RBI and SEBI’s new framework for reclassification of FPI into FDI - A Welcome Move

As per the recent guidelines issued by the Reserve Bank of India, the Foreign Portfolio Investors (along with its investor group) [hereinafter called "FPIs"], having breached the upper threshold of 10 per cent or more of (fully diluted) total paid-up equity capital in a Company, shall now have a new option for divesting its holdings or to reclassify the investment made by it as Foreign Direct Investments (FDI). In this regard the RBI has provided an Operational Framework for reclassification of such holdings as FDI. The reporting of such transactions under the prescribed framework shall be facilitated by the Authorized Dealers (AD) Category-I Bankers. Further, the Securities and Exchange Board of India (SEBI) has also prescribed the new procedures for such reclassification of FPI into FDI in tandem with the recently announced guidelines of the RBI.

What is new?

Now if the investment made by any FPI reaches 10 percent or more of the total paid up equity capital of a company (on a fully diluted basis) and the FPI intends to reclassify its holdings as Foreign Direct Investment (FDI), it shall follow extant FEMA Rules and circulars issued thereunder in this regard.

Further, pursuant to receipt of such intent from the FPI, its Custodian shall report the same to the SEBI and freeze purchase transactions by such FPI in equity instruments of such Indian Company, till completion of the reclassification.

To provide ease of the operations, the Custodian shall process the request received from the FPI for transfer of the equity instruments of such Indian company from its FPI demat account to its demat account maintained for holding FDI investments once the operational procedure for reclassification, as prescribed by RBI, is complete in all respects.

What is the existing operational framework?

The existing Schedule II of Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (hereinafter referred as “Rules”) prescribes that investment made by the FPI shall be less than 10 percent of the total paid-up equity capital on a fully diluted basis and Para 1(a)(iii) of Schedule II of the Rules, provides that if, any FPI investing in breach of the prescribed limit shall have the option of divesting their holdings or reclassifying such holdings as FDI subject to the conditions specified by the RBI and SEBI within five trading days from the date of settlement of the trades causing the breach (hereinafter referred as “prescribed time”).

In case the FPI chooses not to divest, then the entire investment in the company by such FPI and its investor group shall be considered as investment under Foreign Direct Investment (FDI) and the FPI and its investor group shall not make further portfolio investment in the company concerned.

The FPI, through its designated custodian, shall bring the same to the notice of the depositories as well as the concerned company for effecting necessary changes in their records, within 7 trading days from the date of settlement of the trades causing the breach. The breach of the said aggregate or sectoral limit on account of such acquisition for the period between the acquisition and sale or conversion to FDI within the prescribed time, shall not be reckoned as a contravention under the said Rules.

What is the new operational Framework?

The RBI now provides that in case the FPI intends to reclassify its foreign portfolio investment into FDI, the FPI shall follow the operational framework as given below:

1. The facility of reclassification shall not be permitted in any sector prohibited for FDI.
2. The FPI concerned shall obtain the following approvals/concurrence before intending to acquire equity instruments beyond the prescribed limit: (a) Approvals from Government - Necessary approvals are required to be taken from the Government, as applicable, including approvals required in case of investment from land bordering countries and ensure that the acquisition beyond prescribed limit is made in accordance with the provisions applicable for FDI, which means that investment should be in adherence to entry route, sectoral caps, investment limits, pricing guidelines, and other attendant conditions for FDI under Schedule I to the Rules. (b) Approvals from Investee Company - Concurrence of the concerned Indian investee company is required to be taken for reclassification of the investment to FDI to enable such company to ensure compliance with conditions pertaining to sectors prohibited for FDI, sectoral caps and government approvals, wherever applicable, under the Rules.
3. The FPI shall clearly articulate its intent to reclassify existing foreign portfolio investment held in a company into FDI and shall provide the copy of the necessary approvals and concurrence to its Custodian pursuant to which the Custodian shall freeze the purchase transactions by such FPI in equity instruments of such Indian company, till completion of the reclassification: Provided that where the necessary prior approvals/concurrence have not been obtained by the FPI, the investment beyond the prescribed limit shall be compulsorily divested within the prescribed time
4. For reclassification, the entire investment held by such FPI shall be reported within the timelines as specified under Foreign Exchange Management (Mode of Payment and  Reporting of Non-Debt Instruments) Regulations, 2019, in the following manner: --(i) By the Indian company in form FC-GPR where the investment beyond the prescribed limit is resulting from fresh issuance of equity instruments by an Indian company to such FPI. (ii) By the FPI in form FC-TRS, where the investment beyond the prescribed limit is due to acquisition of equity instruments by such FPI in the secondary market.
5. AD bank concerned shall report the amount of reclassified foreign portfolio investment as divestment under the LEC (FII) reporting.
6. Post completion of reporting as above, the FPI shall approach its Custodian with a request for transferring the equity instruments of the Indian company from its demat account maintained for holding foreign portfolio investments to its demat account maintained for holding FDI. After ensuring that the reporting for reclassification is complete in all aspects, the custodian shall unfreeze the equity instruments and process the request. The date of investment causing breach in such cases shall be considered as the date of reclassification. Thereafter, the entire investment of the FPI in the Indian company shall be considered as FDI and shall continue to be treated as FDI even if the investment falls to a level below ten percent subsequently. The Foreign Portfolio investor along with its investor group shall be treated as a single person for the purpose of reclassification of foreign portfolio investment.
7. In terms of the provisions contained in Schedule II to the said Rules, the reclassification or divestment of the holdings, as the case may be, shall be completed within the prescribed time.
8. Post reclassification of foreign portfolio investment to FDI, the said investment shall be governed by Schedule I to the said Rules.

What is the significance of the new operational framework of reclassification of FPI into FDI?

The new operational frame work for the re-classification has been announced in the wake of the recent advent of the FPIs driving out of India due to the increased volatility in the Indian financial markets. Since April month of the current year, the FPIs have been the net sellers in the Indian equity markets. The reasons could be the uncertainties related to general elections in the country and later in the US and other geopolitical factors. The new guidelines have dispelled the lack of clarity on how the offshore portfolio manager could go about classifying and reporting the stake once the holding crosses 10 per cent threshold.

Thee new procedure for the FPI-FDI transition is also expected to give overseas funds more flexibility and also provide for higher exposure to startups and mid-sized firms. While the norms for reclassification are already prescribed under the existing FEMA and rules made thereunder, yet in absence of operational framework, the FPI largely tried to maintain their investments below or even tactically below the maximum threshold. It is likely that now the FPI flows may improve in the Indian economy as the FPIs shall have better clarity about the procedures for the transition of their investments from FPI to FDI, if they would like to opt for it.