As one of the world's fastest growing economies, India's attraction to foreign investors is tempered only by its sometimes unclear legislation
As a destination for foreign investors, India is fast closing the gap on China to become the world's most popular investment hub. Figures released by the country's Reserve Bank in August 2008 showed that foreign direct investment in India for the first quarter of this financial year exceeded the total received in 2005/06, with the country on track to break its FDI target of US$35 billion (Ł19.7 billion) for 2009.
India is the second most populous country on earth with some 1.1 billion people, and the 12th largest economy in the world measured by nominal US dollars. It rises to fourth-largest when measured at purchasing power parity exchange rates, according to the Economist Intelligence Unit.
India gained independence from British colonial rule in 1947, and has been a democracy ever since. At the time of independence the country welcomed multinationals, and until the 1970s the regime was conducive to foreign investment. A spate of nationalisations in that decade and a strong socialist approach resulted in big names like IBM and Coca-Cola retreating from India.
In 1991, India's foreign reserves were at an all-time low, and with the country close to defaulting on its sovereign debts, the government decided to open up the economy. Since then, it has liberalised the exchange control regulations, and moved from a strict regime allowing investments only in particular sectors, to a much more free approach.
India's New Industrial Policy, of 1991, has a stated objective of inviting and facilitating foreign investments, and it approves investments through either an automatic route, that requires no prior approval, or through the government approval route, where applications must be made to the Foreign Investment Promotion Board.
One-hundred per cent foreign ownership is permitted in most activities under the automatic route. Such ownership is subject to compliance with certain conditions, except inter-alia in certain sectors such as airports, asset reconstruction companies, atomic minerals, broadcasting, postal services, courier services, print media, single brand retail, and telecoms. In these sectors there are specified sectoral caps/ thresholds on foreign ownership. Foreign direct investment is prohibited in agriculture, atomic energy, retail trading (except single brands up to 51%), lottery, betting and gambling.
Drafting the laws
India therefore has a system for foreign investors that is pretty straightforward, and rarely requires government approval beyond an investment notification. There are still a number of restrictions that the US and Europe are trying to encourage the government to change, in sectors such as legal, insurance and banking, and those efforts remain ongoing.
The problem with legislation arises when government policy is changed, since new laws can often be badly drafted. In line with all international firms, Herbert Smith is not permitted to practice Indian law, and instead works closely with Indian counsel in the country.
Akshay Chudasama is a senior partner of Indian law firm JSA, and he says: "A lot of government policy in respect of foreign investment is issued through press notes or press releases, which become de facto policy. These are often badly drafted and can be inconsistent, and you can often receive conflicting interpretations of the rules from the government itself."
One particular press note that has caused issues for foreign investors is Press Note 1 of 2005, which is protectionist in that it requires a foreign investor with an existing tie-up or joint venture in India to seek permission from its current domestic partner before setting up another business in the same sector. Such investments require a no-objection certificate from the domestic partner.
Some authorities are willing to give investors an indication of their interpretation of the rules before a decision is made. The tax authorities, for example, have a concept of advance rulings, which are not binding but give an idea of the way the regulators are thinking at the outset.
Akshay says: "Very often the rules and regulations in India are open to interpretation and it is important for investors to take advice from local experts who are familiar with past interpretations made by regulators."
Chris Parsons, the chair of Herbert Smith's India group, says: "There is sometimes a nervousness of going to regulators in India, because investors fear getting the wrong answer. But from a regulatory perspective, foreign investors are treated no differently from local businesses – they all struggle with the regulators at times, so they face the same issues in equal measure."
Risks for investors
One area that can present a problem for inward investors is labour legislation. Akshay says: "The power that labour and the trade unions had a decade ago has been reduced, but we still have a lot of pro-worker legislation."
Thanks to the availability of a skilled workforce in India, many multinationals will be staffed by local workers at all levels, with very few expatriates based in the country. The national strikes that were common in the 1980s are now the exception rather than the rule. However, "Labour can be a challenging issue," says Akshay, "and it's not something that can be dismissed as easy to deal with. On the other hand, in terms of problems within the Indian economy, it is one of the smaller issues behind infrastructure and bureaucracy."
Expropriation and sanctions are not issues that need concern investors in India, and there are no known instances of assets being seized by the government. Akshay says: "We have a pretty well-developed legal system compared to some other developing economies."
The enforceability of contract rights also benefits as a result of this entrenched legal system, with the country having introduced a Contract Act in 1872 that has gone largely unamended since. For all practical purposes it works, with most joint venture agreements governed by Indian law. "We don't have a concept of special or consequential damages in India," says Akshay, "so you have to prove actual loss. But other than that, India had one of the first codified Contract Acts, and it is effective."
In a current high-profile case, it has been the Indian tax authorities that have gone against Vodafone. The authorities issued a US$2 billion tax claim against Vodafone following its acquisition of Hutchison's stake in Hutch Essar. The tax authorities contended that, as the underlying asset was a share of an Indian company, capital gains tax should have been paid. Vodafone, in return, argues that the transaction occurred offshore between two non-residents.
Akshay says: "The case is before the courts and arguments are being advanced by both sides, so we don't know what the final position will be. However, given the impact it will have on foreign investors, it is likely to go all the way to the Supreme Court."
Another concern on the horizon comes in the form of the Competition Act, which was passed by parliament in 2002 but is yet to become law. Expected to come into effect early in 2009, it will enforce merger control legislation in the country, prohibiting combinations that cause, or are likely to cause, an appreciable adverse effect on competition within the relevant market in India.
As India has limited competition rules at present, big mergers and acquisitions have been largely unregulated to date. Chris says: "The new act is going to be quite similar to laws already in place around the world, and is certainly similar to the UK position. It will cover restrictive agreements, abuse of dominant position and merger regulations and approvals, so a lot of the learning outside India will be relevant."
The Indian courts
The courts in India commonly operate using the English language, and the appellate procedure is conducted in English. The law is a common law system, so is familiar to English and American investors, and the higher judicial courts – the High Court and the Supreme Court – are clean and well-operated.
The problems with the Indian judicial systems arise because the pleadings system is archaic, and therefore most court proceedings require large volumes of paperwork since everything needs to be pleaded. Akshay says: "The result is a long drawn-out system, and there's a lot of pressure in terms of volume of cases given that this is a country of 1.1 billion people. Trials can take more than 10 years to complete."
The result is that, from a business perspective, the Indian courts are used more as a means of achieving interim results rather than definitive decisions. Most companies will go to court to get injunctions but will otherwise avoid them where possible. Akshay says: "In India, court fees are relatively low and there is no system for rewarding realistic costs. So access to courts is easy and is a fundamental right. As a result arbitration is the preferred option for dispute resolution. I can't remember a single commercial contract in 15 years where we haven't had an arbitration clause." Investors are advised to include arbitration clauses in all contracts,
India's Arbitration Act is based on the UNCITRAL model, thereby forbidding the local courts from taking any view on the merits of a case where there is an arbitration clause. The Indian Arbitration Act is divided into two parts, domestic and international, based on the venue of arbitration. A recent Supreme Court decision, however, has extended Indian courts' ability to govern international arbitrations. "Even if you have an arbitration in London, the ability to approach an Indian court for interim relief as well as challenge it in the Indian courts has increased," says Akshay.
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