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.

©
2016 Advaita Legal. All rights reserved.

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