Foreign Direct Investment (“FDI”) plays a crucial role in the economic development of a country, providing capital, technology, and expertise to market players ranging from early-stage startups to established multinational corporations. However, strict regulations often govern FDI to ensure that the investment aligns with national interests and economic policies of the country. One of the key questions in the developing FDI jurisprudence is whether FDI brought in for one sector/purpose (for eg: infrastructure, manufacturing, technology etc.) can be repurposed for another. This article will delve into the possibility of an investee company reusing the FDI received under automatic route for a sector that requires prior government approval. This is an important question of law with some ambiguity on the topic. This article provides our two cents on the same.
Can surplus FDI be used for Activities that Require Prior Approval?
The short answer is No. Surplus FDI received under the automatic route for FDI cannot be used for activities requiring government approval. Such a practice would violate established principles of law, regulatory objectives, and settled jurisprudence. The objective of the Consolidated FDI Policy, 2020 and FEMA (Non-Debt Instrument) Rules, 2019 is to ensure:
• Transparency and accountability in foreign investments;
• Sector-specific regulatory compliance to safeguard national interests.
Allowing surplus FDI from an automatic route transaction to fund activities requiring government approval would specifically defeat this purpose. Allowing such a practice would mean a person could bring in FDI for a sector which requires minimum government intervention and use it for highly qualified sectors (and sometimes for illegal activities as well).
Some examples are as follows:
1. Real Estate Development instead of Manufacturing: An investee company brings FDI into India under automatic route for setting up a manufacturing unit but later, invests part of the funds in purchasing land for real estate development, which requires government approval. FDI in real estate and construction (except certain segments like affordable housing) requires prior approval, and unauthorized use may lead to regulatory action.
2. Retail Trade instead of Wholesale Trade: An investee company brings FDI for wholesale cash-and-carry trading (allowed under the automatic route) but later diverts a portion of the funds to establish multi-brand retail stores, which require government approval. Multi-brand retail is subject to strict FDI and FEMA requirements and prior approval, making such a diversion illegal.
3. Financial Services instead of Non-Financial Sectors: An investee company commences business India under automatic route in a non-financial sector like IT services and later diverts the funds to acquire stakes in an NBFC or other financial services, which require prior RBI and government approval. Such a diversion would be problematic.
4. Media and Broadcasting instead of IT Services: An investee company receives investment for IT services under automatic route but later expands into broadcasting or digital media, which require prior approval from the government. Media and broadcasting have sectoral caps and restrictions, and shifting FDI to these areas without approval can lead to regulatory intervention.
Following are possible reasonings for not allowing such a practice in India:
1. Bypassing Government Approval is Not Permissible: The regulatory framework is designed to ensure that foreign investments in sensitive sectors are vetted at the entry point (i.e. prior government approval). Permitting the use of funds raised under automatic route for activities requiring prior approval would undermine this mechanism.
2. What cannot be done directly, cannot be done indirectly: The widely accepted legal maxim highlights the settled jurisprudence: “Quando aliquid prohibetur ex directo, prohibetur et per obliquum” which means “When something is prohibited directly, it is prohibited indirectly as well”. In the context of FDI, this would mean diverting funds from automatic route to sectors which require government approval. Doing so will amount to indirectly achieving an objective which is explicitly restricted.
3. FDI is Transaction-Specific: It is amply clear from the language of the FDI Policy as well as FEMA, 1999 r/w (NDI) Rules, 2019 that compliances related to FDI under automatic/government route are for future and to-be-executed transactions and that the requirements are transaction specific. Some important definitions from the Consolidated FDI Policy that should be kept in mind are as below:
‘2.1.5. Capital means equity shares; fully, compulsorily & mandatorily convertible preference shares; fully, compulsorily & mandatorily convertible debentures and warrants.’
‘2.1.16. FDI or Foreign Direct Investment means investment through capital instruments by a person resident outside India in an unlisted Indian company; or in ten per cent or more of the post issue paid-up equity capital on a fully diluted basis of a listed Indian company’ [Corresponding definition in S. 2(r) of NDI Rules, 2019]
‘2.1.17. ‘Foreign Investment’ means any investment made by a person resident outside India on a repatriable basis in capital instruments of an Indian company or to the capital of an LLP’ [Corresponding definition in S. 2(s) of NDI Rules, 2019]
The conjoint reading of definitions mentioned above highlights that:
FDI involves the issuance of capital instruments (e.g., equity shares, convertible debentures, etc.), and approval requirements are tied to such issuance. Without a transaction for issuance or transfer of capital instruments, there is no basis for seeking approval. In the situation up for discussion, capital instruments in the form of equity shares would have already been issued in the past when the transaction was actually executed when FDI was actually received. Using the amount received under automatic route for any other purposes or taking post-facto government approval would amount to circumvention of the law as that is not the scheme put forward by the Policy.
4. Standard Operating Procedure dated 17.08.2023: Following up on the language used in the FDI Policy and NDI Rules, the SOP released in 2023 also mentions several phrases which point towards the transaction-specific nature of FDI Policy. Some of the phrases include:
Annexure – I – List of Documents to be submitted
• Particulars of the transaction for which approval is sought (Entry 2, Point 4);
• Pre and post-transaction shareholding pattern (Entry 3);
• Diagrammatic representations of flow of funds from investor to the investee (Entry 4);
• Board Resolution of the Investee for proposed investment (Entry 6(d))
Practical Implications
1. The Transaction Has Already Happened: As explained above, the FDI Policy envisages a prospective transaction rather than retrospective one. Whenever capital instruments are issued in exchange for FDI investment, the transaction gets complete and cannot be retrospectively bifurcated to seek additional approvals for a portion of the funds.
2. Approval is Tied to Future Transactions: Seeking government approval requires a proposal for a future transaction, as reflected in the SOP and policy requirements. In the absence of a new transaction, the regulatory framework does not allow for piecemeal approval or retrospective application of government clearance to reallocate funds.
3. New FDI is Required for New Activities: An investee company must initiate a fresh transaction involving the issuance of securities and seek government approval under the approval route.
Conclusion
FDI, as crucial as it is for the development of the Indian subcontinent, still needs to be regulated within strict guardrails to align with the intended purpose of regulatory frameworks and generate investor confidence. While some flexibility may exist depending on national laws, investor agreements, and sector-specific regulations, diverting FDI from its original purpose without proper authorization can lead to legal consequences, reputational risks, and potential loss of future investment opportunities. This article is an opinion piece and explores our reasoning on why FDI would not be allowed to be redirected.