Corporate & Commercial Monthly Newsletter | January 2025

OPERATIONAL FRAMEWORK BY RBI & SEBI FOR RECLASSIFICATION OF FPI TO FDI

Introduction

The Reserve Bank of India ( RBI) and the Securities and Exchange Board of India ( SEBI) vide notifications dated November 11, 2024, introduced an operational framework for reclassifying investments made by Foreign Portfolio Investors and their investor groups (FPIs) as Foreign Direct Investment (FDI), when investment made by the FPIs exceeds the investment limit specified in Para 1(a)(iii) of Schedule II of the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 ( Rules).

Background

A person resident outside India may hold securities in companies incorporated in India, inter alia, by way of investments from FPI or through FDI. As per Rules, foreign portfolio investments means investment by a person resident outside India through equity instruments, where such investment is less than 10% (ten percent) of the post issue paid-up share capital of a listed Indian entity on a fully diluted basis or less than 10% (ten percent) of the paid-up value of each series of equity instrument of a listed Indian company, and whereas FDI means investment through equity instruments by a person resident outside India, in an unlisted Indian company or investment of 10% (ten percent) or more in the post issue paid-up equity capital of a listed Indian company on a fully diluted basis.

Para 1 (a)(iii) of Schedule II to Rules stipulates that if FPI including the investor group, invests more than the limits prescribed (i.e. below 10% of the paid-up equity capital of a listed entity) in a listed Indian company then, such FPIs shall have the option either to divest its excess holding or reclassify its entire investment as FDI within 5 (five) trading days from the date of settlement of the trades causing the breach.

Therefore, if the investment, in a listed Indian company, held by an FPI including the investor group exceeds 10% (ten percent), the same shall be considered as an FDI and the compliance as applicable to FDI under the Rules and other applicable laws shall be applicable, unless the FPI decides to divest such excess holding in the entity within 5 (five) trading days from the date of settlement of the trades causing the breach.

In the event any FPI intends to reclassify its foreign portfolio investment into FDI, the FPI shall follow the operational framework issued by RBI. The operational framework clarifies and formalizes the reclassification process, ensuring compliance with the regulatory requirements. This article highlights the key components of the operational framework, emphasizing its significance and implications.

Consequential changes by SEBI

In line with RBI's operational framework, SEBI has also as aforesaid, vide its circular dated November 11, 2024, modified the procedure for reclassification of foreign portfolio investment into FDI to state that in case the investment made by FPI investment exceeds 10% (ten percent) of the total paid-up equity capital of a company on a fully diluted basis and the FPIs intends to reclassify its foreign portfolio investment into FDI, it shall follow the relevant rules and regulation under FEMA (Foreign Exchange Management Act) and intimate the same to its custodian.

The custodian shall report the same to SEBI and freeze purchase transactions by such FPI in equity instruments of such Indian company, till completion of the reclassification. Thereafter, the custodian will transfer the equity instruments from the FPI's demat account to a demat account designated for holding FDI investments, provided the necessary reporting and compliance prescribed by RBI is met.

Key Highlights of the Operational Framework

In view of the operational framework, if such reclassification is undertaken by the FPIs, the key highlights are as follows:

1. Required confirmation and authorisations: The operational framework mandates obtaining the following before reclassification:
   1. Government approvals: Necessary approvals from the Government are required, especially for investments from countries sharing land borders with India. This aligns with existing FDI guidelines and ensures adherence to sectoral caps, pricing norms, and attendant conditions outlined in Rules.¹
   2. Investee Company Concurrence: The Indian company receiving the investment must concur to facilitate compliance with sectoral restrictions and approvals. This ensures that the investee entity is aware of and abides by the regulatory requirements.
   3. Prohibitions: The framework explicitly prohibits the reclassification of investments by FPIs to FDI in sectors where FDI is prohibited. This ensures regulatory alignment with Schedule I of the Rules, preventing circumvention of sectoral caps and entry route restrictions.
2. Expression of Intent and Freezing of Purchases: FPIs is obligated to clearly express its intention to reclassify its investments in a company as FDI and submit the required approvals to its custodian. Upon receiving such intent, the custodian is required to freeze any further purchase transactions by the FPI in equity instruments of the Indian company until the reclassification process is complete.
3. Mandatory divestment: Upon failure to obtain the requisite prior approvals or concurrence, the FPI is obligated to divest any holdings exceeding the prescribed threshold within the stipulated period of 5 (five) days.²
4. Reporting requirements³ : For reclassification, the entire investment held by such FPI shall be reported as specified under Rules, in the following manner:
   1. Form FC-GPR: The Indian company is liable to report if the investment is beyond the prescribed limit is resulting from fresh issuance of equity investment by an Indian company to such FPI. Then such form shall be filed by the Indian investee company within 30 (thirty) days from the date of issuance of equity instrument;
   2. Form FC- TRS: The FPI is liable to report if investment beyond the prescribed limit is a result of secondary market acquisition of shares by such FPI. Then such form shall be filed by the FPI within 60 (sixty) days from the date of transfer of equity investment.
   3. LEC Reporting: The concerned Authorized Dealer (AD) bank shall report the amount of reclassified foreign portfolio investment as divestment under the LEC (FII) reporting.
5. Transfer of equity instruments⁴ : Post reporting, the FPI must:
   1. Request its custodian to transfer the equity instruments of the Indian company from its demat account for foreign portfolio investments to its demat account for FDI.
   2. The custodian, after verifying the completion of all reporting requirements, will unfreeze the equity instruments and process the transfer.
   3. The date of investment that caused the breach will be considered the date of reclassification.
6. Post Reclassification Scenario:
   1. Once reclassified, the FPI's entire investment in the Indian company will be governed under Schedule I (FDI) as opposed to Schedule II of the Rules.
   2. Even if the investment subsequently falls below the 10% threshold, it will continue to be treated as FDI.
   3. The FPI (including its investor group) will be treated as a single person for the purpose of reclassifying foreign portfolio investments.

Impact of the framework:

1. Increased Compliance Burden: (i) FPIs may perceive the framework as adding significant procedural and reporting requirements, such as obtaining government approvals, investee company concurrence, and adhering to FDI pricing guidelines. Further, FPIs must act swiftly within 5 (five) trading days to avoid mandatory divestment. Also, such compliance requirements increases costs for foreign investors. (ii) For the investee companies they will need to ensure compliance with sectoral caps, FDI-specific approvals, and filing requirements (e.g., FC-GPR or FC-TRS forms), increasing their compliance burden.
2. Long Term Investment Stability: The framework portrays reclassification of investments in a dual angle, one being creation of a more favourable environment for both FPIs and FDIs, leading to an increase in total investment emphasizing on the quantity of capital entering the country, regardless of whether it comes for short-term or long-term investments. The other being that the framework may lead to a transition from short-term, speculative investments typical of FPIs to more stable, long-term investments associated with FDIs. Emphasis being applied on the quality and stability of the investments, indicating a preference for investments that contribute to sustainable economic growth rather than those that may be more volatile.⁵ Further, investments made pursuant to this regulatory shift may be seen as a step toward flexibility and transparency, allowing FPIs a compliant method to increase holdings in Indian companies.

Significance of the Framework:

1. Possible Risks: In its consultation paper dated May 31, 2023⁶ , SEBI highlighted two key concerns regarding FPIs. Firstly, some FPIs are concentrating significant portions of their equity portfolios in single investee companies or corporate groups, potentially allowing promoters to circumvent Minimum Public Shareholding (MPS) requirements and increasing price manipulation risks. Second, that the FPI route could be misused to circumvent restrictions on investments from land-bordering countries. Identifying highrisk FPIs with substantial holdings linked to these countries is crucial.
2. Market Performance: Regardless of India's impressive performance in capturing a 36% share of total listings in Q3 2024, surpassing the United States' at 13%, in the capital market. India achieved the highest quarterly listings in 20 (twenty) years, with 27 (twenty seven) initial public offerings raising $4,285 million (INR 36,027 crore), a 142% increase from the previous year.⁷ Such growth underscores the need for regulatory vigilance as the market expands.

Conclusion

The operational framework issued by RBI provides clarity to FPIs in terms of process for conversion of foreign portfolio investments into FDI, and at the same time it also ensures due compliance of Rules as applicable to FDI on reclassification of investment. Outlining the prerequisites for reclassification—such as obtaining necessary government approvals and the concurrence of the investee company, along with reporting obligations—will not only streamline the process but also allow Indian authorities to monitor FPI investments more effectively, ensuring better compliance between FPI and FDI regulations This subsumes several practical difficulties that investors and custodians previously faced with respect to similar conversions. Ultimately, the framework fosters a transparent and wellregulated investment environment, bolstering foreign investor confidence and paving the way for deeper, long-term engagement with the Indian market. However, it remains to be seen whether this framework will effectively meet the evolving

Footnotes

1. Para 1 and 2, Annex, Operational framework for reclassification of Foreign Portfolio Investment to Foreign Direct Investment (FDI), https://rbi.org.in/Scripts/NotificationUser.aspx?Id=12749&Mod e=0#ANN1 

2. Id., Para 3.

3. Supra, note 3. Para 4.

4. Supra, note 3. Para 5.

5. https://www.financialexpress.com/market/portfolio-investorsgiven-the-option-to-raise-stake-beyond-the-10-cap-withoutdivesting-3662334/ 

6. Consultation Paper on framework for mandating additional disclosures from Foreign Portfolio Investors that fulfil certain objective criteria, to 1) guard against possible circumvention of Minimum Public Shareholding, and 2) to guard against possible misuse of the FPI route to circumvent the requirements of Press Note 3, dated May 31, 2023, https://www.sebi.gov.in/reportsand-statistics/reports/may-2023/consultation-paper-onframework-for-mandating-additional-disclosures-from-foreignportfolio-investors-fpis-that-fulfil-certain-objective-criteria-to-1- guard-against-possible-circumvention-of-minim-_71946.html

7. https://www.business-standard.com/finance/personalfinance/india-leads-global-ipos-raising-4-3-bn-in-q3-2024-taximpact-decoded-124111200638_1.html

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