On November 16, 2015, RBI issued a notification allowing pooling vehicles registered with SEBI to raise funds from non-residents. The notification marks several firsts in the history of FEMA. First, it allows non-residents to subscribe to units of trusts and companies which are engaged only in the business of making downstream investments.1 Second and more importantly, it allows funds which are fully raised abroad to override the framework on capital controls, so long as the sponsor and manager of the fund are Indian owned and controlled. This constitutes an important step forward in capital account liberalisation, within the unsavoury strategy of requiring that money is routed through Indian owned and controlled funds.
From 2012 onwards, SEBI implemented numerous frameworks for registering and regulating funds set up in India. These frameworks classified funds into different categories (such as real estate funds, infrastructure funds, venture capital funds, hedge funds, etc.), depending on the objectives of the fund. Thus, funds meant for investment in real estate were regulated differently from funds meant for investment in infrastructure. Funds other than those investing in real estate and infrastructure were regulated differently. The SEBI-frameworks explicitly enabled these funds to raise money from non-residents 2. However, pending amendments to the relevant FEMA regulations, Indian funds could not directly raise money abroad.
Nearly three years after the implementation of the first of such frameworks, the RBI notification allows non-residents to subscribe to units of funds registered with SEBI.
Regulating downstream investments by funds
While it is easy to propose capital controls in the form of sectoral caps on foreign investment, there is tremendous complexity in writing law and enforcing it. For instance, the rule is that Indian companies, which are owned and controlled by non-residents may invest downstream on the same conditions as the foreign investor herself could have made such investment.3 The idea is that one cannot do indirectly what she could not have done directly. How does one address this problem in the case of pooling vehicles having foreign investment?
The notification addresses the problem by attributing the nationality of the asset manager and sponsor to the nationality of the fund corpus itself. 4 It provides that where the asset manager and sponsor are not Indian owned and controlled, the fund corpus will not be regarded as Indian owned and controlled.
As a natural corollary, where the asset manager and sponsor are Indian owned and controlled, the fund corpus will be regarded as Indian owned and controlled (notwithstanding that the fund is raised abroad). Consequently, the capital controls framework will not apply to the downstream investment made from such fund.5
When is an asset manager or sponsor "Indian owned and controlled"?
This gets us to the question as to when can an asset manager be regarded as Indian owned and controlled. Going by FEMA 6, an asset manager is Indian owned and controlled, if:
- More than 50% of its capital is beneficially owned by resident Indian citizens or companies which are ultimately owned and controlled by resident Indian citizens; and
- Majority of its directors are appointed by and the management and policy decisions, are made by Indian resident citizens or by companies which are ultimately owned and controlled by resident Indian citizens.
The same principle applies to a sponsor for it to qualify as Indian owned and controlled.
Linking downstream investment to ownership and control of asset manager and sponsor
Attributing the nationality of the asset manager and sponsor to the nationality of the fund means that an asset manager and sponsor which is Indian owned and controlled, may raise the entire fund abroad. But the fund will be regarded as Indian money for the purpose of downstream investment. Such a fund can then be potentially invested in real estate business, in which foreign investment is otherwise prohibited, or even in the insurance sector, where there is a cap on foreign investment.
Presumably, the character of the fund is attributed to the character of the asset manager and sponsor, for ease of administration of the capital controls framework. This is because, one cannot control the transfer of fund units to non-residents.
Simply put, today, if a 100% domestic fund acquires say, more than 49% (the present sectoral cap) in an Indian insurance company, the regulator cannot control the transfer of the units of that fund by domestic investors to non-residents. It will be impossible to alter the downstream portfolio of the fund depending on the ownership of the fund.
Matters get complicated even further where a completely domestic fund has made downstream investments in sectors which have FDI-linked conditions (such as retail or NBFCs). If the domestic investors in such a fund transfer their investment to non-residents, again, the rules regarding FDI-linked conditions would be subverted. Take a 100% domestic fund which invests in retail. Now, FDI in retail is allowed subject to compliance with minimum sourcing and other norms. If the investors in the fund transfer their units to non-residents, then the downstream retail company (in which the fund has invested) will have to begin complying with domestic souring norms, etc. It is impossible to monitor this kind of compliance and also practically not feasible for the downstream company to change their sourcing strategies depending on the ownership of (what may be one of many) investors.
On the other hand, it is easier to monitor the control and ownership of the sponsor and the asset manager. Hence, the fix.
Better than some worse alternatives
This approach is creatively flexible, and is better than some things which could have been done. For instance, another tool that the regulator could have adopted to address the problem of subversion of sectoral caps, is to restrict the transferability of units of funds which have made downstream investments in sectors prohibited for FDI or restricted sectors. This would have left investors worse-off with restricted liquidity. The current approach reflects the progressive attitude of the administration. It potentially dispenses with sectoral caps and FDI-linked performance conditions that FEMA stipulates for various sectors.
The method, however, raises two concerns:
- The rule creates incentives for a foreigner who wants to set up an asset management company in India to tie up with an Indian entity (and give majority ownership and control to an Indian) to make sure that she is able to raise funds from abroad. Only then will the fund be treated as Indian to enjoy the flexibility of making downstream investments in sectors restricted or otherwise prohibited for downstream investment. The rule, thus, creates a protectionist bias in favour of residents. This would, in general, diminish the quality of fund management services that emerge out of the competitive market for fund management.
- What will happen to existing downstream investments made by the fund if the Indian asset manager wishes to sell his business to a non-resident? Will the downsteam investment be wound up if they are in a prohibited or restricted sector?
Succumbing to the temptations of FEMA-style policy thinking
In some respects, the notification has, however, yielded to the discretionary framework that pervades FEMA. For instance, the notification allows foreign investors to transfer or redeem the units of such funds on terms and conditions specified by RBI and SEBI. This approach suffers from the following flaws:
- The pricing of units in a fund is linked to the NAV of the fund. There are no restrictions on the transfer of units of such funds between domestic investors. We must stop imposing different standards for transfer of securities between domestic investors inter-se and non-residents.
- Today, there are no restrictions on the transfer of units of mutual funds bought by foreign investors. This principle should hold true for all pooling vehicles.
- Reliance on future directions issued by SEBI and RBI adds to uncertainty and discretion, which has been repeatedly written about here, here and here.
Similarly, it states that since it is difficult to identify whether a LLP is Indian owned and controlled, a LLP cannot act as an asset manager or sponsor of the fund. Now, this is taking the ease of administration argument too far.
While the notification has shown maturity in dealing with the problem of downstream investments by pooling vehicles, it remains to be seen whether the administration will be able to shrug off its long standing bias in favour of sectoral caps, and the mindset of FEMA, and allow this new framework to actually operate.
- Hitherto, foreign investment in a purely holding company could be made only under the approval route. Similarly, foreign investment in trusts, except a mutual fund and VCF, was prohibited. If the VCF was structured as a trust, foreign investment was allowed only under the approval route. Back
- See Regulation 10(1) of the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012, Regulation 14 of the Securities and Exchange Board of India (Real Estate Investment Trusts) Regulations, 2012. Back
- See Regulation 14(6) of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000. Back
- The notification states: Downstream investment by an Investment Vehicle shall be regarded as foreign investment if neither the Sponsor nor the Manager nor the Investment Manager is Indian `owned and controlled' as defined in Regulation 14 of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000. Back
- The notification expressly states that the extent of foreign investment in the corpus of the Investment Vehicle will not be a factor to determine as to whether downstream investment of the Investment Vehicle concerned is foreign investment or not. Back
- Regulation 14(1) of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000. Back
Bhargavi Zaveri is a researcher at the National Institute for Public Finance and Policy.