The framework for issuance of Depository Receipts (DRs) has seen a number of changes over the past few years on account of multiple regulatory concerns surrounding the structure of these instruments as well as of those who invested or traded in them. In October last year, the Securities and Exchange Board of India (SEBI) introduced the revised framework for issuance of depository receipts (2019 Circular). These norms required Indian depositories to develop a system to monitor foreign holding, including by way of DRs, as per the limits prescribed under the Foreign Exchange Management Act, 1999 (FEMA) and applicable SEBI regulations, and disseminate the information regarding outstanding DRs and available limit for conversion. Almost a year later, on October 1, 2020, SEBI notified the framework for foreign holding in DRs (2020 Circular), which expounds upon the manner in which such foreign holding will be computed.

There are two key aspects of the 2020 Circular which require some consideration. Firstly, inclusion of DRs while monitoring investments for FPIs; and secondly, FPIs providing investment holding details to Designated Depository Participants (DDPs, intermediaries which on-board FPIs) and custodians, including details on holdings through Offshore Derivative Instruments (ODIs). This piece examines the scope of these changes, their possible implications and impact on the manner in which FPIs carry out business in India.

Foreign Exchange Limits

Before delving into the specific aspects of the 2020 Circular, it is relevant to understand the foreign exchange framework as applicable to DRs so far.

The Report of the Committee to Review the FCCBs and Ordinary Shares (Through Depository Receipt Mechanism) Scheme, 1993 under the chairmanship of Mr. M.S. Sahoo (Report), had analysed the erstwhile DR related regulations and suggested a number of suggestions for rationalisation and improvement of the framework, keeping in mind the broader objective of promoting foreign investment into Indian companies. The Report specifically recommended that subject to the overall foreign investment limits, there should be no restriction on the amount up to which DRs can be issued

The Depository Receipts Scheme, 2014 notified by the Ministry of Finance (DR Scheme) captured this principle. Changes were also made to the existing foreign exchange laws. In terms of the new landscape, the aggregate of permissible securities which could be issued or transferred to foreign depositories for issue of DRs, along with permissible securities already held by persons resident outside India, could not exceed the limit on foreign holding of such permissible securities under FEMA as applicable to an Indian company as a whole.

In relation to voting rights, the Companies (Issue of Global Depository Receipts) Rules, 2014 permitted holders of DRs to become a member of the company and to vote only upon conversion of the DRs into underlying shares after following the prescribed procedure. Until conversion, the overseas depository would remain entitled to vote on behalf of the holders as per the agreement between the depository, holders of DRs and the company.

Reading the 2019 Circular and the 2020 Circular together, the following points emerge:

  1. Persons resident in India and Non-Resident Indians (NRIs, a specific class of individuals under Indian citizenship laws) are not permitted to hold DRs, directly or by way of beneficial ownership, with the onus of ensuring compliance with this requirement being on the holder (including its beneficial owner). This clause is found in the law on foreign portfolio investment in India as well and is intended to thwart misuse of the foreign investment route by Indian residents and NRIs.
  1. FPIs are required to report the details of all FPIs as well as ODI subscribers and / or DR holders having common ownership, directly or indirectly, of more than fifty percent or on the basis of common control (if any), to its DDP/ custodian. The DDP/custodian will provide this information to the relevant depositories.
  1. In case of FPI groups, the depository will club the investment pertaining to DR holding, ODI holding and FPI holding and monitor the investment limits. For single FPIs, this responsibility has been placed on the DDP / custodian.
  1. In case where the investment holding breaches the prescribed limits, the depository / custodian will advise the concerned investor / investor group, to divest the excess holding within 5 trading days similar to requirement prescribed for typical FPI holdings in equity shares.

In this context, it may be noted that the foreign exchange regulatory framework does not provide for DRs to be included as a part of the 10% limit allocated to FPIs to make investment in 'equity instruments'. Under the current foreign exchange rules, known as the Foreign Exchange Management (Non-debt Instruments) Rules, 2019 (NDI Rules), DRs do not form part of 'equity instruments' which are defined as equity shares, convertible debentures, preference shares and share warrants issued by an Indian company. The specific schedule dealing with investment in DRs also does not mention any specific limit for holders.

SEBI's own regulations also make a reference only to equity shares while dealing with the 10% limit. While SEBI has required direct and ODI holding to be clubbed under the 10% limit since November 2014, an equivalent requirement for DRs has not been set out under the norms governing FPIs.

Therefore, neither foreign exchange norms nor the DR Scheme support an interpretation that FPI holdings should be necessarily clubbed with DR holdings. Pending any such amendment/ clarification, the 2020 Circular may be singularly expanding upon the appliable foreign exchange laws, especially given that DR holders cannot exercise voting rights themselves.

Information on Investment Holdings

While intimation to DDPs of the constituents of the 'investor group' of an FPI is a pre-existing requirement under the relevant FPI laws, information on ODI issuances, including details of beneficial owners is sent by FPIs to SEBI directly and not shared by the FPIs with DDPs. Given that FPIs operate in a number of jurisdictions, they are subject to privacy and confidentiality norms of such jurisdictions. In the past, FPIs have found it difficult to obtain information from ODI subscribers, however, as the law has become more stringent, these entities have had to comply and implement structures to ensure compliance.

As beneficial ownership information necessarily relates to natural persons, the concerns on the manner in which the information can be onwards transmitted by FPIs are important. In this context, there is a significant difference between providing counterparty information to a regulator (SEBI) as opposed to private parties (the DDPs/ custodian) and ODI issuers. From the point of view of the DDPs/ custodians as well, the cost of compliance will go up as they put in place systems to ensure that international standards on handling personal information are complied with,

Concluding Remarks

DRs permit companies to access capital from outside India apart from the more traditional direct and portfolio investment routes. Thus, the origin of DRs as an instrument are rooted in foreign exchange laws, with SEBI breathing life into it in so far as process, procedure and the mechanics of issue, listing and ongoing compliance are concerned. The Government has been taking steps to ease access to DRs and also introduce certainty in the foreign investment regime. SEBI has, no doubt, been granted wide powers to regulate and supervise the securities market in terms of the SEBI Act, 1992. Specifically, in the case of Pan Asia Advisors Ltd, the Supreme Court, on a review of all applicable laws, including the DR Scheme, noted that regulation of DRs, particularly in cases involving market abuse, fell within SEBI's jurisdiction.

However, the stipulations under the 2020 Circular may need further deliberations, to ensure consistency with the overall regulatory framework that governs DRs. As of now, it is not entirely clear as to why the 2020 circular goes beyond the parent foreign exchange regime, especially when FPIs are acting in a wholly different capacity (i.e., as regular foreign investors) when they trade DRs and are not regulated by SEBI in that avatar.

The 2020 Circular has raised multiple questions and has the potential to impact the manner in which FPIs conduct their business in India and the overall predictability of doing business. Clarifications from the Government will certainly help address the disparity between the securities market, foreign exchange and companies law.

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