By increasing the foreign investment limit in the telecom sector, the government has set aside security concerns regarding foreign ownership in order to attract greater investments. It remains to be seen whether the revised policy will improve India’s stagnant telecom sector.

One of the biggest areas of concern for foreign investors in the telecom sector was the sectoral caps imposed on investments into the sector. All investments that resulted in an ownership of more than 49 per cent of the operating company required government approval and no investment of more than 74 per cent of the share capital of the operating company was permitted under the FDI policy. This meant that even pure play telecom companies had to identify local Indian promoters to hold at least 26 per cent  of the investment of the company.

In the capital intensive telecom sector that requires constant investment, this was a significant ask. Not only were there a limited number of domestic investors, but with that level of capital, most of such investors looked at their 26 per cent share in the telecom company as a financial investment and asked for a high return on their capital investment. As a result, telecom investments in the country have been structured as complex arrangements involving put and call options that offer a pre-agreed internal rate of return. Needless to say, this increases the overall cost of the investment by diverting funds away from building out the telecom infrastructure and towards guaranteeing a reasonable return to the Indian investors.

The ostensible reason for limiting foreign investment in Indian telecom companies has to do with the sensitive nature of the sector. The Indian government has always been concerned that its national telecom infrastructure could be compromised in the event of a military strike. This has been accentuated in the context of investments from so-called "unfriendly countries" – a term than has never been exhaustively defined. Earlier iterations of the telecom regulations went so far as to include specific safeguards in the license to guard against companies from certain countries gaining access to and/or control over Indian telecom resources.

Over time, the regulatory regime has been refined to focus attention more sharply on the equipment being used to rollout the telecom network rather than on the actual ownership of the company. The government has put in place stringent conditions on the manufacturers of telecom equipment to ensure that the basic telecom infrastructure does not contain back-doors or Trojan Horses that would allow the system to be compromised in the event of a hostile attack. Now that the primary security concerns of the government are being met more directly by the regulations on telecom equipment, the restriction on foreign ownership becomes less relevant.

With effect from 22 August 2013, the government has increased the FDI limit in the telecom sector to 100%, applicable across various categories of telecom service providers, including infrastructure providers.
While no Indian telecom company has yet applied to the Foreign Investment Promotion Board (FIPB) for an increase in equity ownership, it is expected that several companies will do so soon. It seems unlikely that the FIPB will deny existing foreign investors permission to increase their percentage ownership in existing telecom companies, given that most of them have already obtained FIPB approval to increase their stake above 49 per cent.

What is not so clear is how the FIPB will react to fresh investment applications. It is likely that the concerns around investors from "unfriendly countries" will persist and all applications will be scrutinized from that perspective. However, in the context of the drying up of investments in India, in general, and more specifically in the telecom sector, one would imagine that barring these security concerns, the government would welcome additional investments in the sector.
The increase in foreign investment limits is likely to result in greater inflows of foreign equity into the Indian telecom market. Investors who were reluctant to enter the market, given the rapacious demands of Indian minority shareholders, will be able to invest without the botheration of having to manage an Indian shareholder. Existing foreign investors will welcome the opportunity to clean up their complex shareholding structures to implement a simpler model that will doubtless reduce their cost of capital.

Disclaimer: This article has been authored by Rahul Matthan, who heads the TMT practice at Trilegal and is based out of Bangalore. The contents of this article are intended for informational purposes only and do not constitute legal opinion or advice. Readers are requested to seek formal legal advice prior to acting upon any of the information provided herein.