Government scraps controversial clause in FDI policy, categorizing PE investment with in-built put-call options as debt.

Over the past 20 hours, we at Lexygen have received innumerable calls and emails seeking our view on the corrigendum issued yesterday by the Department of Industrial Policy and Promotion (“DIPP”) deleting a paragraph of the Consolidated FDI Policy 2011 issued in early October (“FDI Policy”) which prohibited Indian companies from issuing shares under the FDI route “with in-built options”. While the corrigendum has been universally welcomed by the PE/VC community, one question that I have been getting asked repeatedly is as to whether this really means that put and call options can now be considered kosher once again, and whether transaction documents can now revert to including put/call option clauses in favour of foreign investors. This column is a reaction to, and a product of, my discussions with these various querists.

Many of us have followed with interest the put/call options drama unfolding in the Indian PE/VC arena over the past several months. While the issue has been receiving a lot of coverage over the past 3-4 months, some of us have been casting anxious glances over our heads for a much longer time now at this potentially lethal sword dangling dangerously over numerous PE/VC deals. While many readers may be familiar with the issue, for the sake of setting the context, let me begin by giving a very brief background summary.

Background to the Issue

The options controversy started when, a few months ago, the Reserve Bank of India (“RBI”) served notices to some Indian companies questioning the “put/call option” clauses contained in shareholders’ agreements entered into by such companies with foreign investors, despite the applicable laws of India then containing no prohibitions on such clauses. The RBI had taken the position in those notices that the inclusion of any sort of option clauses in shareholders’ agreements with foreign parties effectively amounted to raising foreign debt (external commercial borrowings, or “ECB”s) disguised as equity infusion.

This controversy came to a head in October when the DIPP issued the FDI Policy in which it specifically introduced language stating that any equity infusions by foreign parties with “in-built options of any kind” would be treated as ECB and would have to comply with the stringent restrictions under the ECB Regulations. This new paragraph in the FDI Policy effectively made any sort of option clauses impossible to include in PE/VC transaction documents. This had caused a fair amount of anxiety amongst the PE/VC investor community, as also amongst strategic investors, as it took away a very important downside protection to such investors investing in Indian companies. This move to prohibit options clauses in FDI transactions has been widely been assailed as retrograde, and fears have been vociferously expressed that this move could adversely affect FDI inflows into India, thereby exacerbating an already difficult deal environment.

Implications of the Corrigendum – Will RBI Buy In?

The scheme and structure of the foreign investment laws in India is that while the RBI has been vested with powers under the FEMA to make regulations for the implementation of foreign investment into Indian companies and to administer the same, the broader policy decisions with respect to foreign investment are made by the DIPP. Therefore, the regulations made and administered by the RBI need to be in conformity with the principles of foreign investment policy laid down by the DIPP. The RBI frequently also takes inputs from time to time from the DIPP and the Ministry of Finance on matters of policy with respect to foreign investment.

While, of course, it is not very easy to read the crystal ball with respect to regulatory intent on this issue, by looking at the background and sequence of events, one can get some firm pointers as to the regulatory thinking on this issue. It is worth noting that it was only very recently (after years of investment of several billions of dollars into India with such option clauses) that the RBI started raising objections as to the validity of these options. Quite clearly, it appears that there was a fair amount of discussion between the RBI and the DIPP on this issue, and it would seem that it was in recognition of, and to address, the lack of legal backing for the RBI’s position that the FDI Policy (issued in early October) specifically included paragraph 3.2.2.1 which stated that no “in-built options” could be a part of any FDI into Indian companies.

In other words, it clearly appears to me that the regulator and policy-makers concluded that there was no legal backing (prior to October, 2011) for the RBI to take the position that options to foreign investors are not permitted, and hence, decided to include paragraph 3.2.2.1 in the FDI Policy to give this position legal/policy backing. And yesterday, by issuing a corrigendum specifically to delete this paragraph, the DIPP has taken away this short-lived policy backing to the RBI’s position.

Given this background and sequence of events, it would be a reasonable conclusion to reach, in my view, that the very fact that the DIPP chose to issue a specific corrigendum deleting paragraph 3.2.2.1 in its entirety barely a month after issuing the FDI Policy (which had introduced this prohibition for the first time ever) makes it abundantly clear that the regulatory position and thinking has changed after further consideration of the issue, perhaps after joint discussions between RBI and DIPP, taking into account the widespread backlash from industry.

The DIPP would not, in my view, have reasonably spent the time and effort to formally announce a deletion of that paragraph in such a short span of time unless it wanted to send a clear and reassuring message that it had concluded that such a restriction/prohibition on options was undesirable in the interests of India attracting more FDI.

Having said the above, it is possible that the RBI may continue to question such options in FDI deals notwithstanding the corrigendum. In my view, however, in the absence of a further change or clarification in the FDI Policy by the DIPP, or in the FEMA Regulations by the RBI, any attempt by RBI henceforth to question such put and calls options in FDI deals would be a weak one in law.

The foreign investment policy intent has been made abundantly clear by the DIPP in amending the FDI Policy to remove paragraph 3.2.2.1 in its entirety. The most logical and reasonable conclusion in the circumstances is that the policy-maker has considered the matter further and has arrived at an informed policy choice that the formal deletion of paragraph 3.2.2.1 from the FDI Policy is necessary and desirable in the interests of the Indian economy. Given this clearly demonstrated policy directive from the DIPP, I would think that the RBI should not raise this issue again in FDI transactions till such time as put and call options continue to be not prohibited by the FDI Policy of India.

Why aren’t Indian entrepreneurs as successful as their overseas counterparts? A close look at the critical factors.

If Mark Zuckerberg, Larry Page, Sergey Brin, Jeff Bezos and so on had been Indian residents and had conceived of and started their respective companies in an IIT hostel room, or in a garage in Mumbai or at a Cafe Coffee Day outlet in Bangalore, would they be the billionaires several times over that they have become in such a short span of time? Would their companies have commanded valuations at such stratospheric multiples? Highly unlikely.

Conversely, if the founders of many of the promising Indian start-ups like Flipkart, Snapdeal and so on had started their companies in the USA, or even in markets like China, Israel, etc., would at least some of them be billionaires by now, running companies valued at several billion dollars, commanding astounding valuations? Quite possibly.

So what explains the huge gulf in the value creation between Indian start-ups and their overseas counterparts in comparable businesses? Is it a fundamental difference in the core strength of the ideas? I don’t think so, as Facebook and Google were not exactly new or innovative ideas, but rather, attempts to build better products, services or user experiences than some of their predecessors who were running similar businesses. Is it then, that Indian entrepreneurs are much poorer executors of ideas than their overseas counterparts? Again, I don’t believe so, as evidence does not appear to suggest so. To my mind, the differences that explain these disparities in success lie in a host of other critical factors which place the Indian entrepreneur at a relative disadvantage. Some of these critical factors have been discussed at length in various articles and blogs, and are well-understood. I will, therefore, mention in brief some of these factors (as I believe they do make a big difference), but I will focus the thrust of this article on one other critical factor that does not get talked about enough, which I believe to be a very key impediment to value creation by Indian entrepreneurs — the regulatory framework.

Some of these key factors, which put Indian entrepreneurs at a relative disadvantage, are discussed below:

1. Size and maturity of the market: Undeniably, the domestic market that the US and Chinese companies cater to, for example, are huge in comparison to the Indian market. While India is a large emerging market which attracts increasing interest from several western companies, the fact of the matter is that India is a very price-sensitive market, and in most businesses, has been among the lowest ARPU holders in the world. Further, there are other factors like inadequate infrastructure, low Internet penetration and the fact that several business concepts are just taking root in India, which make it a challenging market for several businesses. In comparison, China and the USA have very deeply penetrated and mature markets which can be more easily tapped and new business offerings can be sold easily as well.

2. The culture: The very culture in the Silicon Valley is supportive and encouraging of starting up. The legendary ‘start-up culture’ of the Valley manifests itself everywhere – from support infrastructure, availability of talent, education system and institutions which all encourage starting up, the ‘rock star’ status accorded to successful entrepreneurs (and equally important, the lack of stigma attached to unsuccessful ones), easy availability of venture funding, the availability and access to great mentors and so on. India, on the other hand, has been producing entrepreneurs with great ideas and passion, but we clearly haven’t yet managed to build an environment and framework which are meaningfully supportive of start-ups. For a decade, Bangalore has been referred to as the Silicon Valley of India, but if we were to be honest with ourselves, we would acknowledge in a jiffy that Bangalore (or any Indian city or state, for that matter) has a long way to go before it can be considered truly deserving of such a sobriquet.

3. The regulatory framework: This is the bit on which I am going to spend some time. For any business that is in its nascent stage and indeed, to encourage entrepreneurship, all the above-mentioned factors are very important. But one cannot ignore the importance of the regulatory environment as a very powerful influencer. I am, in general, a deep admirer of our Indian legal system, which is founded on the notions of rule of law and due process. However, there are certain aspects of our regulatory framework which I do not admire and which, in my view, materially impede the growth of entrepreneurialism in India:

Exchange control: As we all know, India has been an exchange-controlled economy for several decades now. Of course, India had moved away from the draconian FERA to the more globalisation-friendly FEMA about a decade ago. But we still have an exchange control regime that places several restrictions on capital account transactions. Proponents of exchange control will always point to India’s relative insulation from the 1997 Asian meltdown, and more recently, the global financial crisis, to make the case for continued exchange controls. And to some extent, they would be right. However, one doesn’t (or shouldn’t) stop sailing just because the seas get choppy every now and then – cyclicality and periodic volatility are inherent to free markets. While all nations should prepare themselves to deal with such cyclicality, they should not create permanent barriers which prevent ships from sailing in and out when the seas are calm.

Our exchange control laws place various restrictions on the ability of Indian entrepreneurs to attract foreign equity capital, their ability to raise low-cost debt, their ability to grow their businesses overseas, their treasury-management strategies and so on. To be fair, successive Indian governments over the past two decades had undertaken significant reforms to dismantle many of these restrictions and the benefits of such reforms are already evident. However, there still exist many restrictions that impede the growth of Indian businesses, which can be done away with. The Department of Industrial Policy and Promotion (a department under the Ministry of Industry and Commerce) recently came up with a white paper which suggested some sweeping (and sensible) reforms to India’s FDI policy. One hopes that such reform measures find momentum and are given effect sooner, than later.

Listing norms: This is a major ‘non-billionaire’ factor! Indian listing regulations require that an Indian company must first list on an Indian stock exchange before it can list on an overseas stock exchange. The primary concern sought to be addressed by this requirement is that if good quality Indian companies were permitted to conduct their IPOs in overseas markets, that would adversely affect the growth of the Indian capital markets. While this may hold true to some extent and for a certain period, I think the Indian capital markets are strong enough to bounce back from such temporary setbacks. Stock exchanges worldwide have to compete effectively with each other for business and most of them do so remarkably well. So I don’t see why the Indian stock exchanges cannot do the same. In fact, being forced to compete with global stock exchanges for the attention of Indian companies would only foster innovation and enhancement of service of the Indian exchanges, thereby benefitting the Indian public.

The other frequently voiced concern about letting Indian companies to IPO overseas is that the Indian public would be deprived of an opportunity to invest in good quality Indian companies. Again, I think this concern can be very easily addressed by allowing Indian public shareholders to invest in overseas companies, including in stocks of Indian companies listed on overseas exchanges. The Liberalized Remittance Scheme of the RBI already permits Indian residents to invest up to $200,000 in a financial year outside India for permitted purposes. This can be extended to stocks of Indian companies listed on foreign exchanges as well, with possibly a higher limit.

If this requirement is changed, it would result in tremendous wealth creation potential for Indian entrepreneurs and shareholders, as several Indian companies, especially those in certain ‘premium’ sectors like technology, clean energy, pharma, etc., can command much better valuations if they have the flexibility of freely determining the exchange on which they will conduct their IPOs. The comparable case in point is that of Chinese companies, a large number of which have been able to list on the US exchanges at very attractive valuations, which they arguably could not have achieved, had they been forced to IPO in China. There is no reason why Indian companies cannot get comparable or perhaps even better valuations in overseas markets, if they were permitted to conduct their IPOs in non-Indian stock exchanges. Just to be clear, the case I am making is not that a listing on the Indian exchanges cannot create value for entrepreneurs but that, having the flexibility to decide the market to list in would be a very powerful tool in the hands of Indian entrepreneurs, which could result in tremendous wealth creation for Indian residents.

Constantly shifting sands: A client of mine once told me jokingly that in India, if he asks five different law firms for their opinion on a regulatory issue, he gets five different views! Of course, he might be exaggerating a bit, but the fundamental point that he was making was not too far off the mark. I would probably re-phrase what he said to say that if he asked the SAME law firm for an opinion on the same issue during five different months, he would probably get five different answers each time! In other words, while it is very exciting to be part of a fast-evolving economy and the changes spawned by it, it is sometimes frustrating for an entrepreneur to have to deal with constantly changing legal positions and interpretations. Very often, nuanced legal interpretations are required of matters, which ought to be fairly straightforward stuff but which are not because of the way they are drafted. While entrepreneurs and investors can deal with laws or regulatory positions that they don’t like and can plan for them, the uncertainty of very frequently changing or confusingly drafted regulation creates a deep sense of uneasiness among the business community. This can often eat into their mind space, which really should be more productively occupied by matters relating to the growth of their businesses.

The above is not intended to be a comprehensive list of factors that prejudice the growth of Indian companies and entrepreneurs relative to their overseas counterparts. But I do believe that these are very critical factors, which, if addressed constructively, would yield rich dividends. The time to push for these changes is now because we have seen a healthy resurgence of interest in young and fast-growing companies in India. The momentum that has been gathered on this front in the form of more early-stage deals, more aggressive growth plans by young Indian companies, etc., should be effectively leveraged to push for an environment which fosters more entrepreneurship in India, and places Indian entrepreneurs on the same level playing field with their overseas counterparts.

Too many categories of AIFs may require multiple registrations for sector agnostic growth funds.

Market regulator SEBI’s proposed regulations to monitor all classes of Alternate Investment Funds (AIF) seek to make major changes in the way private equity firms operate in India. SEBI has recognised that the investment philosophies of different kinds of funds vary from one another, which is a good step. While, in principle, formulating regulations based on the investment philosophies of various AIFs may be a good thing, ultimately, it all comes down to how investor-friendly and in-touch with industry practice the regulations are. A quick read of the draft regulations reveals some good news (e.g., the proposal to exempt PIPE deals from applicability of Insider Trading restrictions, which will help funds conduct due diligence for PIPE deals), but also a lot of potential bad news. Unfortunately, in my view, the bad news seems to far outweigh the good news.

Here goes some quick notes on the proposed changes:

● There are too many categories of AIFs sought to be created, with separate registrations for each of the category, and a restriction that an entity registered in one category may not undertake other types of deals. I think many PE funds may find this rather unappealing, as they will have to create, maintain and register multiple entities just to ensure that they have maximum flexibility in their investment strategy. For example, most growth equity funds will want to invest in infrastructure companies as well, infrastructure being a booming sector. In the context of the draft regulations, such funds will have to set up two different funds – a ‘Private Equity Fund’ and an ‘Infrastructure Fund’ – to fully implement their India investment strategy. I think the heads of classification adopted by SEBI are way too many, and tantamount to regulation entering the realms best left to fund documentation. Such a classification will only increase the cost of doing business for PE firms, and also place a huge strain on SEBI’s own regulatory bandwidth. My suggestion will be that the only categories of AIFs should be: (i) Private Equity funds (ii) Venture Capital funds and (iii) Residuary Funds (hedge funds, commodities funds etc.).

● I find it a little concerning that the language of the draft regulations appears to indicate that the various governance and disclosure provisions set out therein also apply to pure offshore funds, i.e., funds which have only foreign investors. While the SEBI has rightly expressed concerns over the possibility of private equity funds tapping a retail investor base, the same could have been addressed merely by prescribing that investments may only be raised from sophisticated institutional and HNI investors, rather than prescribing detailed reporting and corporate governance requirements. SEBI’s role as the Indian capital markets regulator is to protect the interests of Indian investors and the Indian capital markets. All the funds that raise funds from non-Indian investors are already subject to a host of regulations in their home markets, apart from under the fund documentation, which adequately safeguards the interests of such investors. I think SEBI need not add one more layer of regulation and compliance to this ecosystem. Some of the restrictions prescribed by the SEBI may be harsher than the norms fixed by offshore funds’ home jurisdiction regulators (for example, the limit on the number of investors), and as such, make regulatory compliance even more complex for such funds. Many of these restrictions do not add any value to the Indian market. Rather, they may adversely affect the appetite of the foreign investment community in the Indian market on account of perceived excessive compliance requirements.

● While so many different categories of AIFs are sought to be created, the draft regulations don’t make clear if the same fund sponsor group can operate various investment businesses under different AIF entities. Most reputable and large asset management businesses worldwide have multiple streams of investment businesses under the same umbrella group. Many of these highly successful groups are listed entities, which need to consolidate the value of these various streams so as to enhance shareholder value. I hope that should the draft regulations be passed, the SEBI will at least make it clear that fund sponsors will be permitted to own and manage different AIFs under the same entity or group. Otherwise, it may disincentivise some highly reputable fund houses from investing in India.

● The restriction that ‘PIPE Funds’ can only invest in small companies that don’t form a part of any of the stock exchange indices is a very worrying proposal. Listed companies of all shapes and sizes require growth/expansion capital as much as smaller companies do, and such a restriction will severely cramp the avenues for funding for large companies, which can only be detrimental to our economy. Needless to say, it will make the universe of listed company investment opportunities in India very limited and unappealing to private equity funds. Also, what about secondary/buyout transactions? They, too, need a fair space to thrive in the market as such deals also bring in foreign exchange and immensely benefit Indian entrepreneurs by providing them profitable exits. If the ability to invest in listed companies is limited to small companies, it will severely affect the interest levels of reputable foreign funds in investing in India.

● Similarly, the restriction that “Venture Capital Funds” cannot have a corpus of more than Rs.250 crore is also undesirable. If one of the stated objectives of the categorisation of AIFs is to help attract more early-stage deals, why would we want to place a cap on the corpus of a VCF? I also disagree with the proposition that a ‘Private Equity Fund’ cannot invest in a VC- type deal. Apart from the fact that it would lead to a lot of confusion among the investor community, it also goes against the grain of encouraging more early-stage investments. If a growth-stage fund spotted a great opportunity to back a start-up and help grow it to be the next Google, shouldn’t that be encouraged rather than prohibited?

● The draft regulations propose that the current Venture Capital Regulations, 1996, will be repealed, but that existing investments made under the VCF Regulations will continue under the said VCF Regulations. But what about the existing FVCIs and their investments? What about the existing FIIs? Is the intention to have these registrations continue as before, or will the proposal completely replace the FII and FVCI regimes with the AIF regime? Several existing FIIs will, no doubt, be caught under one or the other heads of the proposed AIF regime. How will this conflict be addressed? All this needs to be clarified.

● While SEBI’s concept paper makes some points regarding under-regulation and its consequences, I think the draft regulations strongly veer towards over-regulation. Over-regulation of an industry, which has contributed more than $50 billion in capital to the growth of Indian entrepreneurship, might have a counter-productive impact on the Indian economy, by making Indian opportunities more expensive and more risky from a regulatory standpoint to the investment community. I think that any regulation of foreign PE and VC funds should be at the minimum, as most of their investors are non-Indians, and as they are already regulated by appropriate regulations in their home countries.

Last year, Standard Chartered was welcomed with much gusto and fanfare to list its Indian Depository Receipts (“IDRs”) on the Indian bourses, as it represented a sort of coming of age for the Indian capital market. It was the first ever issue of depository receipts in India and was brought about after commendable efforts from the market regulator in tweaking the regime on IDRs. The Securities and Exchange Board of India (“SEBI”), in this regard, had relaxed several eligibility criteria for issuing IDRs in a bid to attract investors for this instrument, after the initial barren years following the introduction of regulatory framework for IDRs in India.

IDRs, like the American Depository Receipts (“ADRs”) or Global Depository Receipts (“GDRs”), are derivative instruments deriving their value from underlying shares listed outside India. The holders of IDRs in India would have a beneficial interest in these underlying shares and be eligible for dividends (and on occasions voting rights too). IDRs provide a means to increase the visibility and brand image of the issuing company in India, apart from being an additional means to raise capital. From the investors’ perspective, IDRs offer them a means to diversify their portfolio and hedge risks, and also provides a way to indirectly invest in a company listed in another country.

However unlike ADRs and GDRs, the Reserve Bank of India (“RBI”) does not allow for two-way fungibility for IDRs. As stated in the prospectus of the Standard Chartered IDRs, the conversion of IDRs into the underlying shares was permitted only after the expiry of one year from the date of their issuance and subsequent to obtaining an RBI approval, which is given on a case-by-case basis. However, with only days left for this one year lock-in period to be over, SEBI, with a single stroke, has undone all its prior good work in heralding the IDR era in India.

SEBI has now, through a circular dated June 3, 2011, mandated that conversion of IDRs after the one year lock-in period would be allowed only if the IDRs were ‘infrequently traded’ on stock exchanges, i.e., if the annualized trading turnover in the IDRs during the six calendar months immediately preceding the month of conversion was less than five percent of the listed IDRs. In case the IDRs were being infrequently traded, the conversion of IDRs into the underlying shares would be permitted during a thirty day window after a public announcement being made by the issuer in this regard. Consequently, the IDRs issued by Standard Chartered, which had an annualised turnover of around 49%, failed to meet the ‘infrequently traded’ criterion and thus could not be converted. The stated logic of this SEBI mandate was that in the absence of a two-way fungibility, the conversion of IDRs would result in an illiquid market for residual IDR-holders. Thus the investors should be encouraged to exit through the sale of IDRs rather than converting them, as long as the IDRs were liquid. There also seems to be an unstated objective of SEBI here- of not letting the Indian capital market bereft of any IDR listings, which could have ensued if its only listed IDR were entirely converted by the investors.

The SEBI mandate left the investors of the IDRs issued by Standard Chartered high and dry, as they were now unable to convert the IDRs. The foreign institutional investors (“FIIs”), who held a major chunk of these IDRs, were particularly disappointed as they were expecting to avail a significant price arbitrage on conversion, as these IDRs were trading at a discount in India. Soon, in a spate of distress selling, the prices of the IDRs, which were trading at around INR 116, tumbled to under INR 100 for the first time since their listing.

The new rules, by allowing conversion of IDRs into underlying shares only if the IDRs are illiquid, in fact, provides an incentive for illiquidity of IDRs in the market. This in itself is paradoxical to SEBI’s objective of maintaining liquidity of IDRs in the market. One could also make out several other cracks in the stated logic behind SEBI’s move. There would be mass conversions of IDRs, as SEBI feared, only if the investors could gain substantially through price arbitrage. However, if ever such a case arose, the ‘invisible hand’ of a free market would have ensured that any such arbitrage would soon disappear as the demand for these IDRs would have gone up. This was exactly what happened to the ADRs issued by the Indian companies after two-way fungibility was allowed for their holders. If the SEBI objective was to contain the outflow of money from India following the conversion by FIIs, that too now stands defeated, since the FIIs were the biggest sellers after the SEBI mandate came out, as the IDRs without conversion seem to have lost favour with them. Further, if the FIIs decide to stay away from these IDRs in the future, their liquidity would anyway get adversely affected.

The FIIs, in particular, would indeed feel short changed by the SEBI’s mandate. It must be noted that FIIs were initially not recognized as a class of investors in IDRs and were brought in by SEBI much later in order to spruce up the IDR market in India. One has to believe that when this decision was taken by SEBI, it would have been known to SEBI that the FIIs would invest in a company through a more circuitous route of IDRs, only because they aim to benefit through any arbitrage opportunity. Further, the RBI, in response to a query by certain institutional investors last year, had reportedly clarified that no prior approval would be required to convert IDRs into underlying shares after one year of listing. Thus, this change in the rules of the game just before the final whistle was against legitimate expectations of the FIIs.

It may seem that an unintended benefit could accrue to the existing holders of the Standard Chartered IDRs since, with the FIIs deciding to stay away, there would be a definite fall in liquidity of the IDRs which could satisfy the ‘infrequently traded’ criterion. However, this could give rise to a tricky loop as the fall in liquidity would be accompanied by substantial price arbitrage, which could again give rise to interest from the buyers which, in turn, would increase the liquidity till it breaches the ‘infrequently traded’ criterion. Thus, the existing holders would benefit only if they hold onto the IDRs even when there is substantial interest among buyers. However, such negative consequences could definitely not be what SEBI intended to achieve through its mandate to protect liquidity of IDRs in the market.

A greater question arising here is whether this regulatory U-turn by SEBI could spell doom for the future of IDR issues in India. One of the major objectives of multi-national companies (“MNCs”), through the issuance of IDRs, is to increase their visibility in the region. This objective still remains undiluted as the SEBI mandate does not seem to have affected the retail investors in India much. In fact, the drop in price of the IDRs may make it more attractive to the retail investors. However, the institutional investors staying away from an IDR issue would indeed be a body blow for MNCs hoping to raise capital through IDRs as retail interest in IDRs would be limited beyond a certain point due to the higher rate of tax attached to IDRs, among other factors. Also retrospective changes from the regulator, which substantially alters the rules of the game, would indeed dent investor sentiments and does not augur too well for our yet-to-be mature capital market.

There are already talks doing the rounds of several MNCs, which had waited and watched the Standard Chartered IDR issue, rethinking their IDR listing plans. Your guess is as good as mine whether we could see another IDR listing in the near future after this whimsical decision from the SEBI.

The archaic restriction with respect to voting rights contained in the Banking Regulation Act, 1949 (“BR Act”), prohibiting a person holding shares in a private bank from exercising voting rights in excess of 10% of the total voting rights of all the shareholders, has been a bane for many a shareholder including foreign investors for a long time now.^[1] However, with the approval of the Banking Laws (Amendment) Bill, 2011 (“Bill”) by the Union Cabinet on March 3, 2011, there finally seems to be light at the end of the tunnel for shareholders in such banks as well as prospective investors, both Indian and foreign. It is pertinent to note that this is the second time an amendment in this regard to the BR Act has been proposed by the Reserve Bank of India (“RBI”), the first one being in 2005, which did not reach its logical conclusion the last time around. Now that the Cabinet has approved the Bill, it will be tabled in the Parliament for being passed by it to become part of the BR Act. In fact, the Finance Minister, in his recent budget speech, has mentioned that the Bill shall be moved in the Parliament along with other legislations relating to insurance, pension, etc.

Section 12(2) of the BR Act states that “No person holding shares in a banking company shall, in respect of any shares held by him, exercise voting rights on poll in excess of ten per cent of the total voting rights of all the shareholders of the banking company”. This has resulted in no entity being able to exercise voting right of more than 10% in a private sector bank despite holding a much larger stake in such banking company, which acts as a huge detriment to majority shareholders who may want to have a say in the management of the bank.

Even from the view point of a foreign investor, I see this restriction working heavily against their inclination to invest in private banks in India. The current FDI Policy allows foreign direct investment in private banks through automatic route for up to 49% of the share capital and via the FIPB approval route for investments from 49% to 74% of the share capital of the private banks. However, although foreign investors are permitted to own shares in a private bank up to 74% of its share capital, they are not allowed to exercise voting right in excess of 10% of the total voting rights of all the shareholders in such a bank as the FDI Policy also mentions this and makes reference in this regard to the BR Act, which, in my opinion, has been and continues to be an unfair constraint on such foreign investors.

This restriction has hampered investment by some foreign banks into Indian private banks and in the past, this was one of the main reasons for a proposed investment by a major south-east Asian bank in an Indian private bank not going through. Though it is clear from many instances reported in the media that foreign banks are keen to ride on the India growth bandwagon and access the deep and vast market available here, their plans are nipped in the bud as this voting restriction usually does not bode well with the senior management in such foreign banks which would consider such an impediment a major roadblock in their typical strategy of protecting their investment through pro-active participation in the running and management of their investee banks in other jurisdictions. With the passing of the Bill, the abovementioned restriction under Section 12(2) of the BR Act shall be done away with and voting rights in private banks shall be aligned in proportion with the shareholding.

It is heartening to know that this antiquated provision is finally on the verge of being amended to bring it in line with the current position of law in other developed economic jurisdictions across the globe. This, in my view, would indeed be a shot in the arm for the Indian banking industry, resulting in increased financial activity, both domestic and foreign, in this burgeoning sector.

^[1] The situation is bleaker still in public sector banks where a person can have a maximum of 1% voting right. However, it could be said that this does not matter in the public sector banks because the government is a majority shareholder in almost all instance.

A fund could derive various benefits from publicizing its anti-portfolio.

Celebrating success is an understandable and universally practised phenomenon. And it is consistent with the commonly accepted notion of success attracting more success. While failure is equally commonly considered in popular wisdom to be a stepping stone for success, failures are very seldom externally acknowledged by organizations, let alone celebrated!

While every successful organization no doubt, conducts meticulous post-mortems of deals or decisions that have gone wrong and seeks to learn from its mistakes, most organizations, nonetheless, appear to treat these wrong decisions as dirty linen not to be washed or slung out in public. It is a fiercely competitive world in private equity/venture capital these days, and may be most PE/VC firms just don’t think it pays to highlight to the world the misses that one has made, especially when it subsequently turns out that a competitor has profited out of such a miss.

I am not from the PE/VC industry and as such, many would argue that am not qualified to preach to a highly sophisticated industry that am not a part of – and they’d be absolutely right! However, as someone who has spent more than the past decade representing and working closely with a diverse set of PE/VC funds, and as someone who has gone through (and continues to go through) the pains and gains of growing an organization myself, I do wish to take the liberty of seeking to make the case that PE/VC firms could stand to benefit immensely from openly celebrating their “anti-portfolios” (investment opportunities that they passed up, which went on to become blockbusters).

There are barely a handful of funds which flaunt their anti-portfolio, the most notable amongst them being Bessemer Venture Partners. Bessemer’s by-now-legendary anti-portfolio page is filled with an eye-popping list of names, with a great humour-laced story behind each such blockbuster company that Bessemer turned down when those companies were not so well-known (my personal favourite is the story about how David Cowan turned down Google).

Of course, I do not have any empirical or correlative data to establish if flaunting their anti-portfolio benefited Bessemer or any of those other funds in any manner. However, I do believe that a lot more PE/VC funds should consider flaunting their anti-portfolios for the following reasons:

1.  Tool of Introspection – First and foremost, the decision to announce an anti-portfolio and the process relating thereto can be a very useful tool of introspection. In an environment where one is constantly chasing more and more deals, one often tends to not spend enough time analyzing why a certain deal did not work out. Several business leaders who, when looking back on their illustrious careers, have observed that there were some decisions that they took which seemed right at the time, but seemed not very well-advised to them upon future reflection.

The whole process of identifying an organization’s anti-portfolio and penning down the circumstances or reasons that led to the decision not to pursue those opportunities and placing it all for public scrutiny on the organization’s website can therefore, be a rather humbling and at the same time, enriching experience. I believe that this process can play a meaningful role in shaping future priorities, strategies and values of a fund.

2. Turn Your Famous Misses into Branding Hits – While publicizing successful investments and exits undoubtedly contributes to building a very strong brand for the fund and aids in future fundraisings and deals, in my view, publicizing the anti-portfolio in the right manner could play as important a part in enhancing a fund’s brand. An impressive anti-portfolio, if appropriately presented to the world, could demonstrate that the fund in question is a very strong player in the premium end of the deal eco-system, and is a natural contender for being given the first look at high-quality deals.

Picture this – You were one of the few funds from whom Google, eBay, Cisco and Apple all tried to raise funding at a time when they were promising start-ups – now, if I were an LP (which, am of course, not!), I’d be very impressed by that. I’d think it says something about your reputation, your brand and your access to top-quality deals. Further, an anti-portfolio that is presented in the appropriate fashion could also communicate a strong message to the market that the fund in question is very secure and confident about its position in the market, not afraid or ashamed to acknowledge its missed opportunities and those, in turn, could be very positive image enhancers in favour of the fund.

3. Mending Bridges – Though this does not always happen, I have seen that on a fair number of occasions, when deals fall through after a lot of discussion, a considerable amount of bad blood gets generated or a breakdown of trust and comfort occurs amongst the parties concerned. In some cases, an entrepreneur can feel slighted by a fund’s decision to turn him/her down. Such instances can often mean that companies that a fund turned down may not consider doing business with such fund in the future, even if perfectly rational economic and business reasons then exist to do so.

Publicizing a well-written anti-portfolio, I think, can contribute in a huge way to mending such broken bridges. This is because, to the entrepreneur in question, the inclusion by the fund of his/her company’s name in such fund’s anti-portfolio could be a very meaningful olive branch from the fund – by the fund admitting that the company in question was a good opportunity missed for the fund. This, in my view, can pave the way for the two organizations to put the past behind and once again objectively and rationally evaluate if it makes sense for them to partner together and if yes, on what terms.

4. The Human Feel – Companies that are looking to raise funds almost always do some basic background checks on the funds that they are considering partnering with, just like funds do background checks on the entrepreneurs in question. In such a circumstance, while finding the fund’s anti-portfolio listed on its website may not necessarily swing the decision in a fund’s favour, it likely will give an entrepreneur a lot of comfort around the “human feel” of the fund in question – these guys are not just an IRR-chasing machine, they have the ability to reflect on and admit to some of the opportunities they failed to see, and they actually have a sense of humour, they might just be a good and supportive partner to work with!

The above may not be a comprehensive list of benefits that a fund could derive from publicizing its anti-portfolio, but these are some key reasons to consider in taking that decision. And needless to say, some of the benefits discussed above will kick in only if the quality of the anti-portfolio is impressive. These benefits will be even more magnified if the quality of the companies on the “Portfolio” and “Exits” lists of a fund is as good as or better than those on the anti-portfolio.

I’ll end by humbly suggesting to many of the successful PE/VC firms out there – if you’ve got an impressive anti-portfolio, just flaunt it!

SPOTLESS PAC!! OK, that does not really make sense, but just because I really liked the movie Eternal Sunshine of a Spotless Mind, I was inspired to title my blog along the same lines.

OK, now I better stop thinking how flawless the script was and move on to the real issue before I get barred from writing any further blogs.

During one of my recent transactions, I spent a substantial amount of time understanding the concept of a person acting in concert (“PAC”) and a deemed PAC and here I am, summarizing my conclusion on the same. PAC has been defined under Regulation 2(1)(e) of the SEBI (Substantial Acquisition of shares and Takeovers) Regulations, 1997 and is divided into two parts: (i) the first part gives a general definition of the PAC, as per which two persons should share a common intention of the substantial acquisition of shares or voting rights or gaining control over the target company to be called PAC. Such intention can be achieved pursuant to an agreement or understanding, which can be either formal or informal (“Part 1”); and (ii) the second part is a deeming provision wherein certain categories of persons are deemed to be acting in concert (“Part 2”). However, the definition of “deemed to be persons acting in concert” would apply without any prejudice to the generality of Part 1 of this definition.

Accordingly, Part 2 of the definition merely creates a presumption which is rebuttable on the ground that such person does not intend to acquire any shares/voting rights/control of the target company. Therefore, if two persons do not share a common intention of substantial acquisition of shares or voting rights or acquisition of control, they will not be treated as a PAC even if they fall in the deemed categories listed out in Part 2 of the definition.

Suddenly my memory is disappearing and I just hope my analysis on PAC provides some perspective to the readers at the end of it all just like the way Mary provides it to Clementine and Joel. BTW, before I sign off, I MUST say: Charlie Kaufman is incredible!!!

“I think we should have a blog!” – thus spake Devanshi, the youngest member of our Website Launch Group, in the Group’s first brainstorm on our soon-to-be-launched website. The brief silence that followed was the only time in the next several weeks that this question did not draw the most passionate and interesting set of reactions from everyone in the Group, self included.

“Will we really have the time for all this?”, asked Roshan, clearly looking and sounding sceptical. “Well, if we want to do this, we will just FIND the time to do it”, I said, in as sagely a voice as I could manage. “I think it’s a great idea. We should just do it. No other Indian law firm has one!”, said Smita, to which Madhumita responded with “Sure, but what are we going to SAY in it?”. Hearty laughter all around. We all looked expectantly at Prashant, who just shrugged and gave us one of his cryptic, zen-like smiles. Devanshi chimed in once again, “How about a blog on ‘One Day in the Life of a Lexygenian’?”. Someone (don’t remember who) responded rather cheekily with, “A guy called Alexander Solzhenitsyn wrote an entire book on that already. A long time ago too”. More hearty laughter (from those of us who got the joke, anyway).

And so on it went. For weeks, over multiple one-hour sessions. And oh, that “What do we call it?” question! Don’t even go there! After spending an eternity tossing around suggestions that ranged from the complex to the profound to the plainly bizarre, we finally agreed on the highly imaginative “The Lexygen Blog”! As we have always managed to do in our own way, though, in the midst of all that jocularity and creative chaos, we found the direction we wanted. And clarity and consensus began to emerge as to whether we wanted to have a blog on our website, what the Lexygen Blog should be all about, content-management processes and so on.

We unanimously agreed that we wanted the Lexygen Blog to be a useful and current source of analysis to our readers on various issues pertaining to the law and the transactional eco-system, while at the same time also serving as a creative, yet informal means for Lexygen lawyers to express their individual views and to share their transactional experiences on a wider platform, tempered of course, with confidentiality and professional etiquette considerations. The Lexygen Blog is therefore, intended to be as much a client-empowerment and knowledge-sharing initiative as it is a digital voice for our lawyers to air their views and analysis, irrespective of whether they are first year associates or partners.

So here we are, kicking it all off. To all our readers, I hope that you will enjoy reading the Lexygen Blog from time to time and that you will find it to be a useful resource of crisp and insightful analysis. Given that one of the objectives of the Lexygen Blog is to provide a broader forum for Lexygen lawyers to share their views and transactional experiences, I’d urge you to recognize that any views expressed herein by any of the bloggers are to be construed as their own individual views, and are not to be treated as, or assumed to be, the Lexygen view on those issues.

To my fellow Lexygenians, the Lexygen Blog is now all yours to express your selves more immediately, and in an informal structure, on legal issues of relevance and current importance. Happy blogging!

P.S.: The ever pragmatic Amit had a question at the end of the Group’s last brainstorm session. “So….should we create a Timeslips code called ‘Lexygen Blogging’?”. That one drew the heartiest laughter!