Confusing signals to private equity investors in realty

Confusing signals to private equity investors in realty
Business Standard, September 7, 2009, Page 10

Vivek K Chandy

At the beginning of 2005 the Department of Industrial Policy and Promotion (DIPP) falling under Ministry of Commerce and Industry, came out with Press Note 2 of 2005 (Press Note 2) under which foreign direct investment (FDI) was permitted in townships, housing, built-up infrastructure and construction development projects.

As a result of Press Note 2, billions of dollars of FDI flowed into the real estate sector through various funds. Press Note 2 was strictly interpreted and all investments were made in companies which were only developing green field projects where the minimum size of each project was 10 hectares in the case of housing plots or 50,000 square metres in the case of construction development projects. In cases where FDI was sought by companies that had projects which did not comply with the criteria set out in Press Note 2 (non-compliant projects), efforts were made to have the non-compliant projects moved out of the companies in question before they accepted FDI.

Press Note 2 also prescribes a minimum capitalisation which is $10 mllion in the case of wholly-owned subsidiaries and $5 mllion in the case of joint ventures. There is a stipulation that the original investment cannot be repatriated for a period of three years from the completion of minimum capitalisation. Based on clarifications that were provided from the DIPP, it was made clear that what was sought to be locked in for a period of three years was the minimum capitalisation of $10 mllion or $5 mllion as the case may be.

The DIPP also clarified the fact that FDI could be infused into companies that had both 'non-compliant projects' and projects that complied with Press Note 2 (Compliant Projects) as long as the FDI was used only for the 'compliant projects' that commenced after the FDI was accepted. In 2008, the Foreign Investment Promotion Board (FIPB) rejected an application made by Vatika Limited to retain 'non-compliant projects' in the company that had received FDI and to bring back 'non-compliant projects' that were earlier hived off. Although this case received huge publicity, it being suggested that the FIPB had taken a stand that there could be no FDI in a company with non-compliant projects, what distinguished the rejection from the earlier positive clarifications, was the fact that permission was sought to bring non-compliant projects back into the company, after they had been hived off. In the recent past the DIPP has apparently stopped providing confirmations that FDI can be sought by a company in which there are both 'compliant projects' and 'non-compliant projects' even if the FDI were to be used only for 'compliant projects'. In the recent past, the DIPP has also suggested that what is locked in for a period of three years is not the minimum capitalisation, but the entire FDI infused into a company.

It is necessary to point out that based on the various clarifications provided by the DIPP, the infusion of FDI into various companies was structured in a manner that was efficient to the various investors that had to comply with the laws of more than one country. The recent conflicting positions that are being canvassed by the DIPP could result in irreparable hardship being caused to investors who have brought FDI into the country based on their reading of Press Note 2 along with the various clarifications that have been available. These investors would have no option but to approach courts of law to seek enforcement of the rights promised to them. Apart from taxing the courts of law, such a change in policy would also send out wrong signals to investors and ultimately prejudice the efforts of the government to encourage FDI.

The foreign exchange regime in India ordinarily permits the free transfer of shares in an Indian Company from one non-resident to another. A reading of Press Note 2 with the extant regulations would make it appear apparent that a non-resident investor that has brought FDI into an Indian Company can transfer its shares to another non resident and that this would not amount to repatriation of the investment.

The FIPB has, however, in the case of ICP Investments held that there could be no non-resident to non-resident transfer before the expiry of three years as it would amount to repatriation of the original investment before the period of three years from completion of minimum capitalisation. The FIPB has taken the view despite the fact that Press Note 2 is concerned with the "Investment" brought into India and not with the "Investor".

It is pertinent to point out that there have been changes in the law after Press Note 2 was issued, including changes which brought optionally convertible debentures and optionally convertible preference shares outside the purview of equity under the foreign exchange regime. These changes were made vide press note dated April 30, 2007 and were brought into force as it was felt these instruments facilitated the easy repatriation of FDI structured more as debt than equity. Although these changes in the law took away several structuring options that were otherwise available, all these changes were made prospectively and could not really be faulted as in the case of what has been discussed above.

It is therefore important for the DIPP to recognise that any change that it makes can only be made with prospective effect and only by changing the law and Press Note 2 in particular, and not by simply providing clarifications which are inconsistent with earlier clarifications that have been provided. While only investors who have received clarifications from the DIPP will be able to raise the ground of promissory estoppel, other investors may be able to make out a case of discrimination and legitimate expectation.

The critical issues relating to Press Note 2 that need to be resolved are:

1. Whether FDI can be made in a company which has Compliant and Non-Compliant Projects, provided FDI is used for Compliant Projects commencing post FDI coming into the company?

2. Whether it is only the minimum capitalisation of $10 million or $5 million as the case may be, that is locked in for a period of three years?

3. Whether there should be no restriction on the transfer of shares made by one non resident to another even if the transfer is before the expiry of three years from the minimum capitalization?

What the DIPP also needs inter alia to clarify is:

i. Whether the 50,000 square meter minimum built up area criteria would include basements, terraces and other areas not taken into consideration for the purposes of floor area ratio and floor space index calculation?

ii. Whether FDI can be used for Compliant Projects at the initial stages of development, including those that are about 20-30% completed?

Clarity provided by the DIPP will go a long way in boosting the FDI inflow into India in the realty space.

Vivek K Chandy is a partner at J Sagar Associates.

The views contained in this article are those of the author and not necessarily of the firm.