Sunday, March 13, 2016

FDI in retail: Rising demand for a ‘level playing field’

  This article was jointly authored by Satyajit Gupta (Principal, Corporate M&A, Advaita Legal) and Saurabh Sharma (Associate, Corporate M&A, Advaita Legal) and appeared in the Nov 2015 - Jan 2016 issue of Sameeksha, the firm's newsletter.

Birth of e-commerce business

India, as a nation, has gone through a phenomenal change since the advent of 2000s - something which cannot be attributed to one factor. However, a ripple effect of this change was seen and felt across sectors, industries and classes. The first decade of 21st century saw a rise in spending habits, brand culture and preference of 'convenience' over 'cost' which led to growth of branded retail shops, ranging from groceries to apparels. Unlike the local neighborhood stores, these stores provided convenience of 'everything under one roof', more options and better rewards. This also meant that they require large investments and soon it became a preferred choice of business for the key market players of India who had a dream run. 
Fast forward to 2007 - internet was more accessible, banking was getting easier and Indian consumers were ready for another change. They now wanted services being available at their doorsteps rather than waiting in long queues to get things done. It started with e-filing of bills and home delivery of goods but with the birth of Flipkart and Snapdeal, things started to change. Even though there were similar e-commerce websites earlier, the impact and reliability of these two e-commerce market giants caused people to trust electronic payment systems and pre-payment for goods. And it was further propelled by the smartphone revolution in India. It would not be an overstatement to say that today everything is available at your fingertips and spending an entire day to shop groceries seems thing of a distant past. As per a NASSCOM report of October 2015, India is home to more than 4000 start-ups and ranks 3rd globally in this regard.

Modus operandi

From the business point of view, there are two models of e-commerce. The first model is 'Inventory Based' model. In this model, an e-commerce company maintains the inventory of goods it is advertising and is directly engaged in e-commerce. To give context, this is the initial model on which companies like Flipkart and Snapdeal started their operations. The second model, commonly referred as 'Market Place' model, works like exchange for buyers and sellers. The market place provides a platform for business transactions between buyers and sellers to take place and in return for the services provided, earns commission from sellers of goods/services. The ownership of the inventory in this model vests with the number of enterprises which advertise their products on the website and are ultimate sellers of goods or services. In other words, the market place, works as a facilitator of e-commerce. E-commerce companies like Amazon, Flipkart and Snapdeal have now migrated to the 'Market Place' model which broadens their horizon in terms of products and consumers, while reducing their costs of maintaining an inventory.

Legal position

The foreign investment in India is governed by Foreign Exchange Management Act, 1999. The Government of India has also put in place a policy framework on Foreign Direct Investment (FDI), embodied in a consolidated FDI policy which may be updated every year (FDI Policy). 

The FDI Policy provides that an Indian company carrying on the business of wholesale trading can receive 100 per cent FDI through automatic route i.e. without any approval from Government of India. As per the FDI Policy, in order to determine whether a sale is wholesale or not would depend on the type of customers to whom the sale is made and not the size and volume of sales. In contrast to the wholesale trading, FDI is restricted in retail trading. In case of retail trading of products under a single brand, though an Indian company can receive 100 per cent FDI, it would require prior government approval in order to receive equity investments beyond 49 per cent. Even stricter restrictions are applicable to retail trading of products under multiple brands where an Indian company can receive only up to 51 per cent FDI subject to certain conditions and after taking prior permission of Government of India.
Similar regulations apply to e-commerce as well. B2B (i.e. Business to Business) e-commerce transactions are included in the wholesale trade category and therefore, such e-commerce companies which are engaged in B2B wholesale trading are allowed to receive 100 per cent FDI through automatic route. B2C e-commerce companies are subject to the restrictions stated above.

Virtual vs. Real

The law of balance mandates that if e-commerce businesses have to rise, the traditional 'brick and mortar' retailers will be at the losing end. While the consumer base is surely a deciding factor, the rapid growth of e-commerce business can largely be attributed to the foreign investments in the sector - which is a matter of concern for traders operating in the physical space. The traditional brick and mortar retailers have repeatedly claimed that the ecommerce players have arranged their affairs in a manner to circumvent the FDI policy by inviting FDI into themselves and purporting themselves to be only a 'market place'.
They also claim that there is also no difference between physical sale of goods by a retailer or through e-commerce except that in the case of sale in the real world, the goods are seen and felt prior to purchase and delivery is made immediately on payment of price, but in the case of ecommerce the person does not see or feel the goods prior to the purchase but only sees it on the website and on payment of price, the delivery is postponed to the date of delivery through courier. It needs to be noted that while the e-commerce companies are receiving foreign investment claiming that the transactions are B2B, ‘brick and mortar’ traders have not been able to do so. 
It should be noted that the enforcement directorate had investigated companies like Flipkart in past and have found the company in violation of the FDI Policy. These companies established a separate entity to receive foreign investment while a separate entity was transacting with customers and allegedly acting as a front for retail operations.

The legal tussle

In order to bring the much-needed parity between ecommerce and brick and mortar retail trade, the Retailers Association of India (RAI) filed a petition with the Delhi High Court in May 2015 [Retailers Association of India v. Union of India (W.P. (C) 5034/2015)] seeking a 'level playing field' amongst the 'retailers in the physical world' and 'retailers in cyberspace' in relation to application of Indian laws, including the FDI regulations. The petition alleged that the government is treating equals unequally and violating the fundamental right under Article 14 of the constitution; while India bars FDI in e-commerce firms that sell products directly to consumers, foreign companies are allowed to operate online marketplaces that offer a platform for sale of global brands, putting the Indian e-commerce firms at a disadvantage. Even though FDI is not permitted in 'retail trade' (which is Business to Customer (B2C), FDI is permitted in cash and carry 'wholesale trade'.
In 2012, the Government of India allowed 51 per cent FDI in 'Multi Brand Retail Trade' through government approval route with certain conditions which, as claimed by the RAI, are unworkable. There are no distinguishable features mentioned in the FDI Policy as regards 'market-place ecommerce' being different from 'e-commerce'. Ecommerce by an Indian company having a website hosted within India being fully governed by the FDI policy, would be unable to execute any B2C transaction or Consumer to Consumer (C2C) transaction and only allow B2B transaction, if any FDI is invited into the said entity.
The said petition was disposed off by the Hon’ble Court by converting the petition to a representation and directing the Government of India to provide responses upon the representation within four months. We are not aware if the Government actually provided responses to the representation.
Subsequently, in August 2015 the All India Footwear Manufacturers & Retailers Association (AIFWMRA) filed a separate writ petition with the Delhi High Court [All India Footwear Manufacturers & Retailers Association v. Union of India (W.P.(C) NO. 7479/2015)], alleging that the entities retailing goods through the internet are not being restrained from accepting foreign investment which is in violation of the FDI policy and prejudices the petitioners. It has been alleged that the e-commerce companies are evading the law by creating a complex and convoluted business structure by creating a façade of a 'market place' model.
Further, the valuation of the e-commerce websites being manifold, the investment into them despite losses shows that there is a clear financial bungling of the e-commerce entities and there should be an in-depth and a forensic investigation into the matter. The petitioners accused the Government of India of acting arbitrarily and discriminately against the Petitioners in complete violation of Article 14 and 21 of the Constitution of India by warping the level playing field in favour of e-commerce websites who have illegally obtained FDI despite there being a prohibition in the FDI Policy.
AIFWMRA further alleged that the Government of India has allowed the e-commerce companies to artificially and fraudulently purport themselves to be 'market places' to somehow allow them to obtain and use the FDI to the prejudice of the brick and mortar traders. The FDI Policy puts a full ban on any FDI in e-commerce in the B2C sector and also prohibits such FDI where a physical retailer is involved in single brand retail or multi brand retail is entering into the e-commerce sector. However, the ecommerce companies, through separate entities for retail and B2B model, have managed to find loopholes in the FDI Policy. The petitioners claimed unequal treatment of equals by the Government of India. 

What’s next?

While the matter is still pending before the court, it is going through interesting twists and turns. The Delhi High Court in one of the orders observed that there has been 'a prima facie violation' of FDI regulations by the e-commerce companies. The Department of Industrial Policy and Promotion (DIPP), though informed the Delhi High Court that the marketplace model used by e-commerce companies is 'not recognised' in the FDI policy, it does not want the judiciary to interfere in the functioning of executive.
DIPP is of the view that AIFWMRA has failed to show that the FDI policy is arbitrary, mala fide or ultra vires of the Constitution. It is of the view that the policy has been arrived at after detailed consultation with all the stakeholders, and is sound, transparent and predictable with an effective regulatory mechanism. The review of the FDI policy is an ongoing process and significant changes are made in the FDI policy regime from time to time to ensure that India remains an attractive investment destination. Moreover, any violation of the policy is covered by the penal provisions of the Foreign Exchange Management Act, 1999 and would be dealt with by the Enforcement Directorate, which is the competent agency.
The stakes are high. There are compelling arguments from both sides and the industry is tracking each activity on this issue closely. It could bring the next revolution in Indian economy or make it more rigid. In either case, it would be a significant development.
However, the Indian consumers are not complaining. They do not want 'this or that', they want 'this and that'. It doesn’t matter if they can buy a car online, they would still want to take a test-ride at the local showroom beforehand. The 'look and feel' of products still matter to the Indian consumers and therefore, the physical and virtual worlds are required to coexist.

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