporate the provisions of a circular issued by the Reserve Bank of India (RBI) on 2 May, which permitted a pledge of shares of an Indian company by a non-resident in favour of (i) an authorized dealer bank in India to secure credit facilities being extended to a resident investee Indian company for bona fide business purposes and (ii) an overseas bank to secure credit facilities being extended to a non-resident investor or promoter of the Indian company or its overseas group company, subject to certain specified conditions.

Prior to the RBI’s May circular, other than the pledge of shares by a non-resident promoter of the borrower Indian company as security for external commercial borrowings obtained in accordance with the RBI guidelines, non-resident shareholders were not permitted to create a pledge over their shares in an Indian company without the prior approval of the RBI.

Paragraph 3.5.7(C) of the FDI policy now permits non-residents to obtain a loan outside India and pledge shares held by them in an Indian company, subject to the following conditions: (i) the loan is provided by an overseas bank; (ii) the loan is used for genuine business purposes overseas and not for any investments directly or indirectly in India; (iii) the overseas investment will not result in any capital inflow into India; (iv) on enforcement of the pledge, a transfer of shares will only be made in accordance with the FDI policy existing at the time of creation of the pledge; and (v) submission of a declaration and annual certificate from a chartered accountant that the non-resident borrower will or has used the loan proceeds for the declared purpose.

Takeover code

The takeover code was notified by the Securities and Exchange Board of India on 23 September and replaced the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations 1997, as amended, with effect from 23 October.

Regulation 31 of the takeover code requires non-resident promoters of a listed Indian company that create a pledge over their shares in the company to disclose details of the shares “encumbered” by them or by persons acting in concert with them, and also details of any invocation or release of such encumbrance, within seven working days from the creation or invocation or release of encumbrance, as the case may be.

The term “encumbrance” has been defined under the takeover code to include a pledge, lien or any such transaction, by whatever name called.

Non-resident pledgees that seek to enforce a pledge on shares of a listed Indian company may be subject to the requirement of making an open offer under the takeover code if they acquire 25% or more of the shares or voting rights or acquire control over such company at the time of enforcement of the pledge.

Exemption for banks

Regulation 10(1)(b)(vi) of the takeover code exempts any acquisition in the ordinary course of business upon enforcement of a pledge by scheduled commercial banks or public financial institutions as pledgees.

All banks which are included in the Second Schedule to the Reserve Bank of India Act, 1934, as amended, are scheduled banks. These scheduled banks comprise scheduled commercial banks and scheduled cooperative banks.

Scheduled commercial banks in India are categorized by the RBI into five groups according to their ownership and/or nature of operation: (i) the State Bank of India and its associates; (ii) nationalized banks; (iii) regional rural banks; (iv) foreign banks (such as Standard Chartered Bank, Citibank and UBS) and (v) other Indian scheduled commercial banks (in the private sector).

In all other cases, non-residents (including overseas banks) that acquire shares or voting rights or control following the enforcement of a pledge may be subject to the open offer requirements under the takeover code.

Mohit Gogia is a lawyer at S&R Associates, a law firm with offices in New Delhi and Mumbai. The views expressed above are those of the author and not a substitute for legal advice.

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