Conversion of excess FPI stake as FDI: what does this mean for foreign investors?

15-11-2024

The Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI) recently issued updated guidelines regarding the reclassification of foreign portfolio investment (FPI) to foreign direct investment (FDI) when an FPI’s holdings in an Indian company exceed the 10% threshold.
The guidelines are issued in response to provide more operational flexibility to foreign portfolio investors (FPIs), thereby paving the way for a smoother and greater flow of foreign investment.

RBI’s power with respect to FPI and FDI.

1. Foreign Portfolio Investment (FPI):

FEMA (1999), Section 10(1): RBI regulates FPI through its control over foreign exchange transactions.
FPI Regulations, 2014 (SEBI & RBI): Sets guidelines on how FPIs can invest in Indian companies, including limits (like 10% stake in a company)

Monitoring & Compliance: RBI ensures FPIs follow rules, like reporting their holdings to banks and custodians

2. Foreign Direct Investment (FDI):

FEMA (1999), Section 6: RBI manages and approves FDI based on government policies, deciding where foreign investments can come in.
FEMA Notification No. 120/2004-RB: Deals with conditions under which foreign entities can invest in Indian companies.
Sectoral Caps: RBI ensures FDI adheres to sector-specific rules (e.g., restrictions in sensitive sectors like defense).

What are the key guidelines on latest RBI directives?

The latest guidelines issued by RBI include certain provisions in accordance with the powers under the Foreign Exchange Management Act and Foreign Exchange Management (Non-Debt Instruments) Rules, 2019.

10% Holding Threshold: If an FPI (Foreign Portfolio Investor) owns more than 10% in an Indian company, they must either sell the excess shares or change this holding to FDI (Foreign Direct Investment). This rule applies even if their stake later drops below 10%.
Reclassification Process:

FPIs wishing to reclassify their holdings must notify their custodians and report the intent to SEBI.
The custodian will help transfer the shares to a designated FDI Demat account once reporting is complete.
The process must be completed within 5 trading days from the date of settlement of the trades causing the breach.

Government Approval: Before FPIs can make further investments beyond the 10% limit, they must obtain government approval, including approvals required in case of investment from land bordering countries and the consent of the investee company.

FDI Conditions: The reclassified investments will be subject to FDI norms, including sectoral caps, pricing guidelines, investment limits, and other attendant conditions for FPI under the rules.

What were the earlier guidelines?

Under the foreign exchange management (non-debt instruments) rules, 2019, investment made by the FPIs should be less than 10 percent of the total paid-up equity capital on a fully diluted basis.
Now, any FPI investing in breach of the prescribed limit would have the option of divesting their holdings or reclassifying such holdings as FDI within the prescribed time limit.

What is the difference between PDI and FPI?

Features	FDI (Foreign Direct Investment)	FPI (Foreign Portfolio Investment)
Ownership	Investor gains a significant ownership stake in the company (more than 10%).	Investor holds smaller stakes (less than 10%) in Indian companies.
Control	Provides investors with control over company decisions, especially in joint ventures.	No control over company decisions, mainly for financial returns.
Regulatory process	Requires approval from the government or RBI in many sectors.	Typically, no government approval needed unless limits are breached.
Investment horizon	Long-term investment, often leading to active participation in company management.	Short-term, focused on capital gains and dividends.
Exit strategy	Difficult to exit quickly, requires significant time and effort.	Easier to exit by selling shares in the open market.

What do RBI guidelines mean to foreign investors?

More Flexibility: Foreign investors can now exceed the 10% limit in a company, helping the foreign investors to increase their participation in the Indian market.
Clearer Rules: The process of reclassification is more structured, which would reduce confusion for investors.
Five-Day Divestment Window: If limits are breached, FPIs have five days to divest or face conversion to FDI. This process allows a transparent and effective communication process.
Regulatory Clarity: The new rules create more predictability for investors, encouraging long-term investments.

What do RBI guidelines mean to Indian Companies?

More Investment: Companies can attract more foreign investments, even beyond the 10% limit.
Compliance: clear and effective guidelines would ensure easy compliance by Indian companies that would reduce their compliance burden.
Regulatory Clarity: Clearer guidelines make it easier for companies to understand and manage foreign investments.

The RBI’s new guidelines on excess FPI offer flexibility for foreign investors, allowing them to exceed the 10% limit with proper reclassification. This encourages investment while maintaining regulatory oversight. Indian companies benefit from clearer rules, although they must manage the transition to FDI if limits are breached.