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'Control’ under the new FEMA Overseas Investment regime

Regulating outward investments by Indian residents has been an area of contention under the foreign exchange laws of India. More so, such regulation has to keep in mind that at times minority investors from India, who cannot control the affairs and decision-making of the foreign investee company, may be prejudiced if such company conducts its affairs in a manner that may be contravening Indian laws. The new overseas investment regime under FEMA has attempted to solve this problem. This article explains a crucial aspect in this vein – the aspect of ‘control’ over the investee foreign entity.


I. Introduction

In various areas of law, including securities regulations, competition law, insolvency, company law, Foreign Exchange Management Act, 1999 (‘FEMA’), the concept of 'control' plays a pivotal role. Defining 'control' is crucial as it helps determine the rights, obligations, and limitations associated with ownership and management in different legal contexts.


The investment in a foreign company by Resident Individual (‘RI’) was previously governed by the erstwhile Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004 (‘TIFS regulations’) issued under FEMA. On 22nd August 2022, the TIFS regulations were superseded by the Foreign Exchange Management (Overseas Investment) Rules, 2022 (‘OI Rules’).


Rule 6 of the OI Rules states that any investment made outside India in accordance with the provisions of FEMA or rules or regulations made thereunder and held as on the date of publication of the OI Rules shall be deemed to have been made under the OI Rules and the applicable regulations under FEMA.


Rule 13 of the OI Rules further states that a RI can make or hold an overseas investment in the manner and subject to the terms and conditions provided in Schedule III. Para 1(2)(i) of Schedule III of the OI Rules states a resident individual can make or hold overseas direct investment in an operating foreign entity not engaged in financial services activity and which does not have a subsidiary or step-down subsidiary (‘SDS’) where the resident individual has ‘control’ in the foreign entity.


This article discusses an important issue that arises because of the manner in which the expression is defined in the OI Rules and the unintended consequences for the RIs who have made and continue to hold overseas investments in foreign companies.


II. Understanding the concept of “control”

There are two main facets of control – ‘de jure’ control and ‘de facto’ control. De jure control refers to the control that is formalized through legal documents such as the Articles of Association (AOAs), Memorandum of Association (MOA), and other constitutive documents. This form of control is evident through the appointment of directors and managers who are responsible for making decisions related to the company’s operations. De jure control is established through the legal process of appointing and electing directors and managers, as specified in the company’s constitutive documents.


On the other hand, de facto control refers to the control that is exercised even without a formal appointment or election of directors and managers. This type of control is based on the actual management and decision-making practices of the company. For example, a shareholder may not have been formally appointed as a director but may still exert significant influence over the company’s management and decision-making through informal means such as personal relationships, financial control, or other forms of influence.

In practice, both de jure and de facto control are considered when determining who has ‘control’ over a company. Various statutes, standards, regulations, and rules have incorporated both aspects of control in their definitions. Thus, the concept of ‘control’ is multifaceted, with both de jure and de facto aspects playing a role in determining who has control over a company. The incorporation of both aspects of control in legal definitions ensures that shareholders and other stakeholders are aware of who has ultimate control over the company’s affairs and decision-making.


III. Need to identify persons/groups of persons who may be controlling various aspects of the affairs of the company

The identification of de jure and de facto control in the case of a company poses unique challenges since companies possess a distinct organizational structure, characterized by a separation of ownership and decision-making. Unlike partnerships or sole proprietorships, where owners typically make decisions, companies involve a more intricate framework. Shareholders play a critical role in controlling the company, despite not being directly involved in day-to-day management.


In a company, the board of directors is appointed by the shareholders, who indirectly control the company by choosing the board members. This process underscores the need for a clear definition of 'control' to determine the individuals ultimately responsible for the company's policy and management decisions.

Understanding who controls the policy and management decisions of a company is thus essential in the realm of corporate governance. While the board of directors operate the company, the ultimate control lies with the shareholders. Defining 'control' becomes crucial in identifying the individuals or groups responsible for shaping the company's direction.


Within Indian legal frameworks, the focus lies in identifying the 'controlling shareholder.' Shareholders exert control over the company's policy decisions, even if they are not directly engaged in its daily operations. Defining 'control' ensures clarity in determining who holds ultimate authority over a company's affairs.

The definition of 'control' in various laws aims to identify the controlling shareholder—the entity that influences policy and management decisions. This distinction is vital in corporate governance as it establishes responsibility and accountability within the company's structure.


IV. Overview of the definition of ‘control’ in various laws

Keeping in mind the above concept of control and the need for identifying the controlling shareholders, various laws define ‘control’ differently in light of specific objectives sought to be achieved under the respective law, as under:


SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011

Under the SEBI laws, defining 'control' is essential when triggering a public offer. Previously, the absence of a clear definition led to ambiguity. However, in 1997, SEBI introduced a comprehensive definition of 'control,' including the right to appoint directors, control management, and influence policy decisions. This definition has been widely adopted in subsequent regulations.


Competition Act, 2002

The Competition Act aims to prevent anti-competitive practices. It defines 'control' to encompass the influencing of affairs or management by one or more enterprises or groups over another entity. The interpretation of 'control' under this Act focuses on preventing adverse effects on fair competition and market dominance resulting from acquisitions or mergers.


Insolvency and Bankruptcy Code, 2016

While the Insolvency and Bankruptcy Code doesn't explicitly define 'control,' it addresses related aspects. The Code identifies 'related parties' and prohibits their control over corporate debtors to prevent potential conflicts of interest and ensure impartial resolution processes. Judicial interpretation emphasizes active management or policy control as opposed to passive control.


Companies Act, 2013

The Companies Act provides a consistent definition of 'control,' aligning it with the SEBI Regulations. This definition aids in determining relationships between companies and their shareholders, prevents disputes over ownership and management, and promotes transparency. It also safeguards minority shareholders' interests and prevents oppression and mismanagement of companies.


FDI Policy, 2014:

Foreign Direct Investment (‘FDI’) is subject to specific regulations and restrictions. The FDI Policy defines 'control' inclusively, considering the right to appoint directors, influence management, and policy decisions. It aims to determine the extent of foreign investors' ownership and management control over Indian companies while ensuring transparency and safeguarding domestic interests.


OI Rules:

The definition of 'control' in the OI Rules holds significance in curbing round-tripping and regulating investments by Indian residents and companies in overseas entities. It provides clarity on the extent of ownership and management control Indian entities can exercise in such investments, thereby preventing potential misuse of funds.


V. Analysis of the definition of ‘control’ in SAST Regulation

The definition of ‘control’ under the SAST Regulations can be divided into 3 limbs:

i. ‘control’ includes the right to:

  • appoint majority of the directors, or

  • control management or policy decisions

ii. exercisable by a person or persons acting individually or in concert, directly or indirectly,

iii. including by virtue of their

  • shareholding

  • or management rights

  • or shareholders’ agreements

  • or voting agreements

  • or in any other manner

First Limb: Meaning of 'Control':

The first limb of the definition outlines two conditions for establishing 'control.' It states that 'control' refers to either (a) the right to appoint the majority of directors, granting de jure control, or (b) the right to control management or policy decisions, reflecting de facto control. Failure to fulfil either of these conditions renders a person or group of persons not in control of the company.


Second Limb: Exercise of Control:

The second limb clarifies how control can be exercised. It highlights that control can be exerted by an individual or a group of persons acting individually or in concert, directly or indirectly. This provision recognizes the various ways in which control can be exercised within the regulatory framework.


Third Limb: Manner of Acquiring Control:

The third limb of the definition enumerates illustrative instances through which the rights mentioned in the first limb can be acquired. The use of inclusive language implies that these instances are not exhaustive and cover methods such as shareholding, management rights, shareholders' agreements, voting agreements, or any other manner. The third limb supplements the first limb and is subservient to it.


It is essential to read the first and third limbs of the definition together. The third limb's prescribed manner must lead to the acquisition of one of the two rights specified in the first limb for control to exist. If the prescribed manner does not fulfil these conditions, the person or group of persons cannot be considered to have acquired control.


SEBI's Discussion Paper on Control:

In 2016, SEBI published a discussion paper to address uncertainties surrounding the definition of 'control' in SAST regulations. Two potential solutions were suggested: Option 1 focused on identifying protective rights that do not amount to control, while Option 2 proposed a numerical threshold (bright line test) based on voting rights or the right to appoint directors. The definition of control was proposed to be amended as under:

“(a) the right or entitlement to exercise at least 25% of voting rights of a company irrespective of whether such holdings gives de facto control, and/or

(b) the right to appoint majority of the non-independent directors of a company.”

However, due to concerns about potential misuse and regulatory scope, the existing definition of control was retained under the SAST Regulations.


VI. Analysis of the definition of ‘control’ in OI Rules

The OI Rules have replaced the erstwhile TIFS Regulations in India. One of the major points of contention under TIFS Regulations was the interpretation of overseas direct investment by resident individuals. It was interpreted that under the automatic route, if a RI acquires shares of a foreign company (JV/WOS), then such a company cannot have or set up an SDS. However, this created issues for RI investors as they did not always have control over the investee company’s actions, and they were forced to unwind their investments even though they had not contravened any substantive provision of FEMA. Moreover, the creation of an SDS by a foreign investee company was seemingly permissible for an Indian Party, resulting in differential treatment for various persons.


The OI Rules, in substance, are benevolent and have given more relaxation as compared to the TIFS regulations. The OI Rules addressed the issue discussed above and permit RI investors to make or hold investments in foreign companies, which have or may set up subsidiaries, provided that such RIs do not have ‘control’ over such foreign investee companies. As compared to TIFS regulations where such transactions were not permitted at all under the automatic route, the same are allowed under the OI Rules provided that the RI does not have control over the foreign entity. Thus, OI Rules are beneficial for RI investors who can now invest or continue to hold investments in foreign companies.


Definition of 'Control' under OI Rules vis-à-vis SAST Regulations

The definition of ‘control’ as provided in the OI Rules is similar to the definition provided in SAST Regulations with two alterations in the following manner:

First Limb

control includesmeans [(a) the right to appoint majority of the directors or (b) the right to control the management or policy decisions] –

Second Limb

[exercisable by a person or persons acting individually or in concert, directly or indirectly,]

Third Limb

[including by virtue of their shareholding or management rights or shareholders agreements or voting agreements that entitle them to ten per cent or more voting rights or in any other manner.]

The definition of 'control' in the OI Rules aligns closely with the one in SAST Regulations, with two key modifications. Firstly, the phrase "shall include" in the OI Rules replaces "means" in the SAST Regulations, suggesting an exhaustive meaning of ‘control’ under the OI Rules. Control' is acquired under the OI Rules if there is either (a) the right to appoint a majority of directors or (b) the right to control management or policy decisions, as stated in the first limb.


Secondly, the third limb of the definition in the OI Rules introduces the requirement that voting agreements must entitle shareholders to 10% or more voting rights. This addition implies that the Central Government intends to provide a quantitative value to voting agreements, which can contribute to acquiring control.


Implications of the 10% Voting Rights Threshold:

The inclusion of the 10% voting rights threshold in the third limb of the definition is significant. Shareholders have a distinct right to vote, and they can create voting agreements to support a particular person or cause. However, for the agreement to be valid, the parties involved must possess enough voting power to prevent dilution of their combined voting strength.


Notably, the 10% voting rights threshold is specific to the third limb, which outlines the manner in which control can be acquired. It should not be read as a standalone form of control or applied to the first limb. In other words, if a shareholder has more than 10% equity share capital in a company and consequently has more than 10% voting rights, such a person cannot be said to have control as per the OI Rules unless such person satisfies the first limb of the definition of ‘control’. Since the 10% voting rights threshold is not provided in the first limb of the definition of ‘control’ under the OI Rules, it is clear that if a person or group of persons have 10% voting rights in a company, such person or group of persons cannot be said to control the company unless the said person or group of persons have the right to appoint majority directors of a company or are in control of management or policy decisions of a company.


If the intention of the Central Government was to create this bright line test as a standalone test for determining control, the aspect of 10% voting right would have been provided in the means portion of the definition of ‘control’ itself similar to the proposal in the Discussion Paper of SEBI discussed above. Such interpretation is neither reflected grammatically, nor it is reflected by the alteration in comparison to the definition of ‘control’ in SAST Regulations. Wherever this numerical threshold is inserted, the purpose is to remove subjectivity or to replace the balancing test with the bright line test.


If a view is taken that 10% voting rights in a company itself amount to ‘control’ as has been suggested by the Reserve Bank of India in the FEM (Overseas Investment) Directions, 2022, it would defeat the benevolent nature of OI Rules and lead to unnecessary ambiguity in the implementation of the OI Rules. In any case, RBI directions cannot be considered exhaustive aids for interpreting rules set by the Central Government. Furthermore, the RBI's clarification pertains to the interpretation of 'subsidiary' rather than the definition of 'control,' and its loose usage of words cannot be relied upon for the purpose of interpretation of the definition of ‘control’ under the OI Rules.


VII. Conclusion:

The definition of 'control' in the OI Rules brings more flexibility for resident individuals to invest in foreign companies with SDS, provided they do not exercise control over such SDS. The inclusion of a 10% voting rights threshold in the third limb of the definition of ‘control’ highlights the quantitative aspect of voting agreements, but it does not create a standalone form of control. To establish control, the presence of the right to appoint majority directors or control management or policy decisions is absolutely essential and cannot be lost sight of.


However, a situation could arise that a RI having more than 10% share capital (which on this basis alone entitles him to more than 10% voting power) but no power to appoint a majority of directors or take management or policy decisions, can be treated as having ‘control’ over the SDS thereby rendering him ineligible to hold the overseas investment under the automatic route. This may have a considerable impact on the investments of the RI, and he may be forced to either surrender/transfer his investments or seek RBI approval for such investments which is very time-consuming and uncertain. A suitable clarification from the Central Government or the RBI in this regard would help the RIs and the larger investment community in taking their investment decisions with clarity and certainty.


Authored by the Editorial Team, Metalegal Advocates. The views expressed are personal and do not constitute legal opinion.

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