VODAFONE saga has occupied the centre-stage of Indian policy and regulatory space for reasons more than one. And most of these issues appear to be legacy issues that it is saddled with after it acquired Indian subsidiary Hutchison Essar Limited (HEL) from Hutchison Telecommunications International Limited (HTIL) in 2007. HEL, rechristened as Vodafone Essar Limited (VEL) after the acquisition and finally as Vodafone India Limited (VIL), is the vortex of all legacy issues.

One such issue that is bound to come under intense scrutiny and influence both the policy and regulatory framework is its latest admission on breach of foreign equity cap of 74% applicable to telecom services providers.

In its latest 20-F filing with US Securities and Exchange Commission (SEC) for financial year ending 31 March 2012, VGP says: “At 31 March 2012, the Group had a 64.4% interest in Vodafone India Limited (name changed from Vodafone Essar Limited on 11 October 2011) (‘VIL') through wholly owned subsidiaries and a further 20.1% indirectly through less than 50% owned entities giving an aggregate 84.5% interest.” It continues: “The Group has call options to acquire shareholdings in companies which indirectly own a further 4.5% interest in VIL. The shareholders of these companies also have put options which, if exercised, would require Vodafone to purchase the remaining shares in the respective company. If these options were exercised, which can only be done in accordance with the Indian law prevailing at the time of exercise, the Group would have a direct and indirect interest of 89.0% of VIL.”

Compare this with what it disclosed a year ago and the breach becomes crystal-clear. In its previous year 20-F filing, VGP stated: “Our aggregate direct and indirect interest in Vodafone Essar Limited (‘VEL'), our Indian operating company, is 59.9% at 31March 2011. We have call options to acquire shareholdings in companies which indirectly own a further 7.1% interest in VEL.

The shareholders of these companies also have put options which, if exercised, would require us to purchase the remaining shares in the respective company. If these options were exercised, which can only be done in accordance with Indian law prevailing at the time of exercise, we would have a direct and indirect interest of 67.0% in VEL. On 30 March 2011 the Essar Group exercised its underwritten put option over 22.0% of VEL following which, on 31 March 2011, we exercised our call option over the remaining 11.0% of VEL owned by the Essar Group.”

The 74% foreign equity cap in telecom services comes with several riders. One of the main conditions is that “Both direct and indirect foreign investment in the licensee company shall be counted for the purpose of FDI ceiling. Foreign Investment shall include investment by Foreign Institutional Investors (FIIs), Non-resident Indians (NRIs), Foreign Currency Convertible Bonds (FCCBs), American Depository Receipts (ADRs), Global Depository Receipts (GDRs) and convertible preference shares held by foreign entity. In any case, the ‘Indian' shareholding will not be less than 26 percent.”

VGP's implicit admission that it has breached FDI cap puts the ball in the Indian Government's court. Would the Finance Ministry use this breach to arm-twist VGP to settle the capital gains tax/withholding tax case? Would the Department of Telecommunications (DOT) issue a show-cause notice to VGP for violation of the stipulation relating to FDI cap in the telecom service license agreement? Or would Department of Industrial Policy and Promotion (DIPP) bail out VGP by seeking Cabinet approval to relax /rewrite the foreign equity cap policy?

In June 2011, DIPP had issued a discussion paper on FDI caps that attracted feedback from several quarters including Vodafone. What is significant to note is the fact that the discussion paper itself was inspired by media write-ups about Essar making a killing from VGP by taking advantage of FDI cap. Essar group sold its 33% stake in Vodafone Essar to VGP at $ 5 billion, a price considered well above the market valuation and expectations. The discussion paper captioned ‘FDI Policy-Rationale and Relevance of Caps' has two media write-ups on Essar-Voda deal as its annexure. One write-up is headlined ‘Passport to Riches – FDI cap allows businessmen to make fortunes only by virtue of citizenship'.

Indian FDI policy specifies different ceilings on foreign equity stake that can be held in India-registered companies in different sectors. The method of computation of these ceilings also varies from sector to sector. The policy maintains four caps starting from 26% in defence sector to 74% in telecom services. The policy provides for 100% foreign equity stake in companies operating in certain other sectors such as chemicals. The two other caps are 49% and 51%. As put by the discussion paper, “The FDI equity caps in a sector essentially reflect the levels of control that a foreign direct Investor is permitted to exercise in a company operating within that sector.”

A few industry experts consider these FDI caps as a major barrier to attracting investments. Others point out that these caps have outlived their utility as they can be and have been circumvented by smart players. Some experts believe that they objective of FDI cap can be achieved by other means such as licensing regulations or other legal stipulations.

As put by the discussion paper, “It is logical to argue that ‘what can be done indirectly, should as well be allowed to be done directly' . Therefore, there is a clear case of abolishing all caps below 49%. In fact, through an inverted pyramid structure of downstream investments, the level of indirect FDI can be even more than 49%. What, therefore, becomes important is not the percentage of beneficial equity but the level of control in a company. Control, perhaps, can be better exercised by having sectoral regulations in sensitive sectors.”

The discussion paper has rightly pointed out that ownership, control and management are emerging as distinct domains in globalized corporate world. Keeping in view this emerging trend, the policy makers have to ponder whether they should regulate control through sectoral policies and laws or through equity caps.

VGP's Dutch subsidiary, Vodafone International Holdings B.V. (VIHBV), has been quite forthright on this count. In its feedback dated 15 July 2011 on the issues raised in the discussion paper, VIHBV tossed the issue back as “the critical question is whether equity cap can be reliably effective in delivering any objective related to control.” It answered: “we think not.” The company wonders how an Indian partner with mandated 26% equity stake as in telecom services sector achieve the policy objective of controlling companies in this arena. After all, 26% stake merely ensures a company board cannot take certain decisions without the presence of the nominee of this stake. It does not empower this stake holder to exercise operational control over the joint venture in which majority stake is held by foreign partner. VIHBV thus concluded: “equity caps are a very blunt weapon in delivering the finer objectives of control. There are more direct and effective means of achieving a desired level of control over entities with foreign ownership.”

The Government can exercise effective control over the companies through a licensing regime in sensitive sectors such as telecom services, defence equipment manufacture and airline operations, where FDI is prohibited at present while is permitted in other segments of aviation sector.As put by VIHBV, “Control and restrictions that are achieved through the license conditions also have the benefit of applying to all licensed operators in a non-discriminatory manner, thus creating a level playing field.” It adds: “A license-based approach also avoids any accusations under the terms of International Trade Agreements of discrimination on the basis of nationality.”

Vodafone as well as other foreign telecom companies have had to go through forced marriages with Indian companies due to policy stipulations. In fact, Indian telecom services sector is replete with stories of clashes and bargains between Indian and foreign joint ventures. It is time to take a definitive call on segregation of ownership and control in strategic and sensitive sectors. This call should not result in waiver to the Vodafone and its ilk for violation of FDI caps. Future policy framework and existing policies are two separate domains.