Introduction
India’s foreign investment landscape is currently undergoing a transformative restructuring. It is proposed to be designed to modernise capital inflow mechanisms and simplify compliance frameworks. On July 21, 2026, the Reserve Bank of India (RBI) released “The Draft Foreign Exchange Management (Foreign Investment) Rules, 2026 (Draft FI Rules)” for public consultation. Once formally notified, these proposed rules will replace the existing “Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (NDI Rules).” Aligns the Union Budget’s 2026-27 objective of the investment regime and the government’s eagerness to promote and ease investment. The Draft FI Rules adopt a principle-based approach with the aim of reducing the regulatory complexity.
One of the hallmarks of proposed restructuring seems to be building a distinct separation of the duties and functions of regulators. The new regime would give the RBI the power to administer, interpret, and issue regulations and clarifications about the rules. At the same time, a separate regulatory function is mandated on the foreign investment policy by giving a fresh mandate to the “Department for Promotion of Industry and Internal Trade (DPIIT)” to interpret the policy and issue circulars. The article critically reviews the Draft FI Rules with a focus on the structural classifications, the stance taken towards pledges as a mode of investment and the strengthening of the protections of beneficial interest, both reviewed against the backdrop of recent landmark decisions and in practice for corporate professionals.
Definitions and Classifications as Required
The Draft FI Rules seek to regulate and consolidate fragmented entity categories into a unified framework.
1. Eligible Investee Entity
The rules consolidate and replace the various schedules into the umbrella term “Eligible Investee Entity”. This definition is consolidated and includes companies and body corporates created under Central or State Acts. “It clearly covers the Limited Liability Partnerships (LLPs), SEBI-registered investment vehicles (such as Real Estate Investment Trusts (REITs), Infrastructure Investment Trusts (InvITs), Alternative Investment Funds (AIFs), Venture Capital Funds (VCFs) and Mutual Funds or Exchange Traded Funds (ETFs) investing more than 50% of their assets in equity), partnership firms and sole proprietorships.”
2. Definition of Equity
The Draft FI Rules, in a major deviation from the “NDI Rules”, defined the term “equity instruments” as a list of instruments which were compulsorily convertible into equity shares or may contain an optionality clause but with certain restrictions relating to lock-in or without any right to exit at an assured price. However, the proposed framework definition of ‘Equity’ has been proposed to directly link the treatment of the instrument to applicable accounting standards that apply to the eligible investee entity. Equity is now defined to include instruments classified as equity by the “eligible investee entity (excluding investment vehicles) under accounting norms, units of SEBI-registered investment vehicles, and participating interests in oil fields or mines.”
3. Foreign Investment
A proposal has been made to consolidate both direct and indirect investments in the single term “Foreign Investment”. Further, indirect investments can occur through a Foreign Controlled Entity (FCE), which is similar to the earlier term “Foreign Owned or Controlled Company” or any non-resident person under “control or common ownership or control of a person resident outside India”.
4. FDI and FPI
Proposed introduction of criteria of less than 10% of diluted equity to be a foreign portfolio Investment seems to be a transformative reform towards ease of doing business. It has the potential to attract a large number of foreign investors, who are looking for investment opportunities in the fast-growing economy of India without facing much hassle relating to approvals, etc. However, the Draft FI Rules has not explicitly provided for governance of foreign portfolio investment, and it is expected to provide a detailed framework once the same is formalised.
“FDI, as per Annexure II of the draft rules, is managed by the Consolidated FDI Policy laid down by the DPIIT in Chapters 3, 4 and 5. They provide general conditions on FDI, procedures for government approvals, and sector-specific conditions on FDI. It requires foreign investment of 10% or more in equity.”
Pledges as a Mode of Acquisition
The recognition of pledges without the “Debt Instruments Rules” is a noteworthy change in the earlier “FEMA (Non-Debt Instruments) Rules, 2019”. Previously, the equity pledges were restricted to certain prescriptive offers, such as equity pledges from resident promoters for external commercial borrowing from AD Banks and/or overseas banks and equity pledges from non-resident promoters for specific credit facilities from domestic banks.
The 2026 framework makes no such restrictions on lenders. Instead, it adopts a principles-based approach which will enable foreign private credit funds and institutional investors to provide acquisition financing globally via collateralised lending.
This business growth, however, will have to be restricted to the narrow lanes of the statutory foreign exchange control. In the case of “PTC India Financial Services Ltd. v. Venkateswarlu Kari (2022)”, the Supreme Court has cleared the air between absolute ownership and contractual remedy under the Indian Contract Act, 1872, and the public policy mandates by holding that neither invoking pledge nor depositary registration translates into absolute ownership.
Absolute title can only be obtained by final sale from a third party.
As a result of the enforcement of the pledge, equity transfer will be treated separately from the transfer at the time of the pledge and will have to adhere to the entry regime and sectoral ceilings and pricing guidelines as applicable in the international sphere, with the valuation done following the accepted arm’s length principles and the valuation certificate obtained from a chartered accountant/SEBI-registered merchant banker.
Legal Framework for Pledge of Shares with Non-Residents
The legal framework surrounding the pledge of shares with non-residents is a complicated one, interacting private civil law with foreign exchange regulations. It involves a fundamental interaction between the Indian Contract Act, 1872, and FEMA, 1999.
“Under the Indian Contract Act, a pledge constitutes a bailment of securities where the Pawnee acquires a special property right and statutory powers such as the right to sell or invoke the asset upon default under Section 176.”
In cross-border situations, however, this contractual autonomy of the private sector is rigidly subject to FEMA’s public policy goals.
Interaction Between Contract Law and FEMA
The creation, operation, and default remedies of the pledge are subject to contract law; the permissibility of flows of assets and the eventual transfer of equity instruments is subject to FEMA, 1999.
Therefore, a completely legally binding agreement under normal contract law cannot automatically override foreign exchange restrictions when called upon to do so.
The regulatory requirements of FEMA take precedence over contractual rights of the Contract Act when an enforcement of a pledge leads to a transfer of shares that contravenes sectoral caps, entry routes or pricing guidelines and thereby causes a cross-border transfer of shares.
Consequential Commercial Liberalisation in the Draft FI Rules
Now one of the most consequential commercial liberalisations in the Draft FI Rules is the explicit recognition of pledges as a formal mode of foreign investment.
1. Expanded Scope
Under “Rule 6A(4)” of the Draft FI Rules, persons resident outside India and FCEs are permitted to make foreign investments by way of a pledge.
2. Principles-Based Flexibility
The NDI Rules used to be limited to specific types of pledge creation, such as the pledge of shares for the borrowing of External Commercial Borrowings (ECBs) by “the promoters” or the pledge of the instruments by the non-residents in favour of the domestic or overseas banks or NBFCs.
The Draft FI Rules are based on principles and eliminate the prescriptive lender category restrictions.
3. Invocation Constraints
Though the making of a pledge is regulated, the rules have strictures on the transfer of equity instruments in case of invocation of the pledge in respect of the entry route, sectoral cap, FDI policy conditions and pricing guidelines.
4. Pricing Guidelines
In case of an unlisted entity, the pricing on transfer should be in accordance with the internationally accepted “arm’s length pricing principles” certified by a chartered accountant or SEBI-registered merchant banker/cost accountant.
The price of listed companies is decided as per the SEBI regulations.
Key Regulatory Changes at a Glance
| Area | Earlier Framework | Draft FI Rules |
|---|---|---|
| Pledge as a Mode of Foreign Investment | More prescriptive and limited | Explicitly recognised |
| Lender Restrictions | Specific lender categories | Principles-based approach |
| Foreign Investors | Specific permitted situations | Persons resident outside India and FCEs are permitted to make foreign investments by way of a pledge. |
| Invocation of Pledge | Subject to prescribed conditions | Subject to entry route, sectoral cap, FDI policy conditions and pricing guidelines |
| Unlisted Entity Pricing | Subject to applicable regulatory requirements | Internationally accepted arm’s length pricing principles |
| Listed Company Pricing | Subject to applicable regulatory requirements | As per SEBI regulations |
Impact on Cross-Border Acquisition Financing
This regulatory change creates new opportunities for acquisition financing across borders, allowing foreign investors and private credit funds to arrange acquisitions using collateralised debt, while not only relying on the traditional banking system.
Contracts and Legal Provisions
The structure of debt in modern cross-border finance has heavily depended on ensuring strong collateralisation for accessing international capital from institutions. A breakthrough development in this scenario was the launch of Masala Bonds by the International Finance Corporation (IFC, the private sector arm of the World Bank Group), which enabled Indian corporate borrowers to tap into global liquidity without facing foreign currency exchange risks for the domestic issuers. Lending of Indian securities has become a standard security package for such cross-border debt arrangements to be credit-enhanced.
In India the principles of law which govern pledges are of old origin and reflect a balancing of the rights of creditors and the protection of debtors. In “Lallan Prasad v. Rahmat Ali (1967), the Supreme Court held that the claim of a pledgee for the underlying debt was of a purely contingent nature, and it would be impossible for the pledgee to enforce such a claim unless the underlying claim was satisfied and the pledgee was able to return the pledged security.”
The principle was extended to the area of corporate equity in “Balkrishan Gupta v. Swadeshi Polytex Ltd. (1985)”, where the Apex Court held that it is not withered away the legal ownership of the stock or the statutory rights of a shareholder, for example, the right to vote. These precedents set forth that the act of establishing an encumbrance is of a fundamentally different nature than transfer of ownership, which is important for the enforcement of securities in structured finance.
Legal Framework for Pledges Over Indian Securities
The operationalisation of pledges over Indian securities is governed by the intersection of the Indian Contract Act, 1872, the Depositories Act, 1996, and the SEBI (Depositories and Participants) Regulations, 1996. The enforcement mechanics were definitively settled by the Supreme Court of India in the landmark case of “PTC India Financial Services Limited v. Venkateswarlu Kari and Another (2022).”
Rights of the Pawnee and Pawnor
By the act of making the pledge, a special property right is created in favour of the person pledged to (pledgee), and the general property rights remain with the person pledging (pawnor).
A Pawnee is not allowed to sell dematerialised securities on their own without a transfer of ownership under the Depositories Act and Regulation 58 of the Regulations of 1996.
The Pawnee must formally call a pledge before he shall enforce a sale and shall be entered as the ‘beneficial owner’ in the books of the depository.
The act of depository recording the Pawnee as the ‘beneficial owner’, however, was not an ‘actual sale’ for the terms of Section 177 of the Indian Contract Act, the Supreme Court explicitly decided.
The Court found this registration to be “only a procedural mechanism to allow the Pawnee to effect a subsequent sale”.
The right of the pawnor to redeem the goods pledged by him does not cease to exist and remains valid even after the pawnor becomes the beneficial owner of the pledged goods.
The right of redemption can only be terminated with the lawful execution of an “actual sale” to a third party in accordance with the provisions of Section 176, which requires the delivery of a reasonable notice to the pawnor.
Moreover, the Court very clearly stated that the sale to themselves of the pledged goods is of no legal effect.
The act constitutes a wrongful appropriation of the property and revivability of the contract of pledge and the pawnor’s right to reclaim it.
This is relevant for company secretaries and legal counsel when structuring foreign debt under the Draft FI Rules and lays down the specific requirement of notice periods and mechanics of the third-party sale of debt.
Under “Rule 6A(4)” a pledge will result in a change of beneficial ownership at the depository level and the ultimate transfer, and therefore FEMA compliance – with respect to pricing and sectoral caps- will only occur when the pledge is sold to a third party.”
Transfer of Beneficial Interest and National Security Safeguards
The Draft FI Rules loosen up modes of capital inflow, while the net of the regulations on beneficial ownership has been tightened to protect national security.
Draft FI Rules and Beneficial Ownership
- The Draft FI Rules introduce the concept of a “Foreign Owned and Controlled Company” (FOCC) and replace it with “Foreign Controlled Entity” (FCE) and Ownership Thresholds. In this model, the “ownership” of a non-resident entity is limited to the beneficial ownership of more than 50% of the entity.
- Control Determinations – The definition of “control” has not remained consistent across the population. Rather, the Draft FI Rules refer to the sector-specific prescriptions prescribed by the regulators in consultation with the Central Government. If there is no specific definition, the control will be determined by basic laws such as the Companies Act, 2013, and the SEBI AIF Regulations.
- The Draft FI Rules was accompanied by “Press Note 2 (2026 Series) dated 15 March 2026”, which was issued to make amendments in the FDI Policy and restrictions on the countries sharing land borders with India (LBC). In Press Note 2, it was clarified that the mapping of beneficial ownership would have to be done in relation to the thresholds as provided in the Prevention of Money-laundering (Maintenance of Records) Rules, 2005 (PMLA). This is “consistent with the established standard of 10% beneficial ownership to identify LBC nexus and to include multi-tire investment vehicles and nominee arrangements that had previously taken advantage of the ambiguous interpretation of the regulations.”
- The Draft FI Rules change the burden of compliance – crucially. In the case of the NDI Rules, the burden primarily lies with the Indian investee entity, but the new framework makes the foreign investor and the eligible investee entity (or the transferor and the transferee) joint and several liable.
Way Forward / Recommendations
The paradigm shift brought in by the Draft FI Rules requires a proactive and very strategic approach for the company secretaries, general counsel and compliance officers.
Partnering with the Auditor on Hybrid Instruments
Since the definition of ‘equity’ has become subject to accounting standards, legal counsel needs to work closely with chartered accountants on structuring hybrid instruments. Instruments with variable conversion ratios will need to be well drafted to prevent being misclassified as financial liabilities, thereby effectively losing their foreign equity investment framework.
Updating Cross-Border Pledge Agreements
All cross-border pledge agreements need to be updated in view of the Supreme Court decision in PTC India Financial Services. The registration of the Pawnee as a beneficial owner must be separated from the actual sale in the agreements. Mechanisms that allow for proper enforcement of reasonable notice requirements are essential in contractual timelines provided for in Section 176 of the Contract Act.
Strengthening Know Your Customer (KYC) Controls
Investee companies need to use strong Know Your Customer (KYC) controls as part of their compliance and the high LBC beneficial ownership requirements. Compliance matrices need to be followed to the natural person level before any foreign investment transaction is made.
Monitoring Definitions of “Control” Issued by the Sectoral Regulators
Definitions of “Control” issued by the sectoral regulators- The uniform test for downstream investments has been devolved to the sectoral regulators, and companies have to keep an eye on these.
Conclusion
“The Draft Foreign Exchange Management (Foreign Investment) Rules, 2026”, represents a sophisticated maturation of India’s regulatory architecture. By dismantling artificial barriers between listed and unlisted entity investments, simplifying entity classifications, and formally integrating pledges into the investment mainstream, the framework significantly enhances the ease of doing business.
This liberalisation is offset, however, by a heightened sense of national security and accounting considerations. By abandoning rigid, prescriptive lender categories in favour of a principle-based architecture under Rule 6A(4), the new framework formally unlocks pledge-backed acquisition financing. This enables foreign private credit funds and institutional investors to structure sophisticated cross-border debt facilities without solely relying on traditional banking channels.
For company secretaries, legal counsel, and dealmakers, navigating this evolving regime demands precise contractual drafting, robust ultimate beneficial owner (UBO) tracing, and close coordination with financial auditors. Ultimately, the 2026 Rules successfully reconcile contractual autonomy with public policy imperatives, positioning India as a dynamic, secure, and credit-friendly destination for global capital.
Also, the rise of beneficial ownership tracking and the shared responsibility of compliance mean that capital structures will be more innovative, but regulatory review will be more thorough. Understanding the complex relationship between these draft rules, the judo-decision of the Supreme Court and the changing accounting standards will be one of the most important requirements for the practitioners to successfully traverse the next phase of foreign direct investment in India.
References
- Supreme Court of India, PTC India Financial Services Limited v. Venkateswarlu Kari and Another, Civil Appeal No. 5443 of 2019 (2022).
- Talwar Thakore & Associates (TT&A), “Draft Foreign Exchange Management (Foreign Investment) Rules, 2026 – Key Changes” (July 2026).
- Khaitan & Co (ERGO), “India’s Foreign Investment Regime: The Draft Foreign Exchange Management (Foreign Investment) Rules, 2026” (July 29, 2026).
- Government of India, Ministry of Commerce & Industry, DPIIT, Press Note 2 (2026 Series).
- Reserve Bank of India (RBI), Draft Foreign Exchange Management (Foreign Investment) Rules, 2026, issued on July 21, 2026.
- Department for Promotion of Industry and Internal Trade, Ministry of Commerce & Industry, Government of India, Consolidated FDI Policy (eff. Oct. 15, 2020).
