Friday, October 7, 2011

w w w. f i n a n c i a l e x p re s s . c o m

Should FDI in pharma be restricted?

The issue is multi-faceted, with fears ranging from increased FDI making the pharma industry oligopolistic, to raising drug prices for consumers and even focusing less on R&D in drugs that are important for India
NE wonders if anyone would have thought, when the Press Note 4 (2001 Series) was issued in May 2001, that someday it would be used by MNCs to acquire domestic companies. With the re-introduction of product patent for pharmaceuticals, the attention then was focused on attracting foreign investments in new projects. The expectation was that MNCs would live up to theirpromiseof investinginthecountry and bring new technology Howev. er, with some exceptions, the Press Note has remained dormant for eight years. It was only when the MNCs were forced to change their business model with the stagnation in the mature markets and the growing challenge of the Indian generics in their own backyard, that they started looking at the Press Note 4 as a solution to their problems. They saw an opportunity in takeovers of domestic companies to stave off the challenge from the Indian generics and an opportunity in the generic business from the patent cliff. They also saw an opportunity in the emerging markets to leverage their well-oiled sales and marketing infrastructure to capture a share of the rapidly growing demand for medicines. The acquisition of domesticcompanieshelpedthemto fast-track their new business model. The change in the business model of the MNCs have posed new challenges for the government. It is faced with a dilemma over the FDI policy in the pharmaceutical sector. Should it or should it not fine-tune the Press Note 4 of 2001 with regard to the changed global situation? If it does not, what could be the consequences for public health and the sunrise domestic pharmaceutical industry , which has become the pride of the nation? If it does, and musters courage to fine-tune the FDI policy for the pharmaceutical sector, would it provideahandletoMNCs(whichhaveinvested substantial sums in acquiring domestic companies, but very little in technology transfer or local production of patented medicines) to discredit the government? The governmenthastomakeupitsmindwhether pharmaceuticals is a sensitive industry In doing so, it has to bear in mind . that it is sensitive not only due to ac-

Reflect 9

DG SHAH
GOVERNMENT CANNOT AVOID FINE-TUNING THE FDI POLICY WITH A VIEW TO ENCOURAGE DISCOVERY RESEARCH, TRANSFER OF TECHNOLOGY AND PREVENT GROWING DEPENDENCE ON IMPORTS OF PATENTED MEDICINES

TAPAN RAY
ANY MOVE TO RESTRICT FDI IN THE PHARMA INDUSTRY WILL BE A RETROGRADE STEP IN THE FINANCIAL REFORM PROCESS OF INDIA, ADVERSELY AFFECTING FDI NOT ONLY IN THE PHARMA SECTOR, BUT POSSIBLY FAR BEYOND IT

Ideas caFE

cess to medicines, but also important to retain the competitiveness of the entire manufacturing sector to controlthehealthcarecostsof employees in the organised sector. If it decides to respond to the changed global situation and correct the unintended use of the Press Note 4, the second dilemma is how to do so. The Planning Commission Committeehassuggestedthatitshouldbeleft to the Competition Commission of India (CCI). However, CCI is only a regulator and for the regulator to be effective, it needs a policy framework within which to operate. The government needs to first lay down or modify the FDI policy insofar as it relates to the pharmaceutical sector. The regulators role then is to implement it. Merely empowering CCI to examine every deal will not serve the purpose. Moreover, without a policy framework, it would be very arbitrary to establish dominance to invoke provisions of the Competition Act in a highly fragmented pharmaceutical market where 50 companies arecompetingforan80%shareof the market. Yet, collectively, the MNCs can continue to acquire a dominant share of the market and change the structure of the domestic industry . The government, therefore, cannot

avoidfine-tuningtheFDIpolicywitha view to channelising FDI in the pharmaceutical sector in a manner that would encourage discovery research, transfer of technology prevent grow, ing dependence on imports of patented medicines and encourage backward integration to the API. These foreign investments can be through the automatic route and allow up to 100% ownership. However, mere acquisitions of the existing domestic companies do not serve the country . They do not augment capacity do not , create jobs and more often reduce the competition, to the detriment of the consumer. They may even induce or force the surviving domestic companies to get out of the pharmaceutical business. These FDIs may not serve the larger national interests and may even compromise the medicine security as has happened in several coun, tries in the past. They therefore, re, quire filters to be selective. Both the FIPBrouteandtheCCIcancontribute effectively .Thefearof arbitrarinessin their decision-making can be allayed through well-defined conditionality . The author is CEO, Vision Consulting Group (www.vision-india.com), and secretary general of Indian Pharmaceutical Alliance

HE consolidation process within the pharmaceutical industry in India started gaining momentum since 2006, with the acquisition of Matrix Lab by Mylan. 2008 witnessed one of the biggest mergers in the industry till that period, when Daiichi Sankyo of Japan acquired Ranbaxyof Indiafor$4.6billion. Last year, Abbotts acquisition of Piramal Healthcare for $3.72 billion followed several media reports on the governments keen interest in instituting new restrictions on foreign direct investment (FDI) in the pharmaceutical sector due to various apprehensions. First, it feared that this will create an oligopolistic market, with an adverse impact on public health interest. The Indian pharmaceutical market (IPM) has over 23,000 players and around 60,000 brands. Consolidated Abbott, being the largest domestic player, enjoys a market share of just 6.1% in a highly fragmented market. Thus, the apprehension that an oligopolistic market will be created through acquisitions by the MNCs is unfounded. Thesecondfearwasthatitwilllimit the power of the government to grantcompulsorylicences(CL).With

a CL, the government can authorise any pharmaceutical company to make any medicine required by the country in an emergency situation for public health interest. With more than 20,000 registered pharmaceutical manufacturing companies in India, there will always be skilled manufacturers willing and able to make much-needed medicines, as happened during the H1N1 influenza pandemic. The creation of a legal barrier by putting a cap on FDI to prevent domestic pharma players from voluntarily selling their respective companies at a lucrative price, just from the CL point of view, sounds highly protectionist in the globalised economy . The government also believes that lesser competition will push up drug prices. The equity holding of a company has no bearing on prices or access, especially when prices are governed by the National Pharmaceutical Pricing Authority (NPPA) and competitionpressure. Thus, prices of medicines of Ranbaxy Shantha Biotechnics and , Abbott have remained stable even after acquisition. Both greenfield and brownfield FDI contribute not only to the creation of high-value jobs for the country but also improve ,

accesstohigh-techequipmentandcapital goods. Technological cooperation with the MNCs stimulates growth in the manufacturing and R&D spaces of thedomesticindustry . Any restriction to FDI in the pharmaceuticalindustrycouldmake overseas investment even in the R&D sector less attractive. India has already suffered a 40% drop in FDI between 2009 and 2010, with a 17% drop in pharmaceutical FDI. Foreign investors look up to India for cost arbitrage and expertise in contract research and manufacturing services for improved market access. Thus, FDI can lead to increased domestic exports. Countries like China and Brazil have programmes to encourage partnerships with MNCs to bolster their domestic industry, helping the nation to benefit more from FDI. Protectionism is harmful, aptly commented Pranab Mukherjee, the finance minister, in the context of the US move to hike visa fees and clamp downonoutsourcing. It is ironic that, almost at the same time,ourgovernmentismullingaproposaltodoawaywiththecurrentpractice of allowing 100% FDI through the automatic route with similar protectionist measures. This is happening at a time when any possible adverse impact of M&As on competition is being effectively scrutinised by CCI and anyunreasonablepriceincreaseisbeingeffectivelyaddressedbytheNPPA. The pharmaceutical sector was openedupfor100%FDIthroughtheautomatic route only in 2002 as a part of the financial reform process, positioning India as an attractive investment destination for pharmaceuticals. This reform process needs stability as, by , partnering with MNCs, local drug companies have begun to gain access tointernationalexpertise,technology , resources, good manufacturing practicesandmarkets. Any move to restrict FDI in the pharmaceutical industry will be a retrograde step in the financial reform process of India, adversely affecting FDI not only in the pharmaceutical sector,butpossiblyfarbeyondit. The author is director general, Organisation of Pharmaceutical Producers of India (OPPI)

The governments call on options

VAIBHAV KAKKAR
HE last few months have been a nervous time for Indian financial markets, with the fear of another global economic downturn as a result of the continuing Eurozone crisis. Amidst this, not much attention was paid to the fact that the Reserve Bank of India had in recent months issued show-cause notices to certain Indian companies where foreign investors had sought to exit their investments through a socalled put option. Even as the debate on RBIs stance on this exit-related issue, both at a legal and a policy level, began gathering steam, in an extremely surprising move, the Ministry of Commerce in its revised Consolidated Policy on Foreign Investment issued last Friday, has announced that all FDI instruments issued/transferred to nonresidents having in-built options or supported by options sold by third parties would lose their equity character. As per the revised policy, such instruments would be regarded as debt and would be subject to compliance with the highly restrictive ECB guidelines. The effect, plain and simple, is to render a number of corporate transactions involving such options, across several sectors, virtually impossible. An option is essentially a right (but notanobligation)of theholdertobuyor sell an underlying asset in the future, at a specified price. In the present context, a put option is the right of a holder of shares in a company to sell those shares to another person at a specified price, while a call option grants a person the right to acquire shares in a company from an existing shareholder at an agreed price. From a foreign investors perspective,optionsareparticularlysignificant in two contexts. Call options are useful to strategic investors in sectors such as insurance and telecom, where foreign investment is currently subject to sectoralcaps,asitgivessuchinvestors,who may have expended significant efforts

The commerce ministrys latest announcement on FDI instruments is especially concerning given how critical foreign inflows are to Indias growth story
and resources in establishing the company and business, the right to acquire further shares in the event the sectoral caps are enhanced. Put options assume significance for investors such as private equity and venture capital investors, who are essentially in the nature of financial investors. While investinginpromoter-controlledIndian companies, options are used by such investors as a device to ensure adequate returns, where an exit is provided through a put option upon its controlling shareholders in the event the company does not meet certain benchmarks, or fails to list on the markets. The enforceability of options in the respect of shares of Indian public companies (whether listed or unlisted) has been the subject of intense debate in the past, and their legality under Indian securities laws has been questioned, primarily on the basis of two arguments: (i) Section 111A of the Companies Act, 1956 mandates that shares of public limited companies shall be freely transferable, and, therefore, any call option in relation to such shares impinges upon their free transferability; and (ii) options contracts for the sale and purchase of shares entered into outside the stock exchange mechanism are not permitted under the provisions of the Securities Contracts (Regulation) Act, 1956 (SCRA). While the issue of free transferability of shares is far from conclusively settled, a division bench of the Bombay High Court last year in respect of securities of a public unlisted company held that the concept of free transferability under the Companies Act does not mean that a shareholder cannot enter into consensual arrangements with a third party in relation to its specific shares. The court observed that intrinsic to the concept of free transferability is the right of a shareholder to deal with the shares in the manner that it deems fit, including the right to pledge, mortgage or grant rights of preemption regarding his shares, as in the case of any other movable or immovable property in India. From an SCRA perspective, Sebi has generally been averse to options in respect of public securities entered into outside the stock exchange mechanism. However, it is extremely pertinent to note that the central government, in the exercise of its power under the SCRA to exemptcertaintypeof contracts,hadissued a notification as far back as 1961 exempting contracts for pre-emption or similar rights contained in promotion or collaboration agreements, or in the articles of association of a company, from the application of the SCRA. Accordingly ,aplainreadingof thelawsuggests that option arrangements between existing venture partners/ shareholders contained in joint ventures (JV) or collaboration agreements fall outside the purview of the SCRA. Perplexingly however, neither Sebi nor , any judicial authority has opined on the implications of this notification in the several instances when they have ruled on the validity of options. Amidst conflicting signals on the legal status of options, the stand taken by RBI, and now the policy decision of the Ministry of Commerce virtually prohibiting options being granted to nonresident investors, is extremely unfortunate and disruptive. The RBI position, as may be gathered from media reports, is that under the provisions of the Foreign Exchange Management Act, 1999 (FEMA), that no other class of foreign investor other than Sebi-registered FIIs and NRIs are allowed to enter into any derivative contract where the underlying asset is an equity share of an Indian company . This view is simplistic, flawed at some levels, and an unduly technical interpretation of the foreign exchange regulations. First, such a position finds no mention in the provisions of FEMA and the rules framed thereunder. Second, such an interpretation completely ignores the well-established practice of options over shares of Indian companies being granted to resident and non-resident shareholders to protect their investment positions including resolution of deadlocks and default or breach scenarios between the parties. Third, it is apparent that when such arrangements are entered into with no speculative intention, they have been encouraged by the government which had taken the proactive step (as early as in 1961!) to exempt such arrangements from the provisions of the SCRA in the interests of trade, commerce and economic development, and they should therefore not be considered violative of the intended objective of restricting non-residents from entering into derivative contracts in respect of Indian securities. Fourth, at a policy level, while there may be a concern that some foreign investors are not taking genuine equity positions (with its attendant risks) in Indian companies, and instead seeking an exit at guaranteed returns (with debt thereby masquerading as equity), this practice by a few cannot be the basis for a reclassification of all equity is-

suances with in-built options as debt. The intended policy objective of this restriction is especially unclear in the respect of call options provided to nonresidents, which are nothing but a right to acquire shares at a later date, subject to compliance with the minimum prescribed pricing guidelines and the FDI policy. It is also unclear why genuine commercial transactions, where the non-resident investor is provided an exit at the then prevailing fair market value, should be painted with the same tainted brush. Finally, in sectors where ECB is permitted, there is no question of opportunistic parties trying to disguise debt as equity Accordingly, if the . intent had been to prevent debt masquerading as equity, it would have been appropriate to limit the present restriction on options to certain specific sectors where there was a concern. The current regulatory position appears to take a uniform stand on such structures, instead of laying down policy guidelines or tests to determine what constitutes a genuine equity position in Indian companies. While efforts have been made by the government in the pasttostreamlinethepolicyandmakeit conducive to foreign investors, in a classic case of throwing the baby out with the bathwater, this recent policy prescription is bound to seriously impact genuine commercial transactions, and has the potential to destroy an investorfriendly climate painstakingly built over the years. It is all the more worrying that the government has pushed through this change without the slightest hint of any formal consultation with stakeholders, a process which had become almost customary in respect of major policy changes and has been welcomed by all. This gains special significance in the context of the current turbulent economic climate, where the government acknowledges that increased forex inflows are crucial to achieving the avowed objective of 9% growth. It is absolutely imperative that the government intervenes immediately to clarify the intent and scope of this restriction on options, as it places a question mark not only on any increase in foreign investment, but even its sustainability at current levels. The author is a senior associate, Luthra & Luthra Law Offices