Legal reform as a factor in economic reform: The Indian experience

Author: | Published: 12 Jul 2001
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The government of India began the process of economic liberalization and reform in 1991, a process that has continued to date. This article focuses on legal reform in India during this period to highlight the fact that India embarked on an ambitious agenda of legal reform to support its economic reform process. The article is divided into the following sections:

Entry of foreign capital

Globalization of Indian business

General statutory and regulatory reform

Sector-specific statutory and regulatory reform

Conclusion

Entry of foreign capital

To liberalize its economy, permit the entry of foreign capital, continue the trend of capital account inflows exceeding the current account deficit and the need for Indian industry to access capital and technology, the Indian government and regulators adopted a policy of gradually opening up the Indian economy.

  • The foreign direct investment (FDI) regime

Consistent with the gradual liberalization of the sectors in which FDI would be permitted, the Indian government recently opened up the defence sector to private participation (subject to licensing), with 26% FDI being permitted. FDI in the drugs and pharmaceuticals sector, and in city and regional-level urban infrastructure facilities such as road and bridges is now permitted up to 100%. FDI in the information technology sector and B2B e-commerce is permitted up to 100%, though FDI in B2C e-commerce requires the approval of the government. Foreign investment in courier services, the hotel and tourism sector and airports has been liberalized. FDI in select telecom services like ISPs providing international gateways, radio paging and end-to-end bandwidth providers is permitted to the extent of 74%, and 100% is permitted for ISPs not providing international gateways (though FDI in excess of 49% requires the prior approval of the government). Cellular and basic telecom is still restricted to 49% FDI, while insurance is restricted to 26% FDI.

As a consequence, India now permits foreign participation in almost all businesses and there are very few areas (such as print media and the retail trade industry) that are out of bounds to foreign investment.

Foreign institutional investors

One of the main components of capital inflow into India is by way of investment by foreign institutional investors (FIIs). FIIs registered with the Securities and Exchange Board of India (SEBI)can now make portfolio investments in Indian companies up to a maximum of 49% (an increase from the earlier 40% limit) of the capital of the company, subject to shareholders' approval by a special resolution. Such investments are, however, not permitted in Indian companies engaged in the print media sector.

Venture capital funds

To encourage nascent business, the government and SEBI have sought to regulate the venture capital industry through separate regulations for foreign and domestic venture capital funds/companies (VCFs). Regulations have been introduced that prescribe a framework aimed at encouraging a diverse investment strategy. For example, a foreign VCF cannot invest more than 25% of the funds committed for investments to India in one portfolio company, and at least 75% of the funds set aside for India is required to be invested in unlisted equity/equity-linked instruments. It is possible for a foreign VCF to own the entire capital/funds of a domestic VCF. Recent amendments to the income tax law have clarified that gains realized by a VCF from divestment of shares held in companies that are primarily listed or to be listed Indian companies, will continue to be exempt from tax even after listing.

Globalization of Indian business

Over the last few years, the government and the Reserve Bank of India have permitted Indian companies to look globally to raise capital or acquire companies. A number of Indian companies have raised capital under the GDR/ADR route and have acquired companies abroad (by way of cash or an ADR/GDR stock swap route).

American depositary receipts (ADRs) and global depositary receipts (GDRs)

Indian companies have been permitted to issue GDRs/ADRs for a number of years. Recent changes on the ADR/GDR front with respect to dual fungibility of ADRs/GDRs, utilization of 100% of the ADR/GDR proceeds for international acquisitions, and permitting a secondary sale of shares by existing private Indian shareholders (and not just the government of India as has been the case until now) through an issue of ADRs/GDRs) is expected to give a significant fillip to such transactions.

Cross-border acquisitions

Pursuant to recent amendments, Indian companies can now invest without any governmental approvals in companies organized outside India up to $50 million on an annual basis without being subject to any profitability criteria. Previously, a company could make overseas investments only if it had a track record of profitability in the immediately preceding three years. Further, this $50 million limit was previously applicable to a block of three financial years. Acquisitions beyond the $50 million limit would require the prior approval of the Reserve Bank of India (unless permitted without governmental approvals under another scheme). Partnership firms, duly registered in India, providing professional services have also been permitted to make overseas investments.

Special economic zones (SEZs), software technology parks and electronic hardware technology parks

The Export-Import Policy has introduced a new scheme for the establishment of SEZs across the country, with a view to providing an internationally competitive environment for export production. The units operating in these zones would be deemed to be outside the country's customs territory and will have full flexibility of operations. Prior to the SEZs, the government had permitted the setting up of software technology parks and electronic hardware technology parks. Significant tax incentives were provided for business activities conducted in such parks. A number of such zones/parks have been established.

General statutory and regulatory reform

To permit greater freedom in the nature of corporate transactions, as well as fulfil the need to lay down a clear policy and regulatory framework and ensure compliance with international obligations and to modernize Indian law, there have been significant changes made to various Indian commercial laws and regulations.

Exchange control

To prescribe a regulatory framework that moves from the regulation of exchange control (with penal consequences for non-compliance) to the management of foreign exchange, the Foreign Exchange Regulation Act 1973 was replaced with the Foreign Exchange Management Act 1999. This replacement has led to a clear distinction between capital account transactions (which are still subject to significant regulation albeit much less) and current account transactions (which have been liberalized significantly). In addition, violations of exchange control regulations result only in civil penalties and not in criminal prosecution. With this change, India has put in place the legislative framework for full convertibility of the Indian rupee on the capital account, as and when appropriate.

Transfer pricing

Transfer pricing regulations have recently been introduced in the Income Tax Act 1961, and provide that pricing of international transactions between two associated enterprises (either or both of whom are non-Indian residents) should conform with the arm's-length principle. Exhaustive and extremely wide definitions of "international transactions", "arm's-length price" and "associated enterprises" have been provided.

Detailed methods (examples being the resale price method, cost plus method etc) for calculation of the arm's-length price have been prescribed. The burden of proof is spread over the taxpayer and the revenue authorities. The revenue authorities can, only after giving the taxpayer an opportunity to explain, determine the price based on the arm's-length principle. A penalty is levied to the extent of three times the amount of tax sought to be evaded or avoided in addition to the additional tax determined to be payable.

Intellectual property

To address the needs of globalization, a new Trade Marks Act 1999 (which is expected to be brought into force in July/August 2001) has been passed adopting the international classification system with regard to the registration of marks. Consequently, the new Act provides for the registration of service marks and expands the classes of goods/services in which registration is permitted. The period of registration of a trademark has been increased from seven years to 10 years. The Act also recognizes the concept of "well-known trade marks" and "collective marks".

The Copyright Act 1957 has been amended in 1994 and 1999. The effect of the former amendment was to expand the definitions of certain key phrases such as "literary work" and "computer program". The prerequisites for the assignment of copyright were clearly stipulated and clear remedies were provided for insufficient exercise of assigned right and/or for non-payment of royalties by the assignee. The latter amendment introduced the concepts of the exclusive right to sell/rent computer programs in the bundle of rights available to copyright holders in computer programs, and expanded the principles of "fair use" in relation to computer programs.

India has also passed the Geographical Indications of Goods (Registration and Protection) Act 1999, to comply with TRIPS obligations. The Act is expected to come into force in the next few months and seeks to provide for a sound protection in foreign countries regime for geographical indicators – which would give India the right to claim protection for its geographical indications of goods.

Finally, the patents law in India was amended in 1999 to ensure compliance with obligations under TRIPS, particularly with respect to exclusive marketing rights and to permit product patents for medical drugs.

Alternate dispute resolution

The Arbitration and Conciliation Act 1996 (replacing legislation from 1940) was passed by parliament to bring India in line with international standards of commercial dispute resolution mechanisms (both arbitration and conciliation) and to provide for the enforcement of foreign arbitral awards in India under both the New York Convention and the Geneva Convention.

Significant changes to securities laws

The Securities and Exchange Board of India (SEBI) was established in 1991 as India's capital market regulator and its powers have increased from time to time. Over the last 10 years, SEBI has prescribed a detailed regulatory framework on a number of issues, including:

strengthening of disclosures at the time of listing and on a continuous basis through disclosure and investor protection guidelines prescribed by SEBI and by amendments to the listing agreements with the stock exchanges;

a comprehensive takeover code which stipulates that any person who together with persons acting in concert with it acquires 15% or more, or acquires control, of a listed Indian company is required to make a public offer to the shareholders of the said Indian listed company agreeing to acquire from them an additional 20% (at least) of the total paid-up capital of the company. SEBI has set up a committee that is now in the process of amending these regulations;

Indian listed entities are now required to ensure that they have independent directors on their boards, an independent audit committee and make detailed disclosures on a variety of corporate governance issues; and while India has had stringent regulations prohibiting insider trading since 1992, the lack of an effective enforcement mechanism has seriously compromised the effectiveness of these regulations. Regulatory changes are being made to ensure that corporate India regulates itself through the appointment of compliance officers and ensuring that its employees trade within "trading windows". In addition to insider trading, regulations to prevent manipulation of the markets through unfair trade practices have been in place for some time.

Amendments to the Companies Act have been made from time to time to ensure that the company laws in India keep pace with the needs of the market. Recent years have seen amendments/regulations permitting the buy-back of shares by Indian corporates subject to a maximum of 25% of the total paid-up capital and free reserves of the company and other conditions, the issue of shares with differential rights (which were permitted only for private companies) and the issue of employee stock options. A recent amendment has empowered the government to make rules applicable to the offering of Indian depositary receipts. This is an interesting development, since the introduction of a legal framework would facilitate several companies from the Asia-Pacific region to list on Indian stock exchanges.

The most notable development in the secondary market has been the introduction of derivatives trading (futures contracts, stock index futures and stock index options) on Indian stock exchanges. In addition, internet trading has begun, with SEBI prescribing technical standards to be enforced by Indian stock exchanges for ensuring the safety and security of transactions over the internet. Finally, to achieve increased transparency in the functioning of SEBI, recent amendments have created a Securities Appellate Tribunal to consider appeals of the decisions of SEBI.

Anticipated statutory changes

It is expected that the government will introduce legislation (drafts have already been prepared) with respect to insolvency of companies and competition law, to parliament in the immediate future. The former is intended to speed up the process of winding up defaulting companies and the recovery of dues of creditors by liquidating the assets of defaulters. The latter seeks to establish an anti-trust authority in India that would be entitled to intervene in M&A transactions to prevent monopolistic tendencies. In addition, it is expected that legislation to regulate financial companies will be placed before parliament in the near future. There are also proposals to pass a money laundering statute (a draft of which was circulated two years ago), new legislation to protect industrial designs, and a special statute to protect the intellectual property in semiconductors.

Sector-specific statutory and regulatory reform

As the Indian economy grows and India integrates into the global economy, the need for sector-specific regulatory reform has been acutely felt for two reasons: inputs from experts given rapid changes in technology and/or the need to establish independent regulators.

Electricity

The legal framework for the power sector over the years has comprised the Indian Electricity Act 1910, which deals with the transmission, supply and use of electricity, and the Electricity (Supply) Act 1948, which established three statutory bodies at the central, regional and state level to govern the generation, transmission and distribution of electricity. Parliament passed the Electricity Regulatory Commission Act 1998 recently to establish a Central Electricity Regulatory Commission and State Electricity Regulatory Commissions for the rationalization of electricity tariffs and the promotion of transparent and efficient policies. Any reform of electricity laws in India would necessarily involve the state governments, since electricity falls within the "concurrent list" of the Indian Constitution and therefore both the central and state governments have power to regulate electricity. A few states have sought to reform the state electricity boards set up under the Electricity (Supply) Act 1948 to provide for a State Electricity Regulatory Commission, and separating the board into separate companies for generation, transmission and distribution. To encourage the state governments to reform their electricity boards, preferential investment and surplus power would be made available from the central pool, only if they undertake reforms.

National highways and roads

The National Highways Act 1956 and the National Highways Authority of India Act 1988, provide the legal framework in relation to national highways and roads. The former provides the government with the power to notify any highway as a national highway. The latter establishes an authority for the development, maintenance and management of national highways. Private participation in highways is being permitted by way of rules first introduced in 1997 under the former legislation.

IT services

India has passed the Information Technology Act 2000 (IT Act) to grant legal validity to e-commerce transactions. The IT Act facilitates the electronic filing of documents with government agencies and has introduced the concept of digital signatures to be used for authentication of an electronic record. The IT Act establishes a Controller of Certifying Authorities to regulate the provisions of the Act particularly with respect to granting a "certifying authority" licence to persons who seek to issue digital signatures. The Controller may, with the previous approval of the government, recognize a foreign certifying authority for the purposes of the Act. No person has, to date, received a licence to act as a certifying authority.

Telecommunications

Legislation from the 19th century, the National Telecom Policy and licences issued by the government with respect to different telecom value-added services regulate the telecommunications industry. The development of the industry was hampered due to conflicts between the erstwhile Department of Telecommunications of the government and the Telecom Regulatory Authority of India (TRAI), which was set up to regulate the telecom sector. These conflicts have been resolved by splitting the TRAI into two bodies, one with recommendatory and regulatory functions and the other with adjudicative functions (the Telecom Tribunal). In addition, the Department of Telecom Services – the department that provided telecommunication services – was corporatized in October. This has resulted in a clear separation of policy/licensing functions and service provision functions.

The Videsh Sanchar Nigam Limited (VSNL) continues to have the exclusive monopoly to provide international long-distance telephony, though the government has decided to permit private participation by 2002. ISPs have, however, been permitted to establish international gateways. In line with India's WTO commitments, the government has also liberalized national long-distance (NLD) telephony, and guidelines for licensing are now in place. Guidelines for licensing of infrastructure providers have also been prescribed.

Media and broadcasting laws

The film sector in India has largely been unregulated and has not been entitled to access funds from the financial and banking community. Recently the government accorded the status of an "industry" to the film sector, and consequently the RBI has framed broad guidelines regarding bank finance for the production of films. Banks are now permitted to provide finance (where the total cost of production does not cross Rs100 million) to film producers (corporate or non-corporate entities) with a good track record in their relative fields.

The government has permitted the use of Ku band in India for broadcasting and has thereby opened up the market for direct-to-home (DTH) services in India. The government has also liberalized the norms for uplinking to Indian and foreign satellites (provided such satellite has been coordinated with the INSAT system) by Indian companies (foreign participation up to 49% has been permitted).

Insurance

The liberalization of the Indian insurance sector took place with the passing of the Insurance Regulatory and Development Authority Act 1999, which established the Insurance Regulatory and Development Authority, and the passing of amendments to the Insurance Act 1938. The cumulative effect of these changes has been the participation of the private sector in insurance and the breaking of the monopolies of the Life Insurance Corporation of India and the General Insurance Corporation of India, foreign participation to the extent of 26%, and empowering the authority to prescribe regulations for the conduct of insurance business in India. A number of Indian companies have entered into joint ventures with foreign insurance players and have begun offering insurance services in India.

Conclusion

The link between economic reform and legal reform is particularly interesting given the existence of a well-established constitutional and democratic system in India, an independent judiciary, and the need for Indian institutions to act in a manner that is consistent with the rule of law and transparency in all aspects of its functioning. India has the longest written Constitution in the world, with a guarantee of "fundamental rights" and an elaborate set of economic and social principles for governance (though these principles are not enforceable in a court of law).

In the last 10 years, the Indian economy has taken important steps towards a market economy, which is poised for growth. A prudent monetary policy and rationalization of the tax regime has seen growth in India accelerating while inflation has been declining. Interest rates are down and foreign exchange reserves are up (to the tune of over $40 million at present). GDP growth in India has seen a consistent increase on the back of the growth of the service sector, the depreciation of the rupee against the dollar, and the growth of the US and European markets. Industrial growth has steadily grown though there has been a recent slackening. Consistent with WTO commitments, India has removed quantitative restrictions on the import of most items, though the impact of the movement of international oil prices is significant on India's import bill.

Over the next few years a number of variables will determine the success of economic reform and, by necessary extension, legal reform. The success of the privatization of government companies like VSNL, Air India and CMC Limited would contribute to a positive Indian sentiment and showcase the commitment of the government to reform. Political stability/consensus would ensure continuity of the policies. Water management policies to reduce the dependence on the monsoons would go a long way towards ensuring the success of the agricultural sector on which much of India is dependent. Fiscal responsibility is an important consideration, and recognized deficit. In addition, it is imperative that economic and legal reform percolates to all the state governments.

New business opportunities such as the pharmaceutical and biotechnology sectors should grow in India and will require clarity on a number of legal issues. Technological developments such as convergence would require the establishment of a licensing and regulatory framework for carriage and content in the age of convergence of telecommunications, broadcasting, multimedia and other related technologies. This fact has been recognized, as the government has already made public a draft of proposed convergence legislation that it hopes to pass in the near future. In conclusion, the pace of legal reform in India will need to increase with economic reform.


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