PRIMER: India's new FDI e-commerce rules

Author: Karry Lai | Published: 21 Mar 2019
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What changes does the e-commerce law bring?

India’s Department of Industrial Policy and Promotion (DIPP) made foreign direct investment (FDI) policy changes to the e-commerce sector that came into force February 1 2019.

Although termed by the government as clarifying measures, the changes have disrupted the e-commerce sector without any stakeholder consultation. "The changes come as a diktat to e-commerce marketplaces to operate purely as technology platforms that provide some additional services such as warehousing, logistics and order fulfilment, but restricting their roles severely in the retail space," said Vaibhav Kakkar, partner at Luthra & Luthra.

These measures came as a surprise to the e-commerce sector and the deadline of merely a month for ensuring compliance was troublesome. Amazon and Flipkart, which was acquired by Walmart in 2018, have been especially hard hit. Several e-commerce companies, including Cloudtail which is 49% owned by Amazon, had to restructure their operations quickly and were forced to withdraw a number of products from their platforms.

Under the changes, marketplace entities or their group companies are not permitted to exercise ownership or control over inventory. A company is deemed to exercise control over inventory of a vendor if more than 25% of purchases of the vendor are from the marketplace or its group companies.

Previously, through their wholesale arms, companies purchased products in bulk directly from original equipment manufacturers at significant discounts. They then sold these products at a discount to vendors, who would then sell them on the marketplace. 100% FDI under the automatic route was permitted in the e-commerce sector, so this process was allowed.

However, with the new restrictions e-tailers will be significantly restricted from acting as wholesalers to the vendors who used to ultimately sell their products on the platforms. Furthermore, marketplace entities or their group companies are prohibited to exercise any equity participation in the vendor. While direct equity participation in sellers is clearly prohibited, it is uncertain if indirect equity participation at the holding company level by the marketplace entities or its group companies would also be restricted.

Another impact of the restrictions is that e-tailers will not be permitted to sell private label products on their platform on which they were earning higher margins and had growth potential. 

See also: India FDI rules vexing foreign investors

How will the rules impact foreign businesses?

Anindya Ghose, professor at the Stern School of Business at New York University, said that the new regulations are semi-protectionist and will directly benefit local players such as Mukesh Ambani's Reliance Retail. "Who has been pulling the strings within the government to make this happen is anybody's guess," Ghose said.

"These new regulations have not been well thought through and present government interference and regulation as a potential risk for global investors." 

In the short term consumers, especially those of smart phones and electronics goods, will be the immediate losers as the deep online discounts from the likes of Walmart and Amazon, will disappear. "Walmart and Amazon will feel more than a pinch," said Ghose. "It is not a big stretch of imagination to understand why Walmart may want to back out of the Flipkart deal as these product categories constitute about 50% of its revenues."

Harish Bijoor, a brand and business strategy expert, said that the key issue is that carefully made plans and joint ventures can go awry with just one dictate. The key challenge is an uncertain regulatory environment. Protectionism is another.

"Protecting the local traditional trader is going to be the imperative of any government that seeks votes in a democracy," said Bijoor. "India is a nation of shopkeepers. At last count, we had 14.6 million shops of every kind. The new e-commerce law to that extent is protectionist and pampers the trader community which is already upset with the government at large."

What are the most controversial aspects?

Up to now, 100% FDI in business to business e-commerce was permitted under the automatic route, which essentially allowed marketplace entities and their group companies to act as wholesalers to the vendors who were ultimately selling products on the platform. However, on account of these new restrictions on inventory control, more specifically the 25% restriction, e-tailers will be significantly restricted from entering into such arrangements going forward.  

"By introducing these disruptive measures the government seems to have changed the rules of the game midway," said Kakkar.

While the objective of the policy to create a level playing field for small traders appears suitable, observers believe that it is unfair that these measures would not apply to domestically owned organised e-tailers. "These organised Indian retailers having deep pockets would continue to pose similar challenges for small traders," said Kakkar.

Further, the policy prohibits marketplace entities from mandating vendors to sell products exclusively on their platform. Such exclusivity provisions are widely prevalent in commercial deals and these decisions may be driven purely by commercial motives. "This restriction goes against the principle of party autonomy and appears to be overboard and not in sync with the objectives that are sought to be achieved," said Kakkar.   

What spurred these changes?

These policy measures were introduced by the government to appease traders associations who were lobbying against the deep discounting by e-tailers and to ensure a level playing field for small traders operating through brick and mortar stores. The changes aim to ensure that e-tail should remain a pure marketplace only and their role should be primarily limited to facilitating transactions between buyer and seller through a technological platform. The idea is to make it difficult for marketplace companies to influence the prices of products to be sold over e-commerce platforms.

Vinay Joy, partner at Khaitan & Co explained that although FDI up to 100% was allowed under the automatic route for e-commerce, FDI in entities engaged in the inventory-based model was expressly prohibited. The issue was clarified in a press note issued by the DIPP back in 2016. However, traditional retailers in India felt that the wording was not stringent enough and that the intended goal of the regulation was not being achieved.

Joy added that with the Indian general elections being held in 2019, the government’s decision to bring in stricter rules for e-commerce is not only to plug the alleged gaps in the FDI policy, but also to create some goodwill with brick and mortar retailers.

How are foreign players reacting? 

Since no extension was given for the February 1 2019 deadline, e-commerce companies began restructuring their ownership in the preferred sellers on their platform to ensure compliance with the new guidelines.

Amazon has brought down its equity stake in Cloudtail to less than 25% and has initiated the same process for Appario, meaning that under the FDI rules these entities are no longer considered as group companies of Amazon. Several private label products are currently unavailable on the platform, and some that were previously sold through preferred sellers are now being sold by third party sellers.

Some observers remain optimistic: "The biggest companies are revamping their play," Bijoor said. "Investors who had put deep money into the old-play are having the carpet pulled from under their feet. It will take time, but they will bounce back."

The DIPP has not clarified whether equity participation refers to direct or indirect participation so this is still up for interpretation. "Structures where subsidiaries of an Indian owned and controlled company carry out e-commerce activities on platforms may be workable,’ said Joy. "But until additional clarity is provided, the viability of such structures will remain debatable."

Given that the government has changed the rules of the game midway with policy changes, in the event that there is a significant decline in sales effected through these platforms the possibility of foreign owned e-tailers invoking the provisions of bilateral investment treaties cannot be ruled out, Kakkar said.

While these disruptive policy measures have definitely created some temporary setbacks for e-tailers, it remains to be seen how much of an impact these measures will have on total sales on platforms in the long run, and, whether these measures will achieve their intended objectives.

See also: Failure to enforce contracts damages Indian FDI