On 28th April 2017, in a widely reported judgement, the Delhi High Court allowed the enforcement of an international arbitration award requiring the Tatas to pay damages to the tune of USD 1.17 billion to Docomo, in connection with the investment agreement under which Docomo had invested in Tata Teleservices in 2009.
In this article, we argue that the Delhi High Court judgement presents an opportunity to reform the complex regulatory framework governing foreign investment in India. The Tata-Docomo legal battle for the enforcement of undisputed contractual rights, though unfortunate, can have positive spill-overs if the regulator uses the outcome of the litigation as a feedback loop, and rationalises the regulatory framework governing exits from Indian investment, including price controls applicable to the entry and exit of foreign investment.
The much-talked about Tata-Docomo transaction dates back to 2009 when NTT Docomo of Japan bought a 26.5% stake in Tata Teleservices for for about Rs 12,740 crore at Rs 117 per share. The agreement was that if certain revenue targets were not met, the Japanese company could "put" its shares on the Tatas at a pre-determined price equivalent to roughly 50 per cent of Docomo's acquisition cost. When the Tata-Docomo agreement was signed, the law did not expressly restrict such exit mechanisms for foreign investors. However, the RBI had been implicitly objecting to the creation of put options in investment agreement without clarifying the position by a statutory instrument.
On 30th September, 2011, the Department of Industrial Policy and Promotion allowed investments in instruments with in-built options to be regulated as External Commercial Borrowings (see here). This effectively meant that the agreeements with optionality clauses would be governed by the restrictions covered under the ECB policy, including the end-use requirements and a cap on return. After a month of heavy lobbying, the DIPP withdrew the circular, and there was again a vaccum on whether such options were allowed. In 2014, after more than a year of uncertainty, the RBI issued a circular legitimising put options with a host of conditionalities. The key restriction was that the foreign investor should exit without an assured or pre-agreed return.
Timeline from the date of triggering exit mechanism
When Docomo sought to exit its investment from Tata Teleservices by exercising its put option in 2015, the Tata-Docomo agreement came under the scanner, as it sought to offer a pre-agreed fixed return to Docomo. The pre-agreed return was higher than the market value of Docomo's investment at the time of its exit. Hence, the parties applied to the RBI for a waiver from the restriction on pre-agreed returns imposed in 2014. The waiver application was rejected, and Docomo instituted international arbitration proceedings to recover its contractual dues.
In June 2016, the arbitration tribunal ruled in favour of Docomo awarding damages of USD 1.17 billion dollars. The Tatas challenged the enforcement of the award in the Delhi High Court. The RBI sought to intervene in the enforcement proceedings, objecting to the enforcement of the award, on the ground that the award and the Tata-Docomo agreement were violative of FEMA and its directive against fixed returns.
In April 2017, the Delhi High Court dismissed the RBI's intervention application on the ground that, "...there s no provision in law which permits RBI to intervene in a petition seeking enforcement of an arbitral Award to which RBI is not a party." It also held that the Tata-Docomo shareholders' agreement was not violative of the Foreign Exchange Management Act, 1999 (FEMA), as it required the Tatas to (a) procure a buyer for Docomo's shares; and (b) indemnify Docomo for the difference between the pre-determined price and the price at which Docomo's shares are actually sold. Since FEMA did not prohibit the creation of contractual obligations, the creation of the obligation could not be said to be violative of FEMA. The court concluded by upholding the validity of the arbitration award.
The timeline of events leading up to the Delhi High Court order is important as it shows the time taken to effectively exit an Indian investment. The timeline is summarised in the Table below.
|2009||Docomo picks up 26.5% stake in Tata Teleservices Ltd|
|September 2011||DIPP issues allowing put options to be regulated as External Commercial Borrowings.|
|October 2011||DIPP withdraws circular issued in September 2011.|
|January 2014||RBI issues a circular permitting put options in favour of non-residents, subject to the several conditions, including that the put option must not be exercisable at a pre-determined price.|
|July 2014||Docomo tells Tata of its decision to exercise its put option, as per its contractual arrangement.|
|January 2015||RBI is reportedly keen to exempt the Tata-Docomo transaction from its rule against pre-determined returns.|
|January 2015||Docomo begins arbitration proceedings for recovery of its contractually agreed put option price.|
|June 2016||Arbitration tribunal decides in favour of Docomo|
|September 2016||Tatas challenge the enforcement of the award before the Delhi High Court.|
|April 2017||Delhi High Court rules in favour of Docomo.|
Controls on rupee-denominated put options
This blog has been commenting on the regulatory tangle surrounding the Tata-Docomo dispute. In January 2015, RBI was reportedly keen to exempt the Tata-Docomo transaction from its rule against put options, and allow the remittance. On this blog, we had argued that allowing ad-hoc individual exemptions, would weaken the rule of law in the administration of the regulatory framework governing capital flows into India. We made a case for rationalising the foreign investment regulatory framework, which imposes restrictions on put options that offer 'fixed returns' to foreign investors. In another article on this blog, we had argued that controls on exit mechanisms through the exercise of put options, were not supported by any economic rationale. Put options, which act as a stop-loss for any investor (foreign or Indian), must not be regulated for two reasons. First, there is no market failure involved when an Indian resident is obligated to buy and pay for Rupee-denominated instruments. A sound regulatory framework governing capital controls must address the systemic risk concerns associated with unhedged foreign currency exposure. In case of put options on Rupee-denominated instruments, no such risk arises as the liability of an Indian resident, on whom the put is exercised, to pay for the shares is in local currency. Second, put options are not akin to debt as they do not entitle the non-residents to the same remedies as a debt-default would. In most cases, put options are not secured.
Three options from a policy perspective
How should RBI, as the regulator of foreign exchange, react to the judgement of the Delhi High Court that enforced the award? There are three options:
- RBI may retain the status-quo and not amend the regulatory framework governing the remittance of fixed returns on Rupee-denominated instruments to foreign investors. In such cases, where foreign investors have a stop-loss provision in their contracts, the recoupment of capital by them, will continue to be shrouded in doubt. They may be encouraged by the Delhi High Court judgement to apply to the RBI seeking approval for the remittance. Like many other cases under FEMA, such applications for approval will be dealt with on a case-by-case basis. This is a sub-optimal outcome as there is no regulatory certainty on the conditions in which foreign investors may exit their Indian investment.
RBI may amend the regulatory framework in response to the Delhi High Court judgement. It may dispense with the control on fixed returns on Rupee-denominated instruments, as such fixed returns are in local currency and do not give rise to any systemic risk concerns.
Besides the two reasons explained above, the current framework needs to be re-visited for two reasons. First, as discussed above, fundamentally, put options are not akin to debt. Even if this position is accepted, the closest proxy instrument would be the onshore Rupee-denominated bonds. The regulatory framework governing foreign investment in onshore bonds does not cap the interest rate. There should similarly be no restriction on the return from the exercise of a put option. If this happens, then we will have uniform rules for investments of a similar nature.
Second, in its current form, the regulation mandating that put options should not result in pre-determined or fixed returns to foreign investors, renders itself to multiple interpretations on intent. For instance, the judgement of the Delhi High Court records that the RBI had considered exempting cases of 'fixed return' to foreign investors, where the 'fixed return' was lesser than the original amount invested in the Indian entity. The Delhi High Court order shows that the Tatas had filed an application under the Right to Information Act, 2005 (RTI) seeking information regarding the Tata-Docomo transaction. An abstract of an internal file noting, provided by the RBI in response to the RTI application, reads thus:
"I would take a different view. The assured return applies where the overseas investor gets his entire principal PLUS a certain return. Here both the parties agreed to protect the downside loss at 50% of the invested value. This is according to me a fair agreement/contract and we should facilitate honouring this commitment. ... Although strictly as far as wordings of the regulation this may not be allowed."
Thus, it seems that even within the RBI, there is little consensus on whether the rule against fixed return should be applied in all cases of exit or not. It appears that the RBI intends to exempt the cases from the prohibition on fixed return where the fixed return provides downside protection to an investment.
Apart from price controls on the exercise of put options, even ordinary entry and exits of foreign investors are subjected to controls. For instance, the current regulatory framework does not allow a foreign investor to buy shares from an Indian resident at a price that is less than the 'fair market value' (minimum price). Similarly, it does not allow foreign investors to sell their securities to an Indian resident for a price which is more than the 'fair market value' (cap on price). Protectionist price controls were originally intended to protect Indian residents from over-paying non-residents for purchasing shares of Indian companies, and to prevent mis-invoicing of capital outflows. While they may have been relevant when Indian businesses were not exposed to FDI, there seems to be no reason to continue these restrictions. India has been fully current account convertible now, open to FDI for more than 15 years now and there are multiple foreign investors actively looking for investments in Indian companies. Indian entrepreneurs/ shareholders must be free to negotiate appropriate terms of sale or purchase of their securities. The removal of restrictions will allow flexibility in structuring investments and exits. It will allow the terms of contracts to be determined by the risk appetite and commercial understanding between the parties.
- RBI may react aggressively and appeal against the dismissal of the intervention application by the Delhi High Court. For the reasons explained above, we believe that this will be a loss of an opportunity to rationalise our foreign exchange regulatory regime governing price controls on entry
The international arbitration award awarding damages to Docomo and the time and costs associated with the exit from Indian investments, shows a crying need to rationalise the Indian regulatory framework governing capital flows. The Tata-Docomo dispute made it to the news. There are numerous other instances where Indian residents have used the complex foreign investment regulatory framework to deny contractual rights to their counterparties (see here). While the Delhi High Court order may have put an end to the protracted Tata-Docomo dispute, a permanent solution to the problem calls for a simplified law governing foreign investments. The principles underlying a coherent and simplified design of capital controls framework are discussed here and here.
While transitioning towards a simplified law governing capital controls is a medium term goal, the immediate solution lies in re-thinking the restrictions on fixed returns on Rupee-denominated instruments, applying the tenets of market failure. This is necessary to ensure that the Delhi High Court judgement does not end up incentivising economic actors to either seek recourse through forced international arbitrations (as is reportedly done in China to evade the recent spate of controls on capital outflows) or resorting to a system of individual exemptions from the RBI.
Radhika Pandey is a researcher at the National Institute of Public Finance and Policy. Bhargavi Zaveri is a researcher at the Indira Gandhi Institute of Development Research. The authors would like to thank Ajay Shah and three anonymous referees for their comments and suggestions.