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SEBI’s Latest Ruling Leaves Foreign Investors In A Lurch

SEBI’s Latest Ruling Leaves Foreign Investors In A Lurch

Foreign funds with below 10% stake will be classified as FPI

Around 10-15% of annual FDI inflows will now need reclassification

FPIs exceeding 10% stake need to reduce holdings or will be considered as FDI

Foreign investors are facing uncertainty after the Securities and Exchange Board of India (SEBI) introduced a minimum 10% ownership threshold to classify equity holdings as foreign direct investment (FDI). According to a media report, minority stakes purchased by several offshore funds through the FDI route less than 10% will now be classified as foreign portfolio investments (FPI). 

The classification change will leave foreign investors with no choice but to secure licence as foreign portfolio investors. The application to such a licence will increase their compliance and regulatory burden. On the other hand, there were no such compliance issues with FDI investments. 

While understanding the impact of the move, market participants are currently estimating that around 10-15% of annual FDI inflows will now need reclassification under the new rules that took effect late last month. According to central bank data reports, the FDI route brought inflows of about $62 Bn in FY19.  

Before this rule, the classification of investments was based on the route through which the investment was made. But with the introduction of this rule, if a foreign fund invests in less than 10% stake in an Indian company, it would be considered as FPI irrespective of the route taken by the fund and only foreign funds investing more than 10 % stakes would be classified as FDI. 

A global custodian told ET that if the FPI licence is compulsory for foreign funds owning less than 10%, it could create more problems. “Under the FPI regime, an entity is not allowed to hold unlisted shares, while a large portion of FDI investments are in the unlisted space,” the custodian official said, on the condition of anonymity.

FDI regulating body, RBI has also clarified that the classification is more a function of ownership threshold than the purchase route used to own the stock. In a note, RBI stated, “FDI and FPI are agnostic from the point of view of the schedule under which investment has been made. It is the percentage that defines whether it is direct or portfolio investment.”

RBI has further advised overseas private equity firms to obtain an FPI licence from SEBI to continue holding less than 10% assets in Indian companies. Also, FPIs are expected to provide higher disclosures including know your customer (KYC) documentation for a fund’s key management officials. 

“We have already made representations to both SEBI and RBI seeking clarity on the issue since it would be unfair on several private equity investors”, legal advisor of a leading PE fund said to ET. He further added that the classification of an investment should be based on the purpose of such investment rather than how much stake is being bought.

Usually, FDI and FPI routes followed by foreign investments are used for different purposes. While FDI routes are quite strategic and are meant for long term investments, contrastingly FPI route is used for short-term investments with the liberty to buy or sell stock on the bourses. 

The change in the policy is also going to affect FPI investors as well. SEBI has mentioned that if the stakes of an FPI group exceeds 10% of the total equity of a company, it has to cut the excess stake within five working days, and failure to do so will lead to the investment being classified as FDI. 

In September, the government revoked enhanced surcharge to capital gains arising on sale of any security including derivatives, in the hands of FPIs. 

Recently, SEBI also limited the participation of FPI in India’s investment market. The notification reportedly said that only those foreign portfolio investors located in Financial Action Task Force (FATF) countries or managed by an entity based in a FATF jurisdiction will be allowed to deal in participatory notes (PNs).