Author's Note : Try explaining to a foreign investor what a "Press Note" is. This is a good example of 'delegated legislation' going wrong.

Mar 03

Posted in: Regulatory Posted by: P S Billimoria

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Despite the impressive quantum of foreign direct investment (“FDI”) that India now attracts, foreign companies doing business in India continue to express frustration about the spider web of laws and regulations. While the policies are forward looking and liberal, the enduring refrain is that the manner in which these are implemented leaves much to be desired. The FDI policy in the real estate development sector exemplifies the reasons why foreign businesses continue to maintain that lack of transparency and stability in the regulations is the single most important barrier to greater levels of foreign investment in India.

The policy as set out in Press Note 2 (2005) of March 3, 2005 (“PN2”) sets out several conditions subject to which FDI of up to 100% in real estate is permitted. One of the main conditions of PN2 is that FDI is permissible only in projects of a minimum size (land area of 10 hectares and built-up area of 50,000 sq. mts. for development of serviced housing plots and construction-development projects respectively). Similarly, PN2 also prescribes minimum capitalization norms (U.S. $10 million for wholly-owned subsidiaries and U.S. $5 million for joint ventures with Indian partners). Several questions however remain unanswered. For instance it is unclear as to what constitutes “built-up area”. Further, industry experts point out that there are several ways in which “built-up area” may be computed and it is unclear whether it should include parking space and other common areas or not.

The objective of prescribing size and minimum capitalization norms seems to be to divert foreign capital only to large projects which may be capital intensive. Further, the size criteria of PN2 are more realistic than those prescribed under the earlier policy which allowed FDI only in integrated townships with a minimum size of 100 acres. Therefore, foreign investors are more concerned about other aspects of PN2 which pose serious questions and sometimes irreconcilable problems. One of these is the fact that foreign investment in PN2 is allowed only in the so-called “greenfield” projects. Although PN2 does not specifically mention this restriction, there are several references in PN2 which by implication suggest that PN2 does not contemplate FDI in completed or even semi-finished projects. Moreover, this position has been subsequently clarified by the DIPP. From the policy perspective it may be a sound proposition to restrict FDI only to the development of new projects, since it effectively channels foreign capital into the development of properties instead of trading in completed properties. However, this restriction creates another complexity for the foreign investor by effectively preventing a major exit option. This is because once the foreign investment is made in a development project the investor cannot sell his equity stake to another foreign entity (since the proposed acquirer of such equity would be barred from making investments in an entity which houses completed projects). Given that PN2 already contains a lock-in condition which prevents the foreign investor from repatriation of sale proceeds for three years from the date of minimum capitalization, the added (and perhaps unintended) restriction which prevents the sale to another foreign investor even after the expiry of the lock-in period is unwarranted. Moreover, the lock-in condition of PN2 itself creates more questions. For instance, the lock-in period is applicable to the “original investment.” Since this term is not defined, it could either mean the amount of minimum capitalization, or the total cost of the first project.

Some other conditions which are often debated in conference rooms across India include the requirement that the minimum capitalization is required to be brought in within six months of the commencement of business of the company. One interpretation of this provision is that the FDI can flow only into a new company which is yet to commence business. This would imply that FDI can never flow into existing companies (unless they are merely “shell companies”) and that FDI in the real estate sector must flow only into new companies set up for the purpose. This cannot possibly be the intent of PN2 and is also contrary to general practice in other sectors where FDI is permitted.

Another condition of PN2 is the requirement that at least 50% of the project must be developed within 5 years from the date of obtaining all statutory clearances. Prima facie, this condition should not be of concern since 5 years is a reasonable time for developing a project. Further, the period of 5 years commences only once the statutory clearances are obtained, thus taking into consideration a scenario where project implementation is delayed due to delay in obtaining such statutory clearances. However, even such an innocuous condition can sometimes cause concern to foreign investors. This is because, the condition raises the bogey of what would happen if the project is delayed for reasons beyond the control of the foreign investor. The question of how the percentage completion of a project can be computed is unclear in the first place. Further, although PN2 does not clearly state the implications if the project is not developed within 5 years, by implication, the foreign investor would be unable to unlock value and sell its stake in the project. This constitutes a huge risk to foreign investors since it effectively prevents the abandonment of projects which may have been misconceived or which become unviable due to factors beyond their control. In a way, PN2 would compel foreign investors to throw good money after bad money to complete 50% of the project.

These conditions of PN2 appear to be designed to enable only long-term players and curb trading and speculation in this sector, a scenario which still re-creates horrific visions of the South East Asian meltdown in the minds of Indian regulators. While these policy objectives are sound, every prudent investor will chart out viable exit options as a necessary pre-requisite to the investment. Moreover, an investor needs reasonable assurance that once an investment has been made in a project which he believes is compliant with PN2 then that position will not change thereafter, simply because the regulators issue a clarification subsequent to the investment and the commencement of development. It is questions such as these which create confusion and the perception of instability in the minds of foreign investors. Since the real estate sector has attracted significant interest the Government can go a long way in changing this perception by reformulating some of the conditions of PN2 in an objective and investor friendly manner.



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