2ERGO Perspective P8 Sept 2015 -...

Contents September 2015

Foreword

Glossary

Valuations in E-commerce: Clarifying A Few Myths

From Brick-And Mortar to Click-And-Mortar

Payment Systems: The Regulated Catalyst of the E-commerce Growth Experiment

GST and Supply Chain Management

E-commerce and the Competition Law Regime

IP in E-commerce

Contributors

Foreword

Having achieved a CAGR of over 35%, the e-commerce story in India has charted an unprecedented trajectory of growth. This rapid pace has been fuelled by a confluence of favourable economic, social and demographic factors in India, such as increased spending power and changes in spending behaviour of Indians, rapidly increasing internet penetration and mobile telephony, customer comfort with online purchases and payment, increased access to credit cards and other virtual payment systems.

While the industry is still in a nascent stage based on a number of parameters such as volume of transactions, percentage of gross retail sales, untapped internet population, etc., these very parameters demonstrate the industry’s future potential and the available headroom for further growth. No surprise then that the rapid progress of this industry in India shows no signs of slowing down.

Growth of this magnitude is bound to raise several operational, regulatory, legal and financial issues. Companies are operating in an increasingly regulated environment, which is leading to emergence of a host of issues pertaining to data protection and privacy, payment processing, competition law, intellectual property, etc.

Enormous efforts are currently underway towards enhancing customer experience for online shopping, both for the purposes of acquiring customers of brick and mortar retailers as well as to differentiate from competitors. Competition within this sector has intensified significantly on account of increased advertising and promotion spends, and discounting in order to acquire and retain customers. These efforts are adding to the ubiquitous ‘cash-burn’ resulting in a continuous demand of capital.

Based on the level of capital received by the sector over the last 2 years, one may be tempted to extrapolate and conclude that meeting the estimated funding requirement of USD 20 billion by 2020 would hardly be a significant challenge. However, recent history seems to indicate that the funding tap is not always free-flowing, especially considering the fact that fundamentals of the industry have not changed as much as the momentum has.

This edition of the Ergo – Perspective intends to create awareness amongst the enterprises comprising the e-commerce ecosystem in India (from e-tailers and e-commerce companies to other enablers such as logistics and payment processing companies, etc.) and strategic investors with regard to the operational and regulatory challenges that will need to be addressed going forward.

We hope that the information contained in this edition of the Ergo – Perspective will be useful to you and will help you objectively evaluate your current plans and make informed decisions. Please write to us at [email protected] for any clarification or further information that you may require.

Regards

E-Commerce Practice Group | Khaitan & Co

Glossary

AFI Additional Factor of Information (that is not visible on credit/debit card)

CAGR Compounded annual growth rate

CCI Competition Commission of India

CNP Card Not Present

COD Cash on Delivery

Competition Act Competition Act, 2002

CST Central Sales Tax

Data Protection Rules The Information Technology (Reasonable Security Practices and Procedures and Sensitive Personal Data or Information) Rules, 2011 framed under the IT Act

EU European Union

FDI Foreign Direct Investment

FY Financial Year

GMV Gross Merchandise Value

GST Goods and Service Tax

GTV Gross Transaction Value

IAMAI Internet and Mobile Association of India

INR Indian Rupees

Intermediary Guidelines The Information Technology (Intermediary Guidelines) Rules, 2011 framed under the IT Act

IPO Initial Public Offer

IT Act The Information Technology Act, 2000

KYC Know Your Customer

NBFC Non-Banking Financial Company

PB Payment Banks

PPI Pre-paid Instruments

PSSA The Payment and Settlement Systems Act, 2007

RBI Reserve Bank of India

RPM Resale Price Maintenance

USD United States Dollar

US United States of America

VAT Value Added Tax

KHAITAN & CO | ERGO PERSPECTIVE 1

Valuations in E-commerce: Clarifying A Few Myths

Valuation is an art, not a science.

The year 2014 (and the first 7 months of 2015) have been quite heady for e-commerce and allied technology companies in India. The aggregate amount of funding aside, a notable feature is the rapid increase in valuations of e-commerce companies in successive rounds of funding, sometimes in a matter of few months. While the sector has been buoyant across, most notable for rapidly spiralling valuations were e-tailing companies and service aggregators, which, coincidentally, have also received the bulk of venture funding. In fact, most of the big companies in this segment saw a 2-5X rise in their valuations over the last 6-12 months alone.

This is essentially the genesis of the statement – valuation is an art, not a science. The statement is meant to underline the imprecise nature of valuations in India’s e-commerce industry, and suggests that shades of grey exist in the data and analyses that underlie such valuations. In light of similar concerns being increasingly voiced by investors, a focused ‘path to profitability’ is becoming a business imperative.

M&A in e-commerce

Recent consolidation in the e-commerce industry has been driven by a variety of factors – industry leaders striving to increase market share by adding product or services categories or even customer visits to the platform, targets being compelled to sell due to funding shortages or other market challenges, acquisition of allied services such as payment systems or logistics providers for better forward and backward integration, and in some cases, divestment of captive logistics and other value added services to focus on core offerings. We expect M&A in the sector to increase as the industry matures and attains equilibrium.

As an offshoot of rising valuations, e-commerce M&A has witnessed an increase in share swap deals. It is logical for an acquirer to use stock as currency for an acquisition when valuations are high. In case of horizontal M&A, where the target operates in the same space as the acquirer and is hence valued on similar valuation metrics as the acquirer, the risk of overvaluation or undervaluation of the target is lower. If valuations for the sector were to fall in the future, the valuations of both the acquirer and target are likely to fall at similar rates. Since their valuations relative to each other would remain similar, the risk

of overpaying or underpaying is minimal. However, in the case of vertical or non-synergistic M&A, a downturn for the industry may mean an altogether different relative valuation because the fall in valuation of the acquirer and target may not be at the same rate.

Fundamentals & Metrics

Rapidly spiralling valuations have begun to prompt the question whether the Indian e-commerce sector, and in particular, e-tail companies are overvalued. With their sole focus on customer acquisition (and vendor acquisition as well for online marketplaces) and increasing the total number of transactions through the e-commerce platform, e-tail companies have been burning cash at a staggering rate.

Given their financial performance, how then are e-commerce companies valued at the level they are? The most prominent metric used for valuing e-tail companies is the GMV, i.e., the aggregate in INR terms of the value of all products sold through an e-commerce platform. For non-retail e-commerce companies such as service aggregators or e-payment providers, the equivalent is the GTV, which is the aggregate of all services provided, or payment transactions undertaken through the e-commerce platform.

In the case of pure play inventory model e-tail companies, GMV would also be the revenue; for online marketplaces, the revenue (which consists of commission, and listing or advertising fees charged to vendors) would be a fraction of the GMV. The primary reason why GMV (or GTV) is used rather than revenue for valuing e-commerce companies would be to eliminate the stark difference in revenue between online marketplaces, and inventory or direct service models for the same value of goods (or services) sold over the platform.

GMV is an optimistic and optically pleasing metric for valuation as it does not factor in any operational or financing aspects. GMV-based valuation methods essentially imply that it is more optimal to compare market share rather than financial or operational performance. This may throw up strange results in some cases – for instance, in its last year of full operations, Kingfisher Airlines could have been a much sought after company to invest if it were to be valued only on passenger-kilometres serviced. Accordingly, GMV based valuation may have the effect of


masking the true financial and operational performance, and hence, true value of e-tail companies.

The justification for using GMV based valuation is that during early stages, e-tailing companies would need to acquire customers and build mindshare, which would require substantial spend for marketing and discounting. The model assumes that an acquired customer is a source of repeat sales and adds to the network effect, and hence, that the focus during early stages should be on customer acquisition, even if at high costs. If e-tail companies were to pay attention to profitability at this stage, it would not be able to do the high volume of sales (albeit, heavily discounted) required to build the scale and volume that is required to, first, absorb high promotional, logistics and other fixed costs, and thereafter, to be profitable on the low margins in the generic retail space.

Multiples

Valuation is a product of both the metric and the multiple. Merits of using GMV as a valuation metric aside, what is the multiple that is used in the Indian e-tail space? Flipkart was reported to have a GMV of USD 4 billion for the calendar year 2014 and was valued by venture capital investors at USD 11 billion at the end of this period, and since then, has raised another USD 700 million at a valuation of USD 15 billion.

An IPO would be a more accurate price discovery mechanism for a company given the much broader classes of investors that participate in the process. The current international bellwether of online retail, Alibaba, made a global record IPO for USD 25 billion at a valuation of USD 220 billion in September 2014. By all measures, the Alibaba IPO was considered a huge success. During the 12 month period ended December 2014, Alibaba’s GMV was approximately USD 270 billion. This was the highest for any e-commerce company in the world and represented more than an astounding 80% of all online purchases in China and approximately 7% or all retail sales in China.

Despite being an absolute leader and global powerhouse in terms of value of transactions and the market in which it operates, and having successfully concluded a record breaking international IPO, Alibaba has been valued at less than 1.0x of its GMV at IPO. That is not to suggest investors valued Alibaba solely on GMV (or on GMV at all) – for the FY ended December 2014, Alibaba posted revenues of USD 6.14 billion and pre-tax profits of USD 4 billion.

Transposing the same logic to the Indian e-tail space, it is clear GMV multiples used by investors are at least three times the GMV multiple for the largest global e-tailer, one that is still growing at more than 50% annually and is profitable as well. A counter to the suggestion of overvaluation

could be that since e-tailers are targeting aggressive growth, with some of them aiming to double GMV each year, the mismatch between the present GMV and valuation will come down in the coming years. However, this assumes that subsequent rounds of venture funding (ready availability of which will also need to be assumed regardless of circumstances) would use lower GMV multiples. This is, however, quite at odds with current market events where GMV multiples have only steadily increased in the last year.

Dotcom 2.0?

The many similarities between present situation in India’s e-commerce industry and the dotcom bubble of circa 2000 are indeed hard to miss. In both cases, investee companies had unclear profitability models, though in hindsight, the dotcom bubble was characterized by highly questionable revenue models as well. In both cases, valuation factored in best case growth scenarios based on untested market models and assumptions, without discounting for the potential challenges. And lastly, both involve lack of tangible assets that investors may have recourse to in case of a potential liquidation.

Currently, GMV is being ramped up by e-tailers rapidly, but this is largely on the back of discounts funded by abundant venture capital. However, the roadmap to profitability remains unclear as ever on account of discounting as well as core operational reasons. It also remains to be seen if the related ecosystem for e-tailing comprising of mobile and internet technology, innovative payment solutions, and most importantly, last-mile delivery capabilities would develop at the required pace to facilitate the projected growth in e-tailing.

It is interesting that other segments of e-commerce that do not involve physical delivery of products, such as online ticketing, information and services aggregation, etc., look more robust as they do not have the same operational challenges or cash burn as e-tail. However, these segments have not witnessed similarly aggressive valuations. Makemytrip, which is the market leader with approximately 48% share of online travel in India, reported revenues of approximately USD 300 million for the FY 2014 (and losses of USD 14.5 million), has a market capitalisation of just over USD 800 million.

An uncertain endgame

Going by exit track records of venture capital and private equity investors in India, it looks unlikely that the present investors in e-tail companies are looking for an exit through a public offering. Clearly, the expectation would be to exit through secondary deals.

The possibility of a successful exit through secondary deals is entirely dependent on the


existence of interested buyers with the same view on the growth trajectory of sector, favourable macroeconomic and political conditions and sentiment, etc., at the time of exit. This is by no means certain and there could be number of factors that could trigger a downturn – effect of tapering of US quantitative easing on global capital flows; devaluation of Chinese yuan, fall in valuations in US technology based enablers such as AirBnB; or even an adverse governmental intervention on Indian FDI e-tail structures.

The industry has already felt a faint rumble on valuation – while Alibaba has now invested in Snapdeal, it was only after almost a year since the media reported negotiations having fallen through over differences in valuation. It is only during an adverse environment that the robustness of valuation models and assumptions get tested. As Warren Buffet has famously said, it is only when the tide is down when we know who all are not wearing trunks.

In conclusion

We believe that over the coming years, e-tail in India is likely to surge ahead, based primarily on the momentum attained thus far, increasing reach of companies and their delivery infrastructure to tier II and III towns and cities.

In this context, we believe that a few issues need to be highlighted for consideration of companies active in the e-commerce ecosystem in India:

(a) Further disparity in funding – Venture capital funding opportunities will increasingly chase market leaders making it increasingly difficult

for smaller players to compete and survive. In many cases, this would lead to consolidation in the industry, most likely driven by existing investors in smaller companies.

(b) Valuations, especially for e-tailers, could taper, stagnate or even fall. The trigger could even be a mere change in sentiment as opposed to fundamentals of the industry. A slight change in any of the factors that affect domestic macroeconomics or international capital flows can have a larger than warranted correlation on potential drop in e-commerce industry valuations.

(c) Brick and mortar retail can reinvent itself and make a comeback in India. Brick and mortar will increasingly focus on increasing customer shopping experience through innovative uses of big data analytics and by integrating hospitality, fine dining and entertainment. Leading brick and mortar players will also focus on omni-channel retailing, thereby combining the advantages of existing logistics and back-end infrastructure and long-term cost advantages of online retail.

(d) The battle between e-commerce and brick and mortar will further intensify outside the market. Brick and mortar is likely to push for scrutiny of FDI in e-tail, competition law scrutiny on predatory pricing funded by venture capital, and attempt to organize boycotts of vendors listing on or supplying to e-commerce platforms.


From Brick-And Mortar to Click-And-Mortar

In light of the increasing popularity of online sales platforms, brick-and-mortar retailers have started exploring web portals as an additional channel for sales and consumer reach. Whilst online sales would form a key component of most customer attraction and retention strategies for businesses today, following issues must be borne in mind while selling goods and products online:

Data Protection and Privacy

E-commerce transactions result in transfer of certain personal information from the buyer to the seller. Therefore, privacy and data protection issues are extremely relevant while operating an e-commerce platform.

The IT Act and the rules, regulations and guidelines framed under it, govern the usage of the personal and sensitive personal information.

Data Protection Rules define personal information as any information in relation to a natural person which, either directly or indirectly, in combination with other information available (or likely to be available) with a body corporate, is capable of identifying such person. Further, these rules define sensitive personal data or information to include passwords, financial information, physical, physiological and mental health condition, sexual orientation, medical history and biometric history.

The Data Protection Rules impose certain obligations on entities, which include formulation of privacy policy, maintenance of reasonable security practices and procedures, obtaining specific consents from the provider of sensitive personal data before making any disclosure thereof and providing the option of not supplying the information.

Intermediary Liability

An online business could be structured as a marketplace, which under the IT Act would be an intermediary. An intermediary is a person or entity who on behalf of another person receives, stores or transmits any electronic record or provides any service with respect to such electronic record is an intermediary in relation thereto.

Intermediaries are exempted from any liabilities (except for any copyright and trademark infringement) in relation to any third party information, data or communication link made available or hosted by intermediaries if:

(a) The intermediary’s function is limited to providing access to a communication system over which third party information is transmitted, temporarily stored or hosted;

(b) The intermediary is neither engaged in initiating the transmission of information nor in selecting the receiver of transmission nor is it selecting or modifying the information contained in the transmission;

(c) The intermediary is exercising adequate due diligence and complying with the requirements prescribed in the Intermediaries Guidelines;

(d) The intermediary has not conspired in, abetted, aided or induced, the commission of any unlawful act, in any manner whatsoever; and

(e) After becoming aware of any unlawful act, the intermediary expeditiously removes or disables access to any information, data or communication link residing in or connected to a computer resource controlled by the intermediary, which is being used to commit such unlawful act, without vitiating the evidence in any manner.

Commercial Licenses

Establishing new places of business in relation to online businesses requires obtaining various licenses and registrations from Central and State government authorities. Some of these licenses include direct and indirect tax registrations, shops and establishment registration, registrations under social security legislations, etc.

Further, if any online business engages in warehousing, courier and packaging activities, licenses and registrations under various applicable laws (depending on the nature of the activity undertaken) including Motor Transport Workers Act, 1961, Carriage by Road Act, 2007, the Legal Metrology Act, 2009, etc., would be applicable.

In case of any business concerning food items, registration under the Food Safety and Standards Act, 2006, would also be required to be obtained.

Payment Facilitation

An online business can either:

(a) Establish its own payment system mechanism for enabling its customers to


make electronic payment for the services and goods purchased online, or

(b) Use a third-party payment service provider. In the former case, prior authorisation of the RBI will be required for establishing and operating a payment system.

In the latter case, such businesses will be required to enter into an agreement with a payment system provider that is authorised by the RBI to operate such a payment system. Obtaining an authorisation for payment system is a time consuming process and may take a long time. Further, maintaining and operating a payment system also requires compliance with the PSSA and the rules and regulations made thereunder. These compliances include providing documents and information to the RBI, and allow the RBI to inspect the premises of the payment system provider, in each case, as and when required by the RBI.

On the other hand, if an online business uses a third-party payment service provider, it is important to ensure that such third-party service provider has a valid and subsisting authorisation from the RBI to operate a payment system. Further, agreements with such third-party service providers must have appropriate representations, warranties and covenants in connection with its compliance with the PSSA and the rules and regulations made thereunder, which should be backed by indemnities for any non-compliance

with the provisions of the PSSA and the rules and regulations made thereunder.

Jurisdiction in Cyber Space

Territorial jurisdiction of courts is based on two fundamental principles: (a) place of defendant’s residence, and (b) place of cause of action. In case of online transactions, the place of cause of action could be at multiple locations.

Courts in India have followed the tests of active and passive interaction of websites for determining jurisdiction. Further, courts have held that the plaintiff should establish that:

(a) The defendant ‘purposefully availed’ itself of the jurisdiction of the court,

(b) The prima facie nature of the activity of the defendant was with an intention to conclude a commercial transaction in such court’s jurisdiction, and

(c) Such activities resulted in an injury or harm to the plaintiff within such jurisdiction.

It is imperative that the persons/entities running businesses online must have appropriate dispute resolution and jurisdiction clauses in their agreements with their customers/subscribers, in the absence of which, there may be risk of a potential law suit by such customers/subscribers in inconvenient jurisdictions.


Payment Systems: The Regulated Catalyst of the E-commerce Growth Experiment

Electronic payment systems are a key component of India’s e-commerce growth story. Evolution in payment systems has kept a steady pace with the larger e-commerce and e-tailing industry and has been significantly influenced by local issues such as limited penetration of credit cards and hesitation of consumers to mention their credit card/financial information online. Today, the consumer has multiple options of making online payments including through net banking, mobile banking, credit card settlements, debit card transactions and the very recent and effective PPI such as e-wallets and pre-paid cards.

According to industry body IAMAI, the total digital commerce market in India reached INR 81,525 crore (over USD 12 billion by the end of December 2014. Pre-paid cash cards and mobile wallets accounted for 8% of the modes of payment.

Having said that, cash-on-delivery (COD) still remains the preferred mode of payments in e-commerce transactions in India. While COD has played an instrumental role in the Indian e-commerce growth story, the key to sustainable growth of the sector hinges largely on the development and acceptance of customised and innovative online payment solutions. RBI also acknowledged in its Vision Document of 2012-151 that COD system are more prone to fraud risks and create operational leakages in the payment system mechanism. Thus, stressing on the need for an effective ecosystem of various payment system solutions.

Eligibility Criteria for the Applicants

(a) Existing non-bank PPI issuers; and other entities such as individuals/professionals; NBFC’s corporate business correspondents, mobile telephone companies, super-market chains, companies, real sector cooperatives; that are owned and controlled by residents;

(b) Promoter/promoter group can have a joint venture with an existing scheduled commercial bank to set up a payments bank.

1 Payment Systems in India: Vision 2012-15, issued by the

Reserve Bank of India, Department of Payment and Settlement Systems.

(c) Promoter/promoter groups should be ‘fit

and proper’ with a sound track record of professional experience or running their businesses for at least a period of five years in order to be eligible to promote payments banks.

Necessary Regulatory Push

With the lack of bank penetration in India, the industry desperately required non-banks to step in and participate in the delivery of payment systems solutions. With this in context, the enactment of the PSSA is a necessary milestone. Under the PSSA, the RBI as the designated authority has developed an effective regulatory framework for various categories of payment systems. These directions, inter alia set out clearly: (a) the eligibility criteria; (b) capitalisation requirements; (c) safety protocols; (d) detailed reporting; and, (e) deployment of funds and related usage.

Accordingly, post 2007, the industry has witnessed several new players making a foray as “payment systems/facilitators”. From providing payment gateway IT infrastructure to issuance of PPI, it has created tremendous business opportunities, which players continue to cash upon.

In a related development, RBI initiated the process of granting license to PBs and received 41 applications from the industry. RBI has, as of August 2015 given in-principle approval to 11 applicants to operate as PBs. The objective of creating a category of PBs serves a dual purpose. First, it allows the financial inclusion of areas where banks have failed to penetrate. Second, it also creates business opportunities for new age entrepreneurs to exploit the potential of this sector. Interestingly, RBI has accepted various categories of promoters to be eligible to apply for a license.

Pre-paid Instruments as a Solution for Quick Payments

In the current scheme of things, RBI mandates a specific double factor authentication system to prevent cyber frauds and to win confidence of the


consumers for non-cash payment settlements for all CNP credit or debit card transactions.2 This basically implies that an AFI would be required for completing any CNP transaction. An example of such AFI would be one time password received on mobile/email for completing online transactions.

However, this has proved to be two edged sword – with number of failed transactions and the consequent increase in consumer inconvenience, the e-commerce industry has been demanding a relaxation in this system. In response to these concerns, RBI recently relaxed the AFI requirement for small value card present transactions (maximum limit of INR 2,000 (approximately USD 130)) only using contact-less cards3. However, such relaxation would not be applicable for online payments as the same are CNP transactions.

As PPIs do not require AFI, they can emerge as an alternative for CNP credit/debit card transactions. However, this also has its own set of regulatory challenges. Not surprisingly, RBI has issued detailed guidelines with respect to the issue and operation of PPI in India.

PPI are payment instruments that facilitate purchase of goods and services against the value stored on such instruments. The value stored on such instruments represents the value paid for by the holders in cash, by debit to a bank account or by credit card.

The PPI can be issued as smart cards, magnetic stripe cards, internet accounts, internet wallets, mobile accounts, mobile wallets, paper vouchers, and any such instrument, which can be used to access the pre-paid amount.

As mentioned earlier, the issue and operation of PPI requires authorisation from the RBI and adherence to detailed compliance requirements. PPI are classified under 3 categories:

(a) Closed system payment instruments

(b) Semi-closed system payment instruments

(c) Open system payment instruments

Relevant here is the distinction between “closed system payment instruments” and “semi-closed system payment instruments”. Closed system payment instruments allow redemption of value stored in it for the purchase of goods and services from the issuer of such closed system payment instrument. Semi-closed payment systems allow redemption of the value store in such card at a group of clearly identified merchant/locations establishments, which contract specifically with

2 RBI/DPSS No. 1501/02.14.003/2008-2009 February 18,

2009. Effective from 1 August 2009. Further directive by RBI on 22 August, 2014.

the issuer to accept payment instruments (i.e. issuer of the instrument is not the merchant/service provider).

This distinction is critical because a closed system payment instrument is not considered as a “payment system” under the PSSA and is, therefore, not regulated by the RBI. In most cases, including that of order aggregators, the e-commerce players are not the merchant of goods sold on their website. Accordingly, specific arrangements would be required to be made with licensed issuers of PPI for enabling such transactions. The transactions through PPI do not require AFI and thus can be effective in reducing consumer inconvenience.

Forward integration but with caution: assessing your compliance appetite

Despite the challenges, it is true that increased participation and innovation is being witnessed in this sector. Recent interest of private equity, venture capital firms in payment processing/settlement companies is a testimony to the growing investor confidence. Interestingly, the established e-commerce companies are eager to acquire equity stakes in these companies as a business strategy to control the entire e-commerce chain. Similar interest is also seen in other components of the e-commerce ecosystem such as warehousing and logistics.

This forward integration, though an obvious business evolution, must be a well thought-through decision. Primarily, because processing/settlement companies are heavily regulated and closely monitored by RBI.

E-commerce companies have been facing their share of compliance burden, be it the restrictions on FDI on e-tailing of goods or the ever expanding scope of the regulators to extend the intermediary liability. Hence, any potential expansion into financial services domain increases the liability exposure for the companies, which are required to follow detailed reporting and compliance guidelines of the RBI. The issuance of semi-closed/open pre-paid vouchers to facilitate transactions also requires specific RBI license, escrow account and detailed KYC formalities.

Accessing Foreign Funds and classification as undertaking Financial Services

Exorbitant running costs and the high break-even point make it necessary for e-commerce

3 RBI/2014-15/601 DPSS.CO.PD.No.2163/02.14.003/2014-2015 dated 14 May 2015


companies to be adequately funded and hence access to foreign fund is critical for the evolution of these companies. The extant exchange regulations also pose few challenges to such forward integration by e-commerce players. Under the Consolidated FDI Policy, issued by the DIPP for companies engaged in “financial services” for which the FDI Policy does not provide specifically, any foreign investment requires prior approval of the Government of India. Relevant to note here is that most of the activities undertaken by processing/settlement companies are such that cannot be easily classified as being under the “financial services” that are specifically provided for under the FDI Policy. Having said that, case by case analysis of the entire set of business activities undertaken by such companies is required before an assessment of the government approval requirement can be made.

Interestingly, the issuance of semi-closed/open systems is considered to be a “fund based non-banking financial activity” in accordance with the explanation of the credit card business under

Clause 6.2.18.8.2 of the FDI Policy. Consequentially, there are minimum capitalisation requirements for any foreign investment in such companies. In case of companies having more than 75% FDI, the minimum capitalisation requirement is as high as USD 50 Million, out of which USD 7.5 Million is required to be brought in up front and the balance in 24 months.

Way Forward: If not cash less than less cash economy

Consumer confidence (in modes other than COD) and consumer convenience are both critical for the growth of this industry. Prima facie, it appears that the 2 objectives, though much inter-related, are contrary to each other. The very first shift from COD was built on RBI increasing security protocols. Therefore, RBI and the industry should quickly reach a mid-point where neither concern drives the consumers towards COD. Let us hope that the recent relaxation on AFI is a sign for positive things to come in the online payment systems as well.


GST and Supply Chain Management

Background

The ability to manage your supply chain, especially the delivery network, is becoming a critical differentiator in the e-commerce industry in India. The expected roll-out of GST is likely to significantly impact all facets of the e-commerce value chain, from sourcing, warehousing to distribution and delivery of products, including payment processing and other related activities.

In this context, it is a business imperative for e-commerce companies to think ahead and carefully consider the following key issues:

(a) Multiple levies having cascading effect on prices – the subject of taxation is presently divided between the central and state governments, with both having exclusive powers to tax specified categories of transactions enlisted in the Constitution. For example, the power of levy sales tax/VAT on sale transactions lies with the state government, whereas, if such sale transactions are undertaken on inter-state basis, only the Central government can impose the CST. Further, these levies are mostly non-creditable inter-se which has a cascading effect on the final price of these products and services, making them dearer for the end consumer.

(b) Differential treatment of goods and services – Since taxes on goods and services are imposed by different authorities under different legislations, e-commerce players often face a dilemma with respect to categorizing their products (such as software, music, e-books, etc.) since both the service tax and VAT authorities seek to recover their ‘pounds of flesh’ on these products. This issue ends up being resolved after judicial intervention, which has several direct and indirect costs associated with it.

(c) Difficulty in ascertaining the situs of sale or service – This is one of the biggest challenges faced by the e-commerce industry. In terms of the VAT and CST law as it stands today, the liability for payment of VAT or CST arises only upon completion of sale. However, in view of the various transaction and payment models adopted by the e-commerce industry to promote their sales, at times it is difficult for them to determine the situs of sale. Once again, lack of clarity leads to (often) unnecessary litigation and the attendant cost impact on companies.

Situation under the proposed Goods and Service Tax

The current government in India seems sincere in alleviating the negative perception amongst the global community regarding India’s taxation regime. As a key step in this direction, the present Central Government seems committed to introduce the GST on 1 April 2016.

GST is a mega tax reform and will help simplify the tax system in India by replacing various Central and State levies including VAT, service tax, entry tax, etc. with a single creditable tax.

Major implications of the proposed GST on the e-commerce industry are summarized as follows:

(a) Transparent taxation with seamless credit – GST is a consumption based value added tax which is levied at each stage of the value chain. Accordingly, the tax paid by the tax payer at the previous stage is available as credit which can be set off against the output liability.

Besides reducing the tax burden that is finally passed on to the consumer, an obvious consequence of such seamless credit based taxation would be increased transparency between the stakeholders (tax payer and the authorities) and substantial reduction of compliances that companies need to adhere to.

(b) Reduction of prices – With a unified tax like GST, the government proposes to reduce the distortionary effect of multiple non-creditable taxes and also help in reduction of associated costs borne by tax payers. Even if the proposed rate of GST seems to be on a higher side, it would eventually bring down the cost of doing business provided the businesses structure their operations efficiently.

(c) Identical treatment of goods and services and inter-state & intra-state transactions – Under the proposed scheme of unified GST, the distinction between the goods and services would be done away with. This would be a major relief for tax-payers from e-commerce industry since it will mark an end to the classification disputes with the authorities. Similarly, the parity in treatment of intra-state and inter-state transactions in goods and services under the proposed GST would create a common national market as against state markets.


Conclusion

The proposed GST regime seeks to adequately address the concerns of the industry in India as far as the indirect taxes are concerned. The increase in rate of taxes under GST may cause an upside revision in prices of services. Consequentially, the cost of services such as logistics and banking services, which are relevant for e-commerce sector are likely to go up.

However, if the operations of the e-commerce companies are structured efficiently, such incremental costs may be negligible in comparison with the overall reduction in costs of goods and services because of the savings and benefits of GST.


E-commerce and the Competition Law Regime

The increasing focus on e-commerce sector has led to commensurate increase in scrutiny by the CCI, especially around concerns regarding the abuse of dominance and anti-competitive vertical arrangements such as Resale Price Maintenance. The competition law regime in India is fairly new and the evolving jurisprudence in this sector has often looked at other developed jurisdictions (such as the US and the EU, where competition law has been around for decades). Several of the competition law related issues coming up in India now have been around in these jurisdictions for a long time. Looking at their resolution in these foreign jurisdictions and drawing inspiration from the manner in which the e-commerce industry in these countries evolved to comply with relevant laws and regulations might help e-commerce companies in India to plan ahead.

Below, we outline some issues that the CCI already has or could potentially consider in relation to e-commerce companies.

Resale price maintenance

In simple terms, a manufacturer that requires sellers not to sell below a certain price, or not to offer discounts, could be engaging in minimum RPM. Broadly speaking, RPM under Section 3(4) of the Competition Act refers to the practice of trying to fix the resale price of goods through any agreement, arrangement or understanding to the effect that the price to be charged on the resale by the purchaser shall be the price stipulated by the original seller. Minimum RPM can thus be viewed as vertical price-fixing, and that is where the problem may be with respect to manufacturers and e-commerce companies.

The concept of ‘maximum retail price’ or ‘MRP’ for pre-packaged commodities is very different from minimum RPM. MRP is the maximum price that can be charged by the retailer for a pre-packaged commodity. By contrast, the Competition Act’s prohibition on minimum RPM covers any agreement that sets a minimum (or fixed) price if such agreement causes or is likely to cause an appreciable adverse effect on competition in India. Accordingly, any agreement, understanding or arrangement that contains an RPM provision, without a clear statement that all downstream entities are free to charge a price below the amount stipulated by the manufacturer or upstream seller, can be deemed void and a violation of the Competition Act.

1 Section 4, Explanation (b), Competition Act.

2 There is no provision in the Competition Act to look at “collective abuse of dominance”, for example, a possible abuse of dominance by Flipkart and Amazon jointly.

The general rule in a vertical arrangement (such as between manufacturers and distributors/retailers) is that if title to the product changes hands, the upstream seller of the product (e.g., the manufacturer) should not set a floor or fixed price for the product without clearly allowing the downstream company (e.g., distributor/retailer/e-commerce company) to sell at a lower price. It is important to keep in mind that the concept of ‘agreement’ under the Competition Act is extremely broad and covers formal written agreements as well as an informal ‘understanding” or “arrangement’.

Thus, if a manufacturer tells retailers that ‘you cannot sell our product at less than INR 50’ or that ‘you must sell our product at INR 50 and you cannot offer any discounts’, serious issues under the Competition Act can arise. RPM clauses from manufacturers are even harder to enforce against e-commerce companies as several of these are third party platforms or marketplaces, which means that they have no control over the actual price at which retailers who are registered on the platform sell to the final consumers on the platform. Recent news reports also indicate that the CCI is currently looking into resale price arrangements between manufacturers and distributors including e-commerce platforms.

Predatory pricing

Another issue that e-commerce companies have been confronted with recently is ‘predatory pricing’. Predatory pricing under the Competition Act is ‘the sale of goods or provision of services at a price which is below the cost, as may be determined by regulations, of production of goods or provision of services, with a view to reduce competition or eliminate the competitors’.1

Predatory pricing claims fall under Section 4 or the abuse of dominant position provision of the Competition Act. Therefore, it is necessary that dominant position of the e-commerce company be established prior to this claim being made. This may be a challenge to establish against a single e-commerce company2 as e-commerce has been regarded so far by the CCI as a channel of distribution and not a distinct relevant market by itself and so arguably, the entire retail market (of which e-commerce is only a small part thus far) for a product may be quite wide.3

Moreover, even if dominant position is established, it may be hard to show that an e-commerce company is pricing below its cost of production as the nature

3 Ashish Ahuja v Snapdeal.com and Ors, Case No 17 of 2014, 19 May 2014.


of their business model allows them to sell at lower prices compared to the physical shops/stores (due to lower overhead costs, servicing costs etc.).

Exclusivity by manufacturers with e-commerce companies

In Mohit Manglani v. Flipkart, Snapdeal & Ors, the CCI also looked at certain exclusive agreements that e-commerce companies like Flipkart and Snapdeal have with certain manufacturers of phones, tablets, cameras etc. Exclusive agreements are also examined under Section 3(4) of the Competition Act and for an exclusive arrangement between a manufacturer and an e-commerce company/distributor to be regarded as anti-competitive, appreciable adverse effect on competition would need to be demonstrated. The CCI held that there was no appreciable adverse effect on competition as a result of these agreements since e-commerce companies did not individually possess market power which could create any entry barriers to new companies or impact the existing

companies in the markets for mobile phones, tablets, etc. In its analysis, the CCI also specifically noted the benefits of the online distribution channel such as the growing competition in the markets, opportunity for consumers to compare the prices/products and the option of home delivery.

In summary, e-commerce companies provide platforms for sellers and buyers, and the CCI has not found them to cause any market distortions. On the contrary, they have been found to create general consumer surplus and an overall benefit to the economy.

Government entities have also lately engaged e-commerce companies as platforms for sale. However, given the immense interest in this new area of business, it is exceedingly important to be viewed as fully compliant with competition law and the time to get started with this is now.


IP in E-commerce

The growth of the e-commerce industry in India has once again brought issues pertaining to IP to the fore-front. Innovation is one of the key hallmarks for this industry and impacts all facets of its existence, from front-end customer interaction UIs all the way to pricing models and back-end supply chain management and delivery systems.

It would seem that time has now come for companies in this sector to seriously ponder the questions pertaining to their IP and take necessary steps to minimise the attendant risks that might manifest over time. Issues pertaining to housing of IP and its treatment across different jurisdictions, creating a roadmap for IP monetization (which, in many cases, can help e-commerce companies boost their valuations, which are beginning to be questioned by many industry analysts) are critical and need to be explored further.

In this context, we have outlined some of the major IP issues and ‘dos and don’ts‘ for e-commerce companies.

Conception and Ownership

Thinking about IP should ideally start at the ideation and conception stage, where questions regarding ownership of any IP are likely to come up. In case of ownership/joint ownership by natural persons, the founder(s) should decide if they will continue to own the IP in the concept after formation of a company to conduct the business. If an appropriate tax structure is worked out, the founder(s) may retain the ownership and structure an appropriate licensing arrangement with the company. This way, even in case of an investment in the company, the founder(s) may continue to own the IP without the fear of losing control over it.

Incubation

Before investing on the development of the concept, it is necessary that a thorough ‘freedom to operate’ search is conducted through specialists to check whether any features in the concept or the development are likely to violate IP rights of third parties. It is also necessary that appropriate confidentiality, non-disclosure and IP assignment agreements are signed with the employees, independent developers/consultants and prospective clients to whom the concept is likely to be disclosed. In India, ‘work for hire’ concept is not recognised and accordingly there should be an assignment clause in the agreements with independent developers clearly specifying that the assignment is perpetual and for the entire world. In line with standard best practices, obligation, each employee and developer should

be made to maintain a log book of each development process. Further, each developer should be contractually bound to not infringe any third party IP and indemnify the owners.

Identification of IP assets

It is important to identify proprietary technology (whether patentable or not), concepts, designs, artistic works, brands, software and other materials which can be protected by IP registrations in form of patent, trademark, copyright, industrial designs etc. Appropriate analysis should be conducted, amongst other things, in form of trademark availability searches, registrability analysis and patent prior art searches. In case of proprietary know how, the same should be protected through contractual obligations.

Deciding on the appropriate registration/protection is the key, as in some cases; the IP may enjoy dual or overlapping protection in various IP statutes. As an example, logos being protected under trademark and copyright law can fall in the grey area of 3D marks and industrial designs protection, and the company will need to decide on the mode of IP protection which can be leveraged to the fullest, more so in respect of the term of protection. The aforesaid should be on a global scale, as certain protections may not be available in India but may be enjoyed abroad.

Brand

It happens in several instances that what might be a catchy brand for the marketing team may not always be registrable as a trademark. As an example, words which are common to the trade are not registrable under the Trade Marks Act, 1999. If the brand is not registrable, the business may remain undervalued due to lack of monopoly. Once the brand is crystallised (internationally), domain names should be blocked with country level domain names (such as ‘.co.in’ for India and ‘.co.sg’ for Singapore), in addition to the ‘.com’ or the TLDs for the actual website in order to attract more traffic.

Content

Before developing the content for the e-commerce platform, appropriate contracts should be entered with the developers or third parties to maintain ownership of such content. If ownership is not possible, appropriate licenses or permissions should be obtained from third parties. If such third parties are not known, at least the source should be mentioned in the credits. In agreements with


content developers and website hosting agencies, robust representations on original content and indemnities thereto should be included. Further, in contracts with search engine optimization agencies, there should be strict provisions to avoid use of competitor meta-tags and ad-words. Whilst allowing sale of third party products or distribution of content on the platform, the contracts or terms and conditions with such parties should include representations and indemnities to deter sale/distribution of infringing products/content. Links to other websites or framing should be handled with caution and with appropriate permissions.

Compliance with IT Act and Intermediary Liability

On-going compliance with the IT Act and the Indian Contract Act, 1872 is essential. The e-commerce platform should have appropriate privacy policy, user agreement, notices and terms and conditions as required by the IT Act. The aforesaid should clearly mention the notices about IP ownership and credits for third party content. Further, the process to deal with infringing content on the platform should be mentioned by setting out the contact details of the team which would address such issues. E-commerce companies are considered intermediaries under IT Act. Section 79 of the IT Act (which lays down the exceptions to intermediary liability) and the Intermediary Guidelines are important in this regard. The Supreme Court in its recent decision has watered down intermediaries’ responsibility in relation to take down notices by stating that intermediary can retain the impugned content until it receives directions from a court or a notice from the Government or its agency.

Investment and Funding

From the investor’s perspective, it is important that a thorough IP due diligence is conducted on

the e-commerce company before investment flows. From an investors’ point of view, it would be advisable to transfer ownership of IP to the target company rather than the founder(s) owning the same. From the founder(s)’ perspective, the founder(s) should retain their rights in other unrelated IP by ensuring no blanket assignments are agreed to with the investors. Creating a clear structure at this stage itself helps avoid any disputes that come up once the concept takes off.

IP Violations

IP violations are a major concern for e-commerce platforms as it is difficult to monitor violations globally. Further in case of e-tail, it is difficult to monitor upload of infringing content. Unwary users often end up providing their sensitive information to phishing sites which masquerade as original sites. Deciding the appropriate jurisdiction in such cases is complex as the platform is available globally. Another aspect which bothers e-commerce companies is cybersquatting in jurisdictions which do not have appropriate domain name dispute resolution policies. Also, parallel import implications need to be considered from a violation perspective. Fortunately, the law has also evolved to deter such violations. The introduction of ‘John Doe’ orders (advance orders against unnamed and undisclosed infringers) and ‘Cyber Cells’ of police authorities is a welcome development. However, e-commerce companies also need to be wary as the same could be used against them.

Conclusion

It is understandable that any team starting off on a new idea will want to focus their attention on financial and operational issues. However, the age old adage of a stitch in time saving nine holds true in business as well. We hope that this article helps you appreciate the need for thinking about IP issues right from the get go.

Contributors

Abhilekh Verma Partner [email protected]

Niren Patel Partner [email protected]

G.T. Thomas PhilippeAssociate Partner [email protected]

Vineet Shingal Associate Partner [email protected]

Ashutosh Gupta Director, Business Strategy [email protected]

Shailendra Bhandare Principal Associate [email protected]

Abhiraj Krishna Senior Associate [email protected]

Ayush Mehrotra Senior Associate [email protected]

Aditi GopalakrishnanSenior Associate [email protected]

Rishabh Bharadwaj Associate [email protected]

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